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Economics 314 Coursebook, 2012 Jeffrey Parker
2 AGGREGATE SUPPLY AND DEMAND: A
SIMPLE FRAMEWORK FOR ANALYSIS
Chapter 2 Contents
A. Topics and Tools ............................................................................. 1 B. Output and Prices ............................................................................ 2 Levels or growth rates? .................................................................................................. C. Aggregate Supply and Demand ........................................................... 4 Aggregate supply and the natural level of output .............................................................. Upward-sloping aggregate supply ................................................................................... A fixed point on the short-run AS curve .......................................................................... Aggregate demand ........................................................................................................ Does the aggregate-demand curve slope downward? ......................................................... Static equilibrium ....................................................................................................... 11 Shocks to aggregate demand ........................................................................................ 11 Shocks to aggregate supply .......................................................................................... 13 D. Dynamic Equilibrium in the AS/AD Model .......................................... 15 Why the AS curve shifts over time ................................................................................ 15 Why the AD curve shifts over time ............................................................................... 15 Equilibrium with growth and inflation ......................................................................... 16 A “growth recession” .................................................................................................. 18 E. A Preview of Romer’s Text from the Perspective of Aggregate Supply/Demand ................................................................................. 20 Growth models ........................................................................................................... 20 Real business cycles..................................................................................................... 20 The IS/LM and Mundell-Fleming models ................................................................... 21 F. Suggestions for Further Reading ......................................................... 22 G. Works Cited in Text ....................................................................... 22
A. Topics and Tools
Nearly every introductory and intermediate textbook on macroeconomics uses the framework of aggregate supply and aggregate demand to model the macroecon-
omy. Romer’s text refers to this model occasionally, but never describes it in detail. This chapter presents a simple version of aggregate supply and aggregate demand that summarizes what most undergraduates learn about macroeconomics. The goal is not to cram a basic macroeconomics course into one chapter, but rather to describe a simple analytical framework that can be used to provide context for the detailed models we will study.
B. Output and Prices
The central endogenous variables in aggregate supply-demand analysis are real output and the general price level. With the assignment of quantity to the horizontal axis and price to the vertical axis, the AS/AD model resembles the familiar supply- demand model of perfect competition. Indeed they are very similar in some ways, however it is extremely important not to push the parallels too far; some properties of the curves and models are very different. The variables on the axes of the AS/AD model sound very much like the famil- iar quantity and price variables of microeconomics, but there are important differ- ences. The quantity variable on the horizontal axis of the AS/AD model measures the total output of the economy (real GDP) rather than the physical output of some specific commodity. This leads to important differences in the interpretation of the curves. For example, the demand curve for zucchini slopes downward because con- sumers will substitute other foods as zucchini get expensive. In the macro model, GDP is all goods, so there is nothing obvious to substitute for GDP if it gets expen-
sive. 1 Thus, in the macro context we cannot rely on the familiar logic of substitution to motivate the negative slope of the demand curve. The price variable on the vertical axis is also fundamentally different. In the AS/AD model, price refers to the aggregate price of all goods and services—a price index like the GDP deflator—rather than the relative price of zucchini as in the micro model. Again, this has important implications for the behavior of the curves. An in- crease in all prices may not have any effect on either quantity supplied or quantity demanded if, along with the increase in prices, nominal wages and nominal stocks of assets such as money all increase in equal proportion. This is the familiar principle that the economy exhibits no money illusion —people care only about the real value of things, not about the number of dollars attached to them. If all dollar labels are rede- fined in a proportional way, nothing is more or less expensive than before and there is no reason for real purchases or sales to change.
(^1) Future goods and foreign goods are possible substitutes. We’ll have more to say about such
issues later on.
