Santa Monica College Aggregate Demand Aggregate Supply Model Discussion

I’m working on a macro economics question and need guidance to help me learn.

Please respond to the following prompts in a post with a minimum of 150 words, then comment on other post(s).  Comment on other post is optional.

• While over the long run, the economy grows about 2 to 3% per year on average, over the shorter term, the economy goes through business cycles. Think about the growth rate of GDP, the inflation rate, and the unemployment rate over the last 12 quarters. Would you describe the economy as booming, recovering, or in recession during the last few years? Why? Which curve do you think caused the change? Explain your reasoning.

Why It Matters: The Aggregate Demand-Aggregate Supply Model

Why utilize the aggregate demand-aggregate supply model to analyze the economy?

This may be the most important module in the principles of macroeconomics course. The module introduces the key macroeconomic model, the aggregate demand-aggregate supply model, that will be used in nearly every module that follows. Studying this module will be like learning how to cut and join wood for a carpenter, learning how to work with pipes for a plumber, or learning how to write code for a programmer. In short, this is what macroeconomics is all about: using a model model, like AD-AS, to analyze issues and problems in the macro economy. The effort you put into learning this module will be time well spent.

The AD-AS model shows how spending in the economy (AD) interacts with production (AS) to determine the aggregate price level and the level of real GDP. The model works like an ordinary market demand and supply model, but you will see that the way it is interpreted is quite different.

Some of the questions you will explore are:

• What does the macro economy look like in the short run?
• What does it look like over the long run?
• What determines the amount of total spending in the economy?
• What determines the amount of real GDP?
• How do the level of GDP and the price level respond to shocks (i.e., changes) in aggregate demand or aggregate supply?
• How do these answers differ in the short run versus the long run? 

Introduction to the Aggregate Demand-Aggregate Supply Model

What you’ll learn to do: use the AD-AS model to explain the equilibrium levels of real GDP and price level

In this section, you will learn the concepts of aggregate demand and aggregate supply, and how they can be combined in the AD-AS model to identify equilibrium in the macro economy. You will also be able to analyze how shocks to either aggregate demand or aggregate supply affect real GDP and the aggregate price level as the economy moves to a new macro equilibrium. 

The Aggregate Demand-Aggregate Supply Model

LEARNING OBJECTIVES

• Simply describe the aggregate supply-aggregate demand model

Introduction to the Aggregate Demand-Aggregate Supply Model

The economic history of the United States is cyclical in nature with recessions and expansions. Some of these fluctuations are severe, such as the economic downturn experienced during Great Depression of the 1930’s which lasted for a decade. Why does the economy grow at different rates in different years? What are the causes of the cyclical behavior of the economy?

A key part of macroeconomics is the use of models to analyze macro issues and problems. How is the rate of economic growth connected to changes in the unemployment rate? Is there a reason why unemployment and inflation seem to move in opposite directions: lower unemployment and higher inflation from 1997 to 2000, higher unemployment and lower inflation in the early 2000s, lower unemployment and higher inflation in the mid-2000s, and then higher unemployment and lower inflation in 2009? Why did the current account deficit rise so high, but then decline in 2009?

To analyze questions like these, we must move beyond discussing macroeconomic issues one at a time, and begin building economic models that will capture the relationships and interconnections between them. This module introduces the macroeconomic model of aggregate demand and aggregate supply, how the two interact to reach a macroeconomic equilibrium, and how shifts in aggregate demand or aggregate supply will affect that equilibrium. This section also relates the model of aggregate demand and aggregate supply to the three goals of economic policy (economic growth, stable prices (low inflation), and full employment), and provides a framework for thinking about many of the connections and tradeoffs between these goals. This model will aid us in understanding why economies expand and contract over time.

A simple version of the AD-AS graph is shown in Figure 1. The horizontal x-axis shows the real output, or GDP of the macroeconomy. The vertical y-axis shows the price level.

Figure 1. Aggregate Demand-Aggregate Supply Model, showing equilibrium at Pe & Qe.

