Aggregate Demand and Aggregate Supply

Aggregate Demand: This is another way to display the total demand in the economy – but instead of looking at expenditures versus income (AE versus GDP or Y), we will be looking at how the Price Level is connected to the level of total demand in the economy. Since this total demand (Aggregate Demand) is equivalent to Total Expenditures (AE), it is related to the same things – namely Consumption, Investment, Government Spending and Net Exports.

Aggregate Demand Curve: The aggregate demand curve looks like a regular demand curve – and in a way it is. It is the total demand for all goods and services all at once. Since asingle price does not exist for “all goods” we use the closest equivalent – Price Level. Therefore, PL is on the vertical axis instead of P. We also are measuring all goods simultaneously, so “q” just doesn’t cut it on the horizontal axis – we have to use GDP (or it’s income equivalent - Y).

We also have to make some adjustments to the rationale for why the D curve is downward sloping. We used to say it was because as the price for our good rose, the number of goods people would buy from us decreased (as they bought a good instead from one of our competitors) – BUT Aggregate Demand includes the sales of our competitors too. As our price rises, they may buy less from us, but they buy more from our competitor – but when we total it all up, they still bought just as much. There has to be another rationale for why the Ag D curve is downward sloping. There is – well, actually, there are three.

1. Real Balances Effect – here, we realize that incomes and wealth do not simply keep pace with prices. If the PL rises (inflation) our same income will not buy as much stuff. The text presents this as if we were buying from just our savings account balances – saying that money won’t go as far (the purchasing power of our wealth has decreased), but it works just as well to talk about fixed income receivers not being able to buy as much as they used to – or when COLA payments lag behind inflation how our income doesn’t keep up with prices. Consumption spending decreases – therefore Total ore Aggregate Spending decreases (Ag D) as the PL rises.
2. Interest Rate Effect – here we talk about how rising prices actually cause people to dip into their savings more than before – leaving less in the bank. As money in the banks becomes scarcer, interest rates rise (just like any other good’s price rises when it becomes scarcer). This higher interest rate means that many projects that used to be profitable – are no longer profitable at this higher cost of borrowing. Investment spending decreases – therefore, total or aggregate spending (Ag D) decreases.
3. Foreign Purchases Effect – here, we have a disturbance in the net exports portion of total aggregate spending. This is more like the effect we saw in the simple model – but the  competitors are foreign companies – not domestic ones. As our PL rises, foreign goods are relatively cheaper – so we buy more of those and less of domestic ones (Import spending increases – which replaces domestic purchases, --> Aggregate Demand falls). The other end of the coin is that as prices rise, foreigners are less likely to buy our goods as well – and instead buy goods from other nations. Our exports decrease --> Aggregate Demand falls).

Determinants of Aggregate Demand – As we mentioned, this is another way to measure Total expenditures in the economy – so it isn’t surprising that it is related to the same things that effect AE.

Consumer Spending – as “C” rise, Ag D shifts out (rises)

• Consumer Wealth – as our wealth grows we can buy more of everything, so “C” rises.
• Consumer Expectations – as we are more confident about the future, we spend more (save less for a rainy day), --> “C” rises
• Household Debt – as we have more debt, our ability to continue to borrow decreases, so the more debt we have the less “C” can increase. And as our debt rises, the more of present income goes just to pay for past consumption (interest payments as well as principle on the debt)
• Taxes – as taxes rise, we have less left over to spend, so spending falls

Change in Investment – as “I” rises, the AE curve rise – therefore, the AgD must alsoincrease (they measure the same thing after all).

