Ch 33. Aggregate Demand and Aggregate Supply

.title[
# Ch 33. Aggregate Demand and Aggregate Supply
]
.subtitle[
## Macroeconomics for Students of Accounting, Finance and Digital Applications
]
.author[
### Lyuben Ivanov, PhD; Georgy Ganev, PhD
]
.institute[
### Sofia University St Kliment Ohridski
]
.date[
### May 30, 2024
]

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.pull-right[
_In the long run we are all dead..._
<hr style="background-color: black; margin: 0em 0em 0em 0em;">
John Maynard Keynes (1923) &nbsp;
]

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<hr>

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# A Bird's View of the US Economy

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# Long-Run Versus Short-Run Analysis

Long-run analysis by itself cannot explain the fact that in
market economies the long-run trend towards growth and
rising wealth is periodically cut by times of stagnating or
downright decreasing economic activity, characterized by high
levels of underutilization of resources and especially by
unemployment.

The classical macroeconomic analysis presented so far faces
serious problems in attempting to explain these fluctuations in
economic activity.

None of the factors of production – labor, capital in all its
forms, nature, technologies – changes noticeably within the
time frame of months or quarters and even seasonal fluctuations
in them cannot explain macroeconomic fluctuations.

---

# Industrial Production

---

# Employment

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# Three Key Observations

Short-run fluctuations can be characterized as follows:

1. They are irregular and unpredictable.

1. Real economic variables are co-integrated (move in a
pack).

1. An inverse link is observed between amounts
produced and unemployment (i.e. their co-integration
is with a negative sign).

---

<hr>

---

# Monetary Neutrality Revisited

Monetary neutrality is (approximately) valid in the
long run and this means that the classical dichotomy
also holds for the long run – economic wellbeing is not
affected by how much money is circulating
in the economy.

However, in the short run the nature of the money
supply process means that larger amounts of money
indicate different real opportunities facing economic
agents than smaller amounts of money, from there
different decisions and actions by those economic
agents, and thus different real economic outcomes.

---

# Short Run Versus Long Run

The fundamental cause of the relevance of money in
the short run is the incomplete and imperfect
knowledge of people.

The long run is the amount of time which has proven
to be sufficient for people to acquire information and
understanding about what is going on, and thus to
become able to separate nominal from real changes in
the economy.

The short run is an amount of time insufficient for
people to be able to distinguish between nominal and
real changes in the economy.

In the short run people can be fooled by changes in the monetary aggregates
and make decisions which are not optimal for them.

---

<hr>

---

# The Model in Action

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# The Short-Run Macroeconomic Model

The long-run macroeconomic model is concerned with real variables.

The macroeconomic model relevant for the short run
cannot consist only of real variables, because real factors alone cannot
explain short-run fluctuations in economic activity.

Therefore, the macroeconomic model of the short run
must necessarily account for real and nominal economic phenomena.

---

# The Short-Run Macroeconomic Model

The major introductory model that links real and
nominal variables in the short run is the **Aggregate
Demand – Aggregate Supply (ADAS)** model.

Concretely, it combines a real variable in one
dimension (real GDP) with a nominal variable in the
other dimension (the overall price level).

In the short run, due to incompleteness and
imperfection of human understanding, money is not
neutral and different price levels lead to different
actions of economic agents and from there – to
different real output.

---

<hr>

---

# The Aggregate Demand Curve

The aggregate demand curve is situated in the nominal-real twodimensional
space defined by the real output and the overall price
level for a given society at a given moment.

It is the set of points in this space which provide the answer to the
questions how much would economic agents demand various goods
and services in their totality at different levels of the overall price
index in the economy, other things being equal.

The most important “other thing” which must be “equal” in the
context of the aggregate demand curve, is the given-ness of the
money supply.

---

# Money Supply and the Price Level

One and the same amount of money has different purchasing power at
different price levels.

Because of this, different price levels correspond to different real equilibria
in some of the most important markets in the economy.

These different equilibria mean different actions, specifically different
physical quantities demanded of real goods at various price levels.

---

# The Aggregate Demand Curve Diagram

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# AD and the Price Level

Aggregate demand is not a fact. It is a set of answers to the question: “how
much would the economy's demand for consumption goods, capital goods,
public goods and exported goods (net) be if the overall price index were at a
specific level?”

The variables constituting aggregate demand are, at a first glance, the same
as the variables constituting GDP under the expenditure method.

But there
is a difference: GDP is a measure of a set of facts from the past. Aggregate
demand is a set of hypothetical answers about the present or the future
and reflect different plans economic agents would have under different
levels of prices, given the money supply.

---

# Explaining the Slope of the AD Curve

**Wealth effect:** 
at low price levels existing money balances have high
purchasing power, making consumers feel richer and therefore
demand more consumption goods than at high price levels – *lower price level is
associated with higher consumption*, for any given level of money supply.

