Aggregate Demand

key terms

aggregate demand: The amount of total goods and services demanded at a given price level.

Aggregate demand comes from those who make purchasing decisions in an economy. Each contributor to aggregate demand plays an important role in economic fluctuations. Those who make up aggregate demand for a given country are:
- You, your mom and dad, your friend, your next door neighbor, and anyone else who demands stuff – you are all consumers. Consumers make up the part of aggregate demand called consumption (C).
- Businesses — they need stuff to build stuff. They build factories and purchase capital. They are also a part of aggregate demand called investment (I).
- The government — they buy stuff too. They buy big tanks and lots of lawyers (an example of buying a service). They build roads and dams; buy pens and pencils; and pay for a lot of catered dinners. They are also a part of aggregate demand called government (G).
- Foreigners — they buy a lot of our stuff too. They buy our banking services, our airplanes, and our music. They are also a part of aggregate demand for their part in net exports (NX).

Note: These are the same elements of GDP which measures overall output.

Aggregate demand changes when the price level changes. When the general price level is high, there is less demand; when the general price level is low, there is more demand.
- Why?
  - When everything around you is expensive or getting more expensive (so the general price level is rising), you feel poorer. Because you feel poorer, you demand less goods and services. When everything around you is getting cheaper (price level falling), you feel richer and demand more goods and services.
  - There are slightly more complicated ways in which the price level affects investment and net exports, but the relationship is the same. (For a more comprehensive introduction see an introductory economics textbook such as N. Gregory Mankiw's Principles of Economics 4th Edition chapter 33.
- As a result, we can draw the aggregate demand curve on a graph with the general price level on the y axis and output (Y) or GDP on the x-axis.

The graph tells us that if there is a change in the price level of the economy (say from 1 to 2) then GDP will fall (say from 100 million to 70 million).
Price Level versus GDP graph in more detail

Price Level versus GDP graph in more detail

Aggregate demand is also influenced by things other than the price level. Any change to consumption, investment, government spending, or net exports that do not have to do with changes in the overall price level will cause a shift in the aggregate demand curve.

Aggregate Supply

key terms

aggregate supply: The amount of total goods and services supplied at a given price level.
Aggregate supply consists of all the goods and services produced by all the firms in an economy. There is a difference in the decision of how much firms produce in the long and short run.

Long-run aggregate supply curve (LRAS)
- In the long run, firms decide how much of their goods to make by looking at the amount of available capital and labor.

The amount produced based on the amount of capital and labor available is called the natural rate of output. Movements away from the natural rate are called short-run economic fluctuations.
In the long run, if there is a change in the demand for a firm’s good, the firm will change the price of its good or change the wage paid to its employees without changing the amount it produces (the "natural" amount). Every firm in the economy does the same thing.
Therefore, in the long run, firms do not choose the amount they are going to produce based on the overall price level; the price level will adjust to the amount that they decide to produce. Therefore the long-run aggregate supply curve is vertical.

All this graph shows is that if the overall price level changes (say from 1 to 2) there will be no change in output (Y) (in this case it stays at 100).

Short-run aggregate supply curve (SRAS)

In the short run, individual firms do take into consideration the overall price level when they make their decision on how much to produce.
This result is based on the assumption that a firm cannot change its price or wage paid to employees in the short run. (Refer to a textbook such as N. Gregory Mankiw’s Principles of Economics 4th edition chapter 33 for an in depth discussion on why the short-run aggregate supply curve is upward sloping.)
- For example, assume a firm starts to see the general price level rise, but it cannot raise its own prices because it is stuck (assume the firm printed its prices in a catalog and cannot change the price until it prints a new catalog). In order to take advantage of the higher price level, it decides to produce more. A firm without sticky prices will just raise the price of its good when it sees the general price level rise, causing firms with sticky prices to produce even more.

So, as the overall price level rises, more goods are supplied in the short run. Reversing the logic you will see that as the price level falls, fewer goods will be supplied.

The graph tells us that if there is a change in the general price level of the economy (say from 1 to 2) then GDP (Y) will rise (say from 70 million to 100 million).

There are things other than the price level that can affect the aggregate supply curve. Changes in the cost of producing goods will shift the aggregate supply curve.

