Aggregate Demand & Supply: Economics Notes | PDF

Chapter 15: Aggregate Demand and Aggregate Supply Introduction: Real GDP over the long run grows about 3% per year on average GDP in the short run fluctuates around its trend Recessions are periods of falling real incomes and rising unemployment Depressions are severe recessions and are very rare Bu...

Chapter 15: Aggregate Demand and Aggregate Supply Introduction: Real GDP over the long run grows about 3% per year on average GDP in the short run fluctuates around its trend Recessions are periods of falling real incomes and rising unemployment Depressions are severe recessions and are very rare Business cycles: The business cycle is the progression of the economy through growth and contraction periods Four components of the business cycle: 1.) Growth periods: any time GDP is consistently rising 2.) Peak: the end of the growth period and the highest GDP point before contraction 3.) Contractionary periods: any time GDP is consistently falling 4.) Trough: the lowest GDP point after a contractionary phase Recession: A period of negative GDP growth lasting a minimum of six to nine months A recession has negative GDP growth, which means: Real income falls with GDP Unemployment rises Usually, inflation falls as well The classical dichotomy: The theoretical separation of nominal variables and real variables Nominal variables: measured in monetary units Nominal GDP, nominal interest rate (rate of return measured in $), nominal wage ($ per hour worked) Real variables: measured in physical units Real GDP, real interest rate (measured in output), real wage (measured in output) Classical economic theory (pre-1930s): This theory assumes money neutrality, which assumes that changes in the money supply only affect nominal values, but not real values This model only focuses on long-run economic growth because of money neutrality being assumed; any change in the money supply in the short run creates unnecessary inflation or deflation Classical economics- A recap: Classical theory describes the world in the long run, but not the short run In the short run: Changes in nominal variables (like the money supply or P) can affect real variables (like Y or the u-rate) Model of aggregate demand and aggregate supply: P is the price level (inflation rate), and Y is GDP (output) AD is aggregate demand If P rises, then inflation rises, and vice versa When GDP changes, so does unemployment In general, if GDP rises, unemployment rises, and vice versa SRAS (short-run aggregate supply) and AD intersect, creating a short-run equilibrium price level, GDP, and unemployment rate The aggregate demand curve: The AD curve shows the quantity of all goods and services demanded by the overall economy at any given price level AD=C+I+G+NX Assume G is fixed by government policy, omitting it G is omitted because government spending is not usually related to the inflation rate, meaning it doesn’t change with inflation To understand the slope of AD, we must determine how a change in P affects C, I, and NX 3 reasons AD slopes downward: 1.) The wealth effect (C): Suppose the price level falls: This means inflation falls Because inflation is lower, the real value of money is higher, and so is purchasing power The rise in purchasing power makes consumers wealthier People then spend more on consumption, increasing the quantity of goods and services demanded by consumers 2.) The interest rate effect (I) Suppose the price level falls: Inflation falls People have more purchasing power People will then spend more, but also save more by buying bonds and other assets When consumers save more, the supply curve for loanable funds shifts to the right, which reduces the interest rate With lower interest rates, businesses invest more, and this increases the quantity of goods and services demanded for business investment Appreciation and depreciation of currency: A currency appreciates in value when it becomes stronger compared to other currencies Depreciation is when a currency loses value/becomes weaker compared to other currencies 3.) The exchange rate effect (NX) Price level falls (inflation falls) Purchasing power is higher, so people save more This causes interest rates to fall With lower interest rates and a lower price level, a country’s currency depreciates in value Depreciated currency and the trade balance: For exports: If your currency depreciates, it is cheaper for other countries to buy your domestic exports Exports rise For imports: If your currency depreciates, it is more expensive for you to buy foreign goods Imports fall This causes net exports (NX) to rise and increases the quantity demanded of domestic goods and services If P rises, then because of all three of the effects, we would see a fall in the quantity demanded of goods and services Why might AD shift?: AD=C+I+G+NX Anything that affects C, I, G, or NX that is not a direct change in P shifts AD How would a stock market crash affect AD? Which component does it affect? If