**Interest rate effect:** 
at low levels of overall prices the real value of
the money supply is higher than at high prices levels, resilting at
equilibrium real interest rate that is lower than at high price levels. Lower
real interest rates make investment more attractive and translate in
higher quantities demanded of capital goods – *lower price level is associated with
higher investment**, for any given level of money supply.

---

# Explaining the Slope of the AD Curve

**Exchange rate effect:** 
the lower real interest rate at lower price levels
just described means also a larger net capital outflow than at higher
price levels, resulting at a lower real exchange rate and higher net exports than at higher price
levels – *lower price level is associated with higher net exports*, for any given level of money supply.

---

# Non-Price Determinants of AD

**Expectations by households and firms** – when their
expectations are optimistic (good times in the future, e.g.
higher incomes or sales) their demand for consumer or
capital goods is high. When expectations change the
demand also changes, other things equal.

**Tastes and preferences** of domestic economic agents.

**Tastes and preferences** of foreign economic agents.

**The state (government)** through its fiscal policy, monetary policy and structure 
of taxation (including tariffs on foreign goods).

---

<hr>

---

# Aggregate Supply Curves

Supply reflects the behavior of economic agents in their role as
producers who transform raw resources into final goods.Producers are subject to resource constraints and
active in making decisions about the satisfaction of
which human wants these resources are to be allocated.

**The long-run aggregate supply (LRAS) curve** 
reflects the long-run
factors determining the level of aggregate output, which
are already known from the analysis of the production function.

**The short-run aggregate supply (SRAS) curve** 
reflects the
influence of short-run factors, especially the difference
between expected and actual price level, on currency
production decisions by producers.

---

# The Long-Run Aggregate Supply Curve

Money neutrality in the long run means that the long-run aggregate
supply curve LRAS is vertical: real output in the long run is the same
at all price levels.

This level of the real output, which will happen if all economic agents
have sufficient time to adjust to changes in market signals, is called
natural level of production, or natural output.

It is also called potential output, because it happens when the
economy operates at its full potential given the production function,
including optimal levels of employment of all resources.

**Natural or potential GDP (natural or potential output)** 
the level of real GDP which would be produced given the specific
production function and optimal levels of employment of resources.

---

# Non-Price Determinants of LRAS

Technology

Natural resources

Labor

Capital

Physical capital

Human capital

Social capital

**Economic growth** 
A process of consecutive, constant and continuous increase of the
potential (natural) output of an economy.

---

# Economic Growth Diagram

---

# The Short-Run Aggregate Supply Curve

In the short run economic agents act in conditions of
uncertainty and inability to rearrange their positions in
light of decisions already made.

Therefore, changes in nominal variables, especially in the
price level, may for some period of time have a real effect
on production decisions and therefore have an effect on
aggregate real activity.

It has been empirically established that in the short run
higher actually happening price level means higher
aggregate production and quantity supplied of goods,
while lower actually happening price level means lower
aggregate production and quantity supplied.

---

# Explaining the Slope of the SRAS Curve

**The sticky wages hypothesis** 
It takes time to renegotiate wages. Given wages, higher sale
prices (higher prices of final goods) means higher profit margins
and from there higher desired output by firms.

**The sticky prices hypothesis** 
Firms do not change prices often. Given prices, higher than
expected real money balances in the economy mean higher than
expected sales at those prices, leading to increased output by
firms.

**The misperceptions hypothesis** 
Entrepreneurs cannot (in the short run) distinguish between
being able to sell at higher prices because of improved
competitiveness or because of higher consumer demand due to
higher than expected real money balances.

---

# The SRAS Equation

<table class="none">
<tr>
<td style="width: ;"> Quantity of output supplied </td>
<td> = </td>
<td> Natural level of output </td>
<td> + </td>
<td> a </td>
<td> &times; </td>
<td> ( </td>
<td> Actual price level </td>
<td> - </td>
<td> Expected price level </td>
<td> )</td>
</tr>
</table>

where

&nbsp; &nbsp; &nbsp; a &mdash; a parameter that estimates how much output responds to 
&nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp; &nbsp;unexpected changes in the price level.

An actually happening price level which is lower than expected
means a negative value for the expression within the square
brackets, and from there an output level lower than the natural level
in the short run, and vice versa.

---

# The SRAS Curve Diagram

---

# Non-Price Determinants of SRAS

**Fundamental (long-run) factors** also have effect in the
short run:
- Technology
- Natural resources
- Labor
- Capital – all forms

**Current expectations of business about the price level** 
Other things equal, if expected price level was low, any actually
happening price level will mean higher aggregate quantity
supplied due to the sticky wages, sticky prices and misperception
effects than it would be if the expected price level was high.And vice versa.

---

# Role of Expectations

The necessity of economic agents, especially in their role
as producers, to adjust and rearrange their expectations
when circumstances change is the key difference between
the short-run and long-run horizon of economic analysis.

