Week 11: Aggregate Demand and Supply PDF

Week 11 1. The AD-AS Framework Aggregate Demand 2. Aggregate Demand and 3. Aggregate Supply Aggregate Supply 4. Macroeconomic Shocks and Prof. Rabee Tourky Countercyclical Policy...

Week 11 1. The AD-AS Framework Aggregate Demand 2. Aggregate Demand and 3. Aggregate Supply Aggregate Supply 4. Macroeconomic Shocks and Prof. Rabee Tourky Countercyclical Policy 5. Aggregate Supply in the Short Run and the Long Run Macmillan Learning, ©2023 Week 11 Understand how aggregate demand 1. The AD-AS Framework and aggregate supply determine 2. Aggregate Demand macroeconomic equilibrium. Aggregate demand and 3. Aggregate Supply aggregate supply 4. Macroeconomic Shocks and Macroeconomic versus Countercyclical Policy microeconomic forces 5. Aggregate Supply in the Short Run and the Long Run Macmillan Learning, ©2023  Forecast where the economy is headed Macmillan Learning, ©2023  Introducing the AD-AS framework In microeconomics… Explore how the forces of demand and supply determine outcomes in individual markets. Petrol market example: Demand and supply determine the quantity and price of petrol sold. Now, supersise the concepts of demand and supply to get the AD-AS framework! Learn about aggregate demand and aggregate supply. Explore aggregate outcomes: total output and average prices across the economy as a whole 4 Macmillan Learning, ©2023  Forecasting output and the average price level The AD-AS framework focuses on two macroeconomic outcomes: 1. The quantity of output produced across the whole economy. Measured by real GDP 2. The price of that output. Measured by the GDP deflator The price of a basket containing the many goods and services we produce. 5 Macmillan Learning, ©2023  Key Definition Diving into the Definition Aggregate demand curve: shows the A lower average price level leads buyers to relationship between the price level and the demand a larger quantity of output. total quantity of output that buyers plan to Aggregate demand is downward-sloping! purchase. Price level NOTE: We are talking about the purchasing plans of ALL buyers throughout the ENTIRE economy. Consumers, businesses, the Aggregate government, overseas customers, etc. demand Quantity of output 6 Macmillan Learning, ©2023  Key Definition Diving into the Definition A higher average price level leads suppliers to Aggregate supply curve: shows the produce a larger quantity of output. relationship between the price level and Aggregate supply is upward-sloping! the total quantity of output that suppliers collectively produce. Price level Aggregate supply NOTE: We are talking about the production plans of ALL suppliers throughout the ENTIRE economy. Quantity of output 7 Macmillan Learning, ©2023  Visualising macroeconomic equilibrium Price Equilibrium occurs where the two level Aggregate curves intersect. Supply The only point where the quantity of output demanded is equal to the quantity supplied. Price level Macroeconomic equilibrium Equilibrium determines: Equilibrium GDP, $2 trillion Aggregate Average price level Demand $2 trillion Quantity of output Equilibrium GDP 8 Macmillan Learning, ©2023  Macroeconomic versus Microeconomic Forces Familiar… …but different! In the microeconomic framework: The micro- and macroeconomic curves summarise different trade-offs: Equilibrium occurs where the curves cross! Micro: trade-offs across products Same for macro’s AD-AS framework! Example: The opportunity of cost of buying petrol today is that you could have spent your Forecast the impact of changing money on something else. market conditions by shifting the curves and finding the new Macro: trade-offs across time equilibrium. The opportunity cost of buying output today is that you could’ve otherwise saved your money Same for macro’s AD-AS framework! in order to buy more output in the future. 9 Macmillan Learning, ©2023  Key take-aways: The AD-AS framework 10 Macmillan Learning, ©2023 Week 11 Evaluate the forces that shape the 1. The AD-AS Framework total quantity of goods and services that purchasers want to buy. 2. Aggregate Demand Why aggregate expenditure is 3. Aggregate Supply downward sloping 4. Macroeconomic Shocks and Analysing aggregate demand Countercyclical Policy Aggregate demand shifters 5. Aggregate Supply in the Short Run and the Long Run Macmillan Learning, ©2023  The forces that shape the total demand for output The aggregate demand curve illustrates the level of aggregate expenditure associated with different values of the price level. Aggregate expenditure: the total amount of goods and services that people want to buy across the whole economy. AE = C + I + G + NX Aggregate Consumption Planned Government Net exports expenditure Investment purchases Next: Why is aggregate demand downward-sloping? 12 Macmillan Learning, ©2023  Inflation is the rate of change of the price level, so given last year’s prices, Higher real interest rates raise the opportunity cost the higher the price level this year, of spending, reducing aggregate expenditure. the higher the inflation rate. The RBA responds to higher inflation by raising the real interest rate. Aggregate demand curve: summarises the link from the average price level to the quantity of output that buyers demand. Downward-sloping AD: A higher price level leads to less aggregate demand. 