Lecture 9 Macro model

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Information about Lecture 9 Macro model

Published on April 16, 2008

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Lecture 9: Macro Mod 5:  Lecture 9: Macro Mod 5 C.L. Mattoli This week:  This week Chapter 14: A Simple Model of the Macro Economy Prelude:  Prelude We looked at macroeconomic concepts and variables, such as GDP and its make-up, inflation, unemployment, and short- and long-term growth of the economy. In this lecture we shall look deeper into some of the concepts that we have talked about, and we shall discuss supply and demand on the aggregate level. We shall examine some models of the macro economy. Learning objectives:  Learning objectives On successful completion of this module, you should be able to: Articulate Keynes’ rejection of the classical school’s explanation of the Great Depression of the 1930s Explain the economic determinants of the components of aggregate expenditure (consumption, investment, government expenditure, and net exports) Construct and use the ‘aggregate demand-output’ model for macroeconomic analysis Learning objectives:  Learning objectives Construct and use the ‘aggregate demand-aggregate supply’ model for macroeconomic analysis In the next lecture: Use the concepts of money demand and money supply to explain the determination of interest rates in an economy Explain the effect of monetary policy on interest rates, prices, output and employment Describe the Australian financial system as an example of a typical financial system in the 21st century Classical Economics:  Classical Economics In classical economics, as led by the famous Adam Smith who imagined markets having an invisible hand that would make everything right, it was believed that markets would always clear. Classically, it was believed that the forces of supply and demand would lead to all goods and services offered being sold and would naturally lead to full employment. That was taken as a corollary of the flexibility of all prices, including wages and interest rates. Say’s Law…isn’t!:  Say’s Law…isn’t! Laws cannot be broken, or they aren’t laws. Such is the case for one of the laws of classical economics: Say’s Law. Say’s Law states that production of G&S (supply) generates an equal amount of spending (demand). First, since people have unlimited wants, while there is limited supply of anything, it might seem logical. Say’s Law…isn’t!:  Say’s Law…isn’t! Second, suppose that we look at the simple circular flow model of GDP, consider a firm in the economy that produces 100,000 packets of noodles to sell at $1/pack. The supply decision potentially creates $100,000 of income through the factor markets as wages, profits and payment for the wheat. So it creates just enough income to clear the market in demand, and everyone remains employed. Say’s Law…isn’t!:  Say’s Law…isn’t! Indeed, if the market could not clear, the price of bread would be bid down, wages and payments would also fall, and again, there would be just enough to keep everyone employed and clear the bread market. If that might not happen immediately, then, it would happen over a short period of adjustment as the price and resulting factor payments came to new equilibrium levels. A prolonged depression (long recession), like that in the early 1930’s after the great stock market crash of 1929, would be impossible according to this law. Keynes Theory:  Keynes Theory Keynesian economics:  Keynesian economics Keynes, in his General Theory of Employment, Interest and Money, turned Say’s Law around, and said that demand creates it’s own supply. He argued that over long periods aggregate demand (expenditures), C+I+G+(X–M) from the modules about GDP (expenditure approach), can be too small to achieve full employment. We shall examine each of these categories of expenditures, in greater detail in what follows. C is for Consumption:  C is for Consumption HH consumption:  HH consumption The primary factor in determining what you and your family spend on food, clothing, shelter, education, and other things is how much money you have, which depends on how much you earn. Disposable income, DI, is personal income after taxes is how much you earn. Psychologically, it is expected that the more a person earns, the more he or she will consume, although that does not mean she or he will spend all of it. HH consumption:  HH consumption The relationship between C and DI is called the consumption function, C = f(DI), consumption is a function, f, of disposable income. In modern developed countries, C accounts for almost two-thirds of aggregate expenditures and is the largest component. Of course, there are other factors that affect consumption, and we shall also discuss those, below. Marginal Propensities for C & S:  Marginal Propensities for C & S If HH do not use DI for spending, C, what they do with it is to save, S: DI = C+S. Since we are talking about how C will depend on DI, we introduce the concept of marginal propensity to consume, MPC, which is just the change in consumption per change in disposable income, or: MPC = ΔC/ΔDI. For example, if a person’s MPC=0.75, then, for every extra (marginal) dollar of DI she gets, she will use 75% of it for consumption. Marginal Propensities for C & S:  Marginal Propensities for C & S Although there is reason to believe that MPC will be higher for lower income than for higher, in the models that we shall discuss, we assume that MPC is constant for all DI. Hand-in-hand with MPC, we will have MPS, the marginal propensity to save. Certainly, since