Transcript 2.2

2.2
AGGREGATE Demand and
AGGREGATE Supply
Macroeconomic Goals
• Lots of debate
• Not a lot of knowledge among all decision
makers. (homework)
• General agreement on 5 goals
5 main goals
• Full employment
– Controversial as to what this exactly is
• Price stability
– Control inflation
• Economic Development
– - increase HDI
• Economic Growth
– Increase in rGDP
• External Equilibrium
5 main goals
• Full employment
– Controversial as to what this exactly is
• Price stability
– Control inflation
• Economic Development
– - increase HDI
• Economic Growth
– Increase in RGDP
• External Equilibrium
Conflicts among goals
•
•
•
•
Full employment vs price stability
Growth vs development
External vs internal
There is lots of debate about which lever to pull
first
• Let’s start with Economic Growth
– Inflation, employment will be later in Sec 2
– External equilibrium is Sec 3
– Economic Development is Sec 4
Economic Growth
• 2 sides to the economy
2 sector circular flow
Economic Growth
• 2 sides to the economy
– Consumption and Production
• Consumption is also known as “demand”
• Aggregate
Aggregate Demand
WAS Largest Mall in Europe
Remember?
•
•
•
•
•
Formula for GDP
C + G + I + (X-M)
Same formula for Aggregate Demand
r=
Adjusted for inflation
Consumption (C)
• Services
• Goods
– Durable vs non -durable
• N.B. Durable goods affected by credit
availability
Investment (I)
• Replacement investment - maintain
• Induced investment - expand
Trade (x-m)
• Looking at net figure
• AKA Balance of Trade
Simple rule
•
•
•
•
When price goes up
Demand falls
So….
When general price
level is higher….
• rGDP is lower
• (AKA National
Income)
Aggregate Demand
General
Price Level
A
PL
AD
Real National
Income
Y
Aggregate Demand
• What about general price level?
– Consumer price index (CPI)
– Mostly theoretical
– And sometimes hypothetical
CHANGE in AD
• IF PL (general price level) changes then
AD changes inversely
• It is downward sloping curve
Aggregate Demand
General
Price Level
A
B
AD
Real National
Income
2 causes of change in AD
• Macroeconomic Income Effect
– Prices go up or down (be careful)
• Macroeconomic Substitution Effect
– A cheaper alternative is found
– Since it is macro:
• Substitution has to come from outside the economy
– Leakages
– Imports, savings etc
• Very simple AND only along the curve
• Vocabulary - RISE and FALL ….inverse
• NOT what we will spend most of our time on.
SHIFT in AD
• Looking at the total economy:
• Income and/or wealth changes
C
• Income = wages, salaries, tips, etc
• Also includes availability of credit (ie loans)
– So if interest rates go up
– Consumer income goes down
– And also savings could increase (leakage)
• Wealth = assets
– Physical and monetary
– Change in house/stock prices affects this
• Business investments changing
• Also affected by interest rates (credit availability)
I
4 sector flow chart
Shift in AD
• Government policies changing G
• Politically driven
• Happen in two areas
• Fiscal policy
– Direct spending by government
» Military, social welfare, increase/reduce taxes
• Monetary policy
– Control of money supply
» Central Banks (ie Federal Reserve, ECB, Bank al Maghreb )
empowered to make money (loans) easy to get (loose)
» Or hard to get (tight)
Fiscal Policy
• Expansionary
• Contractionary
Monetary Policy
• We will deal with this much more in “inflation”
but for now…..
• Banks are regulated by a Central Bank (Federal
Reserve, ECB, Bank al Maghreb)
• Central Bank loans money - Base Rate or
Discount Rate
• Banks then loan to consumers/business/each other.
• Big businesses get Prime Rate
• Central Bank can also affect “required reserve”
US Central Bank
Comparison
Monetary Policy
• Expansionary (Loose)
• Contractionary (Tight)
Impacts (more in Sec 2.4)
Balance of Trade
•
•
•
•
If you export more…
increase rGDP due to increase in I
More jobs= more spending (affects C)
Also, you are selling more overseas so
affects____
• If you import more….. Tertiary vs
Primary/Secondary ??????
• Why demand for imports? (increased C)
Aggregate Demand
General
Price Level
A
B
AD2
AD
AD3
Real National
Income
Demand Side Shock
• Temporary event
• AD increases (shifts right) or decreases
(shifts left)
• Due to political, natural events
• After shock, AD returns to normal
10 Causes of SHIFT in AD
1. ∆ in wealth/income
2. ∆ in consumer
confidence
(expectations)
3. ∆ in interest rates
4. ∆ in technology
5. ∆ in business
confidence
6. ∆ in fiscal policy
7. ∆ in monetary policy
8. ∆ in exports/imports
9. ∆ in exchange rates
10. Demand side shock
• Vocabulary: increase
and decrease.