the stock market crashed, people would lose savings, causing them to spend less and reducing C. Aggregate demand would then shift left. Generally, we ignore the effect of the stock market on investment because it is a secondary effect. Stocks and the stock market are considered savings Things that cause changes in C: Stock market boom/crash Preferences: consumption/saving tradeoff Lower interest rates → higher consumption Higher interest rates → lower consumption Tax hikes/cuts Expectations: optimism/pessimism Interest rates Monetary policy Things that cause changes in I: Firms buy new computers, equipment, and factories Expectations: optimism/pessimism Interest rates Monetary policy Investment tax credit or other tax incentives Things that change G: Federal spending: defense State and local spending: roads, schools Things that change NX: Booms/recessions in countries that buy our exports: Suppose Canada is going through a boom period (a boom period is when there is a period of strong GDP growth). How does this affect the U.S. economy? Canada has strong GDP growth Canada has a growing national income (GDP is national income) Canada buys more goods, specifically more U.S. exports U.S. exports and net exports rise, and U.S. AD shifts rightward Suppose Canada goes into a recession: GDP and income fall in Canada Canada can’t afford to buy as many U.S. goods U.S. exports fall U.S. AD shifts left Appreciation/depreciation resulting from international speculation in the foreign exchange market USD appreciates (or the USD exchange rate rises): Countries can’t afford as many U.S. exports Exports decrease It is cheaper for people in the U.S. to buy imported goods Imports rise Net exports fall, and AD shifts left USD depreciates (or the USD exchange rate falls): The USD is weaker compared to other currencies Other countries can buy more U.S. exports since it is relatively cheaper now It is relatively more expensive to buy imports for U.S. citizens Exports rise, imports fall Net exports increase, and AD shifts right Examples: What happens to the AD curve in each of the following scenarios? A ten-year-old investment tax credit expires Investment falls, AD curve shifts left This is effectively a tax increase on investment The U.S. exchange rate falls Net exports rise, AD shifts right A fall in prices increases the real value of consumers’ wealth This is just the wealth effect, not a shift in AD This just changes the quantity demanded of goods and services by consumers and is a movement along the AD curve State governments replace their sales taxes with new taxes on interest, dividends, and capital gains Consumption increases, AD shifts right Higher taxes on savings mean people save less, and consumption increases Aggregate supply: Aggregate supply is the amount producers are willing and able to sell at a given price level In the short run, aggregate supply is upward sloping, and in the long run, aggregate supply is vertical Short-run: 1-2 years Long-run: 5-10 years Long-run aggregate supply: YN: the natural rate of output/GDP This amount is what GDP would be if unemployment were at its natural rate (around 5% in the US) YN is also referred to as “potential GDP/output” or “full employment GDP/output” The “F” in YF refers to “full employment” LRAS=A*F(K,L,H,N) Full employment GDP is determined by the level of technology, physical and human capital, the labor stock, and the level of natural resources in a country Potential GDP is an estimate that is included in economic analysis Why is LRAS vertical? The classical theory of economics explains growth in the long run The classical theory assumes money neutrality, which means changes in the money supply affect nominal, but not real variables This means that any change in the price level does not change YF This classical theory applies identically to when AD shifts in response to prices Suppose the economy is in a short-run recession and GDP growth is poor. The Fed wants to use expansionary monetary policy to raise GDP: Money supply increases, consumption and investment increase, and AD shifts right In the classical model, this does not improve long-run growth and instead just creates unnecessary inflation Suppose the Fed wants to use contractionary policy to reduce the money supply: The money supply decreases, and AD shifts left There is no change in YF, but there is negative inflation Shifting LRAS: LRAS=A*F(K,L,H,N) Anything that shifts K, L, H, or N will shift LRAS Example: Immigration increases the labor stock (L), and LRAS shifts right 1.) Changes in L Policies and other things that affect the natural rate of unemployment will shift L and LRAS, too If the natural rate of unemployment falls, L increases Immigration increases L; emigration is when people leave a country, causing L to decrease If a large portion of the labor force retires, then this decreases the labor stock 2.) Physical and human capital If investment in a country rises, then physical capital increases If investment falls, then