Aggregate Supply and Demand

Department of Economics, FIU
Chapter 11 Notes
Prof. Dacal

Chapter 11 Aggregate Supply and Demand

I. A Macroeconomics view
Macroeconomics is the study of aggregate economic behavior, of the economy as a whole.
These basic macroeconomic outcomes include: 
• Output: total volume of goods,
• Jobs: level of employment ,
• Prices: average price,
• Growth: year to year expansions, and
• International balances: international value of the dollar, trade and payment balance.

Macroeconomic Determinants 
These determinants of macro performance include:
• International market forces (e.g. population growth, spending behavior, invention, and innovation)
• External shocks (e.g. wars, natural disasters, and trade disruption)
• Policy levers (e.g. tax policy, government spending, regulation, and changes in money supply.

II. Stable or unstable?
The central concern of macroeconomic theory is whether the internal forces of the marketplace will generate desired outcome.

Classical theory
The classical model assumes:
• Unemployment is zero, for every job destroyed there is one created,
• No government intervention is needed,
• All workers are homogeneous, and
• Prices adjust immediately.
The Classical approach builds on “the invisible hand” of the market. It also assumes the prices will adjust to equilibrium fairly quickly. In general, it disapproves of government intervention.

Self adjustment 
According to the classical model the economy self-adjust to deviation from its long-term growth trends.

Flexible prices
Prices adjust immediately. If market prices are too high, inventories will increase and firms will be force to lower prices.

Flexible wages 
Most importantly, wages adjust quickly. 
1. If individuals temporarily loss their jobs, they would compete for jobs by offering their services at lower wages.
2. As wage rates decline, producers would find it profitable to hire more workers.
3. Finally, flexible wages would endure that everyone who wanted a job would have a job.

Say’s Law
Say’s law states that supply creates is own demand.
Once you find the right price for your product it will sell. 
Side note: I have a certain problem with this law. How low must you go to sell a useless unwanted product? If zero is an acceptable number, then I do agree with this law. However at one cent, I am already skeptical of this law at least from an empirical view.

The Keynesian Model (Revolution)
The main reason for the development of Keynesian theory is the dissatisfaction with the classical explanation of unemployment.
• Keynesian do not disagreed with mismatch of between workers and jobs in the Classical model, but how it fails to explains all of unemployment. Why does help wanted signs decrease when we enter a recession?
• Keynesians believe that recessions are periods of generally low demand for both output and workers throughout the economy.

No self-adjustments
The Keynesian approach assumes the prices do not adjust so quickly. It encourages the intervention of government at times of high unemployment. It essence it believes that to reach equilibrium the economy will need some help form government. 
Price Stickiness is “the resistance of a price (or set of prices) to change, despite changes in the broad economy that suggest a different price is optimal. 
"Sticky" is a general economics term that can apply to any financial variable that is resistant to change. When applied to prices, it means that the prices charged for certain goods are reluctant to change despite changes in input cost or demand patterns.

Price stickiness can also occur in just one direction, as in "sticky-up" or "sticky-down". A price that is sticky-up, for instance, can move up rather easily but will only will move down with pronounced effort.” 

III. The Aggregate Supply-Demand Model
Any influence on macroeconomic outcomes must be transmitted through supply or demand. So to resolve any question about macroeconomic stability, we most focus on the forces that shape demand and supply from a macro prospective.

Aggregate Demand 
Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.

Real GDP
Real GDP is the inflation adjusted value of GDP; it is the value of output produced in a given country at a given time measured in constant price.
• Real GDP is the relation ship between average price and the real spending. 
• The horizontal axis depicts the various quantities of output of all goods and services that might be purchased.
• The vertical axis is the price level

Price Level
The aggregate demand curve illustrates how the volume of purchases varies with average prices.
• Real balance effect: the real value of money is measured by how many goods and services each dollar will buy. The following two reasons explain why AD is upward sloping.
o When real income and wealth increase because of a decline in the price level, consumers respond by buying more goods and services.
o They spend more and save less.
• Foreign trade effect: it is when American made products that are cheaper than those from abroad. When domestic products are cheaper, the US consumer will buy less from abroad and more domestic producers, and vice versa.
• Interest rate effect; the change in price level also affect the amount of money supply and this has an effect on interest rates. As prices decrease, consumers need to borrow less. As demand for loans decreases, interest decline. At lower interest rates, investment and borrowing is stimulated.