DI = C + S, ΔDI/ΔDI = 1 = ΔC/ΔDI + ΔS/ΔDI = MPC + MPS, so that MPS = 1 – MPC. Thus, the person, above will have MPS = 1 – 0.75 = 0.25. Expectations and consumption demand:  Expectations and consumption demand Consumer expectations (sentiment) about the future can also affect spending habits in the present. They will tend to spend more when they are optimistic about the future and less when they are pessimistic. Expectations will cover a number of things, like future inflation, future employment, future income, and future prices. For example, if people expect inflation to move higher, they may buy, now, to avoid higher prices, later. If they expect a recession and the possibility of being unemployed, they might tighten their belts and spend less, now. Wealth:  Wealth The wealth of HH’s includes things, like cars, TV sets, furniture, art, horses, and financial assets, as well (home purchases are part of I). The more wealth HH’s accumulate, the more they are expected to spend, ceteris paribus, and conversely. The large losses of wealth in the stock market crashes of 1929 and 2001 were blamed for large dips in consumption spending, and the latter also resulted in a negative savings rate in the U.S. in the early 2000’s. Price levels:  Price levels Changes in the general level of prices can affect consumption spending (demand) by increasing or decreasing the purchasing power of financial assets that have fixed nominal values. For example, if you have a $100,000 bond, and prices increase by 10%. Then, the same financial asset will buy approximately 10% less in G&S when you sell it. If the real value of wealth drops, HH’s will tend to spend less at any level of current DI. Interest rates:  Interest rates Interest rates, as we learned in the last module, also vary with the rate of inflation. Some HH purchases (big-ticket items), like cars, large appliances, boats and houses, are usually at least partly paid for with borrowed funds. Lower interest rate encourage borrowing, and higher rates discourage taking on debt. As a result, HH’s will be more disposed to using debt to finance consumption, when rates fall, and may be less inclined to make purchases on creidt when rates are higher. I is for Investment :  I is for Investment I and C:  I and C It is widely believed that that changes in private-sector spending, C+I, are the major cause of business cycles. The more volatile of these two components is I. The greater stability of C has to do with factors, other than income, acting to offset one another. Indeed, people might simply be reluctant to change personal spending habits and will dip into savings or borrow money to maintain their lifestyles. Remember: I consists of spending on new residential and non-residential structures, P&E, and inventories. Major factors for I:  Major factors for I The two most important variables in the investment decision are: the expected return from the investment and the interest rate for funds to finance the investment. For example, suppose that I want to buy a truck for transporting beer between Qingyuan and Guangzhou. The cost of the truck is $30,000, it will be scrap in a year, and I can earn $33,000 during the year. Major factors for I:  Major factors for I Then, my return on investment (ROI) is ($33,000 – $30,000)/$30,000 = 10%: my earnings minus cost divided by investment. Next consider the cost of borrowing money to finance the truck. If the interest rate is below 10%, I can make a positive return by borrowing all of the money to finance the truck. If the rate is above 10%, my net return would be negative, and I could not do it. Ceteris paribus, this simplistic example suggests that as interest rates fall, aggregate investment spending will increase The expectations factor in I:  The expectations factor in I If you look closely at our 2 major factors in I, the word expected should pop out. Expectations play a primary role in business decisions since all investment has a future-oriented nature. We invest, now, to get money, then, and many things can affect expected returns. As irrational human beings, business people are moody and can become optimistic or pessimistic about economic conditions. Then, those expectations involve normative analysis in forecasting sales, costs, and ultimately profitability of investment projects. The expectations factor in I:  The expectations factor in I Forecasting, in turn, involves consideration of a mass of ever-changing factors, such as consumer sentiment, population growth, trends in tastes, government spending, taxes, central bank monetary policy, conditions in securities markets, and national and world events. Forecasting and confidence in forecasts is quite difficult, and there can be waves of pessimism and optimism in business because people talk to each other and watch each other, and attitudes spread. All of this is against a background of a current rate of interest for investment funds. The expectations factor in I:  The expectations factor in I The result can be broad-based reductions or increases in investment spending in the economy. That was the case during the Great Depression of the 1930’s. It also played a part in the early part of this century. Thus business confidence is a major cause of fluctuations in investment spending. Technological change:  Technological change Technological progress includes the introduction of new products or new ways of doing things. New technology results in a flurry of investment spending as firms buy the latest technology to improve production and to keep up with or ahead of the competition, so