physical capital falls Natural disasters also cause physical capital (K) to fall If college completion rates rise, then human capital increases Brain drain: when the most educated/productive people leave a country, decreasing human capital 3.) Natural resources Discoveries of new resources cause N to rise Bad weather conditions and storms that affect agriculture cause N to fall If there is a reduction in natural resource imports, natural resources decrease 4.) Changes in technology Technological progress usually leads to more efficient production Showing the pattern of long-run growth over time with AD and LRAS: Over time, the economy has become much larger, due in large part to technological advancements. LRAS shifts right multiple times because of this How do we show that inflation has risen with LRAS? Use AD: When LRAS shifts right, GDP and national income rise More income means people buy more and save more, so the money supply increases and AD shifts right Essentially, AD shifts along with LRAS in response Economic growth in both the short run and long run creates some inflation To show short-run market fluctuations in GDP and unemployment, we need SRAS (short-run aggregate supply) SRAS is upward sloping Over the course of 1-2 years, a higher price level means sellers are willing to sell a larger quantity of goods and services Showing short-run fluctuations with SRAS: Without SRAS, if AD shifts right, then YF stays the same, and the price level rises to P2 With SRAS, if AD shifts right, GDP rises to Y3, and unemployment falls Inflation rises, but only to P3 AD shifting left with SRAS results in the price level falling to P4 GDP falls to Y4 and unemployment rises The three theories of SRAS: Theories that explain why the AS curve slopes upward in the short run: Sticky wage theory Sticky price theory Misperceptions theory Sticky: doesn’t change easily/frequently In each, there is some type of market imperfection: Output deviates from its natural rate when the actual price level deviates from the price level people expected P- the actual price level: From the perspective of the producer, this is the price that is received from the sale of a good PE- the expected price level: Producers make decisions about how much to produce and what wages to pay, etc., based on PE The sticky wage theory: Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly Due to labor contracts, social norms Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail If P>PE: Revenue is higher, but labor costs are not Production is more profitable, so firms increase output and employment Hence, higher P causes higher Y, so the SRAS curve slopes upward The sticky price theory: Imperfection: Many prices are sticky in the short run Due to menu costs, the costs of adjusting prices Examples: cost of printing new menus, cost of changing price tags, etc. Firms set sticky prices in advance based on PE Suppose the Fed increases the money supply unexpectedly: In the long run, P will rise In the short run: Firms without menu costs can raise their prices immediately Firms with menu costs wait to raise prices With relatively lower prices, there is increased demand for products This increases output and employment Hence, higher P is associated with higher Y, so the SRAS curve slopes upward The misperception theory: Imperfection: Firms way confuse changes in P with changes in the relative price of the products they sell If P rises above PE: A firm sees its price rise before realizing that all prices are rising The firm may believe its relative price is rising, and may increase output and employment So, an increase in P can cause an increase in Y, making the SRAS curve upward sloping What the three theories have in common: In all three theories, Y deviates from YN when P deviates from PE: Y=YN+a(P-PE) Y=output YN = natural rate of output (long-run) a>0, measures how much Y responds to unexpected changes in P P = the actual price level PE = the expected price level Check the slides for a graph representing this equation SRAS and LRAS: The imperfections in these theories are temporary. Over time: Sticky wages and prices become flexible Misperceptions are corrected In the LR: PE = P The AS curve is vertical Why the SRAS curve might shift: Everything that shifts LRAS shifts SRAS too Also, PE shifts SRAS: If PE rises, workers and firms set higher wages At each P, production is less profitable, Y falls, and SRAS shifts left In long run equilibrium: P=PE Y=YN Also, unemployment is at the natural rate Four steps to analyzing economic fluctuations in this model: 1.) Which curve shifts? What component causes it to shift? 2.) Does it shift left or right? 3.) After the shift, how do GDP, inflation, and unemployment change? 