Macroeconomics PDF by Dornbusch, Fischer, Startz (2011)

C HAPTER 5 Aggregate Supply and Demand CHAPTER HIGHLIGHTS Output and prices are determined by aggregate supply and aggregate demand....

C HAPTER 5 Aggregate Supply and Demand CHAPTER HIGHLIGHTS Output and prices are determined by aggregate supply and aggregate demand. In the short run, the aggregate supply curve is flat. In the long run, the aggregate supply curve is vertical. It is upward sloping in the medium run. The aggregate supply curve describes the price adjustment mechanism of the economy. Changes in aggregate demand, the result of changes in fiscal and monetary policy as well as individual decisions about consumption and investment, change output in the short run and change prices in the long run. dor75926_ch05_097-117.indd 97 03/11/10 3:19 PM  98 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY Macroeconomics is concerned with the behavior of the economy as a whole—with booms and recessions, the economy’s total output of goods and services, and the rates of inflation and unemployment. Having explored long-run economic growth in the pre- ceding chapters, we turn to the short-run fluctuations that constitute the business cycle. Business cycle swings are big! In the Great Depression in the 1930s, output fell by nearly 30 percent; between 1931 and 1940 the unemployment rate averaged 18.8 percent. The Great Depression was the defining event for a generation. Post–World War II reces- sions have been much milder, but they still dominated the political scene when they occurred. Unemployment rates of 10 percent in 2009 were no fun. Inflation rates vary widely. A dollar stuffed under your mattress in 1970 would have bought less than 22 cents’ worth of goods in 2010. In contrast, during the Great Depression the purchasing power of the dollar rose by one-fourth. The aggregate supply–aggregate demand model is the basic macroeconomic tool for studying output fluctuations and the determination of the price level and the infla- tion rate. We use this tool to understand why the economy deviates from a path of smooth growth over time and to explore the consequences of government policies in- tended to reduce unemployment, smooth output fluctuations, and maintain stable prices. We focus in this chapter on the “big picture” view of the economy: Why do prices go up rapidly at some times and not at others? Why are jobs plentiful in some years and not in others? Shifts in the aggregate supply and aggregate demand schedules give us the tools to answer these questions. In this chapter we get some practice in using these tools. Chapters 3, 4, 6, and 7 provide underpinnings for the details of the aggregate sup- ply schedule. Details of aggregate demand appear in Chapters 9 through 17. For now we’ll work with simplified definitions of aggregate supply and demand in order to con- centrate on why the slopes and positions of the curves matter. Aggregate supply and demand each describe a relation between the overall price level (think consumer price index or GDP deflator) and output (GDP). Taken together—an example appears in Figure 5-1—aggregate supply and demand can help us solve for the equilibrium levels of price and output in the economy. And when a change shifts either aggregate supply or demand, we can determine how price and output shift. The aggregate supply (AS) curve describes, for each given price level, the quan- tity of output firms are willing to supply. The AS curve is upward-sloping because firms are willing to supply more output at higher prices. The aggregate demand (AD) curve shows the combinations of the price level and level of output at which the goods and money markets are simultaneously in equilibrium. The AD curve is downward-sloping because higher prices reduce the value of the money supply, which reduces the demand for output. The intersection of the AD and AS schedules at E in Figure 5-1 determines the equilibrium level of output, Y0, and the equilibrium price level, P0. Shifts in either schedule cause the price level and the level of output to change. Before we go deeply into the factors underlying the aggregate demand and supply curves, we show how the curves will be used. Suppose that the Fed increases the money supply. What effects will that have on the price level and on output? In particular, does an increase in the money supply cause the price level to rise, thus producing inflation? Or does the level of output rise? Or do both output and the price level rise? dor75926_ch05_097-117.indd 98 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 99 P AS Price level E P0 AD 0 Y0 Y Output, income FIGURE 5.1 AGGREGATE SUPPLY AND DEMAND. Their intersection at point E jointly determines the level of output, Y0 , and the price level, P0. Figure 5-2 shows that an increase in the money supply shifts the aggregate demand curve, AD, to the right, to AD'. We will see later in this chapter why this should be so. The shift of the aggregate demand curve moves the equilibrium of the economy from E to E. The price level rises from P0 to P, and the level of output from Y0 to Y. Thus an increase in the money stock causes both the level of output and the price level to rise. It is clear from Figure 5-2 that the amount by which the price level rises depends on the slope of the aggregate supply curve as well as the extent to which the aggregate demand curve