investment demand rises. Indeed sometimes purchases of technology are necessary, like was the case in the 1990’s as everyone rushed to buy technological fixes as the world approached Y2K. Capacity utilization:  Capacity utilization The amount of capacity being used by businesses in the economy will also have a major affect on new investment decisions. During recessions, many businesses are operating below their maximum potential productive capacities. Thus, there is little incentive for business to make new investment to add to their capital stock to increase productive capacity. When cap utilization is high and the outlook for increased sales is good, there is pressure to invest to increase capacity. Business taxes:  Business taxes Since, after all, businesses, as anyone, focuses on profits after tax, changes in taxes can also affect business decisions about investing. If taxes increase, profitability of potential projects will decrease at any interest rate, and investment spending will decrease. On the other hand, government can encourage investment with, for example, investment tax credits of some sort for new investments. For example, the government could offer a tax credit of 10% on new investment in addition to the usual depreciation expense available for investment. G is for Government Demand:  G is for Government Demand G equals government consumption & investment:  G equals government consumption & investment Government spending is considered autonomous expenditure: they are not affected in any systematic way by changing interest rates or income. The rationale for that assumption is that government spending results, primarily, from political decisions, not from economic impetus, like the level of output or interest rates. This particular part of expenditures was crucial for Keynes, in that, even if private sector was fearful about the future and was reluctant to spend for consumption and investment, the government could be the vanguard of spending an could kick start the economy and stimulate private sector spending by improving sentiment about the future. X – M is for Net Exports:  X – M is for Net Exports Export demand = X:  Export demand = X In a first approximation, exports can be treated as independent of a nation’s level of domestic real GDP. So, like G, they are autonomous (versus domestic) expenditures. Export spending depends on economic conditions in the countries that buy export goods from Australia Imports = M:  Imports = M The level of imports will depend on conditions in the domestic economy. As real GDP increases, ceteris paribus, imports, along with other spending, will increase, and net exports, being X – M, may decline, depending on world economic activity and consequent demand for exports. Foreign exchange rates:  Foreign exchange rates Currencies of other countries are generally referred to as foreign exchange (FX), and the rate of one currency in terms of another is called the exchange rate. For example, the rate between Australian dollars (FX symbol AUD) and the Chinese Yuan (CNY) is currently (May 2007) AUD = 6.37 CNY. In general. FX rates change (most countries allow their currency rates to float in the market and allow them to be determined by market forces; China is only now working towards allowing its currency to fully freely float), for example, just several months ago the rate between AUD and CNY was AUD = 5.9 CNY. Foreign exchange rates:  Foreign exchange rates In that regard, when the exchange rate decreases, i.e., if AUD declined to 5 CNY/AUD, exports from Australia to China would be cheaper, and demand for exports might increase. Concurrently with a drop in currency price and cheaper exports, imports become more expensive for Australians. Thus, the net result of a decrease in a country’s currency price will, ceteris paribus, be that net exports, X – M, will increase. Conversely for an increase in the country’s currency vis-à-vis its trading partners’ currencies. Terms of trade:  Terms of trade The terms of trade are defined as the ratio of export prices to import prices. Thus, increased terms of trade means that the country’s exports are becoming relatively more valuable in the international market. In turn, increased terms of trade will encourage exporters to expand output, and exports can be expected to increase and, ceteris paribus, net exports will increase. The opposite will result from a decrease in a country’s terms of trade. The Aggregate Demand-Output Model: Keynesian Model:  The Aggregate Demand-Output Model: Keynesian Model Aggregate demand (AD):  Aggregate demand (AD) In module 4, we used this format, C+I+G+(X – M), to describe the accounting definitions that make up GDP. There, any discrepancy between what was bought and what was produced was accounted for by change in inventory. Now, we are talking about the demand represented by these various components of spending in the economy. Aggregate demand (AD):  Aggregate demand (AD) Spending decisions are made by one set of people based on certain factors, while production decisions are made by another group based on other completely different factors. Keynes was the first to argue that AD might not equal total production, contrary to classical thinking. Aggregate Supply (Production):  Aggregate Supply (Production) Based on expectations and predictions about demand for their products, firms will, at any given time, be offering certain quantities of output for sale at prices that they expect will be acceptable to buyers. Those prices and quantities are linked to the return on investment: the revenues