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15. Aggregate Supply and Demand
Question:
35. Be able to explain how changes in base money, the money multiplier, money supply shocks, money demand shocks, government spending, taxes, consumption, saving, investment, exports, imports, price level shocks, or capacity shocks
influence the price level and real income. Illustrate with an aggregate demand and supply diagram.
Diagram:
36. Use an aggregate supply and demand diagram to show the effects of changes in base money, the money multiplier, money supply shocks, money demand shocks, government spending, taxes, consumption, saving, investment, exports, imports, price level shocks, or capacity shocks.
Short Run Aggregate Supply
Aggregate supply is the willingness of firms to produce goods and services. Short run aggregate supply is positively related to the price level.
A simple argument is that an increase in aggregate demand causes an increase in sales. Firms raise prices and output. A decrease in aggregate demand causes a decrease in sales. Firms decreases prices and output.
There is some controversy as to why this is true. At one time, economists assumed that households and firms expected the current price level (or inflation rate) to exist in the future. Their adaptive expectations would only gradually change as the price level (or inflation rate) actually deviated from expected levels. Until the expected price level (or inflation rate) fully adjusted to a new price level (or inflation rate) real output and income would be positively related to changes in the actual price level (or inflation rate).
Today, most economists assume rational expectations. When aggregate demand changes, firms and households understand that the price level must adjust, so they will change the prices they set. A few economist argue that short run aggregate supply must be independent of the price level.
Most economists believe that short run aggregate supply is positively related to the price level. Some economists argue that firms don't know when aggregate demand changes. They become confused when the price level changes and believe that the price of only their product has changed. This makes it profitable to adjust production.
Other economists argue that explicit or implicit contracts prevent some prices from adjusting when aggregate demand changes. Those who can buy or sell at the sticky prices profit from adjusting their production when the price level changes.
Suppose the following relationship describes the determination of the price level:
lnPt = lnPte + d1(lnyt - lnypt) + δt
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Where δt is a shock to the price level. This says that firms will set prices based on their expectation of the price level that will maximize their profits. They will leave the prices at that set rate unless it results in excessive shortages or surpluses. If there are shortages (real income greater than potential income) firms will raise prices above the levels they thought were sensible. If there are surpluses (real income lower than potential income) they will lower their prices. The coefficient d1 represents how much prices respond to surpluses or shortages. The price level shock involves sudden changes in costs, say due to the oil price shock in the eighties or a bad harvest raising food prices. This shock causes firms to raise their prices.
The price level function can be solved for real income. That gives the short run aggregate supply function:
lnytsSR = lnypt + 1/d1 (lnPt - lnPte - δt)
This says that firms will produce at capacity, but if the price level deviates from its expected level, income will deviate from capacity.
Potential income can be decomposed into two parts: a base capacity and shocks to capacity. That can be written as:
lnypt = lnyt* + εt
Where εt is a shock to capacity. Combining that with the short run aggregate supply function the result is:
lnytsSR = lnyt*+ εt+ 1/d1 (lnPt - lnPte - δt)
The short run aggregate supply function can be graphed to show the short run aggregate supply curve.
Short Run Aggregate Demand and Supply
Aggregate Demand and Short Run aggregate supply represent the process that determines the price level and real income in the short run. These can be graphed showing the equilibrium price level and real income.
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Setting the short run aggregate supply function equal to the aggregate demand function allows for a solution for the equilibrium level of real income and the price level. (Using that price level in the LM relationship also determines the real bond interest rate.)