• interest rates – as interest rates rise, less investments are profitable, so less Investment is done --> Ag D shifts back
• expected returns – expectations are funny things. If we believe that good times are coming, we might increase spending now. If we think bad times are coming, we might start saving for that rainy day now. We do not have to be right – as long as it affects our behavior, it effects investment decisions.
  • expected future business conditions – political leaders can effect the economy too. If business is comfortable with leadership, they feel comfortable about investing. This is why the markets fluctuate more as we near a major election. The uncertainty makes Investment jump all over the place.
  • technology – new technologies present new investment opportunities – increasing investment.
  • degree of excess capacity – the more idle capacity we have, the less likely we are to buy another machine or invest in another plant.
  • business taxes – as taxes on businesses rise, profitability falls, and less investment will be done.

Change in Government Spending – obviously if the government spends more, there is more spending going on.

Change in Net Export Spending -

• National Income Abroad – as our trading partners become wealthier, they can afford to buy more stuff (including stuff from us) so exports rise as foreignincomes rise.
• Exchange Rates – as the dollar weakens, we can simultaneously buy fewer foreign gods and foreigners can afford to buy more of ours. The opposite is true as the dollar becomes stronger.

---

Aggregate Supply – this measures the amount of output that all businesses are willing to provide at each PL. There are two versions of the Aggregate Supply curve – the Long-Run Aggregate Supply Curve (LRAS) and the Short-Run Aggregate SupplyCurve (SRAS)

The Long-Run Aggregate Supply Curve (LRAS) – in the long run, all prices are allowed to adjust fully. Firms can fully adjust their size of operations to produce at the profit-maximizing level etc – but basically it boils down to the idea that all inflation is a temporary adjustment – and that in the long-run, prices eventually all reflect their true value. In this case, the price of output may have risen, but the resulting pressure on wages has risen too – reestablishing the connection between productivity and output value. In other words, you can fool people in the short-run, but not in the long-run. So in the long run output is a level – not a relationship. We’ll use this later, but for now, we need to know only that the LRAS (Long Run Aggregate Supply curve) is a vertical line at the level of potential GDP (the GDP we would produce if there was only natural types of unemployment (4-6% unemployment). If the capacity of the economy increased – more laborers, more productivity, more capital…then the LRAS shifts out. There is no reaction to PL in the Long-Run.

The Short-Run Aggregate Supply Curve (SRAS) - The short run curve is very unusual looking – though the mid-section looks very much like a regular supply curve.

Let’s examine the three distinct regions of the SRAS:

1. Region A - In this region, there is low GDP and the PL is low. We often use the term the “Reserve Army of the Unemployed” to describe this phenomenon. If a firm wants to increase it’s output, they can hire a worker from this reserve Army of the Unemployed because they are available and looking for work. The firm does not have to raise prices to convince this worker to apply because Unemployment is high (low GDP) and they are in no position to bargain for better wages, If they try to hold out for higher wages, there’s another worker only too willing to take that job at the offered wage. Because of this a firm can increase output in this region without having to raise prices. There is no upward pressure on prices.
2. Region B - In this region, the majority of the Reserve Army of the Unemployed is gone. To attract new workers, firms must offer higher wages to induce idle people to enter the  workforce or to entice current workers to work more (generally, overtime pay is a higher wage). Therefore to increase production in region B – a firm might have to raise prices to pay the increased average cost of their labor force.
3. Region C - In this region, there are no more workers to be found. For company A to increase it’s output, it must steal a worker from another company (company B). While company A’s output goes up, company B’s output must decrease. In the aggregate, no increase is found in total production. So why do prices rise? Because in order for company A to steal that worker from company B – they must lure them with better wages, working conditions and benefits. This raises their costs and eventually leads to the higher price of the outputs. This is a capacity area.

Determinants of Aggregate Supply: So what determines the shape and position of the SRAS?
1. Input Prices – as prices of any inputs rise, prices of outputs increase as well. Even if they made no change in output numbers initially, sales will fall (until wages rise – the long run). Firms see inventories rising so they reduce production.

• Domestic Resource Prices
• Price of Imported Resources
• Market Power – this is whether a firm has the ability to control output prices (like a monopoly does). The more market power they have (the more like a monopoly they are), the more control they have.