Economic Fluctuations

key terms

Mouse-over a link for a quick definition or click to read more in-depth!
aggregate demand
aggregate supply
capital
GDP
labor
unemployment

Temporary movements of economic variables away from their natural position. When the movements away from the natural position are caused by unexpected changes, there has been a shock to the economy.
Economic fluctuations are evident in a graph of GDP for the United States.

As you can see there is a general trend showing potential GDP (the level of GDP that corresponds to the amount of labor and capital available in the economy – see the long-run aggregate supply curve growing at a fairly constant rate over time. There are, however, points in time where real GDP is above the growth line (see 1999) and points of time where it is below the growth line (see 1983). These movements way from the natural growth line are economic fluctuations.
Policy makers and the general population are most often concerned with fluctuations in output, inflation , unemployment. Economists think about fluctuations in terms of what is called aggregate demand and aggregate supply. If we place the aggregate demand curve (AD) along with the short-run aggregate supply curve (SRAS) and long-run aggregate supply curve (LRAS) on the same graph, we can find the overall price level as well as the level of output (or GDP) in the economy. Once we know the level of output and how it changes, we can also find the level of unemployment and how it changes using Okun's Law .

As illustrated in this graph, the intersection of the three lines represents the economy in long-run equilibrium. At this point the economy is producing at the level that labor, capital, and technology would dictate according to the long-run aggregate supply curve (YN). The economy is at its natural rate. The natural rate can change through time if there are changes to the long-run aggregate supply curve. In fact, continual technological advancements have caused the long-run aggregate supply curve to persistently move to the right. This is the reason for the growth in potential GDP shown in the United States. The economy represented in the graph above would correspond to an economy where real GDP is equal to potential GDP. We are concerned with fluctuations around the natural rate (when real GDP is not equal to potential GDP), so for simplicity’s sake, assume that the long-run aggregate supply curve remains fixed in the short run.
Fluctuations around the natural rate occur when changes to the aggregate demand curve or changes to the short-run aggregate supply curve lead to a short-run equilibrium that is different from the natural rate (YN). When these changes are unexpected they are called shocks.
Aggregate demand shock:
What would happen if Al Qaeda were to declare a truce with the West? Everyone feels pretty happy about the future and decides to go buy things. This is a positive consumer confidence shock, leading to a shift in the aggregate demand curve.

At the short-run equilibrium (a), output (Y2) is greater than the natural rate (YN) and the price level has risen (from P1 to P2). The result of the increase in consumer confidence is a short-run increase in output and inflation.
Short run to long run:
The economy will not stay at this point (a) forever. Eventually, all the reasons for a short-run aggregate supply curve will disappear (businesses can eventually change their prices or renegotiate a new wage contract). So in the long run there is no short-run aggregate supply curve.

The economy must be in equilibrium and thus cannot stay at point (a). In the long run, the businesses that decided to produce more in the short run because they couldn’t change their price find that they are overworking their machines and workers and would rather increase their price. So when they can, they cut production back to the natural level and prices rise. We move along the new aggregate demand curve to point (b) with permanently higher prices (P3) at the same level of output as before the shock (YN).
Policy:
The policy makers may find that the initial rise in price is harmful and would like to undo the resultant inflation. They can use either monetary policy or fiscal policy to move the aggregate demand curve back to its original position. In terms of monetary policy, the central bank could increase interest rates (by lowering the money supply). That would cause a decrease in investment and thus a shift back of the aggregate demand curve. The fiscal authority, on the other hand, could either increase taxes or decrease spending. Either policy move would bring aggregate demand back to its original position. The economy would return to the original price level and level of output (b).

Short-run aggregate supply shock:
What effect might the floods of 2008 in the Midwest have on the economy? The flood destroyed the crops of many farmers, adversely affecting the short-run aggregate supply curve.

