Aggregate Demand and Aggregate Supply 2024 PDF

Aggregate Demand and Aggregate Supply 1 After attending this session, you will learn: The meanings of aggregate demand Key terms and aggregate supply. Aggregate Why does the short-run AS curve Demand slope upward?...

Aggregate Demand and Aggregate Supply 1 After attending this session, you will learn: The meanings of aggregate demand Key terms and aggregate supply. Aggregate Why does the short-run AS curve Demand slope upward? Aggregate Supply, Why does the AD curve slope Says Law of downward? Market How do aggregate demand and Stagflation aggregate supply affect the Wage-price spiral economy? Factors that shift aggregate supply and aggregate demand How to illustrate economic growth, unemployment, and inflation using the AS/AD model We know business activities fluctuate! Economic activity fluctuates from An example: year to year. In most years, the From the fourth quarter of 2007 to production of goods and services the second quarter of rises. In some years, however, 2009, the real GDP the economy contracts. for the U.S. economy Firms find themselves unable to fell by 4.0 percent. sell all the goods and services The unemployment they have to offer, so they reduce rate rose from 4.4 percent in May 2007 production. to 10.0 percent in Workers are laid off, October 2009—the unemployment becomes highest level in more widespread, and factories are left than a quarter idle. century. What causes business activities to fluctuate? The model of short-run economic fluctuations focuses on the behavior of two variables: 1.Real GDP. 2.The average level of prices Changes in aggregate demand (AD) and aggregate supply (AS) cause changes in these variables and cause short-run fluctuations. Aggregate Demand The aggregate demand shows the quantity of goods and services that households(C), firms(I), the government(G), and customers abroad(NX) want to buy at each price level. AD curve slopes downward. Why does the Aggregate-Demand Curve Slopes Downward? We know that, Note: We assume an economy’s GDP (Y) is the sum of its that the consumption (C), investment (I), government aggregate- purchases (G), and net exports (NX): demand curve is Y=C+I+G+NX drawn holding Each of these components contributes to the AD “other things for goods and services. For now, we assume equal.” That is, that government spending is fixed by policy. how a change in The other three components depend on economic the price level conditions and, in particular, on the price level. affects the Therefore, to understand the downward slope of demand for goods the aggregate demand curve, we must examine and services, how the price level affects aggregate holding the demand (AD) for consumption, investment, amount of money and net exports. in the economy Reasons for downward sloping Aggregate-Demand Curve 1.The Price Level and 2.The Price Level and Consumption (The Investment ( The Interest- Wealth Effect) Rate Effect) A decrease in the price When the price level is lower, households do not need to level raises the real value hold as much money to buy of money and makes the goods and services they consumers wealthier, want. They hold less and lend thereby encouraging them or deposit/invest their excess to spend more. The money in interest-bearing increase in consumer savings accounts/assets. spending means a larger These drive down interest rates. This encourages greater quantity of goods and spending on investment services demanded. Reasons for downward sloping Aggregate-Demand Curve 3.The Price Level and Net Exports ( The Exchange-Rate Effect) A lower price level lowers the domestic interest rate. Some investors will seek higher returns by investing abroad. This will increase the supply of domestic currency in the foreign-currency exchange market. The increased supply causes the domestic currency to depreciate relative to the foreign currency. As a result, domestic goods now become cheaper, and therefore foreigners buy more. So the domestic exports increase. Shift in the Aggregate-Demand Curve Any event that changes consumption (C), investment (I), Government expenditure(G), and net exports(NX) at a given price level shifts the aggregate demand curve. 2.Changes in Investment 1.Changes in For instance, if the computer Consumption For example, if people save industry introduces a faster line of more for retirement, then it computers and many firms decide will reduce their current to invest in new computer systems; consumption and hence the investment demand will be aggregate demand for now higher, which shifts the goods and services. aggregate demand curve to the Therefore, the aggregate right. Conversely, if firms become demand curve shifts to the left. pessimistic about future business Similarly, the stock market conditions, they may cut back on boom makes people investment spending, shifting the 3.Changes in 4. Changes in Net Exports Government For instance, when India expenditures experiences a recession, it If the government buys fewer goods from the rest starts building more of the world. India’s net highways, the result exports decline at every price is a greater quantity level, shifting the aggregate of goods and demand curve to the left. services demanded When it recovers, it buys more, at any price level, and the aggregate demand so the aggregate curve shifts to the right. demand curve shifts Changes in the currency value to the right. also change the net exports and shift the AD curve. Aggregate Supply The aggregate supply is the total quantity of goods and services that firms produce and sell at any given price level. The AS curve depends on the time horizon, i.e., short run(prices, wages, output, and emp do not adjust fully to an economic shock) and long run(all these adjust to the equilibrium). In the long run, the aggregate supply curve is vertical, Why does the aggregate supply Curve slope upward in the short run? In the short run, the price level affects the economy’s output. Macroeconomists have proposed three theories for the upward slope of the short-run aggregate2. supply curve. The Sticky-Price Theory: 1. The Sticky-Wage The sticky-price theory emphasizes that the Theory: Nominal wages are slow to prices of some goods and services also adjust slowly in response to changing economic adjust to changing conditions. economic conditions in the