C. Aggregate Supply and Demand
In competitive microeconomic markets we use the supply curve and the demand curve to represent, respectively, the behavior of the producers and buyers of a com- modity. By examining the interaction of the two curves and imposing an assumption that the price adjusts to clear the market, we model the equilibrium levels of quantity exchanged and price at the intersection of the two curves. The aggregate supply (AS) curve and aggregate demand (AD) curve perform sim- ilar roles for the aggregate macroeconomy. The AS curve summarizes the behavior of the production side of the market: production decisions of firms and activities in the markets for factor inputs. The AD curve summarizes desired purchases in the macroeconomy and activities in asset markets that influence demand behavior. Like microeconomic supply curves, the AS curve often slopes upward, though the underlying logic justifying its shape is quite different. The AS curve can be hori- zontal or vertical under some conditions. Unlike microeconomic supply curves, which tend to me more elastic in the long run than in the short run, the AS curve is perfectly inelastic (vertical) in the long run and may be highly elastic (flat) in the short run. The AD curve is generally downward-sloping, just as the microeconomic demand curve is, but again the reasons for the negative slope and the conditions un- der which it is elastic or inelastic are quite different.
Aggregate supply and the natural level of output
In microeconomic markets, the positive slope of the supply curve is very natural. If a single good becomes more valuable relative to other goods ( i.e. , its relative price increases) then firms will devote more of their productive activity to producing that good, taking resources away from production of other goods. However, this logic does not work the same way in the aggregate macroecono- my. A price increase in the macroeconomy means that the prices of all goods have increased. Will this across-the-board price increase impel firms to use more resources to produce goods and services? Maybe, but not necessarily. The benchmark model of neoclassical economics is the perfectly competitive general-equilibrium (PCGE) model. This is the core model of most microeconomics courses; it is the model that most economists think of first when trying to answer questions about market economies. In the PCGE model, the prices of all goods and inputs are perfectly flexible, all agents are perfectly informed, entry and exit are costless, and no one has any market power. Because buyers and sellers are price-takers, there are well-defined demand and supply curves relating quantities demanded and supplied to price. The quantity
of each good and service produced and sold is determined uniquely by the point of intersection of the supply and demand curves. In competitive general equilibrium, every commodity in the economy has a per- fectly competitive market. Relative prices adjust freely upward and downward in each market based on the relative scarcity of the commodity. Each commodity has a unique equilibrium quantity produced and sold. If we were to add up the real value of all of the commodities produced in equilib- rium of the PCGE model, we would obtain a unique value of GDP that reflects the equilibrium amount of production. This unique equilibrium quantity of aggregate output in the PCGE model is called the “natural level of output,” or sometimes ca- pacity output or full-employment output. Theorems of welfare economics assure us that the competitive equilibrium allocation of resources (and therefore the amount produced) is Pareto-optimal, given the amounts of factors of production that are available and the optimal decisions by laborers about allocating their time between work and leisure. Although natural output is crucially important for macroeconomic theory and policy, it cannot be directly observed or measured. Policymakers must try to estimate the amount that could or should be produced with the current technology and re- source endowments in order to know whether current actual output is too low or too high. The natural level of output does not depend on the dollar value of prices in any way. PCGE determines an equilibrium relative price for each commodity. For exam- ple, equilibrium might require that apples be half as expensive as bananas and that the real wage of unskilled labor be 10 apples per hour of work. However, whether this is achieved by apples costing $0.10, bananas $0.20, and a nominal wage of $1. or by apples costing $500, bananas costing $1,000, and a nominal wage of $5,000 is completely irrelevant to PCGE model equilibrium. Any price level is consistent with production at the natural level of output.^3
(^3) The aggregate dollar price level reflects (inversely) the relative “price” of the dollar. The
PCGE model does not determine the aggregate price level unless we introduce money as one of the commodities. When money is a commodity that has traditional uses, such as gold, its price can be determined in a competitive market within the PCGE model. Modern monetary economies use fiat money, which has no intrinsic value and no use other than in exchange for commodities. PCGE models usually assume that exchange is costless, thus there is no need for agents in these idealized worlds to hold money in order to reduce transaction costs. If no one needs to hold money, then there is no demand for it—money will have a zero price and the aggregate dollar price level will be undefined. In order to establish an equilibrium price of money (and a finite aggregate dollar price level), we must examine the demand for money, which is a central feature of traditional macroeconomic models.