over and above all explicit costs, including interest on debt. This newly produced output for the economy is referred to as aggregate supply (AS). In the marketplace: supply meets demand:  In the marketplace: supply meets demand Buyers, including HH, business, government and foreigners, will be in the market bidding on the output. This aggregate demand will depend on their needs, wants, expectations of the future, prices in relation to their income and to close substitutes, and for large purchases, the price of money, interest rates. Aggregate demand is the willingness to purchase the G&S offered. Where do they cross?:  Where do they cross? AD and AS do not necessarily have to be equal. In national accounting, any difference between the two is accounted for by unintentional changes in inventory, in the period. In subsequent periods, the supply side will respond with change in output, prices, or both. In the Keynesian model, it is assumed that the response to the mismatch in supply and demand, on the supply side, is purely in terms of output, not prices. Aggregate example:  Aggregate example Assume the economy is operating at a particular time at full employment with an output of $500 billion. In the next period, suppose that the demanders were unwilling to take up that amount of output, and purchased only $490 billion of the output. Aggregate example:  Aggregate example Then, firms will end up with inventory of $10 billion on their shelves, an unplanned investment. In response to this disequilibrium between supply and demand, the supply side will lay off workers and will produce less output (supply) in the next period. Thus, the economy will operate below its full employment level. Classical vs. Keynesian:  Classical vs. Keynesian In the classical view, the response to this mismatch between supply and demand would be dealt with trough a price adjustment. Prices, including the underlying wage component would be reduced, and the market would clear at a lower equilibrium price. The Keynesian view was that prices, especially wages, were resistant to downward pressure, and that the real world response to such a situation as supply outstripping demand would be reduction in output, not price. Classical vs. Keynesian:  Classical vs. Keynesian As a result, people would be laid off, and expectations about the future would decline. Moreover, such a situation might continue for an extended period of time, and the economy could continue to operate below its full-employment output capacity, resulting in continued involuntary unemployment. The Keynesian policy solution to such a state of affairs is for government to take up the slack and increase aggregate demand, through G, until the full-employment level is reached. Otherwise, the economy may never readjust and unemployment and poor expectations will continue. That was the way out of the Great Depression of the 1930’s The spending multiplier effect:  The spending multiplier effect In the Keynesian world, increased aggregate demand can be met because there is sufficient excess capacity to increase output to a higher level. The change in the economy is begun with government spending or taxation, which is multiplied in the economy by rounds of re-spending. It is important to note that the components of AD, C, I, G, X – M, are not independent of one another. For example, a stimulus, for some reason, to consumption could lead to firms increasing their output and buying machinery, I, to further expand. The spending multiplier effect:  The spending multiplier effect That would result in higher employment in the equipment manufacturing and related industries, which would feed into more increased consumption. The feedback through the system would continue. The induced expenditures comprise a multiplier effect: the original expenditure increase (or decrease) gets multiplied. The spending multiplier effect:  The spending multiplier effect Thus, in the Keynesian policy prescription, if a government acts to stimulate demand, that will flow over into the private sector by increasing employment, output and consumption. That can be accomplished with a relatively small stimulus due to the multiplier effect. The bad news is that a small decline in aggregate demand due to, say, consumer or business pessimism about the future, can be multiplied on the downside. That could magnify the decrease in output, employment and consumption. Formal Keynes: the Keynes Cross:  Formal Keynes: the Keynes Cross Aggregate demand is aggregate willing ness to consume. Consumption is a major part of AD, and income is a large factor in determining consumption. Also important for consumption are expectations, wealth, price level, and interest rates. Formal Keynes: the Keynes Cross:  Formal Keynes: the Keynes Cross Given the large part of AD represented by C and income Y a large factor in C, we assume that income is a large factor in demand. Also, given the theoretical equivalence of income and output, we represent income by real GDP. Then, we can plot AD versus Income (real GDP) as in the graph in the next slide. The Keynes Cross: Graphically:  The Keynes Cross: Graphically The AD line crosses the 45o-angle line, Y = RGDP = Output: AD=output. 