lnPt = 1/(c2d1+c2b1+b2(1-b3))[d1b2(1-b3)(c0-c1tt+c3lngt+c4lnxt-c5lnnt+γt)
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+ d1c2(lnBt+lnmt+αt-b0-βt) + d1c2b2(1-b3)Pte
- d1(c2b1+b2(1-b3))(lnyt*+εt)+ (c2b1+b2(1-b3))(lnPte+δt)]
lnyt = 1/(c2d1+c2b1+b2(1-b3))[b2(1-b3)(c0-c1tt+c3lngt+c4lnxt-c5lnnt+γt)
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+ c2(lnBt+lnmt+αt-b0-βt) + c2b2(1-b3)Pte
+ d1c2(lnyt*+εt)- c2(lnPte+δt)]
rbt = 1/(c2d1+c2b1+b2(1-b3))[(c0-c1tt+c3lngt+c4lnxt-c5lnnt+γt)
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- (lnBt+lnmt+αt-b0-βt) -b2(1-b3)Pte
- d1(lnyt*+εt) +(lnPte+δt)]
Changes in Aggregate Demand: Short Run Effects
All of the factors the influence the IS or LM curves also influence the aggregate demand curve. The shifts income in the IS-LM diagram are really shifts in the aggregate demand curve.
Factor Relationship to aggregate demand
Base moneyPositive
money multiplierPositive
money supply shockPositive
money demand shockNegative
consumptionPositive
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savingNegative
investmentPositive
government spendingPositive
taxesNegative
budget deficitPositive
exportsPositive
importsNegative
trade deficit Negative
Effects of an Increase in Base Money in the Short Run
Suppose the Federal Reserve uses open market purchases to increase base money. The money supply rises and results in a surplus of money. The excess money is spend on bonds. Bond prices rise and the nominal interest rate falls. Given the expected inflation rate, that lowers the real interest rate. The lower real interest rate stimulates investment and consumption spending. Firms sell more and raise their prices and their output. The price level and real income rise.
Changes in Short Run Aggregate Supply
Changes in short run aggregate supply are very important. The shocks to capacity and the price level can cause stagflation. Usually, a positive price level shock is combined with a negative capacity shock. Short run aggregate supply decreases, leading to rising prices and falling output. This is an especially unpleasant situation. This is called an adverse aggregate supply shock. Favorable supply shocks are more pleasant. They tend to result in lower prices and more output.
Perhaps most important, expected inflation is negatively related to short run aggregate supply. If the changes in the price level that are caused by a change in aggregate demand are correctly anticipated, then they will have no effect. Further, the effects on the price level of any change in aggregate demand will eventually be noticed and taken into account. As the expected price level adjusts to the actual price level, the effects of a change in aggregate demand on the price level will dissipate.
Factor Relationship to short run Aggregate Supply
Base Capacity Positive
Capacity Shock Positive
Price level Shock Negative
Expected Price Level Negative
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Adverse Aggregate Supply Shock
Suppose some war in the Persian Gulf results in efforts to hoard oil. This causes a simultaneous positive shock to the price level and negative shock to capacity. The price of oil rises immediately. Given other prices, the price level rises. Further, less oil is available for production, the resulting decreases in production that reduce income.
The higher price level raises the demand for money, raises the real interest rate, and reduces expenditure. This reduces sales and firms reduce output. While firms also reduce prices, the increase in the price of oil leaves the price level higher.
The reduced capacity implies lower production and income. That tends to lower the demand for money and lower interest rates. The lower interest rates tend to stimulate expenditure. Firms increase prices and increase production relative to capacity, but since capacity is lower, income is on net decreased.
The shock to the price level and the shock to capacity have similar effects on the price level and income. The effects on the real interest rate are opposing and the net effect depends on which shock is larger.
Long Run Aggregate Supply
In the long run, the expected price level must adjust to the actual price level. Ignoring shocks, aggregate supply is equal to potential income. That is, real income equals potential income.
ytsLR = ypt
and if all shocks are zero:
ytsLR = yt*
In other words, long run aggregate supply is equal to base capacity--at least ignoring temporary, unpredictable shocks.
Firms and others responsible for setting prices should be able to figure out what is happening to the price level and adjust their expectations accordingly. But even if they are relatively ignorant, market processes exist which will compel them to adjust their production and pricing decisions.
If firms try to produce beyond capacity, they will compete for limited resources--land, labor, and capital. As their competition bids up the prices of these things, costs rise. As costs rise, firms raise prices.
As prices rise, the demand for money rises. That tends to raise the real interest rate on bonds. (The LM curve shifts to the left.) Investment and consumption are reduced. Firms sell less and produce less. The higher prices and lower production is represented by the short run aggregate supply curve shifting to the left.