13 Macmillan Learning, ©2023  The aggregate demand curve is downward-sloping The aggregate demand curve shows that a higher price level ultimately leads buyers to demand a lower quantity of output. Sometimes called the monetary-policy channel Other economic forces also contribute to the downward-sloping nature: International trade effect (small effect) Wealth effect (small effect) partially offset by debt effect 14 Macmillan Learning, ©2023  Analysing aggregate demand: Important distinction! Changes in the price level cause a movement along the aggregate demand curve. Other changes in spending cause the aggregate demand curve to shift. Any other factor (other than a change in price level) that causes consumers, investors, the government, or foreigners to change their spending plans. 15 Macmillan Learning, ©2023  Movements along the aggregate demand curve Price level Higher price levels: lead the RBA to raise the real interest rate, reducing the quantity of output demanded. Lower price levels: Aggregate lead the RBA to cut the real interest rate, demand raising the quantity of output demanded. Quantity of output 16 Macmillan Learning, ©2023  Price level Higher spending increases Increased Old aggregate aggregate demand, shifting the aggregate demand Aggregate supply curve to the right. demand A An increase in aggregate expenditure A at any price level causes the aggregate demand curve to shift to the right. B New D equilibrium B Leads economy to move to a new Prices rises equilibrium: C Rise in output (economic expansion) D Rise in prices (inflation) Quantity of output C GDP rises 17 Macmillan Learning, ©2023  Price level Lower spending decreases Old aggregate aggregate demand, shifting the Decreased demand curve to the left. aggregate Aggregate demand supply A A decrease in aggregate expenditure A at any price level causes the aggregate demand curve to shift to the left. D B Leads economy to move to a new equilibrium: Prices fall New B Fall in output (recession) equilibrium C D Fall in prices (deflation, or lower inflation) Quantity C GDP falls of output 18 Macmillan Learning, ©2023  Aggregate demand shifters Examples Consumption rises if people feel ↑ Wealth, ↑ Consumer confidence, ↑Government assistance, more prosperous. ↓ Taxes, ↓ Inequality ↑ GDP growth, ↑ Business confidence, ↑ Investment tax Investment rises if it’s profitable to credits, ↓ Corporate taxes, ↑ Easier lending standards and expand production. more cash reserves, ↓ Uncertainty Government purchases rise in Spending bills, Automatic stabilisers response to expansionary fiscal... but not transfer payments (at least not directly) policy. Net exports rise in response to ↑ Global GDP growth, ↓ Australian dollar, ↓ Trade barriers in global factors. foreign markets, ↑ Trade barriers to Australian market 19 Macmillan Learning, ©2023  Interest rate changes don’t always shift the aggregate demand curve Changes in the real interest rate can lead to changes in aggregate expenditure… BUT …only some interest rate changes shift the aggregate demand curve. RECALL: The aggregate demand curve already reflects the changes in aggregate expenditure due to the RBA adjusting interest rates in response to inflation. Some interest rate changes lead to a movement, others lead to a shift. Dig into this more when we analyse monetary policy. 20 Macmillan Learning, ©2023  Key take-aways: Aggregate demand The aggregate demand curve illustrates the level of aggregate expenditure associated with different values of the price level. Aggregate expenditure = C + I + G + NX Shifting aggregate demand: Increased spending shifts AD right Decreased spending shifts AD left. 21 Macmillan Learning, ©2023 Week 11 Evaluate the total quantity of goods 1. The AD-AS Framework and services that businesses want to supply. 2. Aggregate Demand Why aggregate supply is 3. Aggregate Supply downward-sloping 4. Macroeconomic Shocks and Analysing aggregate supply Countercyclical Policy Aggregate supply shifters 5. Aggregate Supply in the Short Run and the Long Run Macmillan Learning, ©2023  Why aggregate supply is upward-sloping A business’ pricing decision depends on the state of the economy: Times of excess demand: Higher output leads to higher prices. Times of insufficient demand: Lower output leads to lower prices. Take-away: The aggregate supply curve is upward-sloping because higher output leads to a higher price level. 23 Macmillan Learning, ©2023  Analysing aggregate supply: Important distinction Changes in the price level cause a movement along the aggregate supply curve. Changes in production costs cause the aggregate supply curve to shift. Changes in production costs can be caused by shifts in… 1. Input prices 2. Productivity Examine these shifters one-by-one, 3. The exchange rate but first visualise basic shifts in aggregate supply. 