CHAPTER 15
Summary
Aggregate Demand & Aggregate Supply
What is the relationship between equilibrium output and price level? This chapter deals with such a relationship. It does so by introducing the neo-Keynesian concepts of aggregate demand and aggregate supply.
Sasan Fayazmanesh
Keynes’s Missing Equation: Price Level Changes
Aggregate Demand Curve (AD)
In Keynes’s General Theory there is no discussion of the price level and its impact on output and employment.
What is the relation between the price level and output of goods and services demanded? The relation is supposed to be inverse.
The lack of discussion left a vacuum that was filled later (in the 1950s and 60s) by the neo-Keynesian theories of aggregate demand and aggregate supply.
Aggregate Demand Curve (AD)
How can we develop such a relation?
Price level (P)
We can do so by looking at the money market and “Keynesian cross.”
AD
Real output (y)
1
Derivation of AD i
The two graphs tell us that if price is at P0, the output of goods and services demanded is y0. AE
Ms1
This gives us one point on the Aggregate Demand function, AD.
AE0
i0
Md0=f(P0)
450
M
y0
Money market
y
Keynesian cross
We need more than one point for a relation. What do we do to get a second point? Price level (P) Change the price level and look at what happens to the output of goods and services demanded.
P0
Real output (y) y0
Suppose the price level increases. What happens to the money demand, interest rate, spending and equilibrium level of income?
Price level increases i
AE
Ms1
AE0
Md i
i2
C, I y
AE1 Md1=f(P1)
i1
Md0=f(P0) M
450 y1
y0
y
2
Def. Aggregate Demand (AD): is a relationship between the price level and goods and services demanded in the economy.
P P1
Everything else remaining the same, as price level rises, goods and services demanded will decrease.
P0 AD y y1
y0
Shifts or “Shocks” in AD
Shift in AD: An increase in G AE
Def. Demand shock: any event that causes AD to shift at the same price level.
P
Example:
Ms1
AE1
An increase in government expenditures, G
AE0
∆G
P0 AD0
450 y0
Another example
The result is a shift in the AD.
y0
y1 y
An increase in money supply
An increase in the supply of money (Ms): Interest rate falls, interest rate sensitive expenditures rise and y at equilibrium increases.
y
y1
AD1
i
AE
Ms0 Ms1
AE1 i0 i1
AE0 Md
450 M
y0
y1
y
3
Aggregate Supply Curve (AS)
An increase in money supply AE
P
What is the relation between the price level and output of goods and services supplied?
Ms1
The usual Keynesian derivation of AS is different than the derivation in your textbook.
AE1 AE0
AD1
P0
AD0
450 y0
y
y1
y0
We will look at both derivations. In either case, graphically we will have:
y1 y
Aggregate Supply Curve (AS)
1) AS Curve: Keynesian Explanation
Price level (P) AS
The Keynesian derivation of AS relies on the labor market theory and the aggregate production function. It assumes that when price level rises, firms produce more output and demand more labor. But as prices rise and real wage falls, workers don’t withdraw from the labor market.
Real output (y)
Recall the labor market and aggregate production function w
D
S
This gives us one point on the Aggregate Supply function, AS.
w0 D0(P0)
S y
The two graphs tell us that if price is at P0, the output of goods and services supplied is y0.
L0
L Aggregate Production Function
y0
L0
L
4
Price level increases: Demand shifts to the right Price level (P) W (Nominal wage) D1
D0
P0
S0 W1 W0 D1(P1) Real output (y) y0
D0(P0)
S0
L L0
If the workers don’t notice that real wages have fallen and don’t withdraw from the market, then output of goods and services rises.
Price level rises: But workers don’t respond D1 w w1 w0
D0
S0 D1(P1) D0(P0) L
S0 y y1 y0
L0 L1
APF
L0
Keynesians: Aggregate Supply Curve (AS) Price level (P)
L1
L1
L
Def. Aggregate Supply (AS): is a relationship between the price level and goods and services supplied in the economy.
AS Everything else remaining the same, as price level rises, goods and services supplied will increase.