III. Aggregate Supply
• Same idea as AD - total amount of
goods/services available
• But reverse holds true:
• When PL is up, AS (aka Y) is up
• Parallel relationship
• Upward sloping curve
Aggregate Supply
General
Price Level
AS
A
P1
Y1
Real National
Income
III. Aggregate Supply
• Same idea as AD - total amount of
goods/services available
– But reverse holds true:
• When PL is up, AS is up
• Parrallel relationship
• Upward sloping curve
• Simple rule - when demand meets supply
the economy is in harmony (equilibrium)
Aggregate Demand and Supply
General
Price Level
AS
A
P1
AD
Y1
Real National
Income
In other words, there are no shortages or excess (surplus) at
point A. Equilibrium
Why is this important?
• Key to understanding:
– Unemployment
– Inflation
– And government policy towards economy
•
•
•
•
Goal:
Moving the equilibrium point…AKA
rGDP = that spot of intersection
AKA:
rGDP/Y/National Income/AD&AS Equilibrium
General
Price Level
AS
A
P1
AD
Y1
Real National
Income
III. Aggregate Supply
• Same as demand - total amount of
goods/services available.
• Simple rule - when demand meets supply
the economy is in harmony (equilibrium)
• UNFORTUNATELY there are two types of
aggregate supply (AS)
– Short Run (SRAS)
– Long Run (LRAS)
Short Run AS
• Producers can change labor input to
increase/decrease production
• BUT don’t have to build new factories etc
• Ex: Holiday shopping season, tourism season.
increase/decrease
• They are not necessarily responding to current
prices.
• Labour costs ∆
Aggregate Supply: short run
• In the short run price is
fixed so the aggregate
supply curve is horizontal.
P
.
SRAS
P*
Y
Y
Y
But what if price isn’t fixed?
General
Price Level
AS
A
P1
Y1
Real National
Income
An example (soon to be
complicated)
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•
•
•
•
•
A gas station
Long weekend approaches
Lots of people are going to take driving vacations
Owner hires a few more attendants. (supply rises)
When weekend ends, he fires extra help
NOW - imagine this on an economy wide scale
Long Run AS
• Remember the PPF?
• Since producers make long term decisions
(hopefully) then they already have the
capacity to handle short term fluctuations
• But…..what if they change their outlook on
the future?
2 views of LRAS
LRAS
General
Price Level
SRAS
National Income
Shifts in Short Run Aggregate Supply
LRAS
General
Price Level
P2
P1
SRAS3
SRAS1
AD
SRAS2
Y2
Y1 Y3
Yfc
Remember Ceteris Paribus
National Income
What makes supply?
• Land
– materials
• Labor
– Skills
• Capital
– Technology
– Machines
• Entrepreneurship/risk
• FACTORS OF PRODUCTION
So we have a conflict
• Based on the issue of “full employment”
and “capacity”
• When is economy able to fully provide
enough supply to meet demand?
• Is it now? Or do we need to manipulate it?
Scenerio: 2 sides
• Team 1
• Brainstorm all the
possible things we
currently make with
Gold or Gold parts.
• Team 2
• Brainstorm all the
possible things that
you could make with
Gold THAT DO NOT
ALREADY EXIST.
Keynesian view
LRAS
General
Price Level
SRAS
National Income
Monetarist(neo classical) View
General
Price Level
LRAS
SRAS
National Income
“Capacity”
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•
•
•
•
Size of workforce
Output per worker
Available technology
Available raw materials
Capital stock
So…
• Is economy using all materials/labor/capital
available?
• Are we on the PPF curve or at “I” ?
• And what is the determination of full
employment?
• Ceteris Paribus
» QUIZ NEXT CLASS
» Homework AS worksheet, pg 1 & 2
Two main schools of thought
• Keynesian
• Monetarist (neo -classical)
Keynesian
• John Maynard Keynes
(1883-1946)
• British
• Lots of assumptions to
challenge.
• For now: full employment
is never reached w/o
government intervention.
• LRAS has three phases
AND is dependent on PL
Keynesian view
LRAS
General
Price Level
1
National Income
Phase 1 - spare capacity exists, producers can increase w/o
incurring more costs, or increasing prices
Keynesian view
LRAS
General
Price Level
2
National Income
Phase 2 - scarcity bids up general price level as producers
pass on costs to consumers. Higher prices increase production
Keynesian view
LRAS
General
Price Level
3
Full Employment
Level of output
National Income
Phase 3- it is impossible to increase production b/c economy
is at full capacity. NOW something must be done to change
capacity. Prices go up, output stays the same.
Keynesian view
General
Price Level
LRAS 1
LRAS 2
National Income
Shift the curve - how do we get supply to increase at same
prices?
