Chapter 15: Aggregate Demand and Supply Reviewer

MACROECONOMICS BASED ON DEMAND AND SUPPLY

- Interplay of aggregate demand and supply
- The reason for looking into this is the 1970s over-dependence of the Keynesian and Classical
economists on the demand-based economics (supply side was paid only a bit of attention).
The present global economic and financial crises and the cases of low productive capacities
in developing countries have made economists now realize the need for a supply-based
analysis as well. – Since we’re already familiar with the significance of the correlation
between prices & output with not only demand but supply as well in the industry sector (we
learned this in the earlier lessons), one must note that it should also be taken into account in
the case of aggregate or macroeconomic level-wise.

AGGREGATE DEMAND CURVE

Why is the ADC downward-sloping?
(It is not because of the prices.)
ADC is not the sum of all in the market demand curves in the economy.

o Pigou Wealth Effect  Higher overall prices would correspond to a lower level
of income than the original state.
 Higher price levels means consumers can buy less goods. Since nominal
income is unchanged, it is viewed more as a decrease in wealth. With
wealth going down, one’s consumption function shifts downward as well.
(There will also be a decline in output)
 This is why price regulators must always make sure that prices are
stable.
o Keynes Interest Rate Effect  With a decrease in real money supply and demand
stable, the price (which is the interest rate), will go up. With higher interest
rates, on the other hand, investments will go down. [With investments and
some consumption (both are components of GDP) decreasing overall
decrease in price leads to decline in the output (especially in the
multiplier)]
o Mundell-Fleming Exchange Rate Effect  Always assumed in an open economy
(an economy open to transacting with the rest of the world)
 When there’s an increase in price, we should look at a country’s
external accounts; domestic and international goods are compared
with one another and the local goods appears to have a higher
price in relation to the international ones, the local goods will
appear less appealing to both foreign and local buyers.
 If there’s lower demand for local goods both from local and
foreign buyers, which means that there will be a net outflow from
the local economy to the rest of the world thus aggregate demand
and income falls.

In conclusion, higher price levels will be associated with lower income/output or vice versa. But the
ADC will depend on so many other factors like consumption function, interest elasticity of
investment, etc.

Shifts in AD Curve
- The national economy is dynamic so it’s safe to assume that the ADC won’t remain stable and
will continue to shift and change through time. A demand curve, as defined in past lessons, is
represented by a schedule wherein prices and outputs are supposed to be compatible
therefore a shift in the demand curve means that the entire schedule of price-output
combination changes.
- Shift to the right = higher output (associated with same/former price levels)
 - Shift to the left = lower output (associated with same/former price levels)
- When there’s a shift in AD (whether by policy/external events), the resulting change in
output and prices are in the same direction – up/+ and down/-.
- Shifts are made possible by the increase/decrease in autonomous spending (which is
equivalent to higher/lower inflows in the circular flow). Autonomous spending comes in the
forms of investments, government expenditures and exports, thus when the three are
affected, there will be a movement in demand (/demand curve will shift).

Aggregate supply curve

- It’s elastic/horizontal – which means that infinite quantities of goods can be supplied at the
same price level
- It represents the levels of outputs that can be available in an economy at different price
levels (it depicts that maximum total amount of goods that a firm would be willing to
produce at each overall level of prices that may exist in the economy).

Ranges in AS Curve:
o Classical range – completely vertical (i.e. the economy has reached full
employment)
– It is no longer possible to increase output so the increase in AD can only
lead to price increases.
o Keynesian range – AS curve is flat
– Changes in AD curve is translated into higher output without the
increase in price
o Intermediate or more normal range – curve is upward-sloping
– Increase/decrease in demand will likely lead to an increase/decrease in
both prices and output

Why is the AS curve upward-sloping?

- Being a supply curve, it will generally be upward-sloping. It is similar to the supply curves of
individual firms or industries. Though both curves are similar, we still have to consider some
more factors for the macroeconomic level – these of which are demand for labor and average
real wage rate, productivity of employed labor, and other significant cost factors.

Shifts in the AS curve

- This means that for the same price schedule, the quantity of goods and services that will be
supplied in the economy will vary. = AS curve of the economy may shift to the left (or
upwards) or to the right (or downwards).
- Shift to the right = increased output, lower price
- Shift to the left = lower output, higher price

Factors that Shift the AS curve

o Changes in the wage rate of the economy
o Changes in productivity in labor (or other inputs which change the output-labor
relationship)
o Significant change in prices of imported inputs to domestic products
o State of technology

