Lecture Outlines - Week 8
Aggregate Supply and Demand (Ch. 11 of Schiller)
In this chapter the major learning objective is to develop a model of the macroeconomy. Recall that a major accomplishment of the microeconomic unit of this course was your mastery of the supply/demand model of a microeconomic market. We will develop a parallel model for a macroeconomy.
The basic inputs and outputs of macroeconomy are rather simple, and we have already discussed them. Schiller in Figure 11.1 describes them, and in fact makes it a bit more complicated than necessary.
The inputs are (a) market processes, including shocks affecting the behavior of producers and consumers, and (b) policy intervention by the federal government or the central bank, such as tax policy, spending, interest rate policy, and the money supply.
The outputs are (a) output levels and changes (economic growth), (b) price levels and changes (inflation), and (c) employment levels and changes (unemployment rates).
Rival Macroeconomic Theories
1. Classical Macroeconomic Theory: Remember our theory of equilibrium in a competitive market? That the market has a self-correcting mechanism that adjusts price to resolve shortages and surpluses. Consequently, the market quickly adapts to an external shock (i.e., the citrus freeze in December 1998) -- the resulting shortage caused price to rise to a new equilibrium value.
Classical macroeconomic theory likewise is based on this notion of prices and wages adjusting to resolve growth periods and recessions.
Under classical theory, how would wages adjust during a recession to reduce the unemployment rate?
Likewise, how would prices adjust during a recession to increase quantity sold?
Classical theory was demolished by the Great Depression because it could not explain the persistently high unemployment rates and the seemingly permanent stalling of economic growth.
2. Keynesian Theory: Named for its advocate, John M. Keynes (pronounced "Canes").
Keynes argued that markets tend to be unstable, and do not equilibrate quickly. Thus, there will be excessively long periods of time in which there are recessions with high levels of unemployment, and likewise excessively long periods of time in which there is high growth and inflation. Thus, Keynesian macroeconomists argue for active government policy to mitigate the highs and the lows of the business cycle.
Aggregate Supply and Demand: Before we look at the classical and Keynesian arguments in detail, let's develop a basic model of the macroeconomy.
There are two elements in this model:
1. Aggregate Demand: In a manner like market demand, aggregate demand represents the inverse relationship between the aggregate price level (like a weighted average of the price of all goods and services) and aggregate real output of goods and services (real GDP) demanded by all consumers. As aggregate prices fall, the aggregate demand curve suggests that real output grows because:
- There has been deflation (aggregate prices have fallen), and consequently purchasing power has increased -- your existing income can buy more goods and services than before, which leads to an increase in real output demanded.
- As domestic US prices fall, export sales to foreign countries rise since now our goods are cheaper to them, increasing real output demanded.
- Lower prices mean people don't demand as much borrowed money, which lowers interest rates, which in turn promotes more borrowing and consequent spending on real goods and services.
2. Aggregate Supply: As in micro markets, higher prices induce an increase in real GDP produced by sellers. Higher prices make it profitable to sell a larger quantity, even if marginal costs rise with output in the short run.
3. Macroeconomic Equilibrium: At any given time we have a static macroeconomic equilibrium where AS = AD, and consequently we can identify an aggregate price level and real GDP.
Note: The macroeconomic equilibrium may be undesirable (i.e., the level of output may be too low, implying excessive unemployment), or it may be subject to lots of fluctuations over time and thus be unstable, leading to swings from high growth to deep recessions.
Note: Some degree of instability is inherent to macroeconomics. There is not a stable equilibrium that persists over long periods of time. Instead demand and/or supply shifts over time, causing increases or decreases in real output (growth or recession) and the price level (inflation or deflation). The business cycle reflects this inherent instability of a macroeconomic equilibrium.
What sort of shocks might cause AD to shift?
- Stick market collapse might shatter consumer confidence, reducing their willingness to spend money at the prevailing price level.
- A rise in interest rates raises the cost of borrowing money and thus will reduce spending on goods and services at the prevailing price level.
What sort of shocks might cause AS to shift?
- Non-price costs of doing business will reduce AS.
Keynesian theory argues that policy should be addressed to changing aggregate demand. During a recession, increase government spending (expansionary fiscal policy) or reduce interest rates (expansionary monetary policy) to induce an outward shift in AD. During a period of excessive growth and inflation, reduce government spending (contractionary fiscal policy) or raise interest rates (contractionary monetary policy) to induce an inward shift in AD.
Supply-side theory argues that we should change policies affecting businesses to increase AS. To expand AS, reduce taxes, reduce environmental, health, or workplace safety (!), etc. Supply-siders convinced Reagan to cut taxes to bring us out of the '81 recession, and along with a big run-up in defense spending, the result was a massive increase in the national debt.