WATCH IT

This video provides a nice overview of the key concepts surrounding the aggregate demand-aggregate supply model that we will cover in the next few sections. Watch it carefully so that you have a context for the explanations, diagrams and examples that follow.

 

You can view the transcript for “(Macro) Episode 24: AD & AS” here (opens in new window).

TRY IT

 

FROM HOUSING BUBBLE TO HOUSING BUST

The United States experienced rising home ownership rates for most of the last two decades. Between 1990 and 2006, the U.S. housing market grew. Homeownership rates grew from 64% to a high of over 69% between 2004 and 2005. For many people, this was a period in which they could either buy first homes or buy a larger and more expensive home. During this time mortgage values tripled. Housing became more accessible to Americans and was considered to be a safe financial investment. Figure 2 shows how new single family home sales peaked in 2005 at 107,000 units.

Figure 2. New Single Family Houses Sold. From the early 1990s up through 2005, the number of new single family houses sold rose steadily. In 2006, the number dropped dramatically and this dramatic decline continued through 2011. In 2012, the number sold rose a bit over previous years, but it was still lower than the number of new houses sold in 1990. (Source: U.S. Census Bureau)

The housing bubble began to show signs of bursting in 2005, as delinquency and late payments began to grow and an oversupply of new homes on the market became apparent. Dropping home values contributed to a decrease in the overall wealth of the household sector and caused homeowners to pull back on spending. Several mortgage lenders were forced to file for bankruptcy because homeowners were not making their payments, and by 2008 the problem had spread throughout the financial markets. Lenders clamped down on credit and the housing bubble burst. Financial markets were now in crisis and unable or unwilling to even extend credit to credit-worthy customers.

Figure 3. At the peak of the housing bubble, many people across the country were able to secure the loans necessary to build new houses. (Credit: modification of work by Tim Pierce/Flickr Creative Commons)

The housing bubble and the crisis in the financial markets were major contributors to the Great Recession that led to unemployment rates over 10% and falling GDP. We can show this using AD-AS, but first we need to learn more about the model. While the United States is still recovering from the impact of the Great Recession, it has made substantial progress in restoring financial market stability through the implementation of aggressive fiscal and monetary policy. 

Building a Model of Aggregate Supply and Aggregate Demand

LEARNING OBJECTIVES

• Define and explain the aggregate supply curve and the economic behavior behind it
• Compare and contrast the short run and long run aggregate supply curves
• Define and explain the aggregate demand curve and the economic behavior behind it
• Differentiate between the two concepts of aggregate demand and aggregate supply

Aggregate Supply

The Aggregate Demand-Aggregate Supply model is designed to answer the questions of what determines the level of economic activity in the economy (i.e. what determines real GDP and employment), and what causes economic activity to speed up or slow down.

We can begin to answer these questions if we think about the concept of the aggregate production function, which we introduced in the context of economic growth. The aggregate production function shows the relationship between the resources (or factors of production) the economy has (e.g. labor, capital, technology, etc.) and the amount of output (i.e. real GDP) that can be produced. If all resources are fully employed, the resulting output is called Potential GDP. (Over time, as the economy obtains more resources as the labor force and capital stock grow and as technology improves, the economy produces more GDP. We have described this process as economic growth.)

Firms make decisions about what quantity of output to supply based on the profits they expect to earn. Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs, like labor or raw materials, the firm needs to buy.

The previous paragraph included a critical assumption: full employment of resources. Why wouldn’t all resources be fully employed? Recall that when we discussed cyclical unemployment, we pointed out that wages are often sticky, that is, they don’t respond immediately to changes in demand for labor. The same thing may be true of other input prices. Let’s think about that in the context of an aggregate supply curve, showing the relationship between the aggregate price level and real GDP.

Aggregate supply (AS) refers to the total quantity of output (i.e. real GDP) firms will produce. The aggregate supply (AS) curve shows the total quantity of output firms will produce and sell (i.e, real GDP) at each aggregate price level, holding the price of inputs fixed.

