Aggregate Supply
and Demand

Macroeconomics

Macroeconomics is the study of the aggregate economic behavior of the economy as a whole.

Macro View

The basic macro outcomes include:

Output — The total volume of goods and services produced (real GDP).

Jobs — The levels of employment and unemployment.

The basic macro outcomes include:

Prices — The average price of goods and services.

The basic macro outcomes include:

Growth — The year-to-year expansion in production capacity.

The basic macro outcomes include:

International balances — The international value of the dollar, trade, and payment balances with other countries

The determinants of macro performance include:

The determinants of macro performance include:

External shocks — Wars, natural disasters, trade disruptions, and so on.

The determinants of macro performance include:

Policy levers — Tax policy, government spending changes in the availability of money, and regulation.

The Macro Economy

Stable or Unstable

The central concern of macroeconomic theory is whether the internal forces of the marketplace will generate desired outcomes.

Classical Theory

Prevalent theory prior to the 1930s.

The economy “self-adjusts” to deviations from its long-term growth.

Self Adjustment

The cornerstones of the Classical Theory are flexible wages and flexible prices.

Flexible Prices

Flexible prices virtually guarantee that all output could be sold.

No one would lose a job because of weak demand.

Flexible Wages

Flexible wages ensure that everyone who wants a job would have a job.

Say’s Law

According to Say’s Law, supply creates its own demand.

Unsold goods will ultimately be sold when buyers and sellers find an acceptable price.

In the labor market, some people will be unemployed, but can find new jobs if they are willing to accept lower wages.

According to Classical economists, government intervention in a self-adjusting macroeconomy is unnecessary.

Inflation and Unemployment, 1900 – 1940

The Keynesian Revolution

The Great Depression was a stunning blow to Classical economists.

John Maynard Keynes provided an alternative to the Classical Theory.

No Self-Adjustment

Keynes asserted that the private economy was inherently unstable.

The Keynesian Revolution

Keynes argued that the Great Depression was not a unique event.

It would recur if reliance on the market to “self-adjust” continued.

In Keynes’ view, the inherent instability of the marketplace required government intervention.

“Policy levers” are necessary and effective.

The Aggregate Supply-Demand Model

Any influence on macro outcomes must be transmitted through supply or demand.

Aggregate Demand

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

Real GDP (Output)

Real GDP is the inflation-adjusted value of GDP.

It is the value of output in constant prices.

Price Level

The aggregate demand curve illustrates how the volume of purchases varies with average prices.

Purchases of real output increase as average prices fall.

Aggregate Demand Curve

The AD is downward sloping for three reasons:

Real balances effect

Foreign trade effect

Interest-rate effect

Real Balances Effect

The real value of money balances is measured by how many goods and services each dollar will buy.

As prices fall, money balances can purchase more goods.

Foreign Trade Effect

If domestic prices decline consumers demand more domestic output and fewer imports.

Interest-Rate Effect

At lower price levels, interest rates fall as consumers borrow less.

Lower interest rates stimulate borrowing and loan-financed purchases.

Aggregate Demand

Aggregate Supply

The total quantity of output producers are willing and able to supply at alternative price levels in a given time-period, ceteris paribus.

The aggregate supply curve is upward-sloping.

Profit Margins

Producers’ short-run costs, like rent and negotiated wages, are relatively constant.

Higher product prices tend to widen their profit margins.

They will want to produce and sell more.

Costs

Production costs tend to increase as producers try to produce more.

They must acquire more resources and use existing plant and equipment more intensively.

The aggregate supply curve is relatively flat when capacity is underutilized.

Aggregate Supply

Macro Equilibrium

Aggregate supply and demand curves summarize the market activity of the whole (macro) economy.

The combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

It is the only price-output combination mutually compatible with both buyers’ and sellers’ intentions.

Disequilibrium

If the price level is higher than at equilibrium, buyers will want to buy less than producers want to produce and sell.

Macro Disequilibrium

Macro Failure

There are two potential problems with macro equilibrium — undesirability and instability.

Undesirability — the price-output relationship at equilibrium may not satisfy our macroeconomic goals.

Macro Failure

Instability — even if designated macro equilibrium is optimal, it may be displaced by macro disturbances.

Undesirable Outcomes

Unemployment — the inability of labor-force participants to find jobs.

Inflation — an increase in the average level of prices of goods and services

An Undesired Equilibrium

Unstable Outcomes

Shifts in aggregate supply and aggregate demand can upset a full employment equilibrium.

Shifts in Aggregate Supply

A leftward shift of aggregate supply results in higher prices and less output.

Shifts in Aggregate Demand

A leftward shift of aggregate demand results in less output.

Recurrent Shifts

Business cycles are a result of recurrent shifts of the aggregate supply and demand curves.

Business cycles are alternating periods of economic growth and contraction.

Macro Disturbances

Shift Factors

There are lots of reasons to expect aggregate supply and aggregate to shift.

Demand Shifts

Consumer tax changes.

Interest rate changes.

Changes in export sales.

Supply Shifts

Price or availability of raw materials.

Business tax changes.

Environmental and work place regulations.

Competing Theories of Short-Run Instability

Economists are not in complete agreement about how to achieve desired macro outcomes.

Competing Theories

Macro controversies focus on the shape of aggregate supply and demand curves and the potential to shift them.

Demand-Side Theories

Keynesian Theory

Monetary Theories

Keynesian Theory

Keynes argues that if people demand a product, producers will supply it.

If aggregate spending isn't sufficient, some goods will remain unsold and some production capacity will be idled.

During World War II, the sudden surge in government spending shifted the AD curve to the right.

In the 1990s, the rise in the stock market provided the impetus for a surge in consumer spending.

Keynesian theory urges increased government spending or tax cuts as mechanisms for increasing aggregate demand.

Monetary Theories

Monetary theories focus on the control of money and interest rates as mechanisms for shifting the aggregate demand curve.

Money and credit affect the ability and willingness of people to buy goods and services.

If right amount of money is not available, aggregate demand may be too small.

Supply-Side Theories

Shifting the AS curve will counter business cycle.

Eclectic Explanations

Shifts in both supply and demand curves may occur.

Origins of a Recession:
Demand Shifts

Origins of a Recession:
Supply Shifts

Origins of a Recession:
Supply and Demand Shifts

Policy Options

The government has three policy options:

Shift the aggregate demand curve.

Shift the aggregate supply curve.

Do nothing.

Fiscal Policy

Fiscal policy is the use of government taxes and spending to alter macroeconomic outcomes.

Congressional debates over budgets occur annually.

Monetary Policy

Monetary policy is the use of money and credit controls to influence macroeconomic activity.

The Federal Reserve is regulatory body that controls supply of money.

Supply-Side Policy

Supply-side policies seek to increase the ability and willingness to produce goods and services.

Supply-side policies include cutting tax rates, deregulation, and other production enhancing mechanisms.

The Changing Choice of Policy Levers

A do nothing approach prevailed until the Great Depression.

The Great Depression spurred a desire for a more active government role.

Fiscal policy dominated the economic debate in the 1960s.

Monetary policy dominated macro policy in the 1970s.

Supply-side policies prevailed in 1980’s with Ronald Reagan.

Bill Clinton pursued a contractionary fiscal policy in the mid-1990s.

Current Policy

The fiscal restraint of the late 1990's helped the federal budget move from deficits to surpluses.

One of the biggest points of debate during the 2000 presidential campaign was whether to use the surplus to cut taxes, increase government spending, or pay down the debt.

The job of fighting inflation was left to the Fed's monetary policy.