Note that in this case we would expect all firms eventually to change their prices (once the old menus wear out), so the justification for an upward-sloping AS curve holds only in the short run. We still expect the long-run response to be an increase in all nominal prices with production back at Y (^) n , so the long-run AS curve is vertical. Another possibility is that some of the firm’s nominal costs fail to rise along with prices. For example, if wages are set in nominal (fixed-dollar) contracts that last a year or more, an increase in prices (assuming no menu costs) would temporarily raise the firm’s revenues relative to their (labor) costs. This would make it profitable to expand output in the short run while this positive gap between revenues and costs exists. Once again, production increases and prices rise in the short run, so the short- run AS curve slopes upward. However, as in the previous example, we would expect production eventually to return to Yn at the higher price level. In this case, nominal wages would rise when contracts expire and workers whose cost of living has in- creased bargain for a compensating wage increase. Thus, again, the long-run AS curve is vertical.
A fixed point on the short-run AS curve
The two simple aggregate-supply theories sketched above have several character- istics in common. As we shall see later, these characteristics are shared by most short-run aggregate-supply models. Two important characteristics have been stressed above: (1) the short-run AS curve slopes upward and (2) the long-run AS curve is ver- tical at Y (^) n. A third property that connects the short-run and long-run supply curves is less obvious: the short-run AS curve passes through the vertical long-run AS ( Y = Yn ) at the expected price level. Thus, the point ( Y (^) n , P e ) always lies on the short-run AS curve. We can explain the logic of this “fixed point” on the AS curve for the two simple models discussed above. With menu costs, we assume that the prices that firms have set for this period (and printed on their menus) are those that they expected to prevail at the time the menus were printed. Thus, if aggregate demand turns out to be as ex- pected, firms will have set the appropriate prices and the economy will be in PCGE with P = P e^ and Y = Yn. When AD is higher than expected, P > P e^ and Y > Yn. In the wage-contract model, we assume that firms and workers try to set the nominal wage in a way that leads to the PCGE real wage ( W/P )*. If they expect the
price level to be P e , then they set the nominal wage at W = P e ⋅ ( W / P ) *. If aggregate
demand is as expected and the price level actually turns out to be P e , then the actual
real wage will be W / P e = ( W / P ) *and the economy will be in PCGE. If aggregate
demand is unexpectedly high and the price level exceeds P e^ then the real wage will be lower than ( W/P )* and firms will expand production. To summarize the conventional properties of aggregate supply, as depicted in Figure 1:
The long-run AS curve is vertical at Y = Yn. In the long run, changes in ag- gregate demand affect only the price level and not the level of real output. The short-run AS curve slopes upward and passes through the point where Y = Yn and P = P e. In the short run, increases in aggregate demand lead to in- creases in both price and real output.
Aggregate demand
The aggregate-demand curve summarizes the desired spending behavior of con- sumers, firms buying durable plant and equipment, governments, and (in an open economy) foreigners. There are many ways to model aggregate demand—some sim- ple and some very complex. We will spend some time looking at aggregate-demand models, although in many of our models we use a simple “place holder” for AD and focus on the details of aggregate supply. The closer focus on aggregate supply is be- cause alternative aggregate-demand theories tend to have similar outcomes whereas the supply side has been highly controversial.
