1、Aggregate Demand, Aggregate Supply, and Modern Macroeconomics,Chapter 9,Introduction,Markets unleash individual initiative, increase supply, and bring about growth. But markets create recessions too.,Introduction,Macro intervention tools monetary and fiscal policy are tools governments use on the ag
2、gregate demand side of the economy to deal with recessions, inflation, and unemployment.,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.,The Historical Development of Modern M
3、acroeconomics,The Great Depression of the 1930s was a defining event in societys view of markets, and in the thinking about government macro policy.,The Historical Development of Modern Macroeconomics,During the Depression, output fell by 30 percent and unemployment rose to nearly 20 percent. People
4、 wanted to work but could not find jobs at any wage.,The Historical Development of Modern Macroeconomics,Before the Depression, the prominent ideology was laissez-faire - keep the government out of the economy.,The Historical Development of Modern Macroeconomics,After the Depression, most people bel
5、ieved government should have a role in regulating the economy.,From Classical to Keynesian Economics,Pre-Depression economists focused on long-run issues such as growth. They were called Classical economists.,From Classical to Keynesian Economics,Depression-era economists began to focus on short-run
6、 economic issues, especially the issue of how to dig out of the Depression.,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.,Classical Econo
7、mics,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.,Classical Economics,When the Great Depression hit with high unemployment, their response was to re
8、fer to supply and demand in the labour market.,Classical Economics,Their solution to the high unemployment was to eliminate labour unions and government policies that kept wages too high.,The Laypersons Explanation for Unemployment,The laypersons explanation for unemployment was different. They were
9、 not pleased with the classical argument but believed instead that the Depression was caused by an oversupply of goods that glutted the market.,The Laypersons Explanation for Unemployment,Lay people advocated hiring people even if the work was not needed.,The Laypersons Explanation for Unemployment,
10、Classical economists opposed deficit spending, arguing that the money to create jobs had to come from somewhere.,The Laypersons 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. Thei
11、r advice was to have faith in the markets.,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”.,The Essence of Keynesian Economics,By changing his focus, he created the macroeconomic fr
12、amework that emphasizes stabilization policy.,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.,The Essence of Keynesian Economics,The Keynesian linkage was: decrease in investment demand jo
13、b layoffs fall in consumer demand firms decrease production more job layoffs further fall in consumer demand, and so forth,The Essence of Keynesian Economics,Too little spending caused unemployment.,To break out of the rut, spending had to increase.,Equilibrium Income Fluctuates,Income is not fixed
14、at the economys long-run potential income it fluctuates. For Keynes there was a difference between equilibrium income and potential income.,Equilibrium Income Fluctuates,Equilibrium income the level of income toward which the economy gravitates in the short run because of the cumulative circles of d
15、eclining or increasing production.,Equilibrium Income Fluctuates,Potential income the level of income that the economy technically is capable of producing without generating accelerating inflation.,Equilibrium Income Fluctuates,Keynes felt that at certain times the economy needed help to reach its p
16、otential income.,Market forces would not work fast enough and not be strong enough to get the economy out of a recession,Equilibrium Income Fluctuates,Because short-run aggregate production decisions and expenditure decisions were interdependent, the downward spiral could start at any time.,The Para
17、dox 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.,The Paradox of Thrift,Saving can be seen as something good, it leads to investments t
18、hat leads to growth.,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.,The Paradox of Thrift,These concerns led to the development of the aggregate demand/aggregate supply model.,The
19、 Paradox of Thrift,It is this model that most economists use to discuss short-term fluctuations in output and unemployment.,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
20、(LRAS).,The AS/AD Model,The short run aggregate supply curve the curve describing the supply side of the aggregate economy.,The AS/AD Model,The aggregate demand curve the curve describing the demand side of the aggregate economy.,The AS/AD Model,The long run supply curve the curve describing the hig
21、hest sustainable level of output.,The AS/AD Model,The AS/AD model is fundamentally different from the microeconomic supply/demand model.,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 axi
22、s.,The shapes are based on the concepts of substitution and opportunity cost.,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.,The AS/AD Model,The AS/AD model is an historical model that st
23、arts at a point in time and says what will happen when changes affect the economy.,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.,The Slope
24、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),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 a
25、ssumed to increase aggregate expenditures, due to the Wealth effect Interest rate effect International effect,The AD Curve, Fig. 9-1, p 215,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 beco
26、me richer, and buy more.,The Wealth Effect,While economists accept the logic of the argument, they do not see the wealth effect as strong.,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
27、level has on interest rates.,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,The International Effect,The international effe
28、ct tells us that as the price level falls (assuming the exchange rate does not change), net exports will rise.,The International Effect,The linkage is: a decrease in the price level in Canada the fall in price of Canadian goods relative to foreign goods Canadian goods become more competitive interna