shifts and its slope. Much of the text is devoted to exploring the slope of the aggregate supply curve and the causes of shifts in the aggregate demand curve. P AS Price level P' E' P0 E AD' AD 0 Y0 Y' Y Output, income FIGURE 5-2 AN INCREASE IN THE NOMINAL MONEY STOCK SHIFTS AGGREGATE DEMAND TO THE RIGHT. The equilibrium point moves from E to E . dor75926_ch05_097-117.indd 99 03/11/10 3:19 PM  100 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY BOX 5-1 Aggregate Supply and Aggregate Demand—What’s in a Name? Figure 5-1 has the friendly, familiar appearance that you probably remember from your study of microeconomics. What’s more, the mechanical workings of the model (demand shifts up … prices and quantities both rise … etc.) are the same as the workings of a microeconomic supply and demand diagram. However, the economics underlying the aggregate supply–aggregate demand diagram is unrelated to the microeconomic ver- sion. (It’s too bad that our macroeconomic version wasn’t given a different name.) In particular, “price” in microeconomics means the ratio at which two goods trade: I’ll give you two bags of candy in exchange for one economics lecture, for example. In contrast, in macroeconomics “price” means the nominal price level, the cost of a basket of all the goods we buy measured in money terms. One particular item from macroeconomics provides a special opportunity for con- fusion. In microeconomics, supply curves are relatively more elastic in the long run than in the short run, at least as a rough rule of thumb. The behavior of aggregate supply is just the opposite. The aggregate supply curve is vertical in the long run and horizontal in the short run. (We will, of course, discuss why this is so.) Figure 5-3 shows the results of an adverse (upward and leftward) aggregate supply shock (the 1973 OPEC oil embargo is a classic example of such a shock). The leftward shift of the aggregate supply curve cuts output and raises prices. P AS' AS Price level P' E' P0 E AD 0 Y' Y0 Y Output, income FIGURE 5-3 A LEFTWARD SHIFT OF AGGREGATE SUPPLY. A shift to AS  moves the equilibrium point from E to E . dor75926_ch05_097-117.indd 100 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 101 5-1 THE AGGREGATE SUPPLY CURVE The aggregate supply curve describes, for each given price level, the quantity of output firms are willing to supply. In the short run the AS curve is horizontal (the Keynesian aggregate supply curve); in the long run the AS curve is vertical (the classical aggre- gate supply curve). Figure 5-4 shows the two extreme cases. We begin by examining the long-run case. THE CLASSICAL SUPPLY CURVE The classical aggregate supply curve is vertical, indicating that the same amount of goods will be supplied whatever the price level. The classical supply curve is based on the assumption that the labor market is in equilibrium with full employment of the labor force. If the idea that the aggregate supply curve is vertical in the long run makes you uncomfortable, remember that the term “price level” here means overall prices. In a single market, manufacturers faced with high demand can raise the price for their prod- ucts and go out and buy more materials, more labor, and so forth. This has the side effect of shifting factors of production away from lower demand sectors and into this particular market. But if high demand is economywide and all the factors of production are already at work, there isn’t any way to increase overall production, and all that hap- pens is that all prices increase (wages too, of course). P P AS Price level Price level P' AS 0 0 Y Y* Y Output, income Output, income (a) (b) FIGURE 5-4 KEYNESIAN AND CLASSICAL AGGREGATE SUPPLY FUNCTIONS. (a) The horizontal Keynesian AS curve implies that any amount of output will be supplied at the existing price level. (b) The vertical classical supply function is based on the assumption that there is always full employment of labor, and thus that output is always at the corresponding level, Y*. dor75926_ch05_097-117.indd 101 03/11/10 3:19 PM  102 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY Y P 0 1 2 3 AS AS AS AS Price level Output Y3 Y2 Y1 Y0 0 0 t0 t1 t2 t3 t Y0Y1 Y2 Y3 Y Time Output (a) (b) FIGURE 5-5 GROWTH OF OUTPUT OVER TIME, TRANSLATED INTO SHIFTS IN AGGREGATE SUPPLY. We call the level of output corresponding to full employment of the labor force potential GDP, Y*. Potential GDP grows over time as the economy accumulates resources and as technology improves, so the position of the classical aggregate supply curve moves to the right over time, as shown in Figure 5-5. In fact, the level of potential GDP in a particular year is determined largely as described by the growth theory models we have just studied.1 It is important to note that while potential GDP changes each year, the changes do not depend on the price level. We say that potential GDP is “exogenous with respect to the price level”; what’s more, changes in potential GDP over a short period are usually relatively small, a few percent a year. We can draw a single vertical line at potential GDP and call it “long-run aggregate supply” without needing to worry much about the rightward movement due to potential GDP growth. THE KEYNESIAN AGGREGATE SUPPLY CURVE The Keynesian aggregate supply curve is horizontal, indicating that firms will sup- ply whatever amount of goods is demanded at the