In the short run the economy moves to point (a). Output falls below the natural rate and prices rise. This combination of low output and inflation is called stagflation. Without any intervention the economy would eventually return to the original point were the aggregate demand curve crosses the long-run aggregate supply curve (recall there is no short-run aggregate supply curve in the long run).
Policy:
Policy makers have a dilemma if they want to offset this particular kind of economic fluctuation. Both the monetary and fiscal authorities are limited in that they can only shift the aggregate demand curve. If they increase aggregate demand, they will increase the level of equilibrium output, but they will also push prices even higher. If they decide to decrease aggregate demand, they can reduce the price level but they will also push equilibrium output further away from the natural rate. Fiscal and monetary coordination is helpful during such a situation.

Investment and Savings

key terms

Notice that the way economists use the word investment is not the same as you may be used to. You may think of someone asking you where you are going to invest your money, or if you put your money into the stock market you might be asked if you felt it was a good investment.

You putting your money in the stock market, an IRA account, a CD, or a savings account is called savings.

Investment is what is done with your savings.

When you buy a stock (savings) you give money to a business (expecting a return) so that they can build a machine or build a new building (investment).
When you put your money in a savings account (savings), the bank doesn’t just leave the money there; it loans your money to a business to build a factory or buy a machine or to a consumer to buy a house (investment)
Thus in the end investment = savings.

Investment is an important piece of GDP and aggregate demand.
Investment is sensitive to the interest rate. In order for a business to purchase capital or build a building or for a homeowner to get a mortgage, they must borrow the money (from you the saver).
- If the interest rate is high, it is more expensive to pay back a loan. As a result, businesses may wait to build a new building and investment falls.

If the interest rate is low, it is easier to pay back a loan. As a result a potential homeowner may decide by build a house now rather than later and investment rises.

This sensitivity to the interest rate, which a monetary authority can control in
Monetary Policy

key terms

Monetary policy is a central bank’s use of either the money supply and/or interest rates to influence economic activity (Froyen, Richard (2009). Macroeconomics Theories and Policies. Pearson Prentice Hall).
How does the central bank conduct its policy?
There are a number of tools that the central bank can use, but most often it uses its control of the supply of money to influence the interest rate.
- Any central bank has a stash of money that it keeps in its vault.
  - If it wants to increase the money supply, it takes money out of its vault and puts it into circulation (usually by buying bonds).
  - If it wants to decrease the money supply, it takes money out of circulation and puts it in its vault where no one else can touch it (usually by selling bonds).
- As the money supply increases, the interest rate falls.
- As the money supply decreases, the interest rate rises.
What is the result of monetary policy?

	Interest Rate	Output	Unemployment	Inflation
Money Supply Increases
Money Supply Increases

Note: Output changes because of the interest rate's affect on investment.

Why does the central bank conduct policy?
- People dislike fluctuations in the economy, especially when unemployment or inflation rises.

People look to the central bank to prevent these fluctuations.
NOTE: There is a trade-off. As the central bank pumps money into the economy it lowers unemployment, but it also causes inflation.
NOTE: If the central bank wants to lower inflation, it must accept an increase in unemployment!

General challenges to the conduct of monetary policy:
- The monetary authority must make its decision on whether to increase or decrease the money supply based on current information (which is not complete) as well as forecasts of what the economic condition will be in the future (which is not perfect). Misinformation could cause the monetary authority to do the wrong thing.
- Though the monetary authority can act quickly to fluctuations in the economy by changing the money supply, it takes a while for the change in the money supply to actually influence prices and unemployment. By the time the policy has an effect on the economy, there may no longer be a need for it (this is called a long outside lag).

Price Levels and Inflation

The price level is the overall measure of prices in a given country or region at a particular point in time.
Inflation is an increase in the price level over a specified period of time.
- The inflation rate is the percentage change in the price level from one period of time to the next. The rate of inflation varies from country to country
Deflation is a decrease in the price level over a specified period of time.

A negative inflation rate would mean there is deflation.