29、tionally Canadian exports rise and imports fall.,The Multiplier Effect,A change in quantity demanded has repercussions on production (supply decisions) and subsequently on income and expenditures (demand decisions). These repercussions are called multiplier effects.,The Multiplier Effect,As the pric
30、e level falls, the initial changes due to the wealth, interest rate, and international effects set in motion a process in the economy that amplifies the initial effects.,The Multiplier Effect,The multiplier effect is the amplification of initial changes in expenditures.,The multiplier effect makes t
31、he aggregate demand curve flatter.,Shifts in the AD Curve,Except for a change in the price level, anything that changes aggregate expenditures shifts the AD curve.,Shifts in the AD Curve,The main shift factors of aggregate demand are foreign income, expectations about future output or prices, exchan
32、ge rate fluctuations, the distribution of income, and monetary and fiscal policies.,Foreign Income,When Canadas trading partners go into a recession, the demand for Canadian goods (exports) will fall, causing the Canadian AD curve to shift to the left. A rise in foreign income leads to an increase i
33、n Canadian exports and a rightward shift of the Canadian AD curve.,Exchange Rates,When a currency loses value relative to other currencies, export goods produced in that country become less expensive and imports into that country become more expensive.,Exchange Rates,Foreign demand for its goods inc
34、reases and its demand for foreign goods decreases as individuals do their spending at home.,The AD curve will shift to the right. When a currency gains value, the AD curve shifts to the left.,Expectations About Future Output,If businesses expect demand to be high in the future, they will want to inc
35、rease their capacity to produce. Their demand for investment, a component of aggregate equilibrium demand will increase as well. The AD curve will shift to the right.,Expectations About Future Output,When consumers expect the economy to do well in the future, they will spend more now.,The AD curve s
36、hifts to the right.,Expectations of Future Prices,If one expects the prices of goods to rise in the future while the current price remains constant, it pays to buy goods now before the prices rise. The AD curve will shift to the right. This is most acutely felt in a hyperinflation.,Expectations of F
37、uture Prices,It is difficult to specify the exact reason why expectations will cause a shift in the AD curve because of the interrelatedness of various types of expectations.,Distribution of Income,People tend to spend a greater percentage of their wage income as compared to their profit income.,Dis
38、tribution of Income,As real wages increase, while total income remains constant, it is likely that the AD curve will shift to the right.,As real wages decrease, it is likely that the AD curve will shift to the left.,Monetary and Fiscal Policy,Activist macro policy makers think they can control the A
39、D curve to some extent. Macro policy is the deliberate shifting of the AD curve to influence the level of income in the economy.,Monetary and Fiscal Policy,If the federal government spends lots of money or lowers taxes, it shifts the AD curve to the right.,Monetary and Fiscal Policy,When the Bank of
40、 Canada expands the money supply, it can often lower interest rates and thereby shift the AD curve to the right.,Monetary and Fiscal Policy,Expansionary macro policy shifts the AD curve to the right.,Contractionary macro policy shifts it to the left.,Multiplier Effects of Shift Factors,An AD curve c
41、annot be treated like a micro demand curve. When a shift factor of the AD curve causes it to move, it moves by more than the initial shift factor because of the multiplier effect.,Effect of a Shift Factor on the AD Curve, Fig. 9-2, p 219,The Aggregate Supply Curve,The Short run aggregate supply (SAS
42、) curve shows how firms adjust the quantity of real output they will supply when the price level changes, holding all input prices fixed.,The Slope of the SAS Curve,The SAS curve is an upward sloping line because:,Firms adjust both price and quantity in response to changes in aggregate demand. Diffe
43、rences between expected and actual price causes firms to i) adjust output believing there was a relative price change; ii) adjust quantity when it is costly to change price; and iii) change employment and production when real wages is not as expected.,Shifts in the SAS Curve,Firms change their quant
44、ity and pricing decisions when aggregate demand changes as well as in response to changes in their cost of production.,Shifts in the SAS Curve,Costs of production include wage rates, interest rates, energy prices, and change in prices of other factors of production.,SAS will shift in response to the
45、 change in productivity, as well as change in costs of production.,Shifts in the SAS Curve,The net effect on prices : % change in the price level = % change in wages % change in productivity,Shifts in the SAS Curve,An increase in factor prices increases the costs of production and shifts the SAS cur
46、ve leftward.,A decline shifts it to the right.,Shifts in the SAS Curve,An increase in productivity reduces the cost of production and shifts the SAS curve to the right.,A decrease shifts it to the left.,The Short Run Aggregate Supply, Fig. 9-3a and b, p 220,P0,P1,SAS0,SAS1,Wage rates rise,Real outpu
47、t,Price level,The Long Run Aggregate Supply Curve,The final curve that makes up the AD/AS model is the long run supply curve. The long run supply curve shows the amount of goods and services an economy can produce when both labour and capital are fully employed.,The Long Run Aggregate Supply Curve,L
48、RAS is vertical since at potential output, a rise in the price level means that all prices, including input prices rise.,Available resources do not rise, thus, neither does the potential output.,The Long Run Aggregate Supply Curve, Fig. 9-4, p 222,Potential output,Price level,Real output,LRAS,Equili
49、brium in the Aggregate Economy,Changes in the aggregate supply, aggregate demand, and potential output curves affect short-run and long-run equilibrium.,Short-Run Equilibrium,Short-run equilibrium is where the SAS and AD curves intersect. Shifts in either AD or SAS will affect price levels and output.,If AD increases (decreases), so do output and prices. If SAS increases (decreases), output will also increase (decrease), while price levels move in the opposite direction.,Short-Run Equilibrium: Shift in Aggregate Demand, Fig. 9-5a, p 222,