existing price level. The idea un- derlying the Keynesian aggregate supply curve is that because there is unemployment, firms can obtain as much labor as they want at the current wage. Their average costs of production therefore are assumed not to change as their output levels change. They are accordingly willing to supply as much as is demanded at the existing price level. The intellectual genesis of the Keynesian aggregate supply curve lay in the Great Depression, when it seemed that output could expand endlessly without increasing prices by putting idle capital and labor to work. Today, we’ve overlaid this notion with what we call “short-run price stickiness.” In the short run, firms are reluctant to change prices (and 1 “Projecting Potential Growth: Issues and Measurement,” the July/August 2009 issue of the Federal Reserve Bank of St. Louis Review, is a good source on how potential output is measured, especially the article “What Do We Know (And Not Know) About Potential Output?” by Susanto Basu and John G. Fernald. dor75926_ch05_097-117.indd 102 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 103 BOX 5-2 Tilting at the Aggregate Supply Curve—How Flat Is Flat? As you have seen, we say in several places that the short-run aggregate supply curve is flat. You have also seen us draw diagrams showing an upward sloping curve. So which is it? In truth, even in the very short run, the aggregate supply curve has a very slight upward tilt. But in building models we always make simplifying approximations. Saying that the short-run aggregate supply curve is completely flat is very nearly true, and it buys us an important simplification: It means that in the short run we can deal with aggregate demand and aggregate supply separately rather than as a pair of simultaneous equations. What happens when aggregate demand increases? In our construction, in the instant that aggregate demand increases output goes up by the full amount of the AD increase. Shortly thereafter, prices rise as the flat AS curve moves up. This upward move- ment of the AS curve reduces demand as it sweeps up the increased AD curve. Separat- ing the two steps makes the whole short-run process much easier to think about with very little loss in accuracy. Of course, the art of using a simplified model lies in knowing when the simplifica- tions are safe to make and when they are not. As Box 6-1 will explain, when output is well above potential output the short-run aggregate supply curve slopes upward signifi- cantly. In this situation the assumption of a horizontal short-run AS schedule is no longer tenable, and we really do need to use a positively sloped AS curve and solve for equilib- rium using AS and AD curves simultaneously. wages) when demand shifts. Instead, at least for a little while, they increase or decrease output. As a result, the aggregate supply curve is quite flat in the short run. It is important to note that on a Keynesian aggregate supply curve, the price level does not depend on GDP. In most countries prices rise in most years; in other words, there is some ongoing, though perhaps small, inflation. For reasons we explore later, this price increase is associated with an upward shift of the aggregate supply curve—not a move along the curve. For the moment, we assume that we are in an economy with no expected inflation. The key point is that in the short run the price level is unaffected by current levels of GDP. FRICTIONAL UNEMPLOYMENT AND THE NATURAL RATE OF UNEMPLOYMENT Taken literally, the classical model implies that there is no unemployment. In equilibrium, everyone who wants to work is working. But there is always some dor75926_ch05_097-117.indd 103 03/11/10 3:19 PM  104 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY unemployment. That level of unemployment is accounted for by labor market fric- tions, which occur because the labor market is always in a state of flux. Some people are moving and changing jobs; other people are looking for jobs for the first time; some firms are expanding and hiring new workers; others have lost business and have to reduce employment by firing workers. Because it takes time for an individual to find the right new job, there will always be some frictional unemployment as people search for jobs. There is some amount of unemployment associated with the full-employment level of employment and the corresponding full-employment (or potential) level of output, Y*. That amount of unemployment is called the natural rate. The natural rate of unem- ployment is the rate of unemployment arising from normal labor market frictions that exist when the labor market is in equilibrium. The current estimate of the natu- ral rate in the United States by the Congressional Budget Office (CBO) is 5.2 percent, but a reliable number has been frustratingly difficult to pin down.2 5-2 THE AGGREGATE SUPPLY CURVE AND THE PRICE ADJUSTMENT MECHANISM The aggregate supply curve describes the price adjustment mechanism of the economy. Figure 5-6a shows the flat short-run aggregate supply curve in black and the vertical long-run curve in green. It also illustrates an entire spectrum of intermediate-run curves. P Long-run AS t = ∞ P t=∞ t=1 t=1 t=0 t=0 Short-run AS AD Y* Y Y (a) (b) FIGURE 5-6 THE DYNAMIC RETURN TO LONG-RUN AGGREGATE SUPPLY. 