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Chapter 5: Aggregate Supply and DemandIntroduction - Aggregate Supply curve describes, for each given price level, the quantity of output firms are willing to supply. It is upward sloping since firms are willing to supply more output at higher prices. - Aggregate Demand curve shows the combination o...

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Chapter 5: Aggregate Supply and Demand Introduction - Aggregate Supply curve describes, for each given price level, the quantity of output firms are willing to supply. It is upward sloping since firms are willing to supply more output at higher prices. - Aggregate Demand curve shows the combination of the price level and the level of output at which the goods and money markets are simultaneously in equilibrium. Downward sloping since higher prices reduce the value of the money supply, which reduces the demand for output. - The intersection of AS and AD determines the equilibrium level of output and price level. Equilibrium

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AS = AD. Equilibrium output is Y0. Equilibrium price is P0.

Shifts in the AD/AS curves - Increase in AD: increases price and Y - Decrease in AD: decreases price and Y - Increase in AS: decrease in P and increase in Y - Decrease in AS: increase in P and decrease in Y The amount of the increase/decrease in P and Y after a shift in either curve, depends on: - The slope of the AS curve - The slope of the AD curve - The extent of the shift The Classical Supply Curve (Long run AS curve) The classical supply curve is vertical, indicating that the same amount of goods will be supplied, regardless of price. - Based upon the assumption that the labour market is in equilibrium with full employment of the labour force.

(a) – Horizontal Keynesian AS curve: any amount of output will be supplied at the existing price.

(b) – Vertical classical AS curve: there is always full employment of labour. Output = potential GDP (Y*). Potential GDP grows over time as the economy accumulates resources and technology improves: position of the classical AS curve moves to the right over time. As potential GDP changes every year, the changes do not depend on the price level: Potential GDP is “exogenous” with the price level. The Keynesian Supply Curve (Short run AS curve) The Keynesian supply curve is horizontal, indicating firms will supply whatever amount of goods is demanded at the existing price level, - Unemployment exists: firms can obtain any amount of labour at the going wage rate. - Average cost of production does not change as output changes: firms are willing to supply as much as demanded at the existing price level. - In the short run, firms are reluctant to change prices and wages when demand shifts (“short-run price stickiness”) – instead, they increase/decrease output. - Price level does not depend on GDP. Frictional Unemployment and the Natural Rate of Unemployment Taken literally: the classical model implies there is no unemployment. In equilibrium, everyone who wants to work is working. In reality: there is always some unemployment. That level of unemployment is accounted for by labour market frictions, because the labour market is always in a state of flux. In other words, there is always some frictional unemployment (some people are changing jobs, first time job seekers etc.) The unemployment rate associated with the full employment level of output (potential output) is the natural rate of unemployment. Natural rate of unemployment: The rate of unemployment arising from normal labour market frictions that exist when the labour market is in equilibrium. The AS Curve and the Price Adjustment Mechanism The Aggregate supply curve describes the price adjustment mechanism of the economy.

The aggregate supply curve is rotating counter clockwise, from horizontal to vertical, with the passage of time. The AS curve: where Pt+1 is the price level of the next period Pt is the price level today Y* is potential output Therefore: - If output is above potential (Y>Y*), prices will increase and be higher next period - If output is below potential (YY*, therefore price will be higher at the next period, t = 1. AS curve rotates up. Price keeps moving up until Y = Y*. The speed of the price adjustment mechanism is controlled by the parameter : - If  is large, AS moves quickly - If  is small, prices adjust slowly  is of importance to policy makers: • If  is large, the AS mechanism will return the economy to Y* relatively quickly • If  is small, might want to use AD policy to speed up the adjustment process The Aggregate Demand Curve The Aggregate Demand Curve shows the combinations of the price level and level of output at which the goods market and money markets are simultaneously in equilibrium. Shifts in the AD curve are due to: - Policies: Changes in G, T and Money Supply - Consumer and investor confidence AD Relationship between Output and Prices - Depends on real money supply (value of money provided by the central bank and the banking system). - Real money supply written as Where M is the nominal money supply and P is the price level. NB: When M/P rises, interest rates fall, investment rises: AD rises NB: When M/P falls, interest rates rises, investment decreases: AD falls. The slope of the AD curve: For a given level of M, high prices result in low M/R OR high prices mean that the value of the number of available Rands is low and thus a high P = low level of AD. Inverse relationship between P and Y: downward sloping AD curve. Aggregate Demand and the Money Market Important to remember that the AD curve represents equilibrium in the goods and money market. Fiscal policy and monetary policy will affect the AD curve. For now, only focus on the money market: The quantity theory of money offers a simple explanation of the link between the money market and AD: • The total number of Rands spent in a year, NGDP, is PxY • The total number of times the average Rand changes hands in a year is the velocity of money, V • The central bank provides M Rands The quantity equation: MxV=PxY Should the velocity of money be assumed constant: (an equation for the AD curve) - For a given level of M, an increase in Y must be offset by a decrease in P - For a given level of M, a decrease in Y must be offset by a increase in P This inverse relationship between Y and P confirms the downward sloping AD curve An increase in the nominal money stock (M) shifts the AD schedule up exactly in proportion to the increase in nominal money.