This slow adjustment of prices occurs in part short run due to long-term because there are costs to adjusting prices, contracts between workers called menu costs (the cost of printing and and firms that fix nominal distributing catalogs and the time required to wages. This stickiness of wages change price tags etc). Not all prices adjust immediately to changing gives firms an incentive to conditions, an unexpected fall in the price produce less output when level leaves some firms with higher-than- the price level is lower desired prices, and these higher-than- than expected and to desired prices lower sales and induce firms Why is the Aggregate-Supply Curve slopes upward in the short run? 3. The Misperceptions For example, wheat farmers Theory may notice a fall in the price of Changes in the overall price wheat before they notice a fall level can temporarily mislead in the prices of the many items suppliers about what is they buy as consumers. They happening in the individual may infer from this observation markets in which they sell that the reward for producing their output. wheat is temporarily low, and As a result of these short-run they may respond by reducing misperceptions, suppliers the quantity of wheat they respond to changes in the supply. level of prices, and this response leads to an upward- Why is the Aggregate-Supply Curve vertical in the long run? In the long run, an economy’s production of goods and services (its real GDP)or AS 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 vertical aggregate supply curve is consistent with the assumption of the classical theory that the quantity of output (a real variable) does not depend on the level of prices (a nominal variable) in the long run. This is known as a classical dichotomy and *The classical monetary dichotomy is the separation of variables into real variables neutrality*. (those that measure quantities) and nominal variables (those measured in terms of money). According to classical macroeconomic theory, changes in the money supply affect nominal variables but not real variables. And therefore, monetary neutrality, which means nominal variables (the money supply and the price level) does not affect real variables (real GDP, the real interest rate, and unemployment). Shift in the Short-run Aggregate-Supply Curve Shift in the AS curve, both in the short-run and the long run, depends on changes in factors such as labor, capital, natural resources, and technology. For example, if technology improves, the economy’s productivity also increases. This results in more production both in the short run and long run. Another important variable that affects the AS curve in the short run is— the expected price level. Changes in the Expected Price Level Wages, prices, and perceptions are based on the expected price level. When people change their expectations of the price level, the short-run aggregate supply curve shifts. when the expected price level rises, wages increase, costs increase, and firms produce a smaller quantity of goods and services at any given actual price level. Thus, the short-run aggregate supply curve shifts to the left. Shift in the Long-run Aggregate- Supply Curve The long-run production level is sometimes called potential output or full-employment output. It is also called as the natural level of output because it shows what the economy produces when unemployment is at its natural, or normal, rate (structural[mismatch of skills] and frictional[look for new jobs] unemployment-4 to 6%). Any economic change that changes the natural output level shifts the long-run aggregate supply curve. Because output in the classical model depends on labor, capital, natural resources, and technological knowledge, shifts in the long-run aggregate-supply Shift in the Long-run Aggregate-Supply Curve 1. Changes in labour In the case of immigration of labor, the LRAS curve would shift to the right. Similarly, if the government enacts a successful job training program for unemployed workers, the long-run aggregate supply curve would shift to the right. 2. Changes in capital An increase in the economy’s capital stock, increases productivity and thereby increases the quantity of goods and services supplied. As a result, the long-run aggregate supply curve shifts to the right. 3. Changes in natural resources The discovery of a new mineral deposit, for example, shifts the long- run aggregate supply curve to the right. A change in weather patterns that makes farming more difficult shifts the long-run aggregate supply curve to the left. 4. Changes in technological knowledge The invention of the computer, for instance, has allowed us to produce more goods and services from any given amount of labor, AD &AS equilibrium According to this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance. So, what are the two basic causes of economic fluctuations? 1. Shift in aggregate demand curve and 2. shift in aggregate supply curve The Effects of a shift in aggregate demand Let us take an example to understand What is the macroeconomic how a shift in AD impacts an impact of such a wave of pessimism? economy: In answering this type of question, follow the following Suppose that a wave of pessimism steps: suddenly overtakes the world 1. determine whether the event affects aggregate economy due to the Middle East demand or aggregate war. supply. This creates trouble for the 2. determine the direction that government; a crash in the stock the curve shifts. market, and so on. 3. use the diagram of AD and Because of the situation, people AS to compare the initial and new equilibria. may lose confidence in the future 4. Use the diagram of AD and and alter their plans. AS to analyze how the Households cut back on their economy moves from its The Effects of a shift in aggregate demand A fall in aggregate demand is represented by a leftward shift in the AD curve from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1 to Y2 , and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the short-run AS curve shifts to the right from AS1 to AS2 , and the economy reaches point C, where the new AD curve crosses the long-run AS The Effects of a shift in aggregate demand To sum up: In the short run, shifts in AD cause fluctuations in the economy’s output of goods and services. In the long run, shifts in AD affect the overall price level but do not affect output. If policymakers influence AD, they can potentially mitigate the severity of economic fluctuations. The Effects of a shift in aggregate demand A decline in investment impacts AD The Effects of a shift in aggregate supply Let us take an example to understand how shift in AS impacts an economy: How do these events impact the economy? 