24 Macmillan Learning, ©2023  Price level An increase in Aggregate supply Increased aggregate supply aggregate supply A A fall in production costs causes the aggregate supply curve to A shift down to the right. D B Leads economy to move to a new Prices fall equilibrium: New B equilibrium C Rise in output (economic expansion) Aggregate D Fall in prices (deflation, or demand lower inflation) Quantity of output C GDP rises 25 Macmillan Learning, ©2023  A decrease in Price level Increased aggregate supply New aggregate equilibrium supply Aggregate A A rise in production costs causes supply the aggregate supply curve to B shift up to the left. A B Leads economy to move to a new D equilibrium: Prices rise C Fall in output (recession) D Rise in prices (inflation) Aggregate Stagflation: the combination of demand declining GDP (economic stagnation) Quantity and rising prices (inflation) of output C GDP falls 26 Macmillan Learning, ©2023  Aggregate supply shifter 1: input prices Higher input prices raise production costs productivity exchange rate If the prices of your inputs rise… Your marginal costs rise You’ll raise your prices Aggregate supply shifts up to the left Same forces operate in reverse if your input prices fall. Key input prices: labour and oil prices 27 Macmillan Learning, ©2023  Aggregate supply shifter 2: Weaker productivity raises production costs input prices productivity Lower productivity means having to buy exchange rate more inputs to produce the same output. Higher production costs Aggregate supply shifts up to the left Example: Productivity growth slowed dramatically from the mid-1970’s and into the 1980s. Same forces operate in reverse if productivity is higher, as this allows you to do more with less. 28 Macmillan Learning, ©2023  Aggregate supply shifter 3: A depreciating Australian dollar raises production costs and reduces competition from abroad input prices productivity Recall: The exchange rate is the price of an Australian dollar in another currency. exchange rate Depreciation of the Australian dollar leads suppliers to set higher prices, shifting aggregate supply up to the left. Appreciation of the Australian dollar leads suppliers to set higher prices, shifting aggregate supply down to the right. Impacts of depreciating Australian dollar: Foreign goods are more expensive for people in Australia. More expensive foreign goods lead to higher prices on domestic goods. 29 Macmillan Learning, ©2023  How a trade war shifted the aggregate supply curve U.S. President Trump imposed tariffs on imported goods More than half of all imports to the U.S. are used by American businesses in production of goods and services. The tariffs raised the cost of purchasing foreign inputs. This shifted the aggregate supply curve up or left. Big picture: A policy intended to increase the aggregate demand curve ultimately instead decreased aggregate supply. 30 ROBYNMacmillan Learning,Images BECK/AFP/Getty ©2023  Key take-aways: Aggregate supply The aggregate supply curve describes the production and pricing decisions that suppliers make, and how they respond as macroeconomic conditions change. Shifting aggregate supply: Higher production A rise in production costs shift AS costs up to the left. A fall in production costs shift AS down to the right. Lower production Shifters: input prices, import prices, costs productivity, exchange rates 31 Macmillan Learning, ©2023 Week 11 Forecast how the economy will respond 1. The AD-AS Framework to changing conditions. 2. Aggregate Demand Monetary policy Fiscal policy and the multiplier 3. Aggregate Supply Forecasting macroeconomic outcomes 4. Macroeconomic Shocks and Countercyclical Policy Diagnosing the causes of macroeconomic shifts 5. Aggregate Supply in the Short Run and the Long Run Macmillan Learning, ©2023  Key Definition Diving into the Definition Monetary policy: the process of setting Inflation-induced interest rates in an effort to influence changes in the interest economic conditions. rate do NOT shift the aggregate demand The RBA cuts interest rates in response to curve. BOTH low inflation and weak output. Inflation-induced response: The RBA cuts the interest rate if they’re worried Output-induced inflation is too low. changes in the interest rate do shift the Output-induced response: The RBA aggregate demand cuts the interest rate to combat curve. declines in GDP. 33 Macmillan Learning, ©2023  Key Definition Diving into the Definition Fiscal policy: the government’s use of Fiscal policy and the multiplier: spending and tax policies to influence An initial increase in spending has a economic conditions. multiplied effect on aggregate expenditure. Expansionary fiscal policy examples: direct purchases of buildings, roads, ∆GDP = ∆Spending × Multiplier and bridges; tax cuts Increased spending shifts Multiplier summarises the direct impact, subsequent ripple effects, and aggregate demand to the right. crowding out. Let’s explore this more! 34 Macmillan Learning, ©2023  Key Definition Diving into the Definition Multiplier: a measure of how much GDP Example: Government spending on bridge changes as a result of both the direct and repair. indirect effects flowing from each extra Direct effect on construction workers and dollar of spending. companies providing materials. Ripple effects: These workers spend ∆GDP = ∆Spending × Multiplier some of their earnings at Bunnings and Bunnings hires more workers. These Example: newly employed workers then spend Multiplier = 2 some of their extra income at Subway, and so on. Initial government spending: $52 b Generates a total of 2 × $52 b = $104 b in Crowding out of some private spending dampens the overall effect on output. additional spending (and hence output). 