Importance of AS Curve Shape

 To see why Classical and Keynesian economists were unable to reconcile their views on the
economy
 Ranges in the curve are split into three zones marked as R1, R2, and R3
 Range 3 or Classical Region
o placed at the far right of the curve
o known as the “full employment of labor”
o Classical economists (20th century)
  The economy would always tend to full employment, for as long as all
prices were allowed to adjust according to market forces (all prices are
flexible)
 Viewed the AS Curve as vertical, and at full employment
 For them, stimulating the economy by increasing something such as money
supply, would not be able to raise output and employment further; it would
only result to higher prices
o Current Theory
 A vertical AS Curve is usually used to depict potential output
 Potential Output is the maximum output that the economy can produce
without putting pressure on the inflation to accelerate
 Considered as the long-run AS Curve and is linked more to long-
term economic growth since it is corollary to the rightward
movement of the production possibilities frontier (PPF).
 Range 1 or Keynesian Region
o Rather flat or horizontal  elastic
 Price level does not change even though more spending is introduced into
the system
o Placed at the left-most part of the AS Curve
o Keynes
 Could not accept the conclusions and presuppositions of Classical
economics; he faced Great Depression
 Great Depression  the U.S. unemployment rate reached 25% by 1933;
Europe also had high unemployment rates for consecutive years
o There is “substantial” unemployment or underemployment of resources or excess
capacity in the economy
 In cases like this, it is possible to hire more labor without increasing the
wage rate since there is abundant labor
 Can be done in such a way as not to affct average costs
o “Substantial”  if unemployment were very slight, the increase in output may not
be possible without increasing the average cost and therefore price per unit of
output.
 Range 2 or Normal Range
o Known as “intermediate range”
o Output will increase only with some corresponding increase in prices
 Overall prices will be greater, the closer economy to range 3
o Curve is not straight, but move upward progressively, with the operation of the “law
of diminishing returns”
 We have assumed the production function and the amount of capital to both
constant
o As more and more labor is employed, the increment to total output of each
additional labor unit becomes smaller and smaller
 Has an effect of increasing average cost for the firm since adding unit of
labor would result in less additional output than previously possible.
o The range is currently referred to as the short-run of the AS Curve; prices may not
be fully flexible and productive capacity not expandable in so short a period, overall
prices will have to aggregate demand-supply imbalances
 Increasing AD at Different AS Ranges
o At “full employment case” or an economy operating in “classical” range
 An increase in the aggregate demand is ineffective in raising output
 The only thing it is able to accomplish is to increase prices
 AD must be controlled, to prevent the economy to fall into an
inflationary situation
  The aggregate supply function for a less-developed country would tend to
hit this range much sooner than the case of a developed country, because of
the many supply bottlenecks of the economy
 Great care in a less-developed country has to be exercised with
great regard to monetary expansion; it is easy to reach relative “full
employment” range and therefore additional demand may only
feed inflation
o Where there is substantial excess capacity, or the economy is operating in Range 1
 An increase in spending or demand is introduced
 AD curve shifts to the right
 There is an increase in output (Y)
 Occurs without a concomitant increase in prices
o Supply curve is perfectly elastic at this range
 Increasing spending in this case is effective in raising income and
employment
o Intermediate Range/ R2
 We see a more realistic situation wherein both output and prices
increase/decrease with an increase/decline in spending or demand
 The change in output (Q) is smaller than when there is substantial
unemployment.
 Due to the impact of increased prices in tempering partly the
aggregate demand

Special Cases
 Stagflation
o A phenomena baffled by the economists in the 1970’s in developed countries
o A combination of stagnation (or recession) and inflation
 Output and employment were going down, while prices are going up
 “overheating”  AD is pushed to the limit, if increased further
would not mean additional output and employment but simply
increased prices
 The opposite of the usual case: prices and output move in the same
direction with changes in the aggregate demand
 During the Great Depression and the big recessions of the 1950’s:
economies saw output and employment moving in the same direction as
prices
 Traditional approach to reduce AD: monetary and/or fiscal policies, thus
shifting the demand curve to the left
 If sudden and large enough, the decrease in prices could be
dramatic; concomitant with it would be a large decrease in output
and employment
o The leftward shift the AS curve is dominant
 Lower output, higher prices
 Exemplified by the inflation of the 1970s: provoked by the twelve-
fold increase in oil prices, an important cost input in energy, and
transport sectors, on which the economy is quite reliant
o Massive input cost increase would alter the productivity schedule of labor leading to
a sharp shift of the AS curve to the left
 Prices will go up, while output and employment go down simultaneously
o When governments feel that “stagflation” is unacceptable, they decide to “reflate”, or
push up demand, their economies
 Tackling Stagflation
o The basic solution to stagflation is “Supply side economics”
 Adjustment emphasized on the AS Curve, since it’s the origin of the problem
  Popularized by late US President Ronald Reagan
o “Reaganomics” is the whole package of economic measures designed to halt
inflation and normalize the US economy
 One of its key features is large tax cut
 More money would be left in the hands of consumers and investors
 It would force the government to reduce its budget in order not to
contribute further inflationary forces as a large deficit would
o Reduction of budget usually tied up with “deregulation”
 With more money and less regulation, business firms are expected
to be more productive, investing to improve their plant and
equipment and their energy sourcing, and the expected result is for
the AS curve of economy to move to the right
o The way out from this economic malaise
 Removal of constraints
o Moving the AS curve of a LDC to the right
o Focused limitations, that generate sharp rise in the supply curve
 Energy
 Finding and promoting indigenous substitutes and encouraging
energy savings are means to achieve this end
 The removal of foreign exchange constraint constitutes a big task for a LDC
 More foreign exchange would have to be generated in order to
provide more inputs to productive resources in the domestic
economy
o Competitive exchange rate  exchange rate made to
adjust to its difference in inflation rates between one
towards the other
o More aggressive policy: exchange rate to be slightly higher
than the “normal”, or “undervalued”, so that exports
exceed imports and foreign exchange
o Why is it desirable and conductive to removing constraints
 A higher exchange rate is conductive to attracting more foreign buyers of
domestic product
 Once foreign demand for local goods comes in and rises fast, foreign
exchange will be generated rapidly
 Higher output requirements and greater labor employment
 Increasing productivity
o THE REAL SOLUTION; however, takes time to put into effect
o Can be considered as a longer-term solution to move AS Curve to the right