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ECN 310--- Aggregate Demand and Aggregate Supply Model

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Yuanyuan Chen

on 8 November 2012

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Transcript of ECN 310--- Aggregate Demand and Aggregate Supply Model

Monetary Theory I: The Aggregate Demand and Aggregate Supply Model Catherine Chen, Ph.D. Structure of this Chapter Aggregate Demand Aggregate Supply Equilibrium The Effects of Monetary Policy Aggregate Demand Curve The Market for Money and the Aggregate Demand Curve Aggregate demand (AD) curve A curve that shows the relationship between aggregate expenditure on goods and services and the price level. The market for money involves the interaction between the demand for M1—currency plus checkable deposits—by households and firms and the supply of M1, as determined by the Federal Reserve. The Market for Money and the Aggregate Demand Curve The analysis of the market for money is sometimes referred to as the liquidity preference theory, a term coined by the British economist John Maynard Keynes. Real money balances The value of money held by households and firms, adjusted for changes in the price level; M/P. The primary reason households and firms demand money is called the transactions motive—to hold money as a medium of exchange. Households and firms face a trade-off. The higher the interest rate on short-term assets such as Treasury bills, the more households and firms give up when they hold large money balances. So, the short-term nominal interest rate is the opportunity cost of holding money. The Market for Money and the Aggregate Demand Curve Aggregate Supply Curve Aggregate supply The total quantity of output, or GDP, that firms are willing to supply at a given price level. Short-run aggregate supply (SRAS) curve A curve that shows the relationship in the short run between the price level and the quantity of aggregate output, or real GDP, supplied by firms. The Short-Run Aggregate Supply (SRAS) Curve One explanation of why the SRAS curve is upward sloping (new Classical view) is based on the misperception theory, which emphasizes the difficulty firms have in distinguishing between relative increases in the prices of their products from general increases in the price level. The Short-Run Aggregate Supply (SRAS) Curve An alternative explanation for why the SRAS curve is upward sloping comes from the argument of John Maynard Keynes and his followers that prices adjust slowly in the short run in response to changes in aggregate demand. That is, prices are sticky in the short run. In the most extreme view of price stickiness, we would observe a horizontal SRAS curve because prices would not adjust at all to increases or decreases in aggregate demand. Rather, firms would adjust their production levels to meet the new level of demand without changing their prices. New Keynesian economists argue that prices will adjust only gradually in monopolistically competitive markets when there are costs to changing prices. The costs of changing prices are sometimes called menu costs. The Long-Run Aggregate Supply (LRAS) Curve Long-run aggregate supply (LRAS) curve A curve that shows the relationship in the long run between the price level and the quantity of aggregate output, or real GDP, supplied by firms. The long-run aggregate supply (LRAS) curve is vertical at In the new Keynesian view, in the short run, many input costs are fixed, so firms can expand output without experiencing an increase in input cost that is proportional to the increase in the prices of their products.
Over time, input costs increase in line with the price level, so both firms with flexible prices and firms with sticky prices adjust their prices in response to a change in demand in the long run. As with the new classical view, the LRAS curve is vertical at potential GDP, or Y = LRAS Shifts in the Short-Run Aggregate Supply (SRAS) Curve Supply shock An unexpected change in production costs or in technology that causes the short-run aggregate supply curve to shift. 1. Changes in labor costs.
2. Changes in other input costs.
3. Changes in the expected price level. Shifts in the Long-Run Aggregate Supply (LRAS) Curve The LRAS curve shifts over time to reflect growth in the potential level of output. Sources of this economic growth include (1) increases in capital and labor inputs and (2) increases in productivity growth (output produced per unit of input). Macroeconomic Equilibrium Short-Run Equilibrium Long-Run Equilibrium Monetary neutrality The proposition that changes in the money supply have no effect on output in the long run because an increase (decrease) in the money supply raises (lowers) the price level in the long run but does not change the equilibrium level of output. Economic Fluctuations in the United States Shocks to Aggregate Demand, 1964–1969 Vietnam War, increases in government purchases, increase money demand and the interest rate. The Fed pursued an expansionary monetary policy. Because fiscal and monetary expansion continued for several years, output growth and inflation rose from 1964 through 1969. Supply Shocks, 1973–1975 and after 1995 The early 1970s, rising inflation and falling output, stagflation, as a result of two negative supply shocks: a sharp reduction in the supply of oil and poor crop harvests around the world. short-run aggregate supply curve shifted to the left, raising the price level and reducing output. A similar pattern by rising oil prices in the 1978–1980 period. In the late 1990s and 2000s, the U.S. economy experienced favorable supply shocks, such as the acceleration in productivity growth. Credit Crunch and Aggregate Demand, 1990–1991 Stringent bank regulation and declines in real estate values-- A credit crunch. consumer spending fell. The decline in spending reduces aggregate demand and puts downward pressure on prices, shifting the SRAS curve down. In fact, output growth fell during the 1990–1991 recession and inflation declined from 4.3% in 1989 to 2.9% in 1992. Investment and the 2001 Recession The brief recession of 2001 began as a result of a decline in business investment. The decline in planned investment shifts the AD curve to the left, reducing both output growth and inflation. Fast-paced productivity growth led to a rightward shift of the SRAS and LRAS curves and cushioned the decline in output. Are Investment Incentives Inflationary? The stimulus to investment translates into an increase in aggregate demand, shifting the AD curve to the right. However, as the new plant and equipment are installed, the economy’s capacity to produce increases, and the SRAS and LRAS curves shift to the right, reducing the inflationary pressure from pro-investment tax reform. Recent evidence suggests that the supply response is substantial and investment incentives are unlikely to be inflationary. Monetary Policy in AD-AS Model Business cycle Alternating periods of economic expansion and economic recession. Stabilization policy A monetary policy or fiscal policy intended to reduce the severity of the business cycle and stabilize the economy. An Expansionary Monetary Policy
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