2 Douglas Staiger, James H. Stock, and Mark W. Watson, “How Precise Are Estimates of the Natural Rate of Unemployment?” in C. D. Romer and D. H. Romer (eds.), Reducing Inflation: Motivation and Strategy, (Chicago: University of Chicago Press 1997a); and Douglas Staiger, James H. Stock, and Mark W. Watson, “The NAIRU, Unemployment and Monetary Policy,” The Journal of Economic Perspectives 11 (1997b). dor75926_ch05_097-117.indd 104 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 105 Think of the aggregate supply curve as rotating, counterclockwise, from horizontal to vertical with the passage of time. The aggregate supply curve that applies at, say, a 1-year horizon is a black dashed line and medium-sloped. If aggregate demand is greater than potential output, Y*, then this intermediate curve indicates that after a year’s time prices will have risen enough to partially, but not completely, push GDP back down to potential output. Figure 5-6a gives a useful, but static, picture of what is really a dynamic process. We focus on the aggregate supply curve as a description of the mechanism by which prices rise or fall over time. Equation (1) gives the aggregate supply curve: Pt1  Pt[1  (Y  Y*)] (1) where Pt 1 is the price level next period, Pt is the price level today, and Y* is potential output. Equation (1) embodies a very simple idea: If output is above potential output, prices will rise and be higher next period; if prices are below potential output, prices will fall and be lower next period.3 What’s more, prices will continue to rise or fall over time until output returns to potential output. Tomorrow’s price level equals today’s price level if, and only if, output equals potential output.4 The difference between GDP and potential GDP, Y  Y*, is called the GDP gap, or the output gap. The upward-shifting horizontal lines in Figure 5-6b correspond to successive snap- shots of equation (1). We start with the horizontal black line at time t  0. If output is above potential, then the price will be higher—that is, the aggregate supply curve will move up—by time t  1, as shown by the black dashed line. According to equation (1), and as shown in Figure 5-6b, the price keeps moving up until output is no longer above potential output. Note that Figure 5-6a and b are alternative descriptions of the same process; (a) illustrates the dynamics of price movements, and (b) shows snapshots after a given amount of time has elapsed. For example, the black dashed schedule shows the cumula- tive effect of price movements after perhaps a year’s time. Figure 5-7 is another way of looking at the adjustment process: plotting the equilibrium points from Figure 5-6 against elapsed time. The speed of price adjustment is controlled by the parameter  in equation (1). If  is large, the aggregate supply curve moves quickly, or, equivalently, the counter- clockwise rotation in Figure 5-6a occurs over a relatively short time period. If  is small, prices adjust only very slowly. Quite a bit of the disagreement among econo- mists about the best course for macroeconomic policy centers on . If  is large, the aggregate supply mechanism will return the economy to potential output relatively quickly; if  is small, we might want to use aggregate demand policy to speed up the process. 3 Sometimes equation (1) is written to show Pt adjusting from Pt − 1 rather than Pt + 1 adjusting from Pt. This alternative puts a little slope in even the shortest-run AS curve, where our version has the shortest-run curve horizontal. Nothing substantive rests on the difference. 4 For the moment, we leave out the very important role of price expectations. If you look ahead in the next chapter, you will see that including price expectations in the aggregate supply curve is necessary to explain inflation when the economy is at Y = Y*. dor75926_ch05_097-117.indd 105 03/11/10 3:19 PM  106 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY P Price 0 Time (a) YSR Output Y* 0 Time (b) FIGURE 5-7 ADJUSTMENT PATHS OF PRICE LEVEL AND OUTPUT. RECAP We summarize the description of the aggregate supply schedule as follows: A relatively flat aggregate supply curve means that changes in output and employ- ment have a small impact on prices, as shown in Figure 5-6a. Equivalently, we could say that the horizontal short-run AS curve shown in Figure 5-6b moves up slowly in response to increases in output or employment. The coefficient  in equation (1) captures this output/price change linkage. The position of the short-run AS schedule depends on the level of prices. The sched- ule passes through the full-employment level of output, Y*, at Pt  1 = Pt. At higher output levels there is overemployment, and hence prices next period will be higher than those this period. Conversely, when unemployment is high, prices next period will be lower than those this period. The short-run AS schedule shifts over time. If output is maintained above the full- employment level, Y*, prices will continue to rise over time. dor75926_ch05_097-117.indd 106 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 107 BOX 5-3 Vertical or Horizontal: Is It All a Matter of Timing? The text describes the aggregate supply curve as vertical in the long run, horizontal in the short run, and implicitly having an intermediate slope in the midterm. This picture oversimplifies in a way that can be very important for policy. The truth is that the aggregate supply curve, even in the short run, is really a curve