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Aggregate supply and aggregate demand
This document discusses aggregate supply and demand models. It explains that aggregate supply curves represent the quantity of output firms are willing to supply at different price levels. Aggregate demand curves show the equilibrium of goods and money markets at different price levels and output. The intersection of the aggregate supply and demand curves determines equilibrium output and price. Fiscal and monetary policies can shift these curves, impacting output and inflation. Expansionary fiscal policy like tax cuts shifts aggregate demand right, increasing output in the short run but raising prices in the long run when supply is fixed.
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Aggregate supply and aggregate demand
- 1. 1 AGGREGATE SUPPLY ANDAGGREGATE DEMAND MD Siyam Hossain Bangladesh Institute of Business & Technology Narayangonj,Dhaka Dhaka,Bangladesh www.facebook.com/mdsiyamhossain
- 2. 2 1. AGGREGATE SUPPLYAND DEMAND MODEL Aggregate Supply-Demand Schedule Aggregate supply-demand curves are tool for studying: Fluctuations in output Price level and Inflation rate Aggregate supply-demand curves helps to understand: Why the economy deviates from growth path over time Aggregate supply-demand curves helps to investigate the impact of policies on: Employment Output, and Inflation
- 3. 3 Aggregate Supply Schedule Aggregatesupply curve (AS) represent: Quantity of output firms willing to supply for a given price levels Aggregate Supply curve is upward sloping Aggregate Supply Says: At higher price firms are willing to supply more output and At lower price firms supply les output (Figure-1)
- 4. 4 Aggregate Demand Schedule Aggregatedemand (AD) Schedule shows that goods and money markets are in equilibrium at certain (Figure-1): Price level and Level of output Aggregate demand (AD) Schedule is downward sloping Aggregate demand (AD) Schedule shows that higher prices: Reduce the value of the money and Demand for output sinks Intersection of the AD and AS Schedule
- 5. 5 Intersection of theAD and AS determines: Equilibrium level of output and Equilibrium level of output price Intersection of AD and AS at E determines the equilibrium level of output Yo , and the equilibrium price level, Po (Figure-1) Shift either of demand and supply schedule causes: Change in price level and Change in output level (Figure-1)
- 6. 6 P Price Level AS Po E AD 0Yo Y (Aggregate supply/demand) Figure-1: Aggregate supply and demand
- 7. 7 Causes for Shiftingof Aggregate Demand Schedule On following grounds the aggregate demand curve shifts: Increases in government spending, Cuts in taxes Increases in the money supply and Consumer and investor confidence also (i) Increases in government spending Increase in government spending increases: Could increase money supply As a result: Demand of output increases And price increases and AD curve moves to the right
- 8. 8 (i) Cuts intaxes Tax Cuts: Increases ultimate income and demand This shifts the demand schedule rightward As a result: Demand of output increases Output increases And price increases
- 9. 9 (ii) Increase inconfidence of the consumer and investor Increase in the confidence of the consumer: Increase in the confidence of the consumer increases demand The AD curve moves to the right As a result: Demand of output increases Output increases And price increases Increase in the confidence of the investor increases: Increase in the confidence of the investor increases investment
- 10. 10 As a result: Output increases, Demand increases And price increases The AD curve moves to the right When confidence of consumer and investor drops demand Demand decreases Output decreases Price decreases The AD curve moves to the left
- 11. 11 (iii) Increases inthe money supply Increase in money supply is only then real money supply, when: Money supply increases the value of the money That is, when money supply increases real income When money supply increases income then it is called real money supply Increases in the real money supply: Increases income Increases demand Increases output Increases price
- 12. 12 Condition of realmoney supply Real money supply depends on the value of M/P Where M is money supply and P is price level So, when M/P increases, real money supply increases That is, when increase in money supply (M) more than price (P) increases When M/P decreases, real money supply decreases That is, when price (P) increase is more than money supply (M)
- 13. 13 When money supplycauses real money supply, then: Interest rate falls Investment rises Output also increases Real income increases Aggregate demand increase On the contrary, when money supply decreases value of money: Interest rate increases Investment decreases Output also decreases Real income decreases Aggregate demand decreases
- 14. 14 ANALYSING BEHAVIOUR OFTHE SUPPLY AND DEMAND CURVE Let us suppose that the government increases the money supply What impact will have this on the price level? Will have the increase in the money supply cause inflation? Will the output increase? Or do both output and the price level rise?