4.) If no other shifts occur over the long run, then what curve shifts responsively? In which direction? How do the GDP, inflation, and unemployment change? Example: Suppose there is a stock market crash: (1 and 2) Consumption falls, AD shifts to the left (3) After the shift, GDP falls to Y2, unemployment rises above the natural rate, and inflation falls (4) Assuming no other shifts: the fall in price from P1 to P2 means that the expected price will fall in the long run. SRAS will shift right responsively due to PE decreasing. After SRAS shifts, GDP goes back to YF. Unemployment is at the natural rate. There is a small fall in P. Graph: Showing a recession: What is a recession? Minimum of 6-9 months of negative GDP growth Rising unemployment Falling inflation We show a recession when AD shifts left by a lot To help get out of a recession, the government or the Fed wants to use expansionary monetary policy to shift AD rightward and get the economy back to YF over time Getting out of a recession: Starting: Stagflation: High inflation and high unemployment Near-zero or negative GDP growth Over time, AS shifts left a lot Graph of going into stagflation: Usually, this involves a large increase in PE Policies from the government and the Fed are not able to shift SRAS very effectively Potential policy interventions have drawbacks Option 1: Do nothing It is possible that PE will fall over time and return SRAS to its original point This is usually not a great idea Option 2: Use expansionary policy to increase AD Graph: When AD increases, so does inflation This is bad, but GDP and GDP growth stabilize at YF, and unemployment goes back to the natural rate Supply-side economics: This is not a thing, just a lie The rationale in the 1980s was that by cutting taxes for the wealthy and reducing regulations that you could cause AS to rise since businesses and the wealthy would reinvest and grow the economy with the extra money However, none of this happens. Wealthy/rich people keep the money and do nothing with it, and businesses with reduced regulations just pay off shareholders and executives This also exacerbated economic inequality, which can cause societal unrest The economy doesn’t grow at all as a result of this policy What does happen is that the national debt grows since the government is now receiving less in tax revenue It is no coincidence that when this policy was implemented during the Reagan administration that they became the first administration to run up the national debt during peacetime The same thing happened in 2001 when it was expected that the government would run a budget surplus for the foreseeable future, and then the Bush administration cut taxes for the wealthy, thus creating unnecessary deficits. This also happened in 2017 John Maynard Keynes: The general theory of employment, interest, and money, 1936 Argued recessions and depression can result from inadequate demand; policymakers should shift AD Famous critique of classical economic theory: The long run is a misleading guide to current affairs. In the long run, we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons, they can only tell us when the storm is long past, the ocean will be flat. Example question: Suppose a government severely cuts research funding for universities, governmental, and non-governmental research entities. As a result, the country experiences a brain drain since the best researchers leave the country to find better funding. In the long run, how is this economy affected? Draw a graph showing the shift and equilibrium change Explain in words what shifts and why. How are GDP, unemployment, and inflation affected? In the long run, the LRAS curve shifts left due to the loss of human capital. GDP will fall to Y2, unemployment rises, and inflation rises to P2 As a result of this, AD will shift leftward in response (this reduces some inflation) Chapter 16: The effect of monetary and fiscal policy on AD *Fiscal policy is government policy in regard to spending and taxes Theory of liquidity preference: Preference for immediately usable assets for purchases vs. saving using illiquid assets like bonds Factors that influence money demand: Y = real GDP/income R = interest rate P = price level Suppose real income (Y) rises: Households want to buy more goods and services, so they need more money To get this money, they attempt to sell some of their bonds An increase in Y causes an increase in money demanded, all else equal Suppose r rises, but Y and P are unchanged. What happens to money demand? R is the opportunity cost of holding money An increase in r reduces money demand: households attempt to buy bonds to take advantage of the higher interest rate Hence, an increase in r causes a decrease in money demanded, all else equal Suppose P rises, but Y and r are unchanged. What happens to money demand? If Y is unchanged, people will want to buy the same amount of goods and services Since P is higher, they will need more money to do so Hence, an increase in P causes an increase in money demand, all else equal How R is determined: The money supply curve is vertical: changes in R do not affect MS, which is fixed by the Fed The money demand curve is downward sloping: a fall in R increases money demand Graph: A fall in P reduces