Recall that the aggregate price level is an average of the prices of outputs in the economy. A decrease in the price level means that firms would like to reduce the wage rate they pay so they can maintain their profits. If wages are sticky downwards, labor becomes too expensive to keep fully employed, so firms layoff workers. (Economists would say that the real wage (W/P) is too high.) With fewer workers employed, firms produce less output and real GDP decreases. In short, when wages are sticky in response to changes in demand, then a lower aggregate price level corresponds to a lower level of real GDP. Similarly, an increase in the price level means that firms would like to raise wages, but it wages are sticky, labor becomes cheap so firms increase employment (or work hours) and real GDP increases.

Figure 1 shows an aggregate supply curve. In the following paragraphs, we will walk through the elements of the diagram one at a time: the horizontal and vertical axes, the aggregate supply curve itself, and the meaning of the potential GDP vertical line.

Figure 1. The Aggregate Supply Curve. Aggregate supply (AS) slopes up, because as the price level for outputs rises, with the price of inputs remaining fixed, firms have an incentive to produce more and to earn higher profits. The potential GDP line shows the maximum that the economy can produce with full employment of workers and physical capital.

The horizontal axis of the diagram shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis shows the aggregate price level. As the price level rises, the aggregate quantity of goods and services produced rises as well. Why? The price level shown on the vertical axis represents the average price for final goods or outputs purchased in the economy, i.e. the GDP deflator. It is not the price level for intermediate goods and services that are inputs to production. Thus, the AS curve describes how suppliers will react to a higher price level for outputs of goods and services, while holding the prices of inputs like labor and energy constant. If firms across the economy face a situation where the price level of what they produce and sell is rising, but their costs of production are not rising, then the lure of higher profits will induce them to expand production.

The slope of an AS curve changes from nearly flat at its far left to nearly vertical at its far right. At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP, which is defined as the quantity that an economy can produce by fully employing its resources of labor, physical capital, and technology, in the context of its existing market and legal institutions. At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time, or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sell—while making the assumption of no rise in input prices—can encourage a considerable surge in real GDP because so many workers and factories are ready to swing into production.

As the quantity produced increases, however, certain firms and industries will start running into limits: perhaps nearly all of the expert workers in a certain industry will have jobs or factories in certain geographic areas or industries will be running at full speed. In the intermediate area of the AS curve, a higher price level for outputs continues to encourage a greater quantity of output—but as the increasingly steep upward slope of the aggregate supply curve shows, the increase in GDP in response to a given rise in the price level will not be quite as large.

WHY DOES AS CROSS POTENTIAL GDP?

The aggregate supply curve is typically drawn to cross the potential GDP line. This shape may seem puzzling: How can an economy produce at an output level which is higher than its “potential” or “full employment” GDP? The economic intuition here is that if prices for outputs were high enough, producers would make fanatical efforts to produce: all workers would be on double-overtime, all machines would run 24 hours a day, seven days a week. Such hyper-intense production would go beyond using potential labor and physical capital resources fully, to using them in a way that is not sustainable in the long term. Thus, it is indeed possible for production to sprint above potential GDP, but only in the short run.

At the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs cannot encourage additional output, because even if firms want to expand output, the inputs of labor and machinery in the economy are fully employed. In this example, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity, and the unemployment rate is relatively low—at the natural rate of unemployment. For this reason, potential GDP is sometimes also called full-employment GDP. 

Shifts in Aggregate Demand

LEARNING OBJECTIVES

• Describe the causes and implications of shifts in aggregate demand

Shifts in Aggregate Demand

Demand shocks are events that shift the aggregate demand curve. We defined the AD curve as showing the amount of total planned expenditure on domestic goods and services at any aggregate price level. As mentioned previously, the components of aggregate demand are consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M). A shift of the AD curve to the right means that at least one of these components increased so that a greater amount of total spending would occur at every price level. This is called a positive demand shock. A shift of the AD curve to the left means that at least one of these components decreased so that a lesser amount of total spending would occur at every price level. This is called a negative demand shock. The next module on the Keynesian Perspective will discuss the components of aggregate demand and the factors that affect them in more detail. Here, the discussion will sketch two broad categories that could cause AD curves to shift: changes in the behavior of consumers or firms and changes in government tax or spending policy.