VERY IMPORTANT: Deriving the AD Schedule The Aggregate Demand schedule maps out the IS-LM equilibrium holding autonomous spending and nominal money supply constant and allowing prices to vary. A higher price level means a lower real money supply, an LM curve shifted to the left, and lower aggregate demand. Suppose the price level in the economy is P1. Panel (a) shows the IS-LM equilibrium. The real money supply, which determines the position of the LM1 curve is M/P1. The intersection of the IS and LM 1 curve gives the level of AD corresponding to price P 1 and marked so in panel (b) Suppose the price is higher, at P2 The LM2 curve shows the LM curve based on the real money supply M/P2 LM2 is to the left of LM1 since M/P2 < M/P1 Point E2 shows the corresponding point on the AD curve Repeat this operation for a variety of price levels and connect the points to derive the AD schedule Output is now lower.

Aggregate Demand Policy under Alternative Assumptions The Keynesian Case

The figure combines the aggregate demand schedule with the Keynesian aggregate supply schedule. - Initial equilibrium: E (AD and AS intersect) – goods market and assets market are in equilibrium. Consider an increase in AD (i.e. increased G, decreased T, increased money supply) - The AD schedule shifts to the right from AD to AD’ - New equilibrium at point E’ - Because firms are willing to supply any amount of output at the level of prices (P0) there is no effect on prices - Increase in output and unemployment The Classical Case

The aggregate supply schedule is vertical at the full-employment level of output, firms will supply the level of output (Y*) at any price level. Unlike the Keynesian case, the price level is not given: depends on interaction between AS and AD. Consider an increase in AD - The AD schedule shits to the right from AD to AD’ - At the initial level of prices, spending would increase to E’, but firms cannot obtain the labour to produce more output (the economy is at full-employment) – output cannot respond to the increase in demand - As firms try to hire more workers, they bid up wages (and cost of production) so they must charge higher prices. - Increase in prices, not output - Economy moves up the AD’ schedule until prices have risen enough, and real money stock has fallen enough, to a level consistent with full employment: to E” where AD=AS. Supply Side Economics Focuses on AS the driver in the economy (increasing potential GDP by moving the AS curve to the right) Supply side policies include: - Removing unnecessary regulation - Maintaining an efficient legal system - Encouraging technological progress

There is a group of politicians and pundits who use the term “supply-side economics” in reference to the idea that cutting tax rates will increase aggregate supply enormously – so much that tax collections will rise, rather than fall. Cutting tax rates has an impact on both AS and AD: - AD shifts to AD’ (large shift, due to increase in disposable income) - AS shifts to AS’ (small shift) In the short run: - The economy moves from E to E’: GDP does rise substantially; total tax revenues fall proportionately less than the fall in the tax rate (pure aggregate demand effect) In the long run: - The economy moves to E”: GDP is higher, but only by a small amount; total tax collections fall and the deficit rises; prices are permanently higher.

Only supply side policies can permanently increase output – demand management policies are useful only for short-term results. Many economists strongly favour supply-side policies, just not exaggerating their effect: - Cutting tax rates for the small incentive effect - Cutting government spending at the same time = Tax collections would fall, but so would government spending, so the effect on the deficit would be nearly neutral. Putting Aggregate Supply and Demand together in the Long Run - The LRAS curve moves to the right over time at a fairly steady rate. - Movements in AD over long periods can be either large or small (depending mostly on movements in the money supply)

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Prices rise whenever AD moves out more than AS Output is determined by AS; Prices determined by the movement of AD relative to the movement of AS....