Aggregate Demand and Supply

Linking Monetary Policy to Price and Output

Aggregate Demand
Define aggregate demand as the total demand for an economys output (production of goods and services) over a given period of time. Demand may come from households (consumption), firms (investment), the public sector (government spending) or foreign households, firms, or governments (net exports).
YAD = C + I + G + NX

We assume an inverse relationship between price and aggregate demand

Aggregate Demand Rises as Price Falls

Suppose aggregate prices in the economy fell This would cause the demand for money to shift in, causing interest rates to decline
Alternatively, the real money supply (M/P) rises, causing interest rates to fall.

With lower interest rates, the opportunity cost of consumption is lower:

P Md i C

With lower interest rates, the direct cost of investment falls:

P Md i I

With lower interest rates a countrys currency will depreciate. A weaker currency makes exports cheaper and imports more expensive
P Md i Exchange Rate NX

The Aggregate Demand Curve

P

AD
100 180 Y

Factors that Shift the AD Curve

Anything (other than price!) that causes C, I, G, or NX to increase will shift the AD curve to the right. C increases when
There is an increase in consumer confidence, leading to more current consumption and less current savings Taxes are cut leaving consumers with more income to spend (assuming Ricardian Equivalence doesnt hold!)

I increases when
Business confidence rises, prompting firms to invest more for the future.

G increases when
Government spending increases

NX increases when
There is increased preference for domestically produced goods.

An increase in the money supply will cause AD to shift right

Interest rates are lower, so C and I rise. The currency weakens, so NX increases.

Increasing the Money Supply

P

AD2

80

140

AD1 200

Long Run Aggregate Supply

In the long run, money is neutral
Any changes in the money supply will be met by a proportionate change in prices Increasing the money supply will not affect the economys output in the long run.

Long run output is determined entirely by an economys productive capacity

Production Function: YP = A*F(K,L,H,N)

Only changes in real variables can affect potential output.

Price does not have any effect on YP

In the long run, all resources are being efficiently utilized such that unemployment equals the natural rate

Long Run Aggregate Supply

LRAS P

YP = 140

Short Run Aggregate Supply

In the short run, money is not neutral
An increase in the money supply need not trigger an immediate increase in price. Prices are sticky due to uncertainty, menu costs, and long-term contracts.

Suppose output prices across the economy rise.

Wage and input contracts do not immediately adjust to higher output prices. Profit per unit rise, leading to an increase in production. Eventually, these contracts will readjust to factor in the higher cost of living, erasing the increased profits and returning output back to YP

Short Run Supply Shocks

Tightness in the labor market.
Suppose that because of a big economic expansion, the economy is producing at an output level Y that is greater than YP. This suggests that the economy is using more labor than it normally does. To get people to work longer hours, you have to pay them more. This increase in labor costs will shift the SRAS curve left, as profit per output falls when labor costs rise.

Expectations about inflation

If workers expect inflation to be higher in the future, they will demand higher wages in anticipation of this increase in the cost of living. Higher wages reduce firm profit and shift SRAS left

Supply shocks to critical raw materials

Suppose a war broke out between the US and Iran. Oil prices would rise dramatically Since oil is such a pervasive part of nearly everything we produce, production costs would rise significantly. The SRAS curve would shift left as the return on production fell.

Lower Expected Inflation

LRAS1 P

SRAS1 SRAS2

YP = 140

200

Short Run Equilibrium

P SRAS

PH Surplus P*

Shortage PL AD Y* Y

Long Run Equilibrium

LRAS
P SRAS2 SRAS1

P* PL

AD YP Y Y

Over-employment Wages must rise!

The Self-Correcting Economy

Suppose that a decrease in consumer confidence causes the aggregate demand curve to shift left. At current prices, there will be a surplus of production as consumers demand fewer goods and services Firms will cut both their prices and their production until the surplus inventory is sold. Output and prices fall in the short run, resulting in a recession. Eventually, lower output prices and less demand for labor will induce a fall in production costs. The SRAS curve will shift right until full employment output is restored at a lower price (assuming consumer confidence never recovered). The economy will always return to full-employment output, but how long does this adjustment process take?

A Drop in Consumer Confidence

LRAS
P SRAS1 SRAS2

P1 P2 P3

AD2 Y YP Unemployment Wages must fall!

AD1 Y

Keynesians vs. Monetarists

If you believe that prices and wages are very slow to adjust, then would you advocate an active or passive role for economic policy?

In the last example, the economy suffered a recession as a result of the drop in consumer confidence.
The duration of the recession was entirely dependant on the amount of time it took for price and wage contracts to readjust and shift the SRAS curve out to the right. If this happened quickly, then the recession was brief.

What if in response to the drop in consumer confidence, the Fed decided to buy bonds from the public?
This would expand the monetary base, and assuming no significant drops in the money multiplier, an increase in the money supply. In the short run (at least) this will cause interest rates to fall and shift AD out to the right. By compensating for the drop in consumer confidence with easy liquidity, the Fed can hasten the end of the recession, albeit at the cost of higher prices.

Central Bank Intervention

LRAS
P SRAS1

P1 P2 P3

AD2 Y YP

AD1 = AD3 Y

Conclusions
Shift in aggregate demand affects output only in the short run and has no effect in the long run Shifts in aggregate demand affects only price level in the long run Shift in short run aggregate supply affects output and price only in the short run and has no effect in the long run The economy has a self-correcting mechanism The pace of self-correction may justify policy intervention.

Vietnam War Buildup

LRAS
P SRAS2 SRAS1

P3 P2 P1

AD2 AD1 YP Y Y

OPEC Oil Shocks

LRAS
P SRAS2 SRAS1

P2 P1

AD1 Y YP Y

The 1990s Tech Boom

LRAS
P SRAS1 SRAS2

P1 P2

AD1 YP Y Y

The Current Situation

LRAS
P SRAS2 SRAS1

P2 P1

Rising oil prices raise production costs

Housing market crash lowers consumer confidence AD2 Y YP AD1 Y