45o AD = C+I+G+(X-M) Aggregate Demand Real GDP The Keynes Cross: Analytically:  The Keynes Cross: Analytically In the graph, we show the AD line versus real GDP = income by relationships from chapter 11. It rises at less than a 1-to-1 rate (slope < 1) because consumption does not rise as fast as income, although it rises as income rises. The plot shows a 45 degree-angle line which is just a plot of when AD = Y = RGDP. Thus, the point at which the actual AD line crosses the 1-1 line is an equilibrium between AD and output. That is a Keynes Cross. The Keynes Cross continued:  The Keynes Cross continued Next, suppose that the AD curve shifts because of some increased spending by government. Then, a new equilibrium will obtain but at a higher level of real GDP but more than was added to shift the AD curve up. That is because of the multiplier effect in the economy (trickle down). The situation is depicted in the next slide. The Keynes Cross continued:  The Keynes Cross continued The multiplier effect makes output increase by more than the initial addition to spending. 45o AD Aggregate Demand Real GDP AD ∆Output ΔAD The double cross:  The double cross What happens is that the initial addition to spending creates more production. The extra production generates more income which generates more production. That continues until a new equilibrium is reached. Moreover by the time that the process has paid itself out, it will have resulted in a greater increase in output than the original increase in spending. Moving the cross:  Moving the cross Factors that can move the AD curve include non-income determinants. These could include an increase in government spending, increased demand for exports, changing sentiment of consumers and/or businesses, or a change in interest rates. Indeed, interest rates are a policy tool of the government. The RBA sets target rates for the shortest-term borrowing in the wholesale market for funds: the overnight, inter-bank borrowing. Break time:  Break time 10 minute break The Aggregate Demand-Aggregate Supply Model:  The Aggregate Demand-Aggregate Supply Model Intro:  Intro Keynes theory had a simple fix for the Great Depression: government begins the spending, jobs are created, and aggregate demand follows suit. Although inflation was not a big problem, back then, his theory also has implications for demand-pull inflation. For that case, the Keynesian solution would be for the government to cut spending and raise taxes to take the heat off aggregate demand. Intro:  Intro However, in order to properly understand business cycles, we must also consider aggregate supply added to the simple Keynes theory of aggregate demand. When we add the two curves, AD and AS, together, we will be able to understand how shifts in these aggregate curves can affect the price level, the equilibrium level of real GDP, and employment in the economy. That will be the AD-AS model of macroeconomics. The AD Curve:  The AD Curve The AD curve construction:  The AD curve construction The AD curve for the economy-wide demand curve for all goods and services. It is the level of real GDP that HH, businesses, government and foreigners would be willing to purchase at different average price levels during a specific period of time, ceteris paribus. Like in the case of demand for a single product, other factors remaining constant, the lower the average economy price level, the higher the aggregate quantity demanded for the aggregate of G&S. It is downward sloping. The AD curve construction:  The AD curve construction While for individual products, the horizontal axis measures physical units, like tons, for AD the units are in terms of real GDP, or the quantity of aggregate production demanded, as measured in the dollars of some base year. The vertical axis for AD is some sort of average measure of prices, an index of prices, like GDP deflator or the CPI. An example is shown in a slide, below. The AD curve construction:  The AD curve construction We must point out that while there is a similarity between the aggregate demand curve and an individual product demand curve, there is a subtle but large difference. When we move along an individual demand curve, we assume that prices of related goods are constant. When we move along the AD curve, that assumption is meaningless because we are using a market basket measure for all G&S. In the next slide we show an example AD curve. Example AD curve:  Example AD curve The AD curve shows the relation between the price index level and the level of real GDP. The lower the price level, the higher the GDP demanded. If the price level is at 100, the demand by HH, business, G and foreigners is $400 bil. At point A; if it is 150, the real GDP demanded is $600 bil. At B. A B 200 100 0 Price level CPI, 1982-84 =100 400 600 800 1000 1200 Real GDP ($ billion/year) Causal Chain Decrease in Price level Increase in Real GDP demanded Determining the shape of the AD curve:  Determining the shape of the AD curve For an individual demand curve, it is downward sloping, partly because we assume that prices of close substitutes remain constant. Thus as the price of an individual product decreases, its price relative to substitutes becomes more attractive, and we expect, ceteris paribus, that a higher quantity will be demanded. Determining the shape of the AD curve:  Determining the shape of the AD curve For the AD curve, the reasons for its shape are very different and include the real balances effect (wealth effect), the interest rate effect, and the net exports effect. Moreover, the wealth and interest rate effects are tempered by the further assumption that the total nominal quantity of liquid financial assets in the economy is fixed during the time period under consideration. Liquid Assets:  Liquid Assets A liquid financial asset is one that can be easily converted into a form of exchange that can be used to purchase G&S. Easily converted means with little time-delay