Resetting expectations takes time, and during this time
the macroeconomic equilibrium may happen at a level
either higher or lower than the natural level of output,
thus the economy may happen to produce either above or
below its potential.

The quickness with which economic agents reexamine and
adjust their expectations when circumstances change
determines how much time is needed for aggregate
output to find itself back at its natural level.

---

# ADAS vs Demand-Supply Model

The major differences between the ADAS model and
the already familiar models based on demand and
supply curves are two:

- The AD and AS curves represent the aggregation of the
behavior of all economic agents in society, and this has a
specific importance for understanding the analysis.

- The relevant curves are three, not two, since the aggregate
supply curves are different depending on the time horizon
envisaged in the analysis.

---

# Main Features of the ADAS Model

The model space is nominal-real, namely it consists of nominal
price level P and real output Y.

The AD curve slopes downward, i.e. exhibits an inverse link
between the price level and aggregate quantity demanded due
to the wealth, interest rate and exchange rate effects.

There are two AS curves, with the LRAS curve being vertical in
reflection of the long-run neutrality of money and its
consequent lack of effect of the price level on real GDP in the
long run.

The SRAS curve slopes upward, i.e. exhibits a direct link
between the price level and aggregate quantity supplied in the
short run due to the sticky wages, sticky prices and
misperception effects.

---

# ADAS Diagram

---

# Analytical Importance of ADAS Model

The ADAS model is built in such a way that it provides
everything needed to develop a theoretical analysis
of:
- The main sources and dynamics of short-run fluctuations in
aggregate economic activity.

- The capacity of the state (government) to influence
aggregate economic activity in the short run.

---

.font200[
&nbsp; Causes of Short-Run &nbsp;&nbsp;Fluctuations in Aggregate &nbsp;&nbsp;Economic Acitivy
]

<hr>

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# Short-Run Macroeconomic Equilibrium

In the short run the equilibrium position of the
(macro)economy, i.e. what is the prevailing level of overall
prices and of real output, is determined by aggregate
demand and the short-run aggregate supply.

Graphically, the macroeconomic equilibrium at any given
moment is defined by the intersection of the aggregate
demand curve and the short-run aggregate supply curve.

What determines the overall price level and the quantity
of real aggregate output is the tendency towards equality
of aggregate quantity demanded and aggregate quantity
supplied corresponding to the relationship the current
actual price level and the current expectations of
producers about the price level.

---

# Deviation From Long-Run Equilibrium

In the general case, as presented in the general graph of the ADAS
model above, short-run equilibrium is simultaneously also a long-run
one, because the intersection of the aggregate demand and shortrun
aggregate supply curves happens to be also on the long-run
aggregate supply curve.

However, sometimes the short-run macroeconomic equilibrium
happens at a real output either below or above the natural level.

This deviation from the natural level can last only until producers
reset their expectations and adjust their production.

Graphically, this means that in the long run the short-run aggregate
supply curve shifts so that the short-run equilibrium moves towards
the long-run natural level of real output.

---

# Return to Long-Run Equilibrium

So, according to the ADAS model, after spending some
time in an equilibrium away from the natural level of
output, aggregate economic activity starts moving
towards it due to the resetting of expectations.

Thus, the economy is generally influenced by events
causing a deviation of short-run equilibrium from the
natural level of output and then resetting of
expectations and a return of output towards its
natural level. It is precisely this phenomenon which
constitutes the fluctuations of short-run economic
activity around its long-run natural level.

---

# Reasons for Deviations

In general, the reasons why the short-run equilibrium may shift away
from its long-run potential level are defined by some external shock
to either short-run aggregate supply or aggregate demand.

**Shocks to Short-Run Aggregate Supply** 
- The major source of shock to short-run aggregate supply are the
business expectations.

- Resource or technology shocks affect simultaneously both the short-run
a ggregate supply and the long-run economic potential and its dynamics.
Despite this, it is often considered that some resource shocks, especially
negative, are more adequately treated as a part of the cyclical, rather than
the long-run, dynamic of the economy.

---

# Reasons for Deviations

**Shocks to Aggregate Demand** 
- The desire of households to consume
- The desire of firms to invest
- The desire of government to spend
- Tastes and preferences influencing net exports
- The money supply.

---

<hr>

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# A Negative Shock to SRAS (Diagram)

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# A Positive Shock to SRAS (Diagram)

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# A Negative Shock to AD (Diagram)

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# A Positive Shock to AD (Diagram)

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# Macroeconomic Growth (Diagram)

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<hr>

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# Competing Schools of Thought

According to mainstream economics, the fluctuations in
aggregate economic activity just shown are mainly due to
the so called by John Maynard Keynes “animal spirits”.

The alternative school of the real business cycle models
the business cycle as the results of strictly real positive or
negative shocks to factors of production or technologies.

Another alternative school, known as the Austrian school
of economics, concentrates on government policies,
especially the manipulation of the monetary environment,
as the main source of fluctuations in aggregate economic
activity.

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# Questions?

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# Thank You!

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