2. Productivity – as productivity increases (measured as output per unit of input -= which is most often “output per unit of labor input” – but it doesn’t have to be, it could be any input), the costs of production decreases and the SRAS curve shifts out and down.

3. Legal-Institutional Environment –

• Business Taxes and Subsidies – more generous subsidies shift SRS right, moretaxes shift it left.
• Government Regulation– the more stringent the environmental policies, their enforcement or other legal costs of operation, the further left the SRAS shifts.

---

Equilibrium and Changes in Equilibrium

The two curves can be displayed on the same graph. The intersection determines the equilibrium level of GDP and PL. This PL clears the market of all production. It is the same level of production we found in out AE graph.

Increases in AD: Demand-Pull Inflation -
If the AgD curve shifts out (for whatever reason),from AgD to AgD’ in the graph below, we find that a new equilibrium is established with higher PL (from PL* to PL’ – which isinflation) and more GDP (from GDP* to GDP’- which is a booming economy).

This is called Demand-Pull Inflation because the change in demand (the AgD shifting out) causes prices to be pulled up. Eventually, these higher prices lead to lower sales (in terms of units of output) and layoffs start. The economy cools back down and AgD shifts back. So in the long-run we are back to GDP* (the potential GDP at the Natural Rate of Unemployment).

Decreases in AD: Recession and Cyclical Unemployment: If the AgD shifts the other way (from AgD to AgD’ in the graph below), we get a lower PL (deflation) at PL’ but also get a slow down in economic activity (recession) at GDP’. Normally we would expect to see prices fall (PL decrease) until the market re-gains momentum and then output rises to meet that increase in sales brought on by decreased prices. When prices re-adjust, we find ourselves back at GDP*. But this doesn’t always happen so easily. Demand-Pull inflation can be self-correcting
but a recession caused by a decrease in AgD may not correct itself anytime soon. The reason is that prices tend not to decrease during recessions – especially wages.

Sticky Wage Theory:

• Wage Contracts – firms are tied in to long-term wage contracts that may forbid decreasing wages in the short-run
• Morale, Effort and Productivity – Trying to lower wages creates mistrust, shirking (the act of wasting company time), stealing, quits, etc. In the end the firm is better off paying above market wages than it would be to allow wages to adjust downward.
• Efficiency Wages - efficiency wage theory says that employers often pay more than the market wage rate to make sure their employees are happy, productive and retained.
• Minimum Wage – legal restrictions n lowering wages exist in minimum wage industries.
• Menu Costs – the cost of changing prices itself is costly and firms might prefer to ride out the losses in the short-term instead of incurring these costs.
• Fear of Price Wars – lowering prices to clear markets may incite other firms to do so too. This could make temporary price reductions permanent and make long-term profits lower.

The net effect is that price levels do not fall – and therefore the recession is bigger than it would be if they did fall (from GDP* to GDP’’ instead of just GDP’). Now instead of GDP falling to GDP’, it falls to GDP’’. This also means there is no self-correction going on, AgD doesn’t just rise back up because there is no artificially low PL to make it adjust back.

Decreases in AS: Cost-Push Inflation: If the SRAS shifts back, we find that price levels rise and GDP falls simultaneously. So we get inflation and a recession simultaneously. The term for this is Stagflation – a stagnated economy (low GDP) and inflation (a rising PL).

This is usually caused by a rise in the price of some input that is used in most industries – like energy prices (oil, gas, electricity, etc) or labor (a raise in the minimum wage).

Increases in AS: Full Employment with Price Stability -

If a shift back in the SRAS gives you a disaster, a shift forward gives you paradise. Rising GDP and falling prices. This is the promise of Supply-Side economics. If you can get the SRAS curve to shift out (from SRAS to SRAS’ in the graph below), then you get more GDP (from GDP* to GDP’) and a lower Price Level (from PL* to PL’)

The trick is “Can we make the SRAS shift out?”