The Monetarists (neo-classicals)
• Friedrich Hayek (Austrian School)
• Milton Friedman (Chicago School)
Monetarist (neo-classical) view
• There is no build up to capacity
• Economy already exists at capacity
• Potential output is dependent on QUALITY
and QUANTITY of factors of production
• Suppliers need incentives to shift supply
curve.
• If you give consumers more money, it will
only raise prices.
Monetarist(neo classical) View
LRAS 1
LRAS 2
General
Price Level
SRAS 1
SRAS 2
National Income
In simple English
• Keynesian view is that suppliers will
respond if more money is injected at
consumer level and/or prices rise.
• Monetarist view is that suppliers will only
respond to incentives (market or forced)
Stickiness
• Wage
– Contracts
– resistance
• Price
– Information speed
– Other factors
Fantasy land
• For Monetarist to work:
• No unions
• No minimum wage laws
• No price guarantees
• For Keynesian to work
• Huge government debts
• Huge tax increases on wealthy
• Huge risk of inflation
Aggregate Demand and Supply
LRAS
General
Price Level
Pe
SRAS
AD
Ye
Yfc
National Income
Inflationary and Deflationary
gaps
• Anytime the AD curve is on the AS curve
BELOW full employment level of output
• We have a Deflationary Gap (aka output
gap)
Deflationary Gap
LRAS
General
Price Level
Pe
SRAS
AD
Ye
Think “I” on PPF
Yfc
National Income
Inflationary and Deflationary
gaps
• Anytime the AD curve is on the AS curve
BELOW full employment level of output
• We have a Deflationary Gap (aka output
gap)
• Conversely, Inflationary Gap is when
Inflationary Gap
LRAS
General
Price Level
AD
SRAS
Yfc
More on this Later……….
National Income
Causes of Change in AS
• There is only 1 thing that will cause a
change (or movement along) the AS curve
Movement along curve
LRAS
General
Price Level
B
A
SRAS
National Income
Keynesian view
LRAS
General
Price Level
B
A
National Income
Monetarist(neo classical) View
LRAS
General
Price Level
SRAS
B
A
B
A
National Income
Note: A-B never happens unless AD
shifts
Change in AS
• If it moves UP the curve then…
• If it moves DOWN the curve
• Remember Vocab here is Rise/Fall
SHIFTS
• 3 Causes of SRAS
Shift
– TEMPORARY
• ∆ in wage rates
• ∆ costs of raw
materials
• ∆ price of imports
(can include F/X rate)
• 4 Causes of LRAS
Shift
• ∆ in quality of FofP
• ∆ in quantity of FofP
• Market Oriented
Supply Side Policies
• Interventionist Supply
Side Policies
Shift in SRAS
General
Price Level
SRAS1
SRAS2
A
P1
B
P2
AD
Y1
Y2
Real National
Income
An Increase (shift) in Long Run Aggregate Supply
LRAS1
LRAS2
YFC1
YFC2
General
Price Level
SRAS1
SRAS2
Real National Income
Aggregate Demand and Supply
General
Price Level
LRAS
P2
P1
SRAS2
SRAS1
AD
Y2
Y1
Yfc
National Income
Shifts in Short Run Aggregate Supply
LRAS
General
Price Level
P2
P1
SRAS3
SRAS1
AD
SRAS2
Y3
Y1 Y2
Yfc
Remember Ceteris Paribus
National Income
Out of the Abstract
• 2 lines
• AS & AD
• Red construction paper is the Equilibrium
Price
• For our purposes, two people will hold it.
Back to Basics
• What does rGDP measure?
• How is the general price level obtained?
• What effect do prices have on demand (includes,
consumers, gov’t and business investment)?
• What effect do prices have on suppliers?
• What are factor costs?…..
• What is the difference between short run and long
run for suppliers?
Cabbage Patch Kids
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Beanie Babies
XBox
Sing-a-ma-jigs
Past 100 years
Top Ten Crazes
IV. Demand Side vs Supply Side
• Viewpoint differs on concept of capacity.
• No argument that capacity is eventually
reached.
• Argument on when. (ferris clip)
Back to the gas station model
• During holiday rush weekend, owner hires a
few more pump attendants.
• Then fires them when demand goes back
down.
• Apply this concept to the whole economy.
• What would make gas station owner open
up more gas stations?
• Keynesians say: if more people are going to
be consistently buying gas then owner will
make long range plans.
• Monetarists say it will only work if the cost
or quality of the new gas stations is made
cheaper/better.