P
Y
LRAS
Yn
SRAS
Pe
Figure 1. Short-run and long-run aggregate supply curves
Another response would be to sell some non-monetary assets such as interest- bearing bonds in order to attempt to restore money holdings. But remember that the price increase applies to everyone in the economy, so everyone will be trying to augment their money balances at the same time. If everyone tries to sell bonds at the same time, there will be no buyers. Only by making the bonds more attractive will buyers emerge and the primary way of making bonds more attractive is to raise the interest rate. Thus, an excess demand for money balances is likely to lead to a rise in market interest rates, which encourages saving over spending and discourages firms from taking on debt in order to invest in real capital. Through either or both of these mechanisms (or a couple of others), an increase in the aggregate price level lowers the desired spending by households and firms. Thus, the aggregate demand curve slopes downward as shown in Figure 2, although it is not necessarily a straight line as the figure suggests. As noted above, changes in monetary or fiscal policy will shift the aggregate de- mand curve, as will anything that affects desired expenditures. For example, changes in optimism about the future, stock-market fluctuations, or changes in international conditions that affect imports and exports can all lead to shifts in the AD curve.
P
Y
AD
Figure 2. Aggregate demand curve
Static equilibrium
It is probably obvious that the short-run equilibrium of the economy occurs at the intersection of the aggregate demand and short-run aggregate supply curves and that the long-run equilibrium is where the aggregate demand curve intersects the long-run aggregate supply curve. The situation depicted in Figure 3 shows a state of long-run and short-run equilibrium at point e. If the aggregate demand curve and aggregate supply curves were to remain unchanged, the economy would continue to produce Y (^) n and have a price level of P e^ indefinitely.
P
Y
LRAS
Y n
SRAS
P e
AD
e
Figure 3. Long-run equilibrium
However, as noted above, there are many reasons why the AD and AS curves could shift. In the next section, we consider ongoing changes such as steady growth in natural output and sustained inflation. Here we examine one-time changes as per- turbations from a static equilibrium such as a point e.
Shocks to aggregate demand
Consider first the effects of a one-time unexpected exogenous positive shock to aggregate demand. This could arise from an expansionary monetary-policy action, an expansionary fiscal-policy action, or an increase in desired expenditures from an-
P
Y
LRAS
Y n
SRAS’
P e
AD
e
AD’
e’
Y 1
P 1
P 2 e’’ SRAS
Figure 4. Effects of an increase in aggregate demand
Shocks to aggregate supply
The most important kinds of supply shocks are those that affect the natural level of output in the economy. For example, an improvement in production technology or an increase in the amount of labor or capital resources available would increase the aggregate amount produced in PCGE and thus shift both the long-run and the short-run AS curves to the right. A storm that destroyed agricultural crops or a sud- den interruption in the availability of imported inputs such as oil might cause a re- duction in Y (^) n and a shift to the left in the AS curves.^7 Figure 5 shows the effects of a positive shock to aggregate supply that increases
the natural level of output from Y n to Y n ′. Assuming no change in the expected price
level, both the LRAS and SRAS curves shift to the right so that the SRAS curve
passed through ( Y n ′ , P e ). If aggregate demand does not change, the short-run equilib-
rium of the economy is at e ′, with output increasing only to Y 1 (by less than the full
(^7) Was the 2008 financial-market disruption that curtailed many firms’ access to financial capi-
tal a supply shock or a demand shock? The monetary and financial system is usually modeled as part of the demand side but constraints on the ability of firms to produce are supply shocks. One can think of both kinds of effects occurring in 2008.
increase in natural output) and price falling to P 1. At e ′ the economy is actually below
its natural output, but it is unlikely that policymakers or the general public would easily recognize this gap because Y (^) n is not directly observable and the absolute level of output has increased. In the long run, the expected price level will adjust downward following the de-
cline in prices. The eventual equilibrium of the economy will occur at e ″, with price
falling further to P 2 and real output increasing to the new natural level. The one-time shocks depicted in Figure 4 and Figure 5 are interesting and they illustrate the short-run and long-run effects of demand and supply shocks. However, they are unrealistic in one important way: the economy in which they occur has nei- ther ongoing growth in natural real output not inflation of the price level. Since output in nearly all modern economies is growing over time and inflation is a common phenomenon in most, we should also examine how the AS/AD model can be used to demonstrate the equilibrium evolution of such economies. We now turn to that task.
