Aggregate Demand, Aggregate Supply, and Modern Macroeconomics

1. Aggregate Demand, Aggregate Supply, and Modern Macroeconomics Chapter 9

2. Introduction • Markets unleash individual initiative, increase supply, and bring about growth. • But markets create recessions too.

3. Introduction • Macro intervention tools – monetary and fiscal policy – are tools governments use on the aggregate demand side of the economy to deal with recessions, inflation, and unemployment.

4. Introduction • Since politicians make policy, it is unlikely that they would do nothing in the face of a recession even if all economists agreed it was the right thing to do.

5. The Historical Development of Modern Macroeconomics • The Great Depression of the 1930s was a defining event in society's view of markets, and in the thinking about government macro policy.

6. The Historical Development of Modern Macroeconomics • During the Depression, output fell by 30 percent and unemployment rose to nearly 20 percent. People wanted to work but could not find jobs at any wage.

7. The Historical Development of Modern Macroeconomics • Before the Depression, the prominent ideology was laissez-faire - keep the government out of the economy.

8. The Historical Development of Modern Macroeconomics • After the Depression, most people believed government should have a role in regulating the economy.

9. From Classical to Keynesian Economics • Pre-Depression economists focused on long-run issues such as growth. • They were called Classical economists.

10. From Classical to Keynesian Economics • Depression-era economists began to focus on short-run economic issues, especially the issue of how to dig out of the Depression.

11. From Classical to Keynesian Economics • They were called Keynesians after economist John Maynard Keynes, author of The General Theory of Employment, Interest and Money, and the founder of modern macroeconomics.

12. Classical Economics • The Classical economists' approach was laissez-faire (leave the market alone). • They felt the market was self-adjusting, and they also concentrated on the long-run and largely ignored the short-run.

13. Classical Economics • When the Great Depression hit with high unemployment, their response was to refer to supply and demand in the labour market.

14. Classical Economics • Their solution to the high unemployment was to eliminate labour unions and government policies that kept wages too high.

15. The Layperson's Explanation for Unemployment • The layperson's explanation for unemployment was different. • They were not pleased with the classical argument but believed instead that the Depression was caused by an oversupply of goods that glutted the market.

16. The Layperson's Explanation for Unemployment • Lay people advocated hiring people even if the work was not needed.

17. The Layperson's Explanation for Unemployment • Classical economists opposed deficit spending, arguing that the money to create jobs had to come from somewhere.

18. The Layperson's Explanation for Unemployment • Government demands for capital would crowd out private demands for money so the net effect would be zero, according to the Classical view. • Their advice was to have faith in the markets.

19. The Essence of Keynesian Economics • The essence of Keynesian economics is stabilization through government efforts. • As Keynes put it: “In the long run we are all dead”.

20. The Essence of Keynesian Economics • By changing his focus, he created the macroeconomic framework that emphasizes stabilization policy.

21. The Essence of Keynesian Economics • Keynes thought that the economy could be stuck in a rut as wages and price level adjusted to sudden changes in expenditures.

22. The Essence of Keynesian Economics • The Keynesian linkage was: decrease in investment demand  job layoffs  fall in consumer demand  firms decrease production  more job layoffs  further fall in consumer demand, and so forth

23. The Essence of Keynesian Economics • Too little spending caused unemployment. • To break out of the rut, spending had to increase.

24. Equilibrium Income Fluctuates • Income is not fixed at the economy's long-run potential income – it fluctuates. • For Keynes there was a difference between equilibrium income and potential income.

25. Equilibrium Income Fluctuates • Equilibrium income – the level of income toward which the economy gravitates in the short run because of the cumulative circles of declining or increasing production.

26. Equilibrium Income Fluctuates • Potential income – the level of income that the economy technically is capable of producing without generating accelerating inflation.

27. Equilibrium Income Fluctuates • Keynes felt that at certain times the economy needed help to reach its potential income. • Market forces would not work fast enough and not be strong enough to get the economy out of a recession

28. Equilibrium Income Fluctuates • Because short-run aggregate production decisions and expenditure decisions were interdependent, the downward spiral could start at any time.

29. The Paradox of Thrift • The paradox of thrift is important to the Keynesian story. • According to the paradox of thrift, an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession.

30. The Paradox of Thrift • Saving can be seen as something good, it leads to investments that leads to growth.

31. The Paradox of Thrift • But if savings were not translated into investment as happened during the Great Depression total spending would fall and unemployment would rise.

32. The Paradox of Thrift • These concerns led to the development of the aggregate demand/aggregate supply model.

33. The Paradox of Thrift • It is this model that most economists use to discuss short-term fluctuations in output and unemployment.

34. The AS/AD Model • The AS/AD model consists of three curves: the short run aggregate supply curve (SRAS), the aggregate demand curve (AD), and the long run aggregate supply curve (LRAS).

35. The AS/AD Model • The short run aggregate supply curve – the curve describing the supply side of the aggregate economy.

36. The AS/AD Model • The aggregate demand curve – the curve describing the demand side of the aggregate economy.

37. The AS/AD Model • The long run supply curve – the curve describing the highest sustainable level of output.

38. The AS/AD Model • The AS/AD model is fundamentally different from the microeconomic supply/demand model.

39. The AS/AD Model • In the microeconomic supply/demand model the price of a single good is on the vertical axis and the quantity of a single good on the horizontal axis. • The shapes are based on the concepts of substitution and opportunity cost.

40. The AS/AD Model • In the AS/AD model the price of all goods,measured by the GDP deflator, is on the vertical axis and aggregate output is on the horizontal axis.

41. The AS/AD Model • The AS/AD model is an historical model that starts at a point in time and says what will happen when changes affect the economy.

42. The Aggregate Demand Curve • The aggregate demand (AD) curve shows how a change in the price level changes aggregate expenditures on all goods and services in an economy. • The AD curve is an equilibrium curve.

43. The Slope of the AD Curve • The AD is a downward sloping curve. • Aggregate demand is composed of the sum of aggregate expenditures. Expenditures = C + I + G +(X - IM)

44. The Slope of the AD Curve • The slope of the curve depends on how these components respond to changes in the price level. • A falling price level is assumed to increase aggregate expenditures, due to the • Wealth effect • Interest rate effect • International effect

45. Price level Wealth, interest rate, and international effects P0 Multiplier effect P1 Aggregate demand Y0 Y1 Ye Real output The AD Curve, Fig. 9-1, p 215

46. The Wealth Effect • The wealth effect tells us that as the price level falls, the value of cash rises so that those who hold money and other financial assets become richer, and buy more.

47. The Wealth Effect • While economists accept the logic of the argument, they do not see the wealth effect as strong.

48. The Interest Rate Effect • The interest rate effect is the effect a lower price level has on investment expenditures through the effect that a change in the price level has on interest rates.

49. The Interest Rate Effect • The linkage is: a decrease in the price level  increase of real cash  interest rates fall  banks have more money to lend  investment expenditures increase  jobs are created  consumer expenditures increase

50. The International Effect • The international effect tells us that as the price level falls (assuming the exchange rate does not change), net exports will rise.