Aggregate Supply
Profit Margins
If the price of a product falls, the profit margin fall and the producer will cut back on production and fire people, and vice versa. We expect the rate of output to increase when the price level rises.
Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

Cost
To increase the rate of output, producers must acquire more resources and use existing plant and equipment more intensively. These greater stains on productive capacity tend to raise production cost. 
Cost pressures tend to intensify as capacity is approached. Capacity is “the maximum level of output of goods and/or services that a given system can potentially produce over a set period of time.” Thus, producers increase prices to recover the higher costs that accompany increased capacity utilization.

Macro Equilibrium
Aggregate supply and demand curves summaries the market activity of the whole economy.
Equilibrium is the combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

Disequilibrium
Disequilibrium is a situation in which the intensions of buyer and sellers are incompatible.

Market adjustments
Equilibrium is unique; it is the only price-output combination that is mutually compatible with aggregate supply and demand.
Market adjustment is the movement of supply and demand that starts at a point of disequilibrium and subsequently moves to the equilibrium point using the forces in the market.

IV. Macro Failure
There are two potential problems with the macro equilibrium:
1. Undesirability: the price-output relationship at equilibrium may not satisfy our macroeconomic goals.
2. Instability: even if the designated macro equilibrium is iptima, it may be displaced by macro disturbances.

Undesirable outcomes 
In an ideal, we (the nation) want to use all our factors of production and be in a state of full employment. If this fails to be in this state, we would want to use the tools that are at our disposal to reach full employment. 
Full employment GDP (Potential GDP) the rate of real output (GDP) produced at full employment.

Unemployment 
When we are not at full employment GDP, cyclical unemployment is greater than the natural rate of unemployment.
or stated more precise, 
Inflation
Inflation occurs when actual prices are above equilibrium prices.

In other words, if the supply of money is greater that the demand for money, there will be excess amount of money. Excess money creates inflation.

Unstable Outcome
Basically, you can be in the equilibrium point and the economy can be hit with a supply or demand shock that will move the economy out of its long-run equilibrium.

Shift Factors 
Demand 
The factors that shift the AD are: 
• C – consumption
• T – income taxes or sales taxes
• τ – transfers
• Y – income 
• E(Y) – expected income
• i - interest rates (not to be confused with investment (I))
• G – government spending

Supply
A shift of the AS curve may be caused by: 
• Real exchange rate 
• Expected exchange rate 
• Prices, such as:
o Imported resources
o Domestic resources
o Wages
• Change in productivity
• Change in the legal environment
o Government regulation
o Court rulings 
o Taxes and subsidies

V. Competing Theories of Short-Run instability

Demand Side Theories
Keynesian 
Keynesian theory urges increase government spending or tax cuts as mechanism for increasing aggregate demand.

Monetary policy 
It is the increase and decrease of money supply and its effects on the real interest rate.

Supply Side Theories
Classical Model
Our failure to achieve full employment may result from the unwillingness of producers to provide more goods and services at existing prices.
That unwillingness may originate in simple greed, in rising cost, in resources shortages, or in government taxes and regulation.
VI. Policy Options
The government has three policy options:
• Shift the aggregate demand curve. Find and use policy tools that stimulate or restrain total spending (fiscal and monetary policy).
• Shift the aggregate supply curve. Find and implement policy levers that reduce the costs of productions or otherwise stimulate more output at every price level (deregulation and production taxes)
• Do nothing. If we can’t identify or control the determinants of aggregate supply or demand, then we shouldn’t interfere with the market.