P
Y
LRAS
Y n
SRAS
P e
AD
e
LRAS’
SRAS’
Y 1 Y n ’
P 1
P 2
e’
e’’
Figure 5. Effects of an aggregate supply shock
The quantity theory of money is a classical proposition that held sway in the early 20 th^ century. It asserts that people desire a stable, proportional relationship between the stock of liquid money they hold and the flow of expenditures they make. For ex- ample, someone might desire on average to keep one month’s worth of expenditures in the bank, so that their average holding of money was 112 of their annual expendi-
ture. Thinking of this in another way, if everyone behaves this way the average dollar is spent 12 times per year, which we call the velocity of money. Money balances held in the economy ( M ), expenditures (equal in nominal terms to nominal GDP, or PY where P is the aggregate price level and Y is real GDP), and velocity ( V ) are linked by the equation of exchange , which is a tautology: MV = PY = total nominal expenditures. If we take the velocity of money to be constant (which might not always be a reasonable thing to do), then we can solve the equation of ex- change for real output Y as Y = MV/P. Taking the Y on the left-hand side to be the quantity of real output demanded, this becomes a very simple mathematical repre- sentation of an aggregate-demand curve that has two realistic properties: it slopes downward in price and responds proportionally to changes in the money supply. Although the constant-velocity behavior is very simplistic, we will find it convenient to use this simple AD curve frequently when we are not concerned with the details of aggregate demand. This simple AD curve shows an important mechanism by which aggregate de- mand moves in the long run: growth in the money supply. Most central banks ac- commodate growth in the economy’s transaction volume (as Y grows) by expanding the supply of money. The growth in M pushes the AD curve up and to the right in proportion to the monetary expansion. It looks from the equation of exchange that other factors such as fiscal policy and expenditure behavior of the public would not affect AD. This is not true; these kinds of shocks can enter the simple AD curve as changes in velocity. You can see from the equation of exchange that if the central bank expands the money supply at the same rate that real output is growing (and if velocity is con- stant), then prices will be stable. The increases in M on the left and Y on the right will exactly balance with no change in V or P. If money growth exceeds real-output growth, then the quantity theory predicts that prices will rise to maintain the equa- tion—there will be positive price inflation. If money growth falls short of output growth, then prices will tend to fall over time, which we call deflation.
Equilibrium with growth and inflation
We have now established engines that can push the aggregate supply and aggre- gate demand curves to the right over time. Figure 6 shows a sequence of equilibria in an economy with both growth and inflation. Growth in labor, capital, and technolog- ical capability is increasing the natural level of output by 3 percent each year, from
Y (^) n, 1 to Y (^) n, 2 to Y (^) n, 3 over the three years shown in Figure 6. This means that the LRAS curve is moving to the right as shown, by 3 percent per year. The money supply is growing at 5 percent per year, which shifts the aggregate demand curve upward and to the right by 5 percent each year. This is shown as AD 1 , AD 2 , and AD 3 in Figure 6. (From the equation of exchange you can see that the AD curve should not be linear. It is drawn as a straight line in the figure for simplicity. We assume that the behavior of the money supply and aggregate demand are correctly predicted by everyone in the model—this is a smooth, ongoing process of growth and inflation with no shocks or surprises. Thus, price-setters and wage-setters would correctly anticipate that the price level would be P 1 in the first period, P 2 in the second period, and P 3 in the third period. Since the SRAS curve always intersects the LRAS at the expected price level, it would move as shown by the SRAS 1 , SRAS 2 , and SRAS 3 curves in Figure 6. Thus, the sequence of equilibrium will be traced out by the intersections of the AD and SRAS (and LRAS) curves at e 1 , e 2 , and e 3. With AD shifting up 5 percent each year and AS shifting only 3 percent, the difference of 2 percent will be the in- crease in the price level. Thus, the economy pictured in Figure 6 would have a steady rate of inflation of 2 percent.