1. An economy is in its long-run equilibrium. Now suppose that suddenly some firms experience an increase in their costs of production due to the bad weather, which destroyed some crops, driving up the cost of producing food products. 2. A war in the Middle East might interrupt the shipping of crude oil, driving up the cost of producing oil products. The Effects of a shift in aggregate supply When some event increases firms’ costs, the short-run aggregate supply curve shifts to the left from AS 1 to AS 2. The economy moves from point A to point B. The result is stagflation: Output falls from Y 1 to Y2 , and The Effects of a shift in aggregate supply The transition from the short-run equilibrium to the long- run equilibrium. Firms and workers may at first respond to the higher level of prices by raising their expectations of the price level and setting higher nominal wages. In this case, firms’ costs will rise yet again, and the short-run aggregate supply curve will shift farther to the left, making the problem of stagflation even worse. This phenomenon of higher prices leading to higher wages, in turn leading to even higher prices, is sometimes called a wage-price spiral. What policymakers will do? Faced with an Policymakers adverse shift in might aggregate supply attempt to from AS1 to AS2 offset some , policymakers of the effects who can of the shift in influence AD the short-run might try to shift aggregate- AD curve to the supply curve right from AD1 by shifting to AD2. the The economy aggregate would move from demand point A to point curve. C. This policy would prevent the supply shift from reducing To sum up: Shifts in aggregate supply can cause stagflation—a combination of recession (falling output) and inflation (rising prices). Policymakers who can influence aggregate demand can mitigate the adverse impact on output but only at the cost of exacerbating the problem of inflation. A note on J. B. Say’s law of markets Classical economists believed that any deviations from the full employment level would be automatically restored without any government intervention. According to them, the market system would ensure full employment of an economy’s resources. J. B. Say opined that the very act of producing goods generates income equal to the value of the goods produced. The production of any output automatically provides the income required to buy that output. In other words, “supply creates its own demand”. For example, in a barter economy, where goods are exchanged with goods. A carpenter produces furniture and sells it to farmers to buy food. In this case, the carpenter’s supply of furniture is the income that he will spend to satisfy his demand A note on J. B. Say’s law of markets However, in 1936 John Maynard Keynes in his book, “The General Theory of Employment, Interest, and Money” explained why cyclical unemployment could occur in a market economy and an automatic restoration of it is not possible. Keynes criticized Say’s law stating that not all income generated will be spent in the same period when goods are produced. Some part of the income will be saved and used for the purchase of capital goods, which in turn increases the spending capacity of the economy. business activities depend on future expectations and if this turns out to be pessimistic, the investment will fall, and savings may not be put to use. This result in insufficient spending. Inventories will pile up and producers will reduce their output; increasing the News analysis Four Factors That May Impact India's Projected Economic Growth of 6.5% in FY24, 04/NOV/2023 https://thewire.in/economy/four-factors-that-may-impact-indias-projected-econ India is projected to record an economic growth of 6.5% for the fiscal omic-growth-of-6-5-in-fy24 year 2023-2024. However, Clickfour factors icon to add picture – declining manufacturing activity, a slowdown in the services sector, rising unemployment, and air pollution – may have the capacity to impact this projected target. PMI services at a seven-month low India’s services sector experienced a slowdown in October, with the Purchasing Managers’ Index (PMI) dropping to a seven-month low of 58.4 from 61 in September, according to a private survey. The survey has attributed this decline to reduced demand, price pressures, and competitive conditions. Presentation Title 31 News analysis Manufacturing activity falls to an eight-month low There is a decline in manufacturing activity in the last month. Rising cost pressures and a decline in demand for consumer goods dragged down manufacturing activity in October, which grew at the slowest pace in eight months. The slowdown in both manufacturing and services indicates low production and productivity. That could mean that fewer goods are being produced and fewer jobs are being offered. Unemployment at a two-year high Separately, India’s unemployment rate rose to a two-year high of 10.09% in October, Bloomberg reported citing data from the Centre for Monitoring Indian Economy (CMIE). A larger number of individuals are self-employed than those in casual labour and the regular salaried class. The share of self- employed [people] in the total workforce Presentation Title is increasing, and within32 News analysis Air pollution Air pollution has a direct, and a particularly debilitating impact on GDP growth and per-capita income levels by way of reduced worker output, lower consumer footfall in consumption-led services, hampered asset productivity, and a surge in health expenses and welfare allocations, especially in the productive age groups. The median annual increase in the level of PM2.5 reduces year-to- year changes in gross domestic product by 0.56 percentage points. A World Bank paper said there’s clear evidence that “the well- documented micro-level impacts of air pollution on health, productivity, labour supply, and other economically relevant outcomes aggregate to ‘macro level Presentation Titleeffects that can be observed 33