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Similarly, if firms are producing less than capacity, then there are surpluses of resources. Firms can lower the amount they offer for land, labor and capital. This lowers costs. (And with growing productivity, they can simply increase their offers of payment by less than the increase in productivity.) The lower costs encourages firms to lower prices. The lower price level reduces the demand for money and the real bond interest rate. (The LM curve shifts to the right.) Investment and consumption is increased, so firms sell more and produce more. The lower price level combined by higher production is a shift in the short run supply curve to the right.
The shifts in the short run aggregate supply curve occur until the expected price level is equal to the actual price level--ignoring shocks.
A graph of the long run aggregate supply curve is simply a vertical line.
Long Run Changes in Aggregate Demand and Aggregate Supply
The various factors that influence aggregate demand have the same effects in the long run as in the short runs. Since the expected price level is equal to the actual price level in the long run, and the price level and capacity shocks are temporary, only changes in base capacity cause shifts in long run aggregate supply.
Long Run Effects of an Increase in Base Money
The short run effects of an increase in base money leaves real income greater than potential income. (The LM curve shifts to the right.) There are not enough resources to maintain production at this high level. Firms compete to obtain resources, resource prices rise. That implies that costs rise, so the firms increase their prices. The price level rises.
A higher price level raises the demand for money. That tends to create a shortage of money. To obtain needed funds, bonds are sold. Bond prices fall and the nominal and real interest rates rise. (The LM curve shifts to the left.) The higher real interest rates discourage investment and consumption spending. Firms sell less and cut back on production. Output and real income fall. (The short run aggregate supply curve shifts to the left.)
So in the long run, an increase in the money supply causes an increase in the price level and leaves real income and the real interest rate unchanged.
Long Run Effects of an Increase in Government Spending
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The long run effects of an increase in government spending are similar to those of an increase in the money supply. The short run effects were shown by a shift of the IS curve and the AD curve to the right. Higher income, higher price level, and higher real interest rate.
But income is above capacity. That tends to raise the price level further. The LM shifts to the left as does the short run aggregate supply. In the end, the price level rises and real income returns to potential. But since the short run effects of an increase in government spending was an increase in real interest rates, the end result is that real income returns to potential while the real interest rate increases by more than it did in the short run. This is an increase in the natural interest rate. (The long run effects of an increase in government spending can be illustrated by a shift of the IS curve to the right and a shift of the LM curve to the left such that real income remains unchanged. Also, the AD shifts to the right and the short run AS shifts to the left so that real income remains unchanged and the price level rises.)
Accounting For Shocks in the Long Run
The economy can be in a long run steady state equilibrium even though there are temporary random shocks. It is possible to solve for the price level, real income, the real bond interest rate and other variables in this scenario. Find the expected price level by setting aggregate demand equal to base capacity and assume that all shocks are zero. This is what the price level would be in the long run without shocks. Then substitute that expected price level into the short run aggregate supply function and set that equal to the aggregate demand function. That gives the solution for the price level. Use that price level, the expected price level, and the short run aggregate supply function to solve for real income. Use that level of real income and the IS relationship to solve for the real bond interest rate.
lnPt = b2(1-b3)/c2 (c0-c1tt+c3lngt+c4lnxt-c5lnnt)
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+ (lnBt+lnmt-b0)+ b2(1-b3)Pte - (c2b1+b2(1-b3))/c2 lnyt*
+ 1/(c2d1+c2b1+b2(1-b3)) [d1b2(1-b3) γt + c2d1(αt-βt) - d1(c2b1+b2(1-b3))εt
+ (c2b1+b2(1-b3))δt]
lnyt = lnyt* + 1/(c2d1+c2b1+b2(1-b3)) [d1c2εt + b2(1-b3)γt + c2(αt-βt) - c2δt]
rbt = 1/c2 (c0-c1tt+c3lngt+c4lnxt-c5lnnt- lnyt*
- 1/(c2d1+c2b1+b2(1-b3)) [d1c2εt + b2(1-b3)γt + c2(αt-βt) - c2δt])