DO IMPORTS DIMINISH AGGREGATE DEMAND?

We have seen that the formula for aggregate demand is AD = C + I + G + X – M, where M is the total value of exported goods. Why is there a minus sign in front of imports? Does this mean that more imports will result in a lower level of aggregate demand?

Actually, imports are already included in the formula in the form of consumption (C) or investment (I). When an American consumer or business buys a foreign product, it gets counted along with all other consumption and investment. Since the income generated does not go to American producers, but rather to producers in another country, it would be wrong to count this as part of domestic demand. Therefore, imports added in consumption or investment are subtracted back out in the M term of the equation.

Because of the way in which the demand equation is written, it is easy to make the mistake of thinking that imports are bad for the economy. Just keep in mind that every negative number in the M term has a corresponding positive number in the C or I terms, and they always cancel out.

How Changes by Consumers and Firms Can Affect AD

When consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, then firms tend to spend more on investment, believing that the future payoff from that investment will be substantial. Conversely, if consumer or business confidence drops, then consumption and investment spending decline.

The Conference Board, a business-funded research organization, carries out national surveys of consumers and executives to gauge their degree of optimism about the near-term future economy. The Conference Board asks a number of questions about how consumers and business executives perceive the economy and then combines the answers into an overall measure of confidence, rather like creating an index number to represent the price level from a variety of individual prices. For consumer confidence, the overall level of confidence in 1985 is used as a base year and set equal to 100, and confidence in every other year can be compared to that base year. Measured on this scale, for example, consumer confidence rose from 100 in August 2006 to 111 in February 2007, but had plummeted to 56 by early 2010. As of October 2017, the index had a value of 125.9.

The University of Michigan publishes a survey of consumer confidence and constructs an index of consumer confidence each month. The survey results are then reported Surveys of Consumers, University of Michigan, which break down the change in consumer confidence among different income levels. According to that index, consumer confidence averaged around 90 prior to the Great Recession, and then it fell to below 60 in late 2008, which was the lowest it had been since 1980. Since then, confidence has climbed from a 2011 low of 55.8 back to a level of 98.5 in October 2017 which is considered healthy.

The OECD, an group consisting of the major developed countries, publishes the Business Confidence Index. After sharply declining during the Great Recession, the measure has risen above 100 again and is back to long-term averages. Of course, none of these survey measures are very precise. They can however, suggest when confidence is rising or falling, as well as when it is relatively high or low compared to the past.

Because a rise in confidence is associated with higher consumption and investment demand, it will lead to an outward shift in the AD curve, and a move of the equilibrium, from E0 to E1, to a higher quantity of output and a higher price level, as you can see in the following interactive graph (Figure 1):

 
Figure 1 (Interactive Graph). Shifts in Aggregate Demand.

Consumer and business confidence often reflect macroeconomic realities; for example, confidence is usually high when the economy is growing briskly and low during a recession. However, economic confidence can sometimes rise or fall for reasons that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure. U.S. presidents, for example, must be careful in their public pronouncements about the economy. If they offer economic pessimism, they risk provoking a decline in confidence that reduces consumption and investment and shifts AD to the left, and in a self-fulfilling prophecy, contributes to causing the recession that the president warned against in the first place. A shift of AD to the left, and the corresponding movement of the equilibrium, from E0 to E1, to a lower quantity of output and a lower price level, can be seen in the following interactive graph (Figure 2):

 
Figure 2 (Interactive Graph). Shifts in Aggregate Demand.

How Government Macroeconomic Policy Choices Can Shift AD

Government spending is one component of AD. Thus, higher government spending will cause AD to shift to the right, as in Figure 1, while lower government spending will cause AD to shift to the left, as in Figure 2. For example, U.S. government spending declined by 3.6% of GDP during the 1990s, from 22.2% of GDP in 1992 to 18.6% of GDP in 1999. However, from 2008 to 2009, U.S. government spending increased from 20.7% of GDP to 24.7% of GDP. If changes of a few percentage points of GDP seem small to you, remember that since GDP exceeded $14 trillion in 2009, a seemingly small change of 1.0% of GDP in annual spending is equal to more than $140 billion.

