chapter 22

Chapter 22

Aggregate Demand and Supply Analysis

• Aggregate demand is made up of four component parts:– C = consumption expenditure, the total demand for consumer goods and services

– I = planned investment spending, the total planned spending by business firms on new machines, factories, and other capital goods, plus planned spending on new homes

– G = government purchases , spending by all levels of government (federal, state, and local) on goods and services

– NX = net exports, the net foreign spending on domestic goods and services

adY C I G NX

Aggregate Demand

• The Quantity Theory of Money (QTM) implies the aggregate demand curve is downward sloping.

• The QTM results when velocity is assumed to be constant in the equation of exchange:

• A constant money supply implies constant nominal aggregate spending

• A decrease in the price level is matched with an increase in real GDP.

• Recall that inflation is defined as follows:

• Hence, a rise in real GDP is associated with a decline in PLis, which causes p to fall for a given value of PLwas.

PL MY V

100wai s

s

s

wa

PL

PL

PL

Aggregate Demand

p AD

QTM:• The quantity of real GDP

demanded decreases in p.

Yad C I NXY T r fb G

Aggregate Demand

AD

Y

p

QTM:• The quantity of real GDP

demanded decreases in p.• AD increases when

o increaseso increases o increaseso is increased o is cuto decreaseso Financial friction decreases

ad C I NXY T r fb G

Aggregate Demand

Aggregate Demand

Aggregate Demand

ad C I NXY T r fb G

The Congress and President are in charge of fiscal policy. Expansionary fiscal policy involves a cut in T and/or increase in GRestrictive fiscal policy involves a raising T and/or cutting G

The Federal Reserve (our central bank) is in charge of monetary policyExpansionary monetary policy involves lowering the federal funds interest rateRestrictive monetary policy involves raising the federal funds interest rate

Aggregate Demand

Aggregate Demand

ad C I NXY T r fb G


The Federal Reserve (our central bank) is in charge of monetary policylves raising the federal funds interest rate

Aggregate Demand

Aggregate Demand

ad C I NXY T r fb G


The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy involves lowering the federal funds interest rateRestrictive monetary policy involves raising the federal funds interest rate

Aggregate Demand

Aggregate Demand

ad C I NXY T r fb G

The Congress and President are in charge of fiscal policy. Expansionary fiscal policy involves a cut in T and/or increase in G Restrictive fiscal policy involves a raising T and/or cutting G

The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy involves lowering the federal funds interest rate

Aggregate Demand

Aggregate Demand

ad C I NXY T r fb G

The Congress and President are in charge of fiscal policy. Expansionary fiscal policy involves a cut in T and/or increase in G Restrictive fiscal policy involves a raising T and/or cutting G

The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy involves lowering the federal funds interest rate Restrictive monetary policy involves raising the federal funds interest rate

Aggregate Demand

Aggregate Demand

ad C I NXY T r fb G

Suppose the economy’s production function shows the volume of output that can be produced by its labor force (L) given its physical capital (K), land and natural resources (R), and technology and entrepreneurial talent (Z).

Suppose R = 0.4 (trillion dollars of land, oil, coal, natural gas…), K = 2.5 (trillion dollars of physical capital like machines, roads, networks…) and z = 1.25 (percent of all knowledge in the universe is known on Earth).

1. What is the economy’s short-run production function?

1.25 0.4 2.5Y L

Y Z K R L

1.25Y L

Long Run Aggregate Supply

Simulated LRAS

Example:

1.25Y L

L Y

0 0

50 8.839

100 12.500

150 15.309


Simulated LRAS

Example (continued):

2. Graph the economy’s short-run production function.

L

3. Suppose there are 9 million workers that are frictionally or structurally unemployed, and 135 million of the 144 million in the labor force are employed. Compute u, un, uc, real

GDP, and Yp.

1.25 1.25 15nY E U 1 9+35

6.25%nn

f

Uu

L

144

9

15

144


6.25%f

f

L Eu

L

144 1

144

35

6.25 6.25 0%c nu u u

Simulated LRAS

1.25 1.25 15p fY L 144


L

15

144

Y

PL LRAS

0 15


10

Simulated LRAS

20

30

p fY Z K R L

15pY


4. Graph LRAS.


GDP, and Yp.