How is the price level measured? The Consumer Price Index (CPI).
- There is a “basket” of goods and services commonly bought by the average consumer. This “basket” is actually a very specific list of what you might buy: apples, chicken, gas, a dishwasher, dry cleaning services, a shirt, a movie ticket, an iPod, a car repair, etc.
- A group of government workers goes out and writes down the prices of everything on that list. They then come back and calculate how much their list, or basket, would have cost.
  - The cost of this basket is the price level, also called the price index, for that time period. Because the basket is specific to what consumers would buy, it is called the consumer price index (CP

How is inflation measured?
- Every few months these workers go back out to measure the price of their basket and record the price index for each new time period.
- Because the basket of goods is not changing, if the price of the basket changes from one period of time to the next you know the general price level has changed. If the price of the basket increases, the country has experienced inflation.
- To calculate the inflation rate, say from period 1 to period 2, you just calculate the percentage change.
  Inflation>_1,2 = 100% * (CPI₁ - CPI₂) / CPI₁

What determines the price level and inflation rate?
- In the long run the price level is determined by the amount of money available in the economy.
  - The relationship between the supply of money, the price level, and inflation is captured in the quantity theory of money:
    M*V = P*Y
    Where (M) is the supply of money, (V) is the velocity of money, (P) is the price level, and (Y) is output.
  - If you look at the percentage change of this relationship and assume that money velocity (V) and output (Y) are fixed, you get:
    % change in the money supply (M) = % change in the price level (P)
  - If the money supply increases 10 percent, prices will increase 10 percent. There is too much money chasing too few goods (remember we assumed the amount produced (Y) stayed the same).
- The supply of money is most often controlled by a country’s central bank.

There are episodes in history (and today) when the amount of money available was controlled more so by politicians than an independent central bank. In times of crisis, some of these countries started printing mass amounts of money, leading to extreme episodes of inflation called hyperinflation.

In the short run the price level and inflation are determined by fluctuations in aggregate demand and short-run aggregate supply. This can result from either shocks or fiscal and monetary policy.

When price fluctuations are minimal and inflation is fairly constant at a low rate (say around 2%), price stability has been obtained.

What are the costs of inflation?
- If your income does not rise at the same rate as inflation, you will not be able to purchase as many things as prices rise.

This is a real problem for those on fixed incomes such as retirees living off of their fixed pensions.

The value of your savings is eroded.

The $100 you save today will not buy as much in the future once you take it out of savings.

It causes uncertainty about future prices and thus complicates today’s economic decisions.

Maintaining price stability is the major goal of the ECB.

Before the ECB came into existence, potential members of the EMU were forced to bring inflation under control in the Maastricht treaty.

Inflation rates for the US and Europe are illustrated below.

Inflation rate in 2007 across the Euro area

Note: CPI measures of inflation were not available for every member or the EU, so I use the GDP deflator for my price level to calculate inflation � though not the same as CPI it does give a similar picture of what is happening with inflation.
Note: The Euro Area inflation rate is from a weighted average of price levels for the members of the EMU.

Unemployment

Unemployment is a measurement reflecting the number of people actively looking for, but unable to find work.

The unemployment rate is the percentage of the labor force that is unemployed:
U = 100 * # of unemployed / # in labor force
The labor force consists of all the workers that are currently working or are actively searching for work
- The natural rate of unemployment or full employment is the level of unemployment or employment that corresponds to the natural rate of output around which the unemployment rate fluctuates in the short run.
  - The natural rate of unemployment is not the same for every country. In fact, the natural rate of unemployment in Europe is much higher than that in the United States.
  - The natural rate of unemployment is higher in Europe because there are laws and conditions in place that make it more difficult to hire workers, make the wage higher than it would be in the market, or make it easier to delay finding a job compared to the United States. For example, in most European countries
    - There are higher minimum wage laws than in the US.
    - Labor unions are much stronger and are able to negotiate higher wages than in the US.
    - The government supports the unemployed (with welfare payments) much more and longer than in the US.
  - Unemployment that is the result of factors such as those listed above is called structural unemployment, and leads to the relatively higher natural rate of unemployment in Europe.
Note: The Euro Area is the weighted average unemployment rate of the 12 original members of the EMU.
- The higher average unemployment rate after the mid 1980s illustrates the higher structural unemployment rate for Europe.
- As you can also see from the chart above, the unemployment rate fluctuates through time. These short-run changes in unemployment coincide with changes in output according to Okun's Law. Therefore the movements around the natural rate of unemployment are due to economic fluctuations.
  - Unemployment that occurs as a result of economic fluctuations is called frictional unemployment.
- What is the role of policy?
  - The government can reduce structural unemployment by:
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Wednesday, October 16, 2013