money demand, which lowers R A fall in R increases I and the quantity of goods and services demanded Monetary policy and the AD: The Fed uses monetary policy to shift the AD curve Policy instrument: the money supply Targets the interest rate: the federal funds rate This is the rate banks charge each other on short-term loans The Fed conducts open market operations to change the MS The effects of reducing the money supply: The Fed can raise R by reducing the money supply An increase in R reduces the quantity of goods and services demanded Example questions: For each of the events below, determine the short-run effects on output, and draw an AD/AS graph showing the effects Determine how the Fed should adjust the money supply and interest rates to stabilize output Events: Congress tries to balance the budget by cutting government spending Government spending falls, decreasing Y in the short run and shifting AD left The Fed should use expansionary monetary policy to increase the money supply and stabilize output A stock market boom increases household wealth If household wealth increases, consumption rises, increasing Y and shifting AD right The Fed should use contractionary monetary policy to decrease the money supply and stabilize output War breaks out in the Middle East, causing oil prices to soar. The expected price level rises PE rises, causing SRAS to shift left The Fed should use expansionary policy to shift AD right, stabilizing output and bringing AD back to YF, reducing unemployment Graph: Liquidity trap: If interest rates are near zero, then expansionary monetary policy could be ineffective This would lead to AD being trapped at low levels, called a liquidity trap This is primarily an issue with open market operations In this case, the Fed has other policy options to expand AD, such as quantitative easing (essentially OMOs with long-term bonds), paying interest on reserves held at the Fed, etc. Expansionary monetary policy (OMOs): The Fed buys bonds from banks Banks have more cash reserves and loan more The money supply increases Money supply/demand graph: As a result, interest rates fall It is now cheaper to borrow, causing C and I to rise AD shifts right Graph: Contractionary monetary policy (OMOs): The Fed sells bonds to banks Banks have less cash and more bonds Banks loan less Money supply falls Graph: As a result, interest rates rise, accomplishing the Fed’s goal Borrowing is more expensive Consumption and investment fall AD shifts left Fiscal Policy and the AD: Fiscal policy: Setting the level of government spending and taxation by government policymakers Expansionary fiscal policy: An increase in G and/or a decrease in T, shifts AD right Contractionary fiscal policy: A decrease in G and/or an increase in T, shifts AD left Fiscal policy has two effects on AD: 1.) The multiplier effect: Example: If the government buys $20b of planes from Boeing, Boeing’s revenue increases by $20b This is distributed to Boeing’s workers (as wages) and owners (as profits or stock dividends) These people are also consumers and will spend a portion of the extra income This extra consumption causes further increases in aggregate demand A $20b increase in G initially shifts AD to the right by $20b The increase in Y causes C to rise, which shifts AD further to the right Multiplier effect: the additional shifts in AD that result when fiscal policy increases income and thereby increases consumer spending Marginal propensity to consume: How big is the multiplier effect? Depends on how much consumers respond to an increase in income Marginal propensity to consume: MPC=CY The fraction of extra income that households consume rather than save Example: If MPC=0.8 and income rises $100, C rises $80 Low and lower middle income people have VERY high MPC, 1 in most cases Middle-income folks also have high MPC (.6 to 1) High-income and very wealthy people have small MPCs (0 to 0.3) The multiplier effect is very large for low and middle-income people and almost nonexistent for high-income and wealthy people If the government wants to most effectively stimulate GDP growth, extra money should be directed to low and middle-income people, similar to what was done for covid relief Formulas: MPC=CY=C2-C1Y2-Y1 Multiplier effect formula: Y=(11-MPC)G The multiplier=(11-MPC) The size of the multiplier depends on the MPC A bigger MPC means changes in Y cause bigger changes in C, which in turn cause bigger changes in Y Other applications of the multiplier effect: The multiplier effect: Each $1 increase in G can generate more than a $1 increase in aggregate demand This is also true for the other components of GDP. It can also work in the negative direction Example: Suppose a recession overseas reduces demand for US net exports by $10b Initially, AD falls by $10b The fall in Y causes C to fall, which further reduces aggregate demand and income Example question: Suppose in a country, when income is $50,000, consumption spending is $45,000. When income is $60,000, consumption