1.25 1.25 13.75nY E U 11 9+2

6.25%nn

f

Uu

L

144

9

15

144


22.22%f

f

L Eu

L

1

144

12144

22.22 6.25 15.97%c nu u u

Simulated LRAS

1.25 1.25 15p fY L 144


L

13.75

121

Unemployment is too high

GDP is lower than what it should be

1.25 1.25 15.26nY E U 14 9+0

15

144


2.78%f

f

L Eu

L

144 1

144

40

2.78 6.25 3.47%c nu u u

Simulated LRAS


GDP, and Yp.

1.25 1.25 15p fY L 144


L

15.26

149

Unemployment is too low

GDP is higher than what it should be

6.25%nn

f

Uu

L

144

9

• Resources rises by 0.5 trillion dollars

• Physical capital increases by 0.5 trillion dollars

• The number of laborers falls by 12 million

• Nominal wage rates rise by 1 dollar per hour

• Nominal prices of other inputs increases by 1 dollar per hour

• Supply side taxes are cut by 1 percentage point.

What is monetary policy, and who conducts it?

What is fiscal policy, and who conducts it?

With the labor force equal to 144 million workers, show what happens if


Simulated LRAS

Example:

http://www.halsnarr.com/excel/f(L)%20and%20LRAS.xlsx

SRAS is the relationship between the quantity of real GDP supplied and p when all other influences on production plans remain the same SRAS shifts upward (decreases) when

Expected inflation riseso Workers expecting the PL to rise will demand one-for-one adjustments in w

Dp e = Dw

o In the short-run, w is the most important factor to producing productso Inflation increases one-for-one in expected inflation

a price shock (up) occurs due to the nominal price of a resource like energy (r). Government permanently changes the supply-side tax rate ( t ) Output gap Y – Yp widens

o workers are being offered higher w and better benefits due to u being too lowo In the short-run, it is believed this pushes inflation higher due to firms raising their

prices.o This makes SRAS upward sloping.

p = p e + r +t + g (Y – Yp)

p = g Y + p e + r +t – g Yp

Short Run Aggregate Supply

Yp = 15

p = g Y + p e + r +t – g Yp


Example: In addition to R = 0.4 (trillion dollars of land…), K = 2.5 (trillion dollars of machines…), Z = 1.25 (percent of all knowledge is known to man), Un = 9 (million frictionally or structurally unemployed workers), E = 135 (million), and L = 144 (million), suppose the sensitivity of inflation to the output gap is 0.5, expected inflation is 1.5 (percent), price shock is 0, and the supply-side tax rate is 6 (percent).

1. Graph the potential GDP you computed in part (3) with AD

Yp = 15

p = g Y + p e + r +t – g 15




Yp = 15

p = 0.5Y + p e + r +t – 7.5





Yp = 15

p = 0.5Y + 1.5 + r +t – 7.5




Yp = 15

p = 0.5Y + 1.5 + 0 +t – 7.5




Yp = 15

p = 0.5Y + 1.5 + 0 + 6 – 7.5



Yp = 15

p = 0.5Y






2. Graph SRAS: p = 0.5Y

Y15

7.5

SRAS

p

Supply-side tax cuts increase SRAS.

SRAS’

17



3. What happens if government cuts supply-side taxes by 1 percentage point?

p = 0.5Y + 1.5 + 0 + 6 – 7.55

-1 Y15

7.5

SRAS

p

p = g Y + p e + r +t – g Yp


p = g Y + p e + r +t – g Yp

The Congress and President are in charge of fiscal policy. Expansionary supply-side fiscal policy involves cutting tRestrictive supply-side fiscal policy involves raising t

The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy lowers the federal funds interest rate Restrictive monetary policy raises the federal funds interest rate


p = g Y + p e + r +t – g Yp

The Congress and President are in charge of fiscal policy. Expansionary supply-side fiscal policy involves cutting t Restrictive supply-side fiscal policy involves raising t

The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy lowers the federal funds interest rate Restrictive monetary policy raises the federal funds interest rate


Aggregate Market Model

Equilibrium


4. Graph LRAS with SRAS: Yp = 15 p = 0.5Y

LRAS

Y15

7.5

SRAS

p


5. Suppose the labor force increases by 25 million workers. Show the effect of this on LRAS and SRAS.

Yp = 16.25 (trillion $)

1.25 0.4 2.5 144Y 169

LRAS’

16.25


Equilibrium

LRAS

Y15

7.5

SRAS

p

p = 0.5Y + 1.5 + 0 + 6 – 0.5 ·15

SRAS’

