Macroeconomics VIII: Equilibrium of Aggregate Supply and Demand, Slides of Macroeconomics

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Macroeconomics VIII:

Equilibrium of Aggregate Supply

and Demand

Gavin Cameron

Lady Margaret Hall

Hilary Term 2004

aggregate demand revisited•^

Aggregate demand comprises four components:•

consumption

-^

investment

-^

primary government spending (i.e. net of transfers)

-^

net exports

•^

The level of income (both current and expected) is a majordeterminant of consumption, government spending and net exports.

-^

The real exchange rate is a major influence on net exports.

-^

The interest rate is also an influence on consumption and investment(with the latter being also dependent upon output expectations and‘animal spirits’).

the aggregate demand curve

income, output

P^1 P^0

the level of output given by any point onthe AD curve is such that if that level ofoutput is produced, planned expenditure atthe given relative price will exactly equalactual expenditure

AD

Y

Y

prices

long-run aggregate supply revisited•^

We say that the labour market is in equilibrium wheninflation is stable.

-^

At the equilibrium unemployment rate, there will be bothvoluntary unemployment (workers who do not wish towork at the current real wage) and involuntaryunemployment (workers who would like to work butcannot find jobs at the current real wage).

-^

If there is a unique and stable level of equilibriumunemployment, then there is also a unique and stableequilibrium rate of output.

-^

In the long-run, the economy should return to itsequilibrium rate of output, ‘money is neutral’.

AS-AD in long-run equilibrium

output (Y)

LRAS

Y*

SRAS

(P^1

e^ =P

) 1

P^1

AD

1

prices

AS-AD in dis-equilibrium

output (Y)

LRAS

Y*

SRAS (P

e =P

) 0

P^2

AD

P^0 P^1

Y

1

In the short-run, the economy canbe in dis-equilibrium with expectedprices too high

SRAS (P

e =P

)^2

prices

an investment boom

output (Y)

LRAS

Y*

SRAS (P

e =P

) 1

P^1

AD

1

AD

2

SRAS (P

e =P

)^3

P^3 P^2

An investment boom shifts theAD curve outwards. At first,expectations lag behind events, sooutput and relative prices rise(‘unexpected inflation’). Onceprices and wages are renegotiated,equilibrium is restored with ahigher relative price level.

prices

an ‘oil price shock’ & labourreal wage

LD employment

1

L

1

W^1

/P

1 W^2

/P

2

L

2

LS LD

2

Labour productivity falls since production has toswitch to less energy-intensive techniques.Hence, the marginal product of labour falls anddemand for labour shifts inwards. Theequilibrium real wage and employment falls

Log Real Oil Price and US Price Level (1995=1)

1959 to 1999

2.5^2 1.5^1 0.5^01959 -0.5^ -

1964

1969

1974

1979

1984

1989

1994

1999

Real Oil Price

GDP Deflator

fiscal policy•^

‘If the Treasury were to fill old bottles with bank notes, bury them atsuitable depths in disused coal mines which are then filled up withtown rubbish, and leave them to private enterprise… to dig them upagain, there need be no more unemployment. It would, indeed, bemore sensible to build houses and the like, but if there are political andpractical difficulties in the way of this, the above would be better thannothing’ J.M. Keynes, 1936.

-^

Changes in the government’s fiscal stance (that is, the differencebetween government spending and taxation) will shift the aggregatedemand curve.

-^

If economy is at equilibrium output, increases in spending (or tax cuts)will lead to an inflationary boom, which eventually will lead only tohigher prices.

-^

If economy is below equilibrium output, increases in spending (or taxcuts) will tend to raise output (as well as prices) and shift the economyback to equilibrium.

monetary policy•^

‘Having regard to human nature and our institutions, it can only be afoolish person who would prefer a flexible wage policy to a flexiblemoney policy, unless he can point to advantages from the former thatare not obtainable from the latter’ J.M.Keynes, 1936.

-^

Monetary policy can be implemented through either changes in themoney supply or interest rate. A cut in the interest rate leads to a risein the money supply.

-^

Changes in the interest rate will shift the aggregate demand curve.

-^

If economy is at equilibrium output, interest rate cuts will lead to aninflationary boom, which eventually will lead only to higher prices.

-^

If economy is below equilibrium output, interest rate cuts will tend toraise output (as well as prices) and shift the economy back towardsequilibrium.

the theory of short-run fluctuations

Keynesian CrossMoney Market

IS Curve LM Curve

IS-LM model

AD curve AS curve

AS-AD model