P
Y
LRAS 2
Y n,
SRAS 2
P 2
AD 2
e 2
Y n,1 Y n,
LRAS 1 LRAS^3
AD 1
AD 3
e 3
e 1
SRAS 3
SRAS 1
P 1
P 3
3% 3%
5% 5%
2% 2%
Figure 6. Inflationary growth in the AS/AD model
P
Y
LRAS 2
Y n,
SRAS 2
P 2
AD 2
e 2
Y n,1 Y n,
LRAS 1 LRAS^3
AD 1
AD 3 e
e 3
e 1
SRAS 3
SRAS 1
P 1
P 3 e
3% 3%
5% 5%
2% 2%
AD 3
Y 3
P 3
3%
SRAS 3 *
e 3 *
Figure 7. A growth recession
This situation is sometimes called a “growth recession.” It does not officially qualify as a recession because real output continues to grow. However, the growth rate of output in period three is less than the growth in natural output—real output falls below its growth trend—hence the term growth recession. The situation shown in Figure 7 suggests that reducing the rate of inflation can be costly—it induces a temporary reduction in output growth. This change is tempo- rary because once expectations adjust to the change in monetary growth, the SRAS curve will adjust downward to reflect lowered inflation expectations and output will return to its natural growth path. Depending on the size of the gap between Y 3 and Y (^) n, 3 and the length of time required for expectations adjustment to occur, this cost of disinflation could be small or large.^8 It is worth noting what would have happened if everyone had correctly anticipat- ed the reduction in money growth in time to set wages and prices. In Figure 7, the expected price level for period three would have remained at P 2 rather than rising to P 3 e , which would have shifted the SRAS curve further to the right to SRAS 3 *. In that
(^8) In a famous article, Laurence Ball (1994) has estimated the “sacrifice ratio”—the amount of
forgone output for each percentage-point reduction in inflation—for late 20th^ century disinfla- tions.
case, equilibrium in period three would be at e 3 *, with output growing at the natural growth rate and inflation immediately jumping to the 0 percent rate that is consistent with the lowered rate of money growth. This makes it clear that it is the delayed adjustment of wages and prices based on faulty inflation expectations that causes the growth recession in Figure 7. In the sim- ple AS/AD model, a fully credible disinflation that is known about far enough in advance to allow wage and price setters to adjust will not lead to a reduction of out- put below its natural level. Disinflation can be costly, but in this model it need not be if monetary policy has sufficient credibility.
E. A Preview of Romer’s Text from the Perspective of
Aggregate Supply/Demand
Growth models
Chapters 1 through 3 of Romer’s textbook describe the evolution of economic growth theory from the Solow model of the 1950s through the optimal growth mod- els that Cass and Koopmans built on Ramsey’s framework in the 1960s to the en- dogenous growth models of Paul Romer and others since the 1980s. These growth models all describe the evolution over time in the natural level of output, ignoring any role of aggregate demand. The emphasis in these models is on increases in aggregate supplies of labor and capital resources and on technological progress— i.e. , on the supply side of the mac- roeconomy. By focusing exclusively on aggregate supply, these models ignore any demand-related fluctuations of output relative to its long-run equilibrium growth path, such as those in Figure 7.
Real business cycles
Romer’s Chapter 5 presents a stylized version of the real business cycle (RBC) model. This model is also entirely based on the supply side of the economy, but ra- ther than looking exclusively at smooth trend movements in natural output it consid- ers situations where the increase in natural output is subject to shocks. These supply shocks, which can be bursts of rapid or slow technological progress, cause the amount of rightward shift in the natural level of output and the LRAS curve to vary from year to year. Like the growth models, the real business cycle model has no role for aggregate demand. It explains business cycles as fluctuations in supply-driven growth of Y (^) n , not as movements of Y around a smoothly growing Y (^) n. This difference is of critical im- portance for macroeconomic policy. Since Y (^) n is the level of output generated by the