and not a straight line. Figure 1 shows that at low levels of output, below potential output Y*, the aggre- gate supply curve is quite flat. When output is below potential, there is very little ten- dency for prices of goods and factors (wages) to fall. Conversely, where output is above potential, the aggregate supply curve is steep and prices tend to rise continuously. The effects of changes in aggregate demand on output and prices therefore depend on the level of actual relative to potential output. In a recession we are on the flat part of the aggregate supply curve, so demand management policies can be effective at boosting the economy without having much effect on the price level. However, as the economy approaches full employment, policymakers must be wary of too much stimulus to avoid running the aggregate demand curve up the vertical portion of the aggregate supply curve shown in the figure. P AD Price level AS Y* Y Output FIGURE 1 AGGREGATE DEMAND AND NONLINEAR AGGREGATE SUPPLY. dor75926_ch05_097-117.indd 107 03/11/10 3:19 PM  108 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY 5-3 THE AGGREGATE DEMAND CURVE The aggregate demand curve shows the combinations of the price level and level of output at which the goods and money markets are simultaneously in equilibrium. Expansionary policies—such as increases in government spending, cuts in taxes, and increases in the money supply—move the aggregate demand curve to the right. Con- sumer and investor confidence also affects the aggregate demand curve. When confi- dence increases, the AD curve moves to the right. When confidence drops, the AD curve moves to the left. The aggregate demand relation between output and prices is quite sophisticated. Indeed, Chapters 9, 10, and 11 are devoted to developing the IS-LM model, which is the underpinning of aggregate demand. Here we give a brief introduction. The key to the aggregate demand relation between output and prices is that aggre- gate demand depends on the real money supply. The real money supply is the value of the money provided by the central bank (the Federal Reserve in the United States) and the banking system. If we write the number of dollars in the money supply (the nominal −− −− money supply) as M and the price level as P, we can write the real money supply as M兾P. −− When M兾P rises, interest rates fall and investment rises, leading overall aggregate −− demand to rise. Analogously, lowering M兾P lowers investment and overall aggre- gate demand. −− For a given level of the nominal money supply, M, high prices mean a low real −− money supply, M兾P. Quite simply, high prices mean that the value of the number of available dollars is low. As a result, a high price level means a low level of aggregate demand, and a low price level means a high level of aggregate demand. Thus, the ag- gregate demand curve in Figure 5-1 slopes down.5 The aggregate demand curve represents equilibrium in both the goods and money markets. Expansion from the goods markets—say, from increased consumer confidence or expansionary fiscal policy—moves the aggregate demand schedule up and to the right. Expansionary monetary policy similarly moves aggregate demand up and to the right. Figure 5-8 shows just such a shift in aggregate demand. Putting together the goods markets and money markets to derive the aggregate demand curve requires considerable detail—which we will supply in Chapter 10. It’s much easier to understand the aggregate demand curve if we forget about the goods market for the moment. So we will! But you should maintain a mental reservation that we owe you another piece of the puzzle. The quantity theory of money provides a simple way to get a handle on the aggre- gate demand curve, even if it does leave out some important elements. The total number 5 Note that, strictly speaking, the aggregate demand curve should be drawn as a curve and not a straight line. We show it as a straight line for convenience. dor75926_ch05_097-117.indd 108 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 109 P Price level P' P0 AD' AD 0 Y0 Y Output, income FIGURE 5-8 AN INCREASE IN THE MONEY SUPPLY SHIFTS AGGREGATE DEMAND UPWARD. A 10 percent increase in the money supply shifts AD up by 10 percent. of dollars spent in a year, nominal GDP, is P  Y. We call the number of times per year a dollar turns over velocity, V. If the central bank provides M dollars, then MVPY (2) For example, a money supply of $5,200 billion (M ) turning over 2 times a year (V ) would support a nominal GDP of $10,400 billion (P  Y ). If we make one additional assumption—that V is constant—then equation (2) turns into an aggregate demand curve. With the money supply constant, any increase in Y must be offset by a decrease in P, and vice versa. The inverse relation between output and price gives the downward slope of AD. An increase in the money supply shifts AD upward for any given value of Y. It is important for what follows to see that an increase in the nominal money stock shifts the AD schedule up exactly in proportion to the increase in nominal money. Why? −− Look at Figure 5-8 and at equation (2). Suppose that M0 leads to the AD curve shown in −− the figure and that the value P0 corresponds to output Y0. Now suppose M increases −− −− 10 percent to M ( 1.1  M ). This shifts the aggregate demand curve up and to the right to AD. The value of P corresponding to Y0 