P1
P0
Real output (y) y0
y1
5
Shifts in the Keynesian AS Curve
Shift in AS: Technological Improvement
AS curve will shift if technological changes shift the aggregate production function.
y
P
AS1
AS2
APF1 y1
APF0
y0
L0
Monetarist Argument:
P0
L
y0
y1
y
Monetarists: Short-run AS Price level (P)
Monetarists argue that in the short-run:
AS (short run)
1) Keynesian argument might be right. 2) Workers might not see rising prices and falling real wages. 3) AS curve is as Keynesians argue
P1
P0 But not in the long-run! Real output (y) y0
In the long run, Monetarists argue, workers:
Price level increases: Workers respond
1) Realize the price hikes 2) Realize falling real wages 3) Withdraw from the labor market This means 1) Supply of labor will shift to the left 2) Employment and output will return to what they were initially 3) AS curve will be vertical!
y1
S1 (P1)
W D0
D1 S0 (P0)
WFinal
W0
D0(P0)
S1
D1(P1)
S0 L L0 = L1
6
Price level rises: Output returns to original state
wFinal w0
W D0
D1
S1 (P1)
Price level (P)
S0 (P0)
AS PFinal
D1(P1)
S1
D0(P0) L
S0 y
Monetarists: Long-run AS Curve
L0
P0
APF
y0 yFinal
Real output (y) y0 = yFinal L L0 = LFinal
2) AS Curve: Textbook Explanation
Mark up pricing:
Your textbook relies on the markup pricing theory to reach the same Monetarist conclusion. What is markup pricing? Example: A car dealer sells a car costing him $8000 at a 10% markup: Price of the car = $8000 +10% (8000) = $8000 +$800 = $8800
GDP
Price per unit = cost per unit + % markup (cost per unit) Your textbook assumes that over the business cycle as output of goods and services rises, cost per unit increases, pushing the average prices up: y P
Note: Text assumes that price of most inputs rise, but wage increases lag behind in the short-run.
Inflation prosperity
Time
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Shifts in the textbook AS Curve
Textbook: Short-run AS Price level (P) AS
AS curve will shift in your textbook if there is a “shock” in the economy, causing the price level to change at the same level of output.
P1 Example of such “shocks”: Oil price changes
P0
Real output (y) y0
y1
AD/AS: Macroeconomic Equilibrium
Textbook: Shift in Short-run AS AS1
Price level (P)
AS0 P1
Macroeconomic equilibrium occurs when the aggregate demand equals the aggregate supply at some price level.
Oil prices increase Output of goods and services is neither expanding nor contracting at this price level.
P0
Real output (y) y0
Macroeconomic Equilibrium Price level (P) AS
Changes in the Aggregate Demand: Short-run Analysis Both fiscal and monetary policies will shift the demand curve.
P0 AD Real output (y) y0
8
Fiscal policy (not considering AS)
Fiscal policy: Short-run
P
P
AS
P1 P0
P0 AD1
AD0
AD1
AD0
y
y
y*
y0
y0
y1
Fiscal policy: Short-run
Monetary policy: Short-run
G
Ms y
y*
i P
C,I y P
Md
Md i
i C, I
C, I y
y
Monetary policy: Short-run P
Changes in the Aggregate Demand: Long-run Analysis (Monetarists)
AS
• In the long-run, the Monetarists assume, the workers realize that their real wages have declined as a result of inflation.
P1 P0 AD0
AD1
y y0
• They will ask for higher nominal wages to match rising prices. • AS curve will shift up.
y1
9
Fiscal Policy: Long-run
Fiscal policy: Long-run
AD
p final
AS1
P
AS0
P and y W P0
AS P y
AD1
AD0
until we return to the original level of output.
y y0 ≡ y final
Long-run AS The long-run AS will be vertical for a monetarist! This means, once again, that neither fiscal policy nor monetary policy will have any effect on output and employment in the long-run.
p final
AS1 (short-run) AS0 (short-run)
P
P0
This is the same as “complete crowding out.”
AD1
AD0 AS (long-run)
y y0 ≡ y final
Stagflation In the case of stagflation prices rise, output declines and unemployment rises. This, as far as textbook is concerned, could be the result of an input “shock” to the economy, such as oil price increases.
Stagflation
AS1
P
AS0
P1 P0 AD0 y y1
y0
10
Is there a way to stabilize prices following a “shock” like this? What should the fiscal policy be? Reduce government spending
Stagflation: Stabilizing Prices AS1 P
AS0
P1 P0
What should the monetary policy be?
AD0 AD1
Tight money policy
y y2
y1
y0
Next stop: Chapter 16!
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