Transcript The short run AS curve

Aggregate Demand
and Aggregate Supply:
Explaining economic fluctuations
Revision of main concepts
Francesco Daveri
Two key facts on fluctuations
1. Economic fluctuations occur systematically, but they are irregular, for
their timing and duration is unpredictable
•
Macroeconomic variables behave as random variables
2. Most aggregate variables fluctuate together: macro-economic variables
are closely related
• Yet: even if most variables move together, their volatility differs
across variables
GDP growth in the world economy: fluctuating
with irregular and unpredictable timing
6
Growth world Gdp, %
5
4
3
2
1
0
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014p
2015p
-1
Growth: usually positive but not constant. One episode of growth<0
Source: IMF World Economic Outlook Database, April 2014
We want to develop basic model to explain
economic fluctuations
•
•
Two variables are used to develop a model to analyze the short-run
fluctuations :
•
The economy’s output of goods and services measured by real GDP
•
The overall price level measured by the CPI or the GDP deflator
We use the model of aggregate demand and aggregate supply
(AD-AS) to explain short-run fluctuations in economic activity around
long-run trends
What the basic model says
•
Three main things
•
Monetary , fiscal and exchange rate policies (AD policies) affect
real GDP in the short run but not in the long run
•
Money and policy do not affect “real” variables” (Gdp, C, I) in
the long run, but they do in the short run. Long-run Money and
policy neutral in the long run, not in the short run
•
Hence: when studying year-to-year changes in the economy, we
will not assume money and policy neutrality
The model of aggregate demand and
aggregate supply
Price
Level
Aggregate
supply
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
AD and AS
•
The aggregate demand (AD) curve shows the quantity of goods and
services that households, firms, and the government are willing to
buy at any price level
–
•
Note: The AD curve is not a market demand curve, and it is
not the sum of all market demand curves in the economy
The aggregate supply (AS) curve shows the quantity of goods and
services that firms choose to produce and want to sell at any price
level
–
Note The AS curve is not a market supply curve, and it is not
the sum of all market supply curves in the economy
AD curve
The four components of GDP (Y) contribute to the aggregate demand for
goods and services:
Y = C + I + G + NX
Price
Level
P1
P2
1. A decrease
in the price
level
0
Y1
2. …increases the quantity of goods and
services demanded.
Aggregate
demand
Y2
Quantity of
Output
Why the AD is downward sloping
Price level   Quantity of good demanded 
Pigou (wealth) effect
Keynes (interest rate)
effect
Mundell-Fleming
(exchange rate) effect
price level 

consumers feel
wealthier

Encouraged to spend
more

larger quantity of goods
and services demanded
price level 

Lower domestic interest
rate

Firms encouraged to
invest more

greater spending on
investment goods
(domestic) price level 

Lower interest rate,
capital goes abroad

Exchange rate
depreciates, gain in
competitiveness

increase in exports and
decrease in imports,
increase in net exports
• Pigou’s effect (or real balance effect):
Wealth
P 
  C   AD 
P
• Keynes’ effect (or interest rate effect):
P   M d  Bonds d  pBonds   i   I   AD 
• Mundell-Fleming’s effect (or exchange rate effect):
IMPORTS 
P   competitiveness  
 NX   AD 
EXPORTS 
Shifts in the AD curve
Anything that makes buyers more or less willing to buy goods and services for
any given level of price shifts the AD curve.
• Consumers, firms: exogenous changes in spending plans by consumers or firms (e.g.
household savings before the Iraq war; pessimism after Lehman Bros bankruptcy)
• Government: exogenous changes in fiscal, monetary and exchange rate policy
Price
P1
AD1
0
Y1
Y2
AD2
Output
The multiplier: by how much AD shifts
Extent of the AD shifts determined by size of multiplier
 Multiplier: process that makes initial increase in income bigger due to
further increases in C and I triggered by initial increase in GDP
Example: Suppose Govt raises defense spending
 G income of G producers consumption of G producers
income of C producers and so on
 Total rightward shift of AD given by sum of all income increments
 If GDP very close to full employment, demand increase feeds into higher
inflation and not Gdp gains
Aggregate supply curve
Preview of main arguments
In the short run, the aggregate-supply curve is upward sloping
In the long run, an economy’s production of goods and services depends
on its supplies of labor, capital, and natural resources and on the available
technology used to turn these factors of production into goods and
services
•
The price level does not affect these variables in the long run
Hence: In the long run, the aggregate-supply curve is vertical
The short run AS curve
In the short run
•
An increase in the overall level of prices in the economy tends to raise
the quantity of goods and services supplied for given costs of
production
•
A decrease in the level of prices tends to reduce the quantity of goods
and services supplied (see picture)
Price
Level
Short-run
aggregate
supply
P1
P2
2. reduces the quantity of goods
and services supplied in the short
run
1. A
decrease in
the price
level
0
Y2
Y1
Quantity of output
Why the short run AS is upward sloping
Price level   Quantity of good supplied 
Keynesian sticky
wages theory
Aggregate price 