must be exactly P ( 1.1  P0 ). At −− this value of P, the new real money supply equals the old real money supply (M兾P  −− −− (1.1  M 0 )兾(1.1  P0 )  M 0兾P0 ). dor75926_ch05_097-117.indd 109 03/11/10 3:19 PM  110 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY 5-4 AGGREGATE DEMAND POLICY UNDER ALTERNATIVE SUPPLY ASSUMPTIONS In Figure 5-1 we showed how the aggregate supply and demand curves together deter- mine the equilibrium level of income and prices in the economy. Now we use the ag- gregate demand and supply model to study the effects of aggregate demand policy in the two extreme supply cases—Keynesian and classical. THE KEYNESIAN CASE In Figure 5-9 we combine the aggregate demand schedule with the Keynesian aggregate supply schedule. The initial equilibrium is at point E, where AS and AD intersect. At that point the goods and assets markets are in equilibrium. Consider an increase in aggregate demand—such as increased government spend- ing, a cut in taxes, or an increase in the money supply—which shifts the AD schedule out and to the right, from AD to AD. The new equilibrium is at point E, where output has increased. Because firms are willing to supply any amount of output at the level of prices P0, there is no effect on prices. The only effect in Figure 5-9 is an increase in output and employment. P Price level E E' P0 AS AD' AD 0 Y Y' Output, spending FIGURE 5-9 AGGREGATE DEMAND EXPANSION: THE KEYNESIAN CASE. Given perfectly elastic supply, shifting AD to the right will increase output but leave the equilibrium price level unchanged. dor75926_ch05_097-117.indd 110 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 111 THE CLASSICAL CASE In the classical case, the aggregate supply schedule is vertical at the full-employment level of output. Firms will supply the level of output Y * whatever the price level. Under this supply assumption we obtain results very different from those reached using the Keynesian model. Now the price level is not given but, rather, depends on the interac- tion of supply and demand. In Figure 5-10 we study the effect of an aggregate demand expansion under classi- cal supply assumptions. The aggregate supply schedule is AS, with equilibrium initially at point E. Note that at point E there is full employment because, under the classical assumption, firms supply the full-employment level of output at any level of prices. The expansion shifts the aggregate demand schedule from AD to AD. At the initial level of prices, P0, spending in the economy would rise to point E. At price level P0 the demand for goods has risen. But firms cannot obtain the labor to produce more output, and output supply cannot respond to the increased demand. As firms try to hire more workers, they bid up wages and their costs of production, so they must charge higher prices for their output. The increase in the demand for goods therefore leads only to higher prices, and not to higher output. The increase in prices reduces the real money stock and leads to a reduction in spending. The economy moves up the AD schedule until prices have risen enough, and the real money stock has fallen enough, to reduce spending to a level consistent with full-employment output. That is the case at price level P. At point E aggregate demand, at the higher level of government spending, is once again equal to aggregate supply. P AS E" Price level P' E E' P0 AD' AD 0 Y* Y Output, spending FIGURE 5-10 AGGREGATE DEMAND EXPANSION: THE CLASSICAL CASE. Given perfectly inelastic supply, shifting AD to the right results in an increase in the price level but no change in output. dor75926_ch05_097-117.indd 111 03/11/10 3:19 PM  112 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY BOX 5-4 Keynesian and Classical— Short Run and Long We have repeatedly used the terms “Keynesian” and “classical” to describe assump- tions of a horizontal or vertical aggregate supply curve. Note that these are not alter- native models providing alternative descriptions of the world. Both models are true: The Keynesian model holds in the short run, and the classical model holds in the long run. Economists do have contentious disagreements over the time horizons in which either model applies. Almost all economists (almost all) agree that the Keynesian model holds over a period of a few months or less and the classical model holds when the time frame is a decade or more. Unfortunately, the interesting time frame for policy relevance is several quarters to a few years. The speed with which prices adjust—that is, how long it takes the aggregate supply curve to rotate from horizontal to vertical—is an area of active research. 