Thursday, October 11, 2007

Aggregate Supply/Demand Model

The aggregate supply and demand model is the model you need to know cold in macroeconomics. It is the model you will use to judge the effects of fiscal and monetary policy in both the short and long run. Let's talk first about aggregate demand and then aggregate supply

Aggregate demand -

The aggregate demand curve looks a lot like your normal demand curve in that it is downward sloping, the lower the price the more aggregate demand. However, the reasoning for the downward slope is different. There are three reasons for the downward sloping demand curve and I cannot explain them better than this website. (You can ignore the part from IS/LM on down. That is intermediate macroeconomics).

Aggregate supply -

There are two supply curves. The first is the long run aggregate supply curve, which you can read about here. In the long run the supply curve is vertical because the price level cannot effect output in the long run. Output in the long run is solely a function of labor, capital and productivity. Inflation (price increases) do not increase supply in the long run because workers will demand higher wages, decreasing the extra profits businesses can make and removing the incentive to boost output given the economies productive capacity.

Short run - The problem is that in the short run prices and wages may not adjust quickly. In fact, the economist John Maynard Keynes argued that in the short run the supply curve was horizontal (flat) because prices did not change at all.

These two radically differing views on the supply curve are the key division between classical and keynesian economists.

Why do Classicals believe the supply curve is vertical in the long run -

Say's law - a common (partially wrong) interpretation of this law is that supply creates its own demand. A more reasonable statement of the law is that wages and prices are flexible enough to ensure production is always at its potential, never more nor less. How? Well if you supply goods to the market you pay wages and you generate income. This income is then used to purchase the products you produced. What if people do not spend but instead save? Well then the increased savings lowers interest rates and this boosts investment. So savings is a case where you shift production from consumption to investment. What if demand for the product falls? Then they cut prices. What if the wages are still too high? Businesses will cut wages in order to prevent unemployment.

Therefore, the market itself will adjust via prices, wages and interest rates to ensure that there are no recessions.

Keynesian supply curve - the problem for this view was the great depression. During the great depression prices were sticky (did not change), wages did not fall, and low interest rate did not generate more investment. This suggested that the market was not correcting itself, at least not fast enough. Because of this Keynes argued against the classical's by saying "in the long run, we're all dead."

Wage stickiness is the easiest to understand because oftentimes workers, especially in unions, do not want to accept nominal wage reductions.

Price stickiness is often explained using the example of menu costs. Menu's cost money to print and restaurants do not like reprinting menu's every day cause its inefficient. But what is efficient for one business is inefficent for the economy as a whole. Other reasons for price stickiness is imperfect competition, where a cut in prices does not immediately translate into higher sales (thus it is not undertaken). Businesses sometimes wait for someone else to lower their prices before they do, etc. etc.

Interest rates falling was a phenomonen in the Great Depression. When we get the monetary policy, we will see that the belief that lower interest rates did not stimulate investment and consumption was the major reason why Keynes argued against monetary policy as a tool to fight against recession. But the way interest rates could fail to stimulate the economy is via a liquidity trap. You can read about it here. but

liquidity trap occurs when the economy is stagnant, the nominal interest rate is close or equal to zero, and the monetary authority is unable to stimulate the economy with traditional monetary policy tools. In this kind of situation, people do not expect high returns on physical or financial investments, so they keep assets in short-term cash bank accounts or hoards rather than making long-term investments. This makes the recession even more severe

So who is right?

If the classicals are right, using fiscal or monetary policy to stimulate the economy will lead only to higher prices, not to higher output. If Keynes is right then using fiscal and (although he didn't believe this) monetary policy will stimulate the economy but not prices (note to fellow economists: I am assuming a hyper-keynesian case in order to demonstrate the theory).

After much debate, the mainstream view is now that fiscal and monetary policies will do both in the short term (that is, boost growth and prices), but in the long term the economy operates the way the classicals assume it does. So when we put the model together we will graph a vertical aggregate supply curve for the long run and an upward sloping aggregate supply curve for the short run.

Then we can analyze the effect of the policies you hear about in the newspaper and on TV.

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