or effort and negligible loss of nominal value. Cash is the most liquid. Then, there are demand accounts at banks and government bonds. There are also things like corporate bonds and stocks, which have a liquid trading market but which might involve some loss of value. Other fixed-term deposits or bonds are much less liquid. The Real Balances (Wealth) Effect:  The Real Balances (Wealth) Effect Liquid financial assets are but one financial asset whose real value changes with changing price level, i.e., in terms of purchasing power (PP). Thus, if you have $1,000 in bank and it will buy 10 weeks worth of groceries, then, if the price level drops by 20%, your money will buy 12 weeks (10 weeks x 1.20) worth of groceries. In that regard, if prices drop, people will have feel wealthier and they will show more willingness to spend their money. The Real Balances (Wealth) Effect:  The Real Balances (Wealth) Effect To them, real value of their financial assets is measured in terms of the quantity of G&S that their “money” will buy. The lower the price level, the higher the real value, and vice versa. When inflation, on the other hand, reduces the real purchasing power value of the nominal stock of financial assets held by HH, they will buy less and real GDP will fall. Prices up, real value of wealth down, people feel poorer and are less willing to part with their reduced stock of financial assets. The Real Balances (Wealth) Effect:  The Real Balances (Wealth) Effect The wealth effect is, then, defined as the impact on total aggregate spending (real GDP) of the inverse relationship between the price level and PP of financial assets of fixed nominal value. Thus, price level ↑, aggregate demand ↓, ceteris paribus, due to the wealth effect. When people feel richer, they are more optimistic and they tend to spend more. When they are feeling poorer, they feel less confident about they future, they tighten their belts and spend less. The Interest Rate Effect:  The Interest Rate Effect As discussed in the lecture about inflation, inflation is built into interest rates. Indeed, if someone decides to save and to limit current consumption, they will want to be compensated by being paid at least the rate of inflation for renting out their money. If they forego consumption, now, they will want to be able to buy at least as much in real value, later, as now. The Interest Rate Effect:  The Interest Rate Effect How inflation enters interest rates will involve present inflation as well as expected future inflation. Thus, increasing price levels, in general, will cause increasing interest rates. As prices are bid up, more people will have less money and will want to borrow to support present consumption, and they will bid up the nominal price of a fixed supply of funds available for borrowing: the interest rate. The Interest Rate Effect:  The Interest Rate Effect As interest rates rise, people are discouraged to borrow. They will put off buying houses, cars, boats, and plant and equipment, on the business side. Thus, a higher price level, further, induces higher demand for limited available credit funds, which pushes up interest rates, which will cause aggregate demand for real GDP to fall, ceteris paribus. Price level ↑, demand for borrowed funds ↑, interest rates ↑, aggregate demand for real GDP ↓. The Net Export Effect:  The Net Export Effect The way that everything is mixed into aggregate demand, products that can, for example, compete with one another, we must especially take note of the relationship between domestic price levels and the prices of foreign goods vis-à-vis competing locally-produced goods. If prices of imports, M, are relatively more favorable than those of local goods, then, M will increase, which will be at the expense of aggregate demand for real GDP. The Net Export Effect:  The Net Export Effect In addition, a higher relative price level for domestically-produced G&S for export will affect the demand for exports, and aggregate demand for real GDP will, again, be adversely affected. Thus, domestic prices ↑ can also lead to net export ↓ will result in aggregate demand for real GDP ↓. The Causal Nature of downward-sloping AD:  The Causal Nature of downward-sloping AD Non-Price-Level Determinants of AD:  Non-Price-Level Determinants of AD In analogy with demand curves for individual products, we must look at non-price factors in aggregate demand. Recall that price changes correspond to movement along a demand curve, while non-price changes cause the AD curve to actually shift and become a new demand curve. Thus, it is with AD. A change in any component, C, I, G, X-M, can shift the entire AD curve: outward for an increase, and to the left for a decrease. We show an example of AD outward shift in the next slide. Increase in non-price-level determinants :  Increase in non-price-level determinants Increase in NPL determinant, C, I, G, X – M, leads to an outward shift of aggregate demand to higher level of real GDP at all prices. Conversely, for decreases. A B 200 100 0 Price level CPI, 1982-84 =100 400 600 800 1000 1200 Real GDP ($ billion/year) Causal Chain Increase in NPL determinant, C, G, I, X-M Increase in AD curve AD1 AD2 Graphical analysis: shifts out:  Graphical analysis: shifts out A cause may have been an increase consumer sentiment (more optimistic), and they decided to loosen their belts and spend some more money. It might have been that prices of LT assets, like houses or stock market prices made people feel richer and spend more money. Maybe business has become more optimistic, expects good returns