spending is $52,000. What is MPC? MPC=0.7 What is the multiplier? Multiplier=3.33 Assuming this country only experiences the multiplier effect, what is the change in AD generated from a change in an increase in government spending of $100,000,000? Change in Y=$333.33 million The crowding out effect: Offset in aggregate demand Results when expansionary fiscal policy raises the interest rate Thereby reducing investment spending Which reduces the net increase in aggregate demand So, the size of the AD shift may be smaller than the initial fiscal expansion How the crowding-out effect works: An initial $20b increase in G shifts AD right by $20b Higher Y increases MD and R, which reduces AD Changes in taxes: A tax cut: Increases households’ take-home pay Households respond by spending a portion of this extra income, shifting AD to the right The size of the shift is affected by the multiplier and crowding-out effects Another factor: household perception: Permanent tax cut: large impact on AD Temporary tax cut: small impact on AD Example question: The economy is in recession. Shifting the AD curve rightward by $200 billion would end the recession. If MPC = 0.8 and there is no crowding out, how much should Congress increase G to end the recession? 200/11-0.8=40 Congress should increase G by $40 billion to end the recession If there is crowding out, will Congress need to increase G more or less than this amount? Congress will need to increase G by more than this amount if there is crowding out Active stabilization policy: Actively using monetary and fiscal policy to return AD to the long-run equilibrium when economic fluctuations occur Keynes: “Animal spirits” cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment Also, other factors cause fluctuations: Booms and recessions abroad Stock market booms and crashes If policymakers do nothing: These fluctuations are destabilizing to businesses, workers, and consumers Proponents of active stabilization policy: Government should use policy to reduce these fluctuations: When GDP falls below its natural rate, use expansionary monetary or fiscal policy to prevent or reduce a recession When GDP rises above its natural rate, use contractionary policy to prevent or reduce an inflationary boom The case against active stabilization policy: Monetary policy affects the economy with a long lag: Firms make investment plans in advance, so I takes time to respond to changes in R Most economists believe it takes at least 6 months for monetary policy to affect output and employment Fiscal policy also works with a long lag: Changes in G and T require acts of Congress The legislative process can take months or years Due to these long lags: Critics of active policy argue that such policies may destabilize the economy rather than help it: By the time the policies affect aggregate demand, the economy’s condition may have changed Contend that policymakers should focus on long-run goals like economic growth and low inflation G and T change with AD: Income taxes and eligibility for social safety net programs are based on income thresholds When AD changes, income changes, so we also have automatic changes in G and T built in Automatic stabilizers: Changes in fiscal policy that stimulate aggregate demand when the economy goes into recession Policymakers don’t have to take any deliberate action for automatic stabilizers to go into effect Examples: The tax system: In a recession, taxes fall automatically, which stimulates AD Government spending: In a recession, more people apply for public assistance (welfare, unemployment insurance) Government spending on these programs automatically rises, which stimulates AD Tariffs: Policies used to restrict imports into a country by increasing the price of goods and making imported goods less attractive Tariffs are generally used to protect domestic industries, especially young industries, from foreign competition However, tariffs reduce competition in markets. This increases prices and hurts domestic consumers (meaning it creates unnecessary inflation) This can also lead to political acrimony, as some industries may be more protected than others Economists don’t agree on a host of issues, but it is universal that economists know tariffs are bad policy for the reasons mentioned above Smoot-Hawley Tariff, 1930: Raised tariffs on over 20,000 goods Incensed other countries, which formed trade blocks to isolate themselves from the U.S. Congress delegated broad tariff powers to the president after this policy Contributed to the worsening of the great depression Trade wars: Another negative side effect of applying tariffs is retaliation from other countries. Other countries retaliate by increasing tariffs on export goods Tariffs decrease demand for imports, lowering them. But because of retaliatory tariffs, they also lower a country’s exports. It is possible that these effects offset each other to some degree in their effect on GDP Tariffs reduce NX overall and cause AD to shift left