5-5 SUPPLY-SIDE ECONOMICS All economists are in favor of policies that move the aggregate supply curve to the right by increasing potential GDP. Such supply-side policies as removing unnecessary regula- tion, maintaining an efficient legal system, and encouraging technological progress are all desirable, although not always easy to implement. However, there is a group of poli- ticians and pundits who use the term “supply-side economics” in reference to the idea that cutting tax rates will increase aggregate supply enormously—so much, in fact, that tax collections will rise, rather than fall. Even political allies of the supply-siders (George Bush [the father] before he was president, for instance) refer to this notion as “voodoo economics.” We use the aggregate supply–aggregate demand diagram in Figure 5-11 to show what happens when tax rates are cut. Cutting tax rates has effects on both aggregate supply and aggregate demand. The aggregate demand curve shifts right from AD to AD. The shift is relatively large. The aggregate supply curve also shifts to the right, from AS to AS, because lower tax rates increase the incentive to work. However, economists have known for a very long time that the effect of such an incentive is quite small, so the rightward shift of potential GDP is small. The large shift in aggregate demand and small shift in aggregate supply are illustrated in Figure 5-11. What should we expect to see? In the short run, the economy moves from E to E. GDP does rise substantially. As a result, total tax revenues fall proportionately less dor75926_ch05_097-117.indd 112 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 113 P AS AS' E'' Price level E' P0 E AD' AD 0 Y0 Y'' Y Output, income FIGURE 5-11 EFFECTS OF CUTTING TAX RATES ON AGGREGATE DEMAND AND SUPPLY. than the fall in the tax rate.6 However, this is purely an aggregate demand effect. In the long run, the economy moves to E . GDP is higher, but only by a very small amount. As a result, total tax collections fall and the deficit rises. In addition, prices are perma- nently higher. The United States experimented with supply-side economics in the 1981–1983 tax cuts. The results were just as predicted. Not all supply-side policies are silly. In fact, only supply-side policies can perma- nently increase output. Important as they are, demand management policies are useful only for short-term results. For this reason, many economists strongly favor supply-side policies—they just don’t believe in exaggerating their effect.7 Many conservative econ- omists favor cutting tax rates for the small, but real, incentive effect. However, these economists also believe in cutting government spending at the same time. Tax collections would fall, but so would government spending, so the effect on the deficit would be nearly neutral. 6 In principle, GDP might even rise so much that tax collections rise. In practice, it appears that the effect is not this strong. 7 For a strong statement along these lines, see Nobel laureate Robert Lucas’s American Economic Association presidential address “Macroeconomic Priorities,” American Economic Review Papers and Proceedings, May 2003. dor75926_ch05_097-117.indd 113 03/11/10 3:19 PM  114 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY BOX 5-5 Dynamic Scoring—Or Supply-Side Economics Revisited When Congress considers tax cuts, the estimated effect of the tax cuts on the budget defi- cit plays a key role in the debate. Supply-siders have urged that the analysis of the deficit should include dynamic scoring. The dynamic scoring argument is as follows: A cut in tax rates will increase eco- nomic growth through a supply-side stimulus. Given enough time, the resulting increase in output will increase the base upon which taxes are levied. The extra tax collections on this higher base will in part offset the increase in the deficit due to the cut in the tax rate. Accounting for this offset over a number of years following the policy change is called dynamic scoring. The principle of dynamic scoring is hard to argue with, but many analysts disagree with its practical application. The first objection is that supply-side effects on increasing the tax base are very small, so that dynamic scoring cannot be very important. The sec- ond objection is that dynamic scoring is hard to do objectively, in particular because it requires analysts to take positions on how the Federal Reserve and future Congresses will change policies in reaction to current policy changes. 5-6 PUTTING AGGREGATE SUPPLY AND DEMAND TOGETHER IN THE LONG RUN The long-run aggregate supply curve marches to the right over time at a fairly steady rate. Two percent annual growth is pretty low, and 4 percent is high. In contrast, movements in aggregate demand over long periods can be either large or small, depending mostly on movements in the money supply. Figure 5-12 shows a stylized set of aggregate supply and demand curves for the 1970s through 2000. Output rises as the curves shift to the right. The shift was somewhat greater in the 1990s than ear- lier, but not overwhelmingly so. In contrast, there were big vertical moves in aggre- gate demand between 1970 and 1980, so prices rose much more quickly in the 1970s than later. Figure 5-12 shows that prices rise whenever aggregate demand moves out more than aggregate supply. Over long periods, output is essentially determined by aggregate supply and prices are determined by the movement of aggregate demand relative to the movement of aggregate supply. dor75926_ch05_097-117.indd 114 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 115 P AS70 AS80 AS90 AS00 AS10 E D Price level C B A AD10 AD00 AD90 AD80 AD70 Y70 Y80 Y90 Y00 Y10 Y Output, income FIGURE 5-12 LONG-RUN SHIFTS IN AD AND AS. SUMMARY 1. The aggregate supply and demand model is used to show the determination of the equilibrium levels of both output and prices. 2. The aggregate supply schedule, AS, shows at each level of prices the quantity of real output firms are willing to supply. 