Chapter Twelve The Aggregate- Demand/Aggregate- Supply Model
Chapter Twelve
The Aggregate-Demand/Aggregate-
Supply Model
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 2
• A model of the overall economy that we can use to understand long-term output growth, business cycles, etc
• Aggregate demand tells us the total amount of goods and services being purchased
• Aggregate supply tells us the total amount of goods and services produced
• Equilibrium is where aggregate demand = aggregate supply
Aggregate Demand & Aggregate Supply
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 3
• Aggregate demand is the total demand for goods and services by everyone in the economy
– Consumption: demand by people for consumer goods
– Investment: demand by business firms for equipment and buildings, and demand by people for housing
– Net exports: demand by foreigners for our goods and services
– Government spending: demand by the government for goods and services, as well as government investment spending
Aggregate Demand
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 4
Consumption
• Largest component of aggregate demand (about 2/3 of total)
• Durable goods: autos, furniture, and major appliances
• Nondurable goods: do not last as long as durables
• Services: consumed immediately
• Housing is not considered a durable good, but rather an investment good, which will be discussed later.
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 5
What affects consumption?• current income …Consumers buy more goods and
services when they have more income
• future income …If you expect a future income increase, you may spend more now
• wealth …People with greater accumulated assets generally spend more
• taxes…The more taxes consumer have to pay, the less disposable income they have to spend
• the real interest rate …Higher real interest rates encourage consumers to save rather than spend
Consumption (cont’d)
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 6
• Investments in physical capital are about 1/6 of aggregate demand
• Physical capital is the equipment and structures firms use in production and houses that people live in
• The total amount of physical capital in an economy is its capital stock
• Financial investment is NOT included; only investment in physical capital
Investment
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 7
What affects business investment?
• Size of existing capital stock compared to desired capital stock
• Future consumption spending on the part of consumers (businesses want to anticipate consumer demand)
• Firms’ ability to pay for the new capital
– May use retained earnings in times of profit
– Lower real interest rates stimulate investment as the opportunity cost of investing or holding cash goes down
Investment (cont’d)
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 8
• International trade must be included when calculating aggregate demand
• Americans import more than they export
• Net exports = exports – imports– This is the only component of aggregate demand which may be
negative
• The level of net exports depends on– Current domestic income (-)
• Domestic citizens import more from abroad if their incomes are higher
– Current foreign income (+)• Domestic companies export more to foreigners if foreigners have
higher income
Net Exports
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 9
• Government spending accounts for about 1/6 of aggregate demand
• Includes payments to government workers, government purchases of goods and services, gross government investment in physical capital
• We assume government spending is chosen exogenously, and not explained by the AD-AS model
Government Spending
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 10
• Aggregate demand is the sum of all spending in the economy (consumption, investment, net exports, and government spending)
• The aggregate-demand curve shows combinations of the price level and output that are consistent with equilibrium in the goods market and money market
The Aggregate Demand Curve
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 11
– Goods market• Endogenous variables: current income, real interest rate
• Exogenous variables: future income, wealth, taxes, future consumption, profits, business optimism, foreign income
– Money market • Endogenous variables: price level, current income, nominal
interest rate
• Exogenous variables: quantity of money supplied, expected inflation rate
– Relationship between them• Nominal interest rate = real interest rate + expected inflation
rate
The Aggregate Demand Curve (cont’d)
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 12
A decline in the price level decreases the demand for money, resulting in a lower nominal interest rate
The Money Market After a Decline in the Price Level
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 13
• The price level is a key endogenous variable.
• An inverse relationship exists between aggregate demand and the price level.
• Any point along the AD curve is one for which both the goods and money markets are in equilibrium.
The Aggregate Demand Curve
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 14
• Aggregate supply is the economy’s total production of goods and services
• Economists distinguish between short- and long-run aggregate supply
• LRAS is fixed at full employment
• In the short-run, output increases with the price level, as producers are incentivized to offer more for sale
Aggregate Supply
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 15
Long-Run Aggregate Supply
• Does the price level affect the amount produced in the long run?– Full employment: when capital and labor are fully
utilized; the unemployment rate = the natural rate of unemployment (reflecting normal job turnover)
– Full-employment output: the output produced when the economy is at full employment
– Full-employment output is not affected by the price level, so the long-run aggregate supply curve is vertical
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 16
Short-Run Aggregate Supply
• Does the price level affect the amount produced in the short run?– The amount of capital in the economy is fixed in the
short run, so SRAS cannot be adjusted
– Producers are reluctant to increase prices when demand increases, so higher demand leads to increased output
– If prices throughout the economy rise (because of inflation), a firm might think increased demand for its product means demand for its product has increased, instead of realizing that it should raise its prices
– The firm is fooled into producing too much
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 17
In the short run, the relationship between output and the price level is positive. In the long run, the economy is at full employment, so
increases in the price level have no effect on output
Aggregate Supply
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 18
• The location of the SRAS curve depends on the expected inflation rate, since whether firms are fooled depends on the inflation rate they expect to prevail. When they are wrong, the economy may be located at a point on the SRAS curve, rather than the LRAS curve
• As inflation expectations adjust, the SRAS curve shifts– Higher expected inflation causes the SRAS curve to
shift to the left
– For a given price level, higher inflation means lower relative prices, so firms produce less
Short-Run Aggregate Supply (cont’d)
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 19
Short-run equilibrium Intersection of the AD and SRAS curves. Determination of output and price
level in the short run; output may differ from full-employment output
Equilibrium in the AD-AS Model
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 20
Short-run equilibrium Intersection of the AD and LRAS curves. Determination of output and price
level in the long run; output must equal full-employment output
Equilibrium in the AD-AS Model
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 21
• How does the economy adjust to move from the short run to the long run?