from new investment, and they will buy more P&E. Graphical analysis: shifts out:  Graphical analysis: shifts out Or maybe even the government will boost its level of autonomous spending. It can also come from a rise in net exports. THIS IS PARTICULRLY TRUE FOR A COUNTRY LIKE AUTRALIA WHICH RELIES HEAVILY ON INTERNATIONAL TRADE. Increased exports can come from better economic outlooks in the economies of trading partners. Graphical analysis: shifts out:  Graphical analysis: shifts out It might also come from the relative value of the country’s foreign exchange rate. As the exchange rate becomes more domestic currency per unit of foreign currency, means foreign money can buy more domestic goods, and export demand will increase. With the price level at a standstill at 100, C pushes total AD outward. At the fixed price level, the new demand will increase from $500 to $600 billion real GDP. Aggregate demand will be higher at any price level and the curve is shifted from AD1 to AD2. Graphical analysis: shifts in:  Graphical analysis: shifts in Similar factors can lead to inward shifts of the AD curve and reduce AD at any price level. It could be that a wave of pessimism might be sweeping the consumer or the business sector or both. Government might, for some reason, reduce its spending. Changes in government spending, for example, might come especially as one government regime exits and a new one enters office after elections. Exports might fall and imports might rise, either from changes in the economies of trading partners or competitors, or from changing terms of the exchange rate between currencies. The AS curve:  The AS curve Intro:  Intro In the short run, the aggregate supply curve, AS, is just like a the supply curve for an individual market. Again, the reasons for upward-sloping AS is quite different from the motivations for upward-sloping individual market supply curves. Intro:  Intro For market supply, producers are motivated by profits-maximization under a constraint of fixed costs and variable costs will supply more quantity at a higher unit price. In the AS situation, rising price level means rising prices of things is not only prices of final output but also some or all of the inputs, including labor. The AS curve defined:  The AS curve defined Thus, the AS curve is defined as the level of real GDP that firms would be willing to produce at different general price levels during a given period of time, ceteris paribus. It is the value of G&S that firms are willing to produce at various sales plus costs price levels. There are two polar opposite characteristics that we shall discuss about AS curves: the Keynesian horizontal supply curve and the classical vertical supply curve. AS in Keynes:  AS in Keynes In Keynes view, an economy in depression has many idle resources. That results in producers willing to supply more at current prices. In turn, the supply of unemployed workers willing to work at current prices diminishes workers’ ability to seek increased wages. Also, all of the excess capacity in the economy will not allow firms to try to raise prices as there are plenty of other firms willing to supply without a price increase. AS in Keynes:  AS in Keynes Then, assuming Keynes’ stickiness of prices, especially to the downside, changes in aggregate demand shift the AD curve outward at the same prices for more G&S. Thus, the Keynesian AS curve is strictly horizontal. We show the basic Keynesian view of aggregate supply and increased demand in the next slide. Keynesian horizontal AS:  Keynesian horizontal AS Sticky prices on the downside and the inability of either labor or businesses to raise prices because of excess competition means that increased AD will be met with increased AS at an unchanged price level. Demand creates its own supply. A B 200 100 0 400 600 800 1000 1200 Real GDP ($ billion/year) AD1 AD2 Full Employment AS G increases AD increases and shifts P constant real GDP & Employment rises A Causal Chain AS, Classically:  AS, Classically The AS curve is vertical in classical theory for two reasons. First, the normal tendency for an economy is to operate at full employment output. Second, prices of output and production cists are flexible and will change rapidly in order to maintain full employment in the economy. This is completely at odds with the Keynesian view. AS, Classically:  AS, Classically Suppose that aggregate spending from HH and businesses because they have developed negative sentiment. That causes AD curve to shift downward. A temporary surplus will exist on the market at the current price, which manifests itself as involuntary inventory accumulation. In order to deal with the new reality, firms begin to cut prices, to move inventory, and they will plan on producing less output in the next period. AS, Classically:  AS, Classically In turn, there will be less demand for factors of production, including raw materials and labor. That labor allows its price to be down is that prices, in general are going down, so real PP is not affected. Owners of other factors of production will also accept lower prices We look at this graphically in the next slide. Supply creates its own demand. Classical vertical AS illustrated:  Classical vertical AS illustrated In the classical view, if the aggregate demand curve drops, at the same price, a surplus will exist, and prices, including wages will adjust downward to a new equilibrium at the same output level as in the beginning, but at a lower price of wages to maintain full employment. E1 ESR 200 100 0 400 600 800 1000 1200 Real GDP ($ billion/year) AD2 AD1 Full Employment AS G increases AD increases and shifts P constant real GDP & Employment rises E2 A Causal Chain Surplus The mid-range of AS: upward sloping:  The mid-range of AS: upward sloping Having examined the asymptotes of the AS curve, we shall look at the middle range of the curve. In this neo-classical interpolation of classical with Keynes AS, an intermediate splice is put into the middle of the curve where both price and output will rise as a country approaches full employment. We show the neo-classical AS supply curve in the next slide. Neo-classical AS curve illustrated:  Neo-classical AS curve illustrated The neo-classical theory is an interpolation of the Keynesian and classical extremes as a j-shaped curve. In the mid-range, AS is curved and upward trending. Keynes range Classical limit Intermediate Range Full Employment AS meets AD:  AS meets AD AS meets AD, neo-classically:  AS meets AD, neo-classically Equilibrium is achieved between AS and AD at a certain price and level of output. If output was below demand, it would be expanded. If it was above, output would be cut back Full Employment AD AS GDP Gap E Changes in AD-AS Equilibrium:  Changes in AD-AS Equilibrium First we can look at changes in AD while the AS curve remains fixed. What will happen in the aggregate market when aggregate demand changes will depend on which range of the AS supply curve we are in. There are three areas and three different types of adjustment processes to consider. Changes in AD-AS Equilibrium:  Changes in AD-AS Equilibrium In the Keynesian region, production will increase through hiring and use of idle capacity. The result will be higher output equilibrium quantity at the same price level as before. In the intermediate range, first, will be some bottlenecks to production when some firms reach full capacity, while others are still below capacity. Changes in AD-AS Equilibrium:  Changes in AD-AS Equilibrium For example, the steel industry might already be at full capacity when car production is not yet at its peak. As a result the price of steel will be bid up along with the price of cars. Also, a shortage of certain labor skills may obtain, and labor will demand a higher price for skills in short supply. That will also increase end prices. Changes in AD-AS Equilibrium:  Changes in AD-AS Equilibrium Finally, as the economy approaches full employment, less productive employees and less productive capacity will be put into use. That creates higher production costs which will be passed on to consumers in the form of higher prices. In the final classical range, as the aggregate demand curve shifts out, only price changes, and inflation is the result as there is already full employment. Changes in AD-AS Equilibrium:  Changes in AD-AS Equilibrium Changes in AD over 3 ranges of neo-classical AS Changes in the AS curve:  Changes in the AS curve Changes can also occur in AS as changes in factors of production change, like cost of resources, both foreign and domestic, taxes, technological change, regulation and subsidies. Each of those factors affects production costs. At a given price level production costs will determine profits. The response will be to cut output, increase prices or both. Shift in the AS curve illustrated:  Shift in the AS curve illustrated Causal chain: change in non-price-level determinant of supply → change in AS curve Full employment Changes in AS:  Changes in AS Other things can change to cause a change in AS. For example, lower oil prices, better management practices, improvements to the infrastructure inputs into the production process (microeconomic reform), lower taxes and government regulation. Opposite shifts in AS can occur for opposite changes in those types of variables. Cost-push & demand-pull Inflation:  Cost-push & demand-pull Inflation We can now examine the two types of inflation from the point of view of the AS-AD Model. Cost-push inflation comes about from an inward shift in the AS curve. Demand-pull inflation is caused by an outward shift in the aggregate demand curve. We shall illustrate these basic types of inflation with historical examples. The Stagflation of the 1970’s:  The Stagflation of the 1970’s Stagflation, stagnation and inflation, occurs when there is high unemployment and rapidly increasing prices. That occurred in the 1970’s after the huge increase in oil prices caused cost-push inflation. In our model, that is represented by a shift to the left of the AS curve. The result will be a new equilibrium with fixed demand at a lower level of output, higher prices, and less employment. On top of that, labor pushed for higher wages without concomitant increases in labor productivity. Demand-pull:  Demand-pull In 1982-84 Australia experienced a recession, and the government tried to kick start the economy through Keynesian expansionary macroeconomic policy. As a result, the AD curve was pushed outwards. The new equilibrium point for AS and AD moved output up but also led to demand pull inflation, as prices also rose. The business cycle:  The business cycle Thus, changes in AS or in AD can result in new equilibriums. It depends on where we are on the aggregate supply curve, considering the 3 regions. Then, changes in AS or AD can lead to swings in output and prices. In the next several modules how other policy can affect the economy, including changes in taxation, spending, and the supply of financial liquidity. Homework:  Homework Chapter 14 All problems and multiple choice. Next week:  Next week END:  END

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