35 Macmillan Learning, ©2023  Price level Expansionary monetary AD with expansionary and fiscal policy AD during a policy Aggregate supply recession A An output-induced interest rate cut, or a boost to government purchases, A will shift the aggregate demand curve to the right. B New D equilibrium B Leads economy to move to a new Prices rises equilibrium: C Rise in output D Rise in prices Quantity of output C GDP rises 36 Macmillan Learning, ©2023  Forecasting Macroeconomic Outcomes 1. Is this a shift in aggregate demand, or aggregate supply? AD shifts in response to changes in aggregate expenditure (C + I + G + NX) AS shifts in response to change in production costs. 2. Is that shift an increase, shifting the curve to the right? Or is it a decrease, shifting the curve to the left? 3. How will the price level and quantity of output change in the new equilibrium? 37 Macmillan Learning, ©2023  Forecasting Macroeconomic Outcomes: Examples In 2008: The government sent stimulus cheques 1. The stimulus cheques caused increased consumption, which shifts the AD curve. 2. Aggregate demand shifts right. 3. Output and price level rise. In September 2008: The world’s financial system froze 1. Higher real interest rate led to decreased consumption, which shifts the AD curve. 2. Aggregate demand shifts left. 3. Output and prices fall. 38 Macmillan Learning, ©2023  Forecasting Macroeconomic Outcomes: Examples Gulf War: Caused oil prices to rise 1. This increased businesses’ production costs, shifting AS. 2. Aggregate supply shifts left. 3. Output falls, and the price level rises. Rapid Advances in Technology: Projected to boost productivity growth 1. This decreases businesses’ production costs, shifting AS. 2. Aggregate supply shifts right. 3. Output rises, and the price level falls. 39 Macmillan Learning, ©2023  Concept check: Forecasting macroeconomic outcomes Scenario: Older workers became reluctant to return to the workplace while COVID rates were high. This reduced labour supply led to labour shortages which caused wages to rise. Circle the appropriate option given the scenario described above. 1) Which curve shifts? Aggregate Demand, Aggregate supply 2) Which direction does the curve shift? Left, Right 3) Result: Output [rises, falls] and the price level [rises, falls] 40 Macmillan Learning, ©2023  A brief recap: The AD-AS model can be used to… 1. Aggregate demand shocks lead predict consequences of output and prices to move in the macroeconomic shocks same direction. diagnose the cause of macroeconomic fluctuations 2. Aggregate supply shocks lead output and prices to move in Let’s focus on the AD-AS framework opposite directions. as a diagnostic tool 41 Macmillan Learning, ©2023  Diagnosing the macroeconomic shock Scenario: As the pandemic hit, basically everything closed down, and so analysts were unsure whether to think about this as a shock to aggregate demand or aggregate supply. In those first few months, output fell, as did the average price level. Diagnosis: Falling prices and falling output occur when aggregate demand decreases, due to a decline in spending. 42 Macmillan Learning, ©2023  Concept check: Diagnosing macro shocks Scenario: Analysts were puzzled to observe inflation rising even as the economy slide into a recession. Diagnosis: Rising prices and falling output occur when aggregate supply decreases, such as when production costs rise. 43 Macmillan Learning, ©2023  Key take-aways: Macroeconomic shocks and countercyclical policy 44 Macmillan Learning, ©2023 Week 11 Distinguish between the immediate 1. The AD-AS Framework effects, short-run effects, medium-run effects, and long-run consequences of 2. Aggregate Demand economic shocks. AS in long run with flexible prices 3. Aggregate Supply AS in very short run with fixed 4. Macroeconomic Shocks and prices Countercyclical Policy AS in short and medium run with sticky prices 5. Aggregate Supply in the Short Run and From very short run to long run the Long Run Macmillan Learning, ©2023  Understanding aggregate supply over different time horizons Changes in aggregate demand → fairly immediate effect. Changes in aggregate supply → can take a while to play out. Why? Businesses take a while to change the prices they charge and the wages they pay. Often adjust quantity of output if they haven’t yet adjusted their prices. RESULT: Initial impact of a shock may be different