Eco 6351Economics for Managers

Chapter 11a. Aggregate Supply and Demand

Prof. Vera Adamchik

The macro economy

DETERMINANTS OUTCOMES

MACROECONOMY

Policy levers

Internal marketforces

External shocks

Output

Jobs

Prices

Growth

Internationalbalances

Macro view The determinants of macro performance

include:• Internal market forces — Population

growth, spending behavior, invention and innovation, and the like.

• External shocks — Wars, natural disasters, trade disruptions, and so on.

• Policy levers — Tax policy, government spending changes in the availability of money, and regulation.

Potential GDP

• The quantity of real GDP supplied when unemployment is at its natural rate and there is full employment is called potential real GDP.

• Over the business cycle, employment fluctuates around full employment and real GDP fluctuates around potential GDP.

Two time horizons

• To study the economy at full employment and over the business cycle, we distinguish two time frames:

- the macroeconomic long run,

- the macroeconomic short run.

• The macroeconomic long run is a time frame that is sufficiently long for economic forces to bring real GDP to potential (full-employment) GDP.

• The macroeconomic short run is a period during which real GDP has fallen below or risen above potential GDP. At the same time, the unemployment rate has risen above or fallen below the natural rate.

The Aggregate Supply-Aggregate Demand model

The AS-AD model enables us to understand three features of macroeconomic performance:

• Growth of potential GDP

• Inflation

• Business cycle fluctuations

Long-run aggregate supply

• The long-run aggregate supply is vertical because potential GDP is independent of the price level.

• A movement along the LRAS is accompanied by a change in two sets of prices: the prices of goods and services and the prices of productive resources. When relative prices remain constant, real GDP also remains constant.

REAL OUTPUT (quantity per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

Long Run Aggregate Supply

Long-run aggregate supply

Potential (Full Employment) GDP

Aggregate demand

Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded. This relationship between the quantity of real GDP demanded and the price level is called aggregate demand.

Aggregate demand

• The AD curve is the relationship between the quantity of real GDP demanded and the price level in a given time-period, ceteris paribus.

• The AD curve is downward-sloping: the higher the price level, the smaller is the quantity of real GDP demanded. Reasons: real balances effect, foreign trade effect, interest rate effect.

REAL OUTPUT (quantity per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

Aggregate demand

Higher prices

Lower prices Less output

demandedMore output demanded

Aggregate demand

Stable or unstable

• The central concern of macroeconomic theory is whether the internal forces of the marketplace will generate desired outcomes.

Classical theory• Prevalent theory prior to the 1930s.• The economy is stable because of its

ability to self-adjust.• The cornerstones of the Classical

Theory are flexible prices and flexible wages.

• According to Classical economists, government intervention in a self-adjusting macroeconomy is unnecessary.

Say’s Law

• According to Say’s Law, “supply creates its own demand.”

• Unsold goods will ultimately be sold when buyers and sellers find an acceptable price.

• In the labor market, some people will be unemployed, but can find new jobs if they are willing to accept lower wages.

The Great Depression• The Great Depression (1929-1939) was

a stunning blow to Classical economists.

• In the Depression’s worst year, 1933, the production of U.S. farms, factories, shops, and offices was only 70 percent of its 1929 level and 25 percent of the labor force was unemployed.

• The science of economics had no solutions to the Great Depression.

Inflation and Unemployment, 1900 – 1940

AN

NU

AL

RA

TE

OF

IN

FLA

TIO

N O

R

UN

EM

PLO

YM

EN

T (

perc

ent)

1900 1910 1920 1930 1940

– 8

– 4

0

4

8

12

16

20

24

Prices

Unemployment

The Keynesian revolution

• John Maynard Keynes provided an alternative to the Classical Theory.

• In 1936, Keynes published The General Theory of Employment, Interest, and Money.

• Keynes asserted that the private economy was inherently unstable. No self-adjustment.

• In Keynes’ view, the inherent instability of the marketplace required government intervention (“Policy levers”).

• Keynes focused primarily on the short term. He wanted to cure an immediate problem almost regardless of the long-term consequences of the cure. “In the long run,” said Keynes, “we’re all dead.”

• Keynes believed that after his cure for depression had restored the economy to a normal condition, the long-term problems of inflation and slow economic growth will return.

Short-run aggregate supply

The short-run aggregate supply curve is the relationship between the quantity of real GDP supplied and the price level in a given time-period, ceteris paribus. That is, when the money wage rate and other resource prices remain constant.

Short-run aggregate supply

• The aggregate supply curve is upward-sloping: the output increases when price level rises.

• The aggregate supply curve is relatively flat when capacity is underutilized. It begins to slope upward as producers approach capacity.

Shape of the SRAS curve

• Short-Run Aggregate Supply (SRAS) has three segments or ranges:

– Horizontal range (Keynesian segment),

– Intermediate (Upward-sloping) range,

– Vertical range (Classical segment)

Short-run aggregate supply

Pric

e le

vel

Real domestic output, GDPQ

P

Horizontalrange

Upward-sloping orintermediate

range

Verticalrange

Macroeconomic equilibrium

• Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied.

Macroeconomic equilibriumin the long run

and the short run

Pric

e Le

vel

Real Domestic Output, GDP

Q

P SRAS

AD

Equilibrium in theHorizontal Range

QeQ1 Q2

Macro-equilibrium: Real output and the price level

Pe

Pric

e Le

vel

Real Domestic Output, GDP

Q

P SRAS

AD

Equilibrium in theIntermediate Range

QeQ1 Q2

Macro-equilibrium: Real output and the price level

P1

Pe

Macro failure

• There are two potential problems with macro equilibrium — undesirability and instability.

Macro Failure

• Undesirability — the price-output relationship at equilibrium may not satisfy our macroeconomic goals

• Undesirable Outcomes:– Unemployment– Recession– Inflation

Three types of short-run macroeconomic equilibrium

(1) below full-employment equilibrium (real GDP is less than potential GDP and there is a recessionary gap);

(2) above full-employment equilibrium (real GDP exceeds potential GDP and there is an inflationary gap);

(3) at full-employment equilibrium (real GDP equals potential GDP).

E

QE

PE

Aggregate demand

Full employmentEquilibrium

output

Aggregate supply

PR

ICE

LE

VE

L (a

vera

ge p

rice)

REAL OUTPUT (quantity per year)

QF

P*F

Below FE equilibrium

Macro failure

• Instability — even if designated macro equilibrium is optimal, it may be displaced by macro disturbances.

• Shifts in aggregate supply and aggregate demand can upset a full employment equilibrium.

Recurrent shifts

• Business cycles are a result of recurrent shifts of the aggregate supply and demand curves.

• There are lots of reasons to expect aggregate supply and aggregate to shift.

F

P2

P*

Q2 QF

AS0

(b) Demand shifts

H

AD0

AD1

GFP1

P*

Q1 QF

AD0

AS1 AS0

PR

ICE

LE

VE

L (a

vera

ge p

rice)

REAL OUTPUT (quantity per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

REAL OUTPUT (quantity per year)

(a) Supply shifts

Macro disturbances

E1 AD0

AD1

Q1 QF

REAL OUTPUT (quantity per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

E0

AS0

Origins of a recession:Demand shifts

AS0E2

Q2 QF

E0

AD0

REAL OUTPUT (quantity per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

AS1

Origins of a recession:Supply shifts

E3

AS1

Q3 QF

AS0

AD0

AD1

E0

REAL OUTPUT (quantity per year)

PR

ICE

LE

VE

L (a

vera

ge p

rice)

Origins of a recession:Supply and demand shift