nominal wages do not
fall immediately

labor costs go up

firms reduce production
New classical
New Keynesian sticky
misperceptions theory
prices theory
Aggregate price 
Aggregate price 


producers temporarily
some firms do not
perceive it as a decline adjust their own price to
in ‘their’ individual sale
save on “menu costs”
price


sales reduced, hence
decrease of goods and firms reduce production
services supplied
Bottom line: Experts’ opinions vary as to why, but – reassuringly - the
SLOPE of the AS is anyway positive!
Shifts in the short run AS curve
AS1
Price
AS2
P1
0
Y1
Y2
output
Why AS might shift
In a nutshell: Anything that shifts costs of production shifts AS
AS shifts to the right if:
• Imported or domestic input prices go down
• Costs of production going up for given price, output to be cut
• Factor productivity goes up (thanks to new technologies)
• allows firms to produce more at a lower cost for an unchanged sale price
• Government cuts distorting taxes and regulations hampering business
practices
•
Reduction of social security contributions reduces labor costs; reduced tax on
profits raises net profitability
• Expectation of lower price level in the future
•
This feeds into lower wage claims and thus decrease labor costs today
Implication: GDP gains due to AD shifts do
not last long
Let’s see why
 Short run AS drawn for given nominal wages
 As nominal wages change,  short-run AS (entire curve)
Why do wages change?
 Today’s P makes wage claims at next wage negotiation round
So what happens?
As AD shifts to the right, this also gives rise to P. This results in rising inflation
expectation for the future
 Higher expected inflation raises wage claims
 Short run AS shifts to the left
 Short run AS keeps shifting leftwards until GDP above its long-run
average
Why AD-originated Gdp gains do not last: graphics
P
E’’
SRAS’
SRAS
E’
E
AD’
AD
GDP
Permanent
GDP
As a result: The long run AS curve is vertical
at the natural rate of output.
Price
Level
Long-run
aggregate
supply
P2
P1
2. …does not affect the quantity of goods
and services supplied in the long run.
1. A change in
the price
level…
0
Natural rate
of output
Quantity of
Output
Long run equilibrium
The intersection of the AD curve and the long-run AS curve determines the
economy’s equilibrium output and price level (E)
• Output is at its natural rate
• The short-run AS curve goes through the point of intersection
Price
Long-run
AS
Equilibrium
Price
Short-run
AS
E
AD
0
Natural rate
of output
Output
Now ready to study the causes of recessions
There are two causes of recessions
•
AD shift to the left
•
AS shift to the left
See them in turn
Recession I: a leftward shift of AD
A decrease in one of the determinants of AD shifts the curve to the left.
Hence, (i) output falls below the natural rate of employment; (ii)
unemployment rises, (iii) the price level falls
Long-run
AS
Price
AS1
AS2
A
P1
3. …but over time,
the short-run
aggregate-supply
curve shifts (B to C)…
B
P2
P3
1. A decrease in
aggregate demand…
C
AD1
AD2
0
2. …causes output to fall in
the short run (A to B)…
Y2
Y1
4. …and output returns
to its natural rate.
Output
Recession II: a leftward shift of AS
A decrease in one of the determinants of AS shifts the curve to the left: hence, (i)
output falls below the natural rate of employment; (ii) unemployment rises; (iii) the
price level rises
Long-run
AS
Price
AS2
AS1
1. An adverse shift in the
short-run AS curve…
B
P2
. 3.
…and
P1
the
price to
rise.
A
AD1
0
2. …causes output to fall…
Y2
Y1
Output
Recession II = Stagflation
Adverse shifts in aggregate supply cause stagflation - a combination of
recession and inflation
•
•
•
Output falls and prices go up
Policymakers can influence the level of aggregate demand (by
increasing public consumption), much less so the level of aggregate
supply
Hence, they cannot offset both adverse effects simultaneously
How to read supply and demand shocks
in the data: the US in the 1990s
US
economy
1991-93
1994-96
1997-00
2001-02
GDP growth
2.4
3.2
4.2
1.3
Inflation
3.2
2.7
2.6
1.7

1990s: GDP up & inflation down, symptom of positive supply shock

2001-02: both GDP & inflation down, symptom of negative demand
shock
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