from the longer-term effects. Our task: adapt our analysis of aggregate supply so that we can forecast over different time horizons. (1) Long run, (2) very short run, (3) short run, and (4) medium run 46 Macmillan Learning, ©2023  Aggregate supply in the long run with flexible prices Long run: a period of time long enough Classical dichotomy thought experiment: that all businesses have had a chance to… All prices are ten times higher Adjust the prices they charge (including your wage). Tweak the wages they pay Nothing really changed. Adapt to any price changes from their No one changes the quantities of suppliers, rivals, and other businesses. stuff they buy, sell, produce, or do. Result: In the long run, a change in the In the long run, a change in the average price level has no effect on real price level has no effect on the variables. quantity of goods produced. 47 Macmillan Learning, ©2023  Vertical long-run Price level aggregate supply curve A Long-run aggregate supply A In the long run, the quantity of output supplied is unaffected by the average price level, yielding a vertical long-run B aggregate supply curve. Strong AD B C In both the equilibrium with strong and weak aggregate demand, output is C the same. D Changes in aggregate demand have no Weak AD effect on output. No change in output D Aggregate demand is irrelevant to long-run output. Potential Quantity output of output 48 Macmillan Learning, ©2023  Horizontal very-short-run Price level aggregate supply curve In the very short run, prices are yet to Very-short-run A change and so the very-short-run aggregate supply aggregate supply curve is horizontal. B C A B If aggregate demand is weak, then output will be low. Strong AD C If aggregate demand is strong, then output will be high. Weak AD D Shifts in aggregate demand have a big effect on output. Low D High Quantity of output Big effect on output 49 Macmillan Learning, ©2023  The response of suppliers depends on the time horizon you’re analysing! Very short run Long run Shifts in aggregate demand lead to… Shifts in aggregate demand lead to… Large changes in output. No change in output. Why? Why? Prices don’t adjust at all in the Prices fully adjust in the long very short run. run. Burden of adjustment falls None of the burden of entirely to quantities. adjustment falls to quantities. 50 Macmillan Learning, ©2023  Aggregate supply over different time horizons So far, we’ve seen the extremes: Long run: prices fully adjust; vertical aggregate supply curve Very short run: no price adjustment; horizontal aggregate supply Now, let’s examine what happens in between the extremes: Short run: sticky prices; upward-sloping aggregate supply curve Medium run: less sticky prices; even steeper aggregate supply curve Let’s look at “sticky prices” and how this impacts the aggregate supply curve. 51 Macmillan Learning, ©2023  Short-run aggregate supply curve Changing prices is costly! Price level Short-run Sticky prices: prices that adjust sporadically aggregate supply and sluggishly to changes in market conditions. D Insufficient A In the very short run, the price level is demand: stuck at its preexisting level. Some sellers Very short- cut prices run AS But as time passes… C A B If insufficient demand… B Excess some sellers will cut prices. demand: C If excess demand… Some sellers some sellers will raise prices. raise prices D Result: upward-sloping short-run aggregate supply curve. Potential Quantity output of output 52 Macmillan Learning, ©2023  Medium-run Medium-run aggregate supply curve aggregate supply In the medium run, prices are less sticky. Price level D A In the short run, some suppliers have adjusted their prices in response to the state of demand. Insufficient A demand: C But as time passes… Short-run more sellers AS cut prices Excess B If insufficient demand… even more sellers will cut prices. demand: B more sellers C If excess demand… raise prices even more sellers will raise prices. D Result: even steeper upward-sloping medium-run aggregate supply curve. Potential Quantity of output output 53 Macmillan Learning, ©2023  Getting from the very short run to the long run 54 Macmillan Learning, ©2023  Key take-aways: Aggregate supply in the short run and long run Very short run: prices are fixed; quantities bear the full burden of adjustment. Short and medium run: prices are less sticky; quantity adjustment dissipates. Long run: prices fully adjust; the economy returns to potential output. 55 Macmillan Learning, ©2023 Week 11 1. Models the impact of changing market 1. The AD-AS Framework conditions on the economy’s output and price levels. 2. Aggregate Demand 2. Relationship between price level and the total quantity of output that all 3. Aggregate Supply buyers plan to buy. 4. Macroeconomic Shocks and 3. Relationship between price level and Countercyclical Policy the total quantity of output that suppliers collectively produce. 5. Aggregate Supply in the Short Run and 4. Monetary and fiscal policy. the Long Run 5. From “fixed” to “fully adjusted” prices. Macmillan Learning, ©2023