-0.625

16.25


Equilibrium

LRAS’LRAS

7.5

SRAS

p

Yp = 16.25 (trillion $)

16.25 Y15


5. Suppose the labor force increases by 25 million workers. Show the effect of this on LRAS and SRAS.

p = 0.5Y – 0.625


6. Graph LRAS, AD & SRAS: Yp = 15 p = 0.5Y p = 15 – 0.5 Y

AD


Equilibrium

LRAS

15

SRAS

p

7.5

Y



AD


Equilibrium

LRAS

Y15

7

SRAS

p

14

AD


Equilibrium

LRAS

Y

SRAS

p



p = g Y + p e + r +t – g Yp

15

7

14



p = g Y + p e + r +t – g Yp

AD


Equilibrium

LRAS

Y

SRAS

p

6.5

15

7

14



p = g Y + p e + r +t – g Yp

AD


Equilibrium

LRAS

Y

p

6.5

15

But wages are inflexible……need active government policy

SRAS

7

14



AD


Equilibrium

LRAS

Y15

8

SRAS

p

16



p = g Y + p e + r +t – g Yp

AD


Equilibrium

LRAS

Y15

8

SRAS

p

16



p = g Y + p e + r +t – g Yp

AD


Equilibrium

LRAS

Y15

8

SRAS

p

16

8.5



p = g Y + p e + r +t – g Yp

AD


Equilibrium

LRAS

Y15

SRAS

p

8.5Wages and prices are flexible

Positive Demand Shock

AD can shift from temporary demand shocks in which the LRAS and SRAS do not shift



AD

LRAS

Y12

SRAS

p

2

3

13



AD

LRAS

Y12

SRAS

p

2

3

3.5

13

Negative Demand Shock


AD

LRAS

Y12

SRAS

p

21.5

11



AD

LRAS

Y12

SRAS

p

2

1.251.5

11

The Volcker Disinflation

AD

LRAS

YYp

SRAS p

13.5


10.3

AD

LRAS

Y

SRAS p

13.510.3

Yp

The Volcker Disinflation Negative Demand Shock

AD

LRAS

Y

SRAS p

13.510.3

Yp


6.2

6.2AD

LRAS

Y

SRAS p

13.510.3

Yp


3.2

6.2AD

LRAS

Y

SRAS p

13.510.3

Yp


4.3

6.2AD

LRAS

Y

SRAS p

13.510.3

Yp


3.6

3.6

6.2AD

LRAS

Y

SRAS p

13.510.3

Yp


1.9

AD

LRAS

Y

SRAS

p

Yp


1.9

AD

LRAS

Y12

SRAS

p

4.53.1

11

2001-2004Negative Demand Shock

Source: Economic Report of the President.

AD

LRAS

Y12

SRAS

p

4.5

1.63.1

11

2001-2004Negative Demand Shock

• Temporary supply shock– SRAS shifts– LRAS does not shift

• Permanent supply shock– SRAS shifts– LRAS shifts– E.g., permanent negative supply shock occurs when ill-advised regulations that cause the

economy to be less efficient are adopted– Real business cycle theory (Edward Prescott of ASU) says that business cycle

fluctuations result from permanent supply shocks

Supply Shock

Temporary Negative Supply Shock

AD

LRAS

Y12

SRAS

p

11

65

1973-1980

Permanent Positive Supply Shock1995–1999

AD

LRAS

Y12

SRAS

p

13

45

AD

LRAS

Y12

SRAS

p

43

Negative Demand and Supply Shocks2007–2009

11

0

AD

LRAS

Y12

SRAS

p

43

Negative Demand and Supply Shocks2007–2009

11

-1

11

0

Conclusions

Aggregate demand and supply analysis yields the following conclusions:

1. A shift in the aggregate demand curve affects output only in the short run and has no effect in the long run

2. A temporary supply shock affects output and inflation only in the short run and has no effect in the long run (holding the aggregate demand curve constant)

3. A permanent supply shock affects output and inflation both in the short and the long run

4. The economy has a self-correcting mechanism that returns it to potential output and the natural rate of unemployment over time

5. Monetary policy has a short-run affect on AD only

chapter 22

Documents

charge of fiscal policy

grestrictive fiscal

expansionary fiscal

raising t andor

federal funds

aggregate demand curve

federal reserve

y aggregate demand income