Aggregate Demand Aggregate Demand and Aggregate Supply:and Aggregate Supply:

Explaining economic fluctuationsExplaining economic fluctuations--

Revision of main conceptsRevision of main concepts

Francesco DaveriFrancesco Daveri

Two key facts on fluctuations

1. Economic fluctuations occur systematically, but they are irregular, for their timing and duration is unpredictable

• Macroeconomic variables behave as random variables

2. Most aggregate variables fluctuate together: macro-economic variables are closely related

• Yet: even if most variables move together, their volatility differs across variables

Growth: usually positive but not constant. One episode of growth<0

GDP growth in the world economy: fluctuating with irregular and unpredictable timing

Source: IMF World Economic Outlook Database, April 2014

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We want to develop basic model to explain economic fluctuations

•Two variables are used to develop a model to analyze the short-run fluctuations :

• The economy’s output of goods and services measured by real GDP

• The overall price level measured by the CPI or the GDP deflator

•We use the model of aggregate demand and aggregate supply (AD-AS) to explain short-run fluctuations in economic activity around long-run trends

What the basic model says

•Three main things

• Monetary , fiscal and exchange rate policies (AD policies) affect real GDP in the short run but not in the long run

• Money and policy do not affect “real” variables” (Gdp, C, I) in the long run, but they do in the short run. Long-run Money and policy neutral in the long run, not in the short run

• Hence: when studying year-to-year changes in the economy, we will not assume money and policy neutrality

The model of aggregate demand and aggregate supply

Equilibriumoutput

Quantity ofOutput

PriceLevel

0

Aggregatesupply

Aggregatedemand

AD and AS

• The aggregate demand (AD) curve shows the quantity of goods and services that households, firms, and the government are willing to buy at any price level

– Note: The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy

• The aggregate supply (AS) curve shows the quantity of goods and services that firms choose to produce and want to sell at any price level

– Note The AS curve is not a market supply curve, and it is not the sum of all market supply curves in the economy

AD curveThe four components of GDP (Y) contribute to the aggregate demand for goods and services:

Y = C + I + G + NX

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P1

Y1 Y2

P2

1. A decrease in the pricelevel

2. …increases the quantity of goods and services demanded.

Why the AD is downward sloping

Price level Quantity of good demanded

Pigou (wealth) effect

price level

consumers feel wealthier

Encouraged to spend

more

larger quantity of goods and services demanded

Keynes (interest rate) effect

price level

Lower domestic interest rate

Firms encouraged to invest more

greater spending on investment goods

Mundell-Fleming (exchange rate) effect

(domestic) price level

Lower interest rate, capital goes abroad

Exchange rate

depreciates, gain in competitiveness

increase in exports and

decrease in imports, increase in net exports

• Pigou’s effect (or real balance effect):

ADCP

WealthP

• Keynes’ effect (or interest rate effect):

ADIipBondsMP Bondsdd

• Mundell-Fleming’s effect (or exchange rate effect):

ADNXEXPORTS

IMPORTSenesscompetitivP

Shifts in the AD curveAnything that makes buyers more or less willing to buy goods and services for any given level of price shifts the AD curve.

• Consumers, firms: exogenous changes in spending plans by consumers or firms (e.g. household savings before the Iraq war; pessimism after Lehman Bros bankruptcy)

• Government: exogenous changes in fiscal, monetary and exchange rate policy

Output

Price

0

P1

Y1 Y2

AD1 AD2

The multiplier: by how much AD shifts

Extent of the AD shifts determined by size of multiplier Multiplier: process that makes initial increase in income bigger due to

further increases in C and I triggered by initial increase in GDP

Example: Suppose Govt raises defense spending G income of G producers consumption of G producers income of

C producers and so on Total rightward shift of AD given by sum of all income increments If GDP very close to full employment, demand increase feeds into higher

inflation and not Gdp gains

Aggregate supply curve

Preview of main arguments

In the short run, the aggregate-supply curve is upward sloping

In the long run, an economy’s production of goods and services depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services

• The price level does not affect these variables in the long run

Hence: In the long run, the aggregate-supply curve is vertical

The short run AS curveIn the short run

• An increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied for given costs of production

• A decrease in the level of prices tends to reduce the quantity of goods and services supplied (see picture)