– Adjustment does not occur immediately• Producers may be fooled and cannot distinguish
changes in overall prices from changes in their own prices
• Wages and prices may be slow to adjust; for example, wages may be negotiated and firms may hesitate to change menus or catalogs
• Adjustment occurs gradually over time as the SRAS curve shifts until it crosses the intersection of LRAS and AD
Equilibrium in the AD-AS Model (cont’d)
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 22
An increase in Causes this curve to shift In this direction
Future income AD Right
Wealth AD Right
Taxes AD Left
Real interest rate AD Left
Future consumption AD Right
Profits AD Right
AD-AS Model Shifters
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 23
AD-AS Model Shifters (cont’d)
An increase in Causes this curve to shift In this direction
Business optimismAD Right
Foreign income AD Right
Government spending AD Right
ATM costs or other
Variables that increase
money demand AD Left
Money supply AD Right
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 24
An increase in Causes this curve to shift In this direction
Productivity LRAS Right
SRAS Right
Capital stock LRAS Right
SRAS Right
Labor force LRAS Right
SRAS Right
Expected price level SRAS Left
Costs of producing Output SRAS Left
AD-AS Model Shifters (cont’d)
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 25
• If business firms lose confidence, they may become pessimistic about the future and decline to invest in new capital
• The AD curve would shift to the left
• In the short run, the price level decreases and output as businesses produce fewer goods
• In the long run, the SRAS curve shifts to the right. Restoring equilibrium
• Long-run equilibrium has the same full-employment output and a higher price level
Example: A Drop in Business Optimism
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 26
The initial effect is a decrease in AD. Eventually, SRAS shifts right and restores equilibrium.
Example: A Drop in Business Optimism
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 27
What if exogenous variables shift?
1. Determine which curve (SRAS, LRAS, AD) is affected and in which direction each curve shifts
2. Find the new short-run equilibrium (price level and output)
3. Determine how the SRAS curve must shift to restore equilibrium
4. Find the new long-run equilibrium
Equilibrium in the AD-AS Model
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 28
• Monetary policy refers to the Fed’s decisions about the size of the money supply
• An increase in the money supply shifts AD right; a decrease in money supply shifts AD left
• If the economy is in a recession, the Fed can shift the AD curve to the right by increasing the money supply, restoring full-employment equilibrium with a higher price level
Monetary Policy & the AD-AS Model
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 29
The economy is in recession when AD intersects SRAS at less than full employment. An increase in the money supply
starts the process back toward long-run equilibrium.
Monetary Policy & the AD-AS Model (cont’d)
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 30
If the Fed uses expansionary policy when the economy is at full employment, the result is temporarily higher output and
much higher prices
Monetary Policy & the AD-AS Model (cont’d)
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 31
• Fiscal policy refers to the government’s decisions regarding levels of taxation and government spending
• The government can increase aggregate demand by reducing taxes or increasing government spending, and vice-versa
• If in recession, the government might cut taxes or increase government spending to attempt to restore full employment
Fiscal Policy & the AD-AS Model
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 32
When the economy is in recession, government might try to shift back toward long-run equilibrium though the
manipulation of aggregate demand
Fiscal Policy & the AD-AS Model (cont’d)
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 33
• Large, structural macroeconomic models are models with many equations that describe the economy in great detail and are based on the assumption that their equations do not change over time
• Their development was led by the Keynesians, focusing on how government could shock aggregate demand to temper the business cycle
• Policymakers use the models to analyze historical events and to guide future policy decisions
• Eventually, equations began to break down and economists became skeptical of the model’s efficacy
Large, Structural Macroeconomic Models
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 34
• In the early 1970s, macroeconomics as a field was considered to be solved. Economists believed– Large macro models provided good forecasts
– Policy control of economy could eliminate the business cycle
– Policymakers needed to decide on the desired trade-off between unemployment and inflation
• The stagflation of the 70s seemed to disprove the models
Large Macro Models & Their Performance in the 1970s
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 35
• Introduced by skeptics of Keynesian theory
• Rational expectations theory means that people use all available information in making economic decisions
• Large macro models assume people do not have rational expectations; treat expected inflation as exogenous, based on past data
• Under rational expectations, expected inflation becomes an endogenous variable to which people can respond in a future-oriented manner
Rational Expectations Theory
Copyright © Houghton Mifflin Company. All rights reserved. 12 | 36
• The argument that the macro models are fundamentally flawed is known as the Lucas critique, which argues– A change in policy will alter the structure of large
macro models
– The large macro models are flawed, because they treat some coefficients as constant; under rational expectations theory, those coefficients will change as policy changes
– Models must consider people’s expectations about policy to gage their reactions to it
Rational Expectations Theory