• Short run - easy to increase supply. Long
run - much more expensive and risky
An Increase in Aggregate Demand
LRAS
General
Price Level
P2
P1
AD2
SRAS
AD1
Y1
Y2
Yfc
National Income
A Fall in Aggregate Demand
LRAS
General
Price Level
P1
P2
AD1
SRAS
AD2
Y2
Y1
Yfc
National Income
Shifts in Aggregate Demand
General
Price Level
LRAS
P2
P1
P3
AD2
SRAS
AD1
AD3
Y3
Y1
Y2
Yfc
National Income
• Monetarist says in the long run you need to
shift the whole curve to avoid price
increases.
An Increase in Long Run Aggregate Supply
LRAS2
LRAS1
General
Price Level
Pe
SRAS
AD2
AD1
Y1
Y1
Follow the numbers…
YFC2
National Income
So let’s put this in the real world
• Economy is experiencing a recession:
• Keynesian vs Monetarists
• KEYNESIAN
• Get demand curve to
shift…… ten causes
• Then apply supply
side when full capacity
is reached
• MONETARISTS
• Shift Supply curve (4
causes)
• Market will create new
jobs which will….
• Shift demand curve
• If inflation is high, shift
AD left to reduce prices
10 Causes of SHIFT in AD
1. ∆ in wealth/income
2. ∆ in consumer
confidence
(expectations)
3. ∆ in interest rates
4. ∆ in technology
5. ∆ in business
confidence
6. ∆ in fiscal policy
7. ∆ in monetary policy
8. ∆ in exports/imports
9. ∆ in exchange rates
10. Demand side shock
• Vocabulary: increase
and decrease.
SHIFTS in AS
• 3 Causes of SRAS
Shift
• ∆ in wage rates
• ∆ costs of raw
materials
• ∆ price of imports
(can include F/X rate)
• 4 Causes of LRAS
Shift
• ∆ in quality of FofP
• ∆ in quantity of FofP
• Market Oriented
Supply Side
Policies***
• Interventionist Supply
Side Policies***
Market Oriented Supply Side
•
•
•
•
•
•
Deregulation
Privatization
Decrease power of unions
Corporate Income tax cuts
Benefit reform
Lower minimum wage
Interventionist Supply Side
•
•
•
•
Research and development
Education and training
Welfare to work programs
Assistance with foreign trade
Now….Let’s Play
• http://www.whitenova.com/thinkEconomics/adas.
html
• Go to LMC, grab website from my moodle
• NO SHARING. EVERYONE ON THEIR OWN.
• For each one, write down what happens to price
level
• Homework…
• Next class..Quiz and simulation
Simulation
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•
•
•
2 groups.
Keynesians and Monetarists
React to scenerios given.
Class debate on pros/cons….must
demonstrate answer with model on board.
problems
Evaluation
•
•
•
•
Assumptions
Short term/Long term
Best pro/best con
Stakeholders
Building Aggregate Supply: short
run
•
In the short run price is fixed so the
aggregate supply curve is
horizontal.
• In this context a shift in AD
causes a change in Y but has no
effect on P.
P
SRAS
P*
AD
AD
Y
Y
Y
Negative Output Gap
LRAS
General
Price Level
Pe
P2
SRAS
AD1
AD2
Y2
PPF
Ye
Yfc
National Income
Causes of Deflation
LRAS
General
Price Level
LRAS2
LRAS1
General
Price Level
Pe
P1
P2
P2
SRAS
SRAS
AD1
AD1
AD2
AD2
Y2
Real National Income
Ye
Yfc
Y1
Y2
YFC2
•
http://www.whitenova.com/thinkEconomics/adas.html
The Risk of Demand Pull Inflation
General
Price Level
LRAS
P3
P2
P1
AD3
AD2
SRAS
AD1
Y1
Y2
Yfc
Real National Income
External Shock – Higher Oil Prices and a Tightening of Monetary Policy
LRAS
General
Price Level
P2
P1
SRAS2
SRAS1
AD1
AD2
Y3
Y2
Y1
Yfc
Real National Income
•
From the Short Run to the Long
The economy begins in long run
equilibrium at point 1.
Run
• If aggregate demand shifts out,
the economy moves from point 1
to point 2, above full
employment output.
• As we approach the long run
there is upward pressure on P. As
P increases Y decreases and we
move along AD to point 3.
• The end result is that Y returns to
the natural level but P is
permanently higher.
P
LRAS
3
2
SRAS
P*
AD
1
AD
Y
Y
Y
Stabilization Policy
• Fluctuations in the economy can
shift either AD or AS.
• Fiscal and monetary policies are
able to shift AD. Because of this
a shock to AD can be corrected
with P and Y returning to their
• pre-shock
However iflevels.
there were a supply
shock then a policy adjustment
would imply a trade off between
Y or P.
• With a negative supply shock
accommodating the shock would
mean returning the economy to Y
causing a higher P in the long
• The alternative would be to wait
run.
for the shock to pass.
P
LRAS
SRAS
SRAS
P*
AD
AD
AD
Y
Y