Y1

P1

P2

1. A decrease in the price level

Quantity of output

Price Level

0

Short-runaggregate

supply

Y2

2. reduces the quantity of goods and services supplied in the short run

Why the short run AS is upward sloping

Price level Quantity of good supplied

New classical misperceptions theory

Aggregate price

producers temporarily perceive it as a decline in ‘their’ individual sale

price

decrease of goods and services supplied

Keynesian sticky wages theory

Aggregate price

nominal wages do not fall immediately

labor costs go up

firms reduce production

New Keynesian sticky prices theory

Aggregate price

some firms do not adjust their own price to save on “menu costs”

sales reduced, hence

firms reduce production

Bottom line: Experts’ opinions vary as to why, but – reassuringly - the SLOPE of the AS is anyway positive!

Shifts in the short run AS curve

Y1

P1

output

Price

0 Y2

AS2AS1

Why AS might shiftIn a nutshell: Anything that shifts costs of production shifts AS

AS shifts to the right if:

• Imported or domestic input prices go down

• Costs of production going up for given price, output to be cut

• Factor productivity goes up (thanks to new technologies)

• allows firms to produce more at a lower cost for an unchanged sale price

• Government cuts distorting taxes and regulations hampering business practices

• Reduction of social security contributions reduces labor costs; reduced tax on profits raises net profitability

• Expectation of lower price level in the future

• This feeds into lower wage claims and thus decrease labor costs today

Implication: GDP gains due to AD shifts do not last long

Let’s see why Short run AS drawn for given nominal wages As nominal wages change, short-run AS (entire curve)

Why do wages change? Today’s P makes wage claims at next wage negotiation round

So what happens?

As AD shifts to the right, this also gives rise to P. This results in rising inflation expectation for the future Higher expected inflation raises wage claims Short run AS shifts to the left Short run AS keeps shifting leftwards until GDP above its long-run

average

AD

SRAS

AD’

SRAS’

E

GDP

P

Permanent GDP

E’

E’’

Why AD-originated Gdp gains do not last: graphics

As a result: The long run AS curve is vertical at the natural rate of output.

Quantity ofOutput

Natural rateof output

Price Level

0

Long-runaggregate

supply

P1

1. A change in the price level…

P2

2. …does not affect the quantity of goods and services supplied in the long run.

Long run equilibrium

The intersection of the AD curve and the long-run AS curve determines the economy’s equilibrium output and price level (E)

• Output is at its natural rate• The short-run AS curve goes through the point of intersection

Natural rateof output

Output

Price

0

EquilibriumPrice

Long-runAS

E

Short-runAS

AD

Now ready to study the causes of recessions

There are two causes of recessions

• AD shift to the left

• AS shift to the left

See them in turn

Recession I: a leftward shift of ADA decrease in one of the determinants of AD shifts the curve to the left.

Hence, (i) output falls below the natural rate of employment; (ii) unemployment rises, (iii) the price level falls

0

AS1

A

B

C

P1

P2

P3

Y1Y2

AD2

AS2

1. A decrease inaggregate demand…

3. …but over time,the short-run aggregate-supply curve shifts (B to C)…

2. …causes output to fall in the short run (A to B)…

4. …and output returnsto its natural rate.

Long-runASPrice

Output

AD1

Recession II: a leftward shift of ASA decrease in one of the determinants of AS shifts the curve to the left: hence, (i) output falls below the natural rate of employment; (ii) unemployment rises; (iii) the price level rises

0

AS1

B

AP1

P2

Y1Y2

AS2

2. …causes output to fall…

. 3. …and the price to rise.

Long-runASPrice

Output

1. An adverse shift in the short-run AS curve…

AD1

Recession II = Stagflation

Adverse shifts in aggregate supply cause stagflation - a combination of recession and inflation

• Output falls and prices go up• Policymakers can influence the level of aggregate demand (by

increasing public consumption), much less so the level of aggregate supply

• Hence, they cannot offset both adverse effects simultaneously

26

How to read supply and demand shocks in the data: the US in the 1990s

1990s: GDP up & inflation down, symptom of positive supply shock

2001-02: both GDP & inflation down, symptom of negative demand shock

US economy

1991-93 1994-96 1997-00 2001-02

GDP growth 2.4 3.2 4.2 1.3

Inflation 3.2 2.7 2.6 1.7