3. The Keynesian supply schedule is horizontal, implying that firms supply as many goods as are demanded at the existing price level. The classical supply schedule is vertical. It would apply in an economy that has full price and wage flexibility. In such a frictionless economy, employment and output are always at the full- employment level. 4. The aggregate supply curve describes the dynamic price adjustment mechanism of the economy. 5. The aggregate demand schedule, AD, shows at each price level the level of output at which the goods and assets markets are in equilibrium. This is the quantity of output demanded at each price level. Along the AD schedule fiscal policy is given, as is the nominal quantity of money. 6. A fiscal expansion shifts the AD schedule outward and to the right. An increase in the nominal money stock shifts the AD curve up by the same proportion as the money stock increases. dor75926_ch05_097-117.indd 115 03/11/10 3:19 PM  116 PART 2 GROWTH, AGGREGATE SUPPLY AND DEMAND, AND POLICY 7. Supply-side economics makes the claim that reducing tax rates generates very large increases in aggregate supply. In truth, tax cuts produce very small increases in ag- gregate supply and relatively large increases in aggregate demand. 8. Over long periods, output is essentially determined by aggregate supply and prices are determined by the movement of aggregate demand relative to the movement of aggregate supply. KEY TERMS aggregate demand (AD) Keynesian aggregate supply potential GDP curve curve price adjustment mechanism aggregate supply (AS ) curve natural rate quantity theory of money classical aggregate supply natural rate of unemployment real money supply curve nominal GDP speed of price adjustment dynamic scoring nominal money supply value frictional unemployment output gap velocity PROBLEMS Conceptual 1. What do the aggregate supply and aggregate demand curves describe? 2. Explain why the classical supply curve is vertical. What are the mechanisms that ensure con- tinued full employment of labor in the classical case? 3. What relationship is captured by the aggregate supply curve? Can you provide an intuitive justification for it? 4. How does the Keynesian aggregate supply curve differ from the classical one? Is one of these specifications more appropriate than the other? Explain, being careful to state the time hori- zon to which your answer applies. 5. The aggregate supply and demand model looks, and sounds, very similar to the standard sup- ply and demand model of microeconomics. How, if at all, are these models related? Technical 1. a. If the government were to reduce income taxes, how would the reduction affect output and the price level in the short run? In the long run? Show how the aggregate supply and demand curves would be affected, in both cases. b. What is supply-side economics? Is it likely to be effective, given your answer to (a)? 2. Suppose that the government increases spending from G to G while simultaneously raising taxes in such a way that, at the initial level of output, the budget remains balanced. a. Show the effect of this change on the aggregate demand schedule. b. How does this affect output and the price level in the Keynesian case? c. How does this affect output and the price level in the classical case? dor75926_ch05_097-117.indd 116 03/11/10 3:19 PM  CHAPTER 5 AGGREGATE SUPPLY AND DEMAND 117 Empirical 1. The textbook identified the 1973 OPEC oil embargo as a classical example of an adverse supply shock. Go to http://research.stlouisfed.org/fred2 and click on “Consumer Price Indexes (CPI).” Then find the series “CPIENGNS” titled “Consumer Price Index for All Urban Consumers: Energy.” The graph that is shown on the page should be from 1957 to the current year, with recession years shaded. Besides the date 1973 given in the textbook, can you identify on the graph other probable dates when supply shocks (oil shocks) took place? Give an example. 2. In Section 5.1 of this chapter we stated that changes in potential GDP do not depend on the price level, or in other words, “potential GDP is exogenous with respect to the price level.” The goal of this exercise is to give you a chance to convince yourself that this is the case. a. Go to http://research.stlouisfed.org/fred2 and download annual data for the period 1949–2009 for the following two variables: Real Potential Gross Domestic Product (po- tential RGDP) and Gross Domestic Product Implicit Price Deflator. (Both sets of data are located under “Gross Domestic Product (GDP) and Components.” For RGDP, go to “GDP/GNP” and for the price deflator, go to “Price Indexes and Deflators.”) Copy the data into an EXCEL spreadsheet. You will need to take the average of the four quarters of each year to get the annual average. (Hint: Use the average command in Excel.) b. Calculate the annual growth rate in potential RGDP and the annual inflation rate in GDP deflator. Create a scatterplot that has the growth rate of potential GDP on the Y axis and the annual inflation rate in the GDP deflator on the X axis. Can you visually identify any relationship between the two variables? *c. If you have taken a statistics class, use EXCEL or a statistical program in order to run the following regression: Potential RGDP growth = c   inflation in the GDP deflator  What do you find? Is the coefficient on the inflation rate statistically significant? Inter- pret your results. *An asterisk denotes a more difficult problem. dor75926_ch05_097-117.indd 117 03/11/10 3:19 PM