Tax policy can affect consumption and investment spending, too. Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment. Shifting C or I will shift the AD curve as a whole.

During a recession, when unemployment is high and many businesses are suffering low profits or even losses, the U.S. Congress often passes tax cuts. During the recession of 2001, for example, a tax cut was enacted into law. Figure 3 illustrates the effect of tax cuts using the AD-AS model. The original equilibrium during a recession is at point E0, relatively far from the full employment level of output. The tax cut, by increasing consumption, shifts the AD curve to the right. At the new equilibrium (E1), real GDP rises and unemployment falls and, because in this diagram the economy has not yet reached its potential or full employment level of GDP, any rise in the price level remains muted. Read the following feature to consider the question of whether economists favor tax cuts or oppose them.

Figure 3. Recession and Full Employment in the AS–AD Model. Whether the economy is in a recession is illustrated in the AS–AD model by how close the equilibrium is to the potential GDP line. In this example, the level of output Y0 at the equilibrium E0 is relatively far from the potential GDP line, so it can represent an economy in recession, well below the full employment level of GDP. In contrast, the level of output Y1 at the equilibrium E1 is relatively close to potential GDP, and so it would represent an economy with a lower unemployment rate.

DO ECONOMISTS FAVOR TAX CUTS OR OPPOSE THEM?

One of the most fundamental divisions in American politics over the last few decades has been between those who believe that the government should cut taxes substantially and those who disagree. Ronald Reagan rode into the presidency in 1980 partly because of his promise, soon carried out, to enact a substantial tax cut. George Bush lost his bid for reelection against Bill Clinton in 1992 partly because he had broken his 1988 promise: “Read my lips! No new taxes!” In the 2000 presidential election, both George W. Bush and Al Gore advocated substantial tax cuts and Bush succeeded in pushing a package of tax cuts through Congress early in 2001. Disputes over tax cuts often ignite at the state and local level as well.

What side are economists on? Do they support broad tax cuts or oppose them? The answer, unsatisfying to zealots on both sides, is that it depends. One issue is whether the tax cuts are accompanied by equally large government spending cuts. Economists differ, as does any broad cross-section of the public, on how large government spending should be and what programs might be cut back. A second issue, more relevant to the discussion in this chapter, concerns how close the economy is to the full employment level of output. In a recession, when the intersection of the AD and AS curves is far below the full employment level, tax cuts can make sense as a way of shifting AD to the right. However, when the economy is already doing extremely well, tax cuts may shift AD so far to the right as to generate inflationary pressures, with little gain to GDP.

With the AS–AD framework in mind, many economists might readily believe that the Reagan tax cuts of 1981, which took effect just after two serious recessions, were beneficial economic policy. Similarly, the Bush tax cuts of 2001 and the Obama tax cuts of 2009 were enacted during recessions. However, some of the same economists who favor tax cuts in time of recession would be much more dubious about identical tax cuts at a time such as 2017 when the economy is performing well and cyclical unemployment is low.

Government Policy Options

Changes in government spending and tax rates can be useful for influencing aggregate demand. Other policy tools can shift the aggregate demand curve as well. For example, the Federal Reserve can affect interest rates and the availability of credit. Higher interest rates tend to discourage borrowing and thus reduce both household spending on big-ticket items like houses and cars and investment spending by business. Conversely, lower interest rates will stimulate consumption and investment demand. Interest rates can also affect exchange rates, which in turn will have effects on the export and import components of aggregate demand.

Spelling out the details of these alternative policies and how they affect the components of aggregate demand can wait until we learn about the Keynesian Perspective in greater detail. Here, the key lesson is that a shift of the aggregate demand curve to the right leads to a greater real GDP and to upward pressure on the price level. Conversely, a shift of aggregate demand to the left leads to a lower real GDP and a lower price level. Whether these changes in output and price level are relatively large or relatively small, and how the change in equilibrium relates to potential GDP, depends on whether the shift in the AD curve is happening in the relatively flat or relatively steep portion of the AS curve.