- 15. 15 An increase inthe money supply: Shifts the aggregate demand curve AD to the right to AD1 (Figure-2) Shifting of aggregate demand curve moves equilibrium of economy from E to E1 The price level rises from Po to P1 This shifting moves also the level of output from Yo to Y1 Increase in money supply increases level of output and price (Figure-2)
- 16. 16 Figure-2: Impact ofan increase in money supply on output and price level P Price Level AS P1 Po E1 E 0 Yo Y1 Demanded Output
- 17. 17 Impact of supplyshock on output and price: Supply shocks means abrupt sinking of the supply In supply shocks supply decreases suddenly creating shock OPEC oil embargo from 1973 created a supply shock As by supply shock supply sinks, supply curve shifts leftward (Figure-3) So, output is cut Price increases (Figure-3)
- 18. 18 Figure-3: Impact ofa supply shock on output and price level P Price Level AS1 AS P1 E1 Po E0 AD 0 Y1 Yo Y Output/Income
- 19. 19 2. THE AGGREGATESUPPLY CURVE Short-run aggregate supply curve Aggregate supply curve presents: Quantity of output that firms are willing to supply at a given price level If in short-run demand increases: Firms increase supply Firms use this opportunity to achieve extra gain They keep price unchanged and increase supply So, in short-run aggregate supply curve remains horizontal (Figure-4a) Long-run aggregate supply curve
- 20. 20 In the long-run: Per capital GDP is constant Per capita capital in constant, and Full employment is achieved So, if the long-run demand increases: Firms have no possibility to increase supply (because of full employment) Hence, if in the long run demand increases: It increases only price level However, output remains unchanged Hence, in the long run aggregate supply curve is Vertical (Figure-4b)
- 21. 21 Figure-4a: Short runaggregate supply curve P Price Level P1 AS 0 Y Output, Income
- 22. 22 Figure-4b: Long runaggregate supply curve P Price Level AS0 P1 P0 AS1 0 Yo Y Output/Income
- 23. 23 2.1 CHANG OFAGGREGATE SUPPLY CURVE OVER TIME Over time the economy accumulates resources, technology improves and GDP grows So, over time aggregate supply curve moves to the right (Figure-5a Figure-5b) The Changes of GDP over a short period is usually small (Bangladesh 5%) So, a single vertical line can be drawn to represent short-run supply of GDP Annual changes of GDP do not depend on the price level Annual supply of GDP is ‘exogenous to the price level’ (Figure-5b)
- 24. 24 Figure-5a: Output ChangeOver Time Y Output Y2 Y1 Y0 0 to t1 t2 Time
- 25. 25 Figure-5b: Supply Independentof Price P Price Level ASo AS1 AS2 0 Y0 Y1 Y2 Y Output
- 26. 26 2.2 SHORT RUN(KEYNESIAN) AGGREGATE SUPPLY CURVE The idea of short run supply curve implies that there is unemployment The firms can obtain as much labour as they want at present wage So, the costs of production do not to change as output levels change Firms are willing to supply as much as demanded at existing price So, short run (Keynesian) aggregate supply is horizontal This indicates that firms supply whatever demanded at the existing price
- 27. 27 2.3 FRIC11ONAL ORNATURAL UNEMPLOYMENT Classical model implies that there is no unemployment Everyone who wants to work get work But practically there is always some unemployment This unemployment is associated with market friction Labour market is in continuous change Some people are moving and changing jobs Other looking for jobs
- 28. 28 Some firmsare expanding and hiring new workers Others firms reduce employment by firing workers Under such condition to find the right job toilsome So, there is always some frictional unemployment Frictional unemployment exists because of shifting one job and for new Such unemployment is also called the natural unemployment It exists when the labour market is in equilibrium Currently natural rate in United States is about 5.5% In spite of some frictional unemployment, we can say there is full employment: If those who wish to work are able to get work
- 29. 29 2.4 STRUCTURAL UNEMPLOYMENT In modem economy, man by himself hardly produces anything Even primitive man needed some tools like bow and arrow for his livelihood With growth of technology, much more capital needed for productive activity All instruments of production constitute stock of capital Now, if working force grows faster than capital stock of a country, entire labour force cannot be absorbed in productive employment So, some will remain unemployed Such unemployment is known as structural (Marxian) unemployment
- 30. 30 2.5 SEASONAL UNEMPLOYMENT Some productive activity has seasonal character In these sectors (activities), during the slack season people become unemployed Such unemployment is known as seasonal unemployment Agriculture work is normally a seasonal occupation So, farmers have not sufficient work to do during the slack season Other examples of seasonal industry are: Ice factories Rice mills Sugar factories, etc
- 31. 31 2.6. KEYNESIAN UNEMPLOYMENTOR CYCLICAL UNEMPLOY-MENT Equilibrium level of income and employment may be established at less than full employment level That means, there is some unemployment It is known as Keynesian unemployment It is due to deficiency of aggregate effective demand It is also called cyclical unemployment It is called cyclical, because business depression occurs at cyclical intervals During depression, business activity is at low ebb and unemployment increases Some people are thrown out of employment altogether Some are partially employed
- 32. 32 This typeof unemployment arises not because of too little capital as for structural unemployment It occurs because of too much capital This type of unemployment occurs because total effective demand is not sufficient to absorb the entire production of goods that can be produced with the available stock of capital Business cannot sell their entire output So, output is reduced that occurs creates unemployment
- 33. 33 Measures Removing Cyclicalor Keynesian Unemployment This unemployment is due to the deficiency of effective demand It could be removed by boosting effective demand Boosting effective demand following should be done: Government boost consumption by reducing tax rates on incomes and consumption Government subsidies private consumption Government increases its own consumption
- 34. 34 4. FISCAL ANDMONETARY POLICY UNDER ALTERNATIVE SUPPLY ASSUMPTIONS 4.1 SHORT RUN (KEYNESIAN) FISCAL POLICY Fiscal policy includes govt income (tax) and expenditure policy The fiscal policy could be expansionary or contractive Expansionary fiscal policy includes tax cut and expansion of the market Contractive fiscal policy includes increasing tax and cutting market Let the market is equilibrium in at point E (Figure-6) At point E the aggregate demand and supply schedules intersect Let us now consider a short run change
- 35. 35 Let usconsider a fiscal expansion Let government expands spending (or cut tax) Demand increases and shifts rightward from AD to AD1 (Figure-6) As it is a short run change, supply schedule is a horizontal line AS passing through E The Supply schedule intersects the new demand schedule at equilibrium point E1 Output increases, but no prices increase (Figure-6) Impact of higher government spending (or tax cut) is: Increase in output (Y1) No prices increase (P0) Generate employment
- 36. 36 Figure-6: Impact ofshort run fiscal expansion P Price Level E E1 Po AS AD1 0 Yo Y1 Output/Spending
- 37. 37 4.2 IMPACT OFLONG RUN FISCAL POLICY Let us analyse the impact of fiscal policy in the long run Fiscal policy includes govt income (tax) and expenditure policy Fiscal policy could be expansionary or contractive Expansionary fiscal policy means tax cut and expansion of the market Contractive fiscal policy means increasing tax and cutting market Let us consider that government follows an expansionary fiscal policy Let government expands spending
- 38. 38 In longrun the aggregate supply curve is vertical Supply cannot be increased because there is full- employment Level of output (Y*) remains constant (Figure-7) Impact of Expansionary fiscal policy in the long run is: No increase in output Per capital GDP remains constant Price increase Let us consider that government follows an expansionary fiscal policy It cuts tax, so: Demand increases and demand schedule shifts rightward from AD to AD1
- 39. 39 If thereis unemployment economy move to E1 in short run Supply increase by unchanged price P0 to E1 Firms cannot obtain labour to produce more output New demand schedule intersects the vertical aggregate supply schedule at point E2 This is new equilibrium and at point E2 there is full employment Supply of output cannot be increased to meet increased demand Firms charge higher prices for their output and price increases Impact of tax cut in the long run is: No increase in output Price increase
- 40. 40 Figure-7: Impact ofexpansive fiscal policy in the long run P Price Level AS E1 P1 Po E E1 AD1 AD 0 Yo Y1 Output/Spending
- 41. 41 The process ofprice increase: Let before the tax cut the real money stock was M/P M was money supple, P was the price level and there was equilibrium Let because of tax cut money supply increases to M1 Demand increases Output can’t be increased So, price level increases Price level increases to P1 so that: M/P = M1 /P1 There is new equilibrium at higher price (P1) That means, same output is supplied at higher price
- 42. 42 4.2.1 Crowding Out Let there was equilibrium between government and private sector spending Let now government spends more (Govt either increases tax or borrows from bank) So, private sector spends less (Because the total income is constant) Spending of private sector falls by amount that government spends more This is known as crowding out Crowding out occurs when increase in government spending lessens private sector spending There is full or partial crowding out
- 43. 43 5. ONGOING MONEYGROWTH AND INFLATION IN LONG RUN In long run money supply leads to increase price level If money supply grows 10% a year Demand schedule would move up 10% annually Point of equilibrium of demand and supply would move up 10% It means, in the long run prices would rise 10% annually So we see ongoing money growth leads to inflation In the long run fiscal policy cannot affect output So, neutrality of money has strong policy implications
- 44. 44 If moneywere neutral, inflation could be reduced For this, growing of the money stock would have to be stopped In practice, it is difficult to reduce inflation without recession Lower growth rate of money leads to demand sinks Consequently, output sinks and unemployment increases So, money is not neutral Changes in quantity of money have real effects Monetary policy affects the level of output
- 45. 45 6. SUPPLY-SIDE ECONOMICS Someeconomists favour policies: Those shift supply curve right ward And increases GDP Arguments are: Increased supply creates job And increases per capita income
- 46. 46 So, following policiessuggested for increasing supply: Removing unnecessary regulation of the economy Cutting tax rates Encouraging technological progress Some economists refer ‘supply-side economics’ as ‘voodoo (curse) economics’ Let us analyse what happens if tax rates are cut Tax cut has effects both on aggregate supply and aggregate demand Aggregate demand increases (Demand schedule shifts right from AD to AD1 /Figure-7)
- 47. 47 This shiftis relatively large Aggregate supply also increases (Supply curve shifts to the right from AS to AS1 /Figure -7) Lower tax rates increase the incentive to work The effect of such an incentive is quite small So, rightward shift of GDP is small So, in short run GDP is higher but very small amount However, total tax collections fall and the deficit rises In addition, prices are permanently higher
- 48. 48 Supply Side Economics:Experiences in the USA Tax was cut in USA in 1981-1983 Output increased very small Price increased Budget deficit increased Many economists don't believe in magic of tax cut Conservative economists argue that tax cut has a small but real effective incentive They suggest that cutting of tax & govt spending should fall at same time: Tax collections fall, so fall also government spending So, effect on budget is nearly neutralised