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1.
Introduction
While macroeconomics has imported the concepts of supply and
demand from microeconomics to understand and analyze the overall economy,
certain important adjustments have been made. The first, and most
important, is the difference between planned (expectations) and actual
outcomes. At any point in time, divergence between these two set in motion
forces that lead to adjustments in subsequent time periods.
Aggregate demand reflects changes in the
aggregate price level measured by a price index. On the other hand, the
aggregate price level is assumed constant to derive aggregate expenditure,
i.e., everyone 'plans' C, I, G, etc., assuming a certain price level.
If that assumption changes then a new aggregate expenditure equilibrium is
derived. At each possible aggregate price level we can derive equilibrium
aggregate expenditure and thereby plot the aggregate demand curve.
The second difference concerns supply. In the
short-run, aggregate supply is assumed to be upward sloping but in the long run
(assuming constant technology and the fixed availability of factors of
production) aggregate supply or 'potential GDP' is assumed to be vertical and
inelastic. Shifts in long-run aggregate supply occur only when these
assumptions are changed. The difference between potential GDP or long-run
aggregate supply and short-run aggregate supply reflects unemployment or
'over-employment' of factors of production. Unemployment and
over-employment results in changes to the price level in the economy which tends
to lead the economy towards an equilibrium of short-run aggregate supply and
potential GDP.
Third, unlike microeconomics in which government is
assumed to play an essentially passive role, in macroeconomics government is an
active player whose decisions are not necessarily based on economic grounds,
that is, government spending and taxation are 'political' decisions. Put
another way, government spending (fiscal policy) and taxes (taxation) policy
tend to be 'autonomous' of the economy as a whole. A correspondence of
economic and political pressures are required for government to simply react to
changing economic circumstances rather than to the interests of the electorate,
i.e. getting re-elected.
Fourth, in microeconomics a determining variable is
the price of a good or service which is reflected in the supply and demand curve
for that commodity. In macroeconomics, however. it is the overall 'price
level' rather than the price of an individual commodity that is the determining
variable. Put another way, in microeconomics it is the individual price
that counts, in macroeconomics it is aggregate prices or the price level
measured by a 'price index' of all goods and services available in an economy,
specifically the GDP Deflator.
Fifth,
market demand in microeconomics is derived through the horizontal
summation of the total quantity of a good each and every consumer will buy
at a given price. Total demand in macroeconomics is derived,
in the planning stage (called 'aggregate expenditure'), through the
vertical summation of the demand of separate and distinct players within
the overall economy: consumers, investors, governments, foreign countries
as buyers of exports and sellers of imports. Unlike microeconomics
players do not react to a shared indicator, i.e. market price, but rather
to sets of very different and distinct signals.
b) Aggregate Demand
Aggregate demand equals the total amount of final goods
and services produced in Canada that individuals (and households),
businesses, governments and foreigners plan to buy. The key word is
'plan'. There is therefore a likelihood that aggregated demand will not in
fact equal actual aggregate expenditures.
Aggregate demand equals planned consumption plus
investment plus government spending plus exports minus imports, or:
Y = C +
I + G + X – M
Some of the principal factors affecting the planning for components of aggregate
demand include:
i - Price
Level
All things being equal, the higher the level of prices, the lower will be
aggregate demand measured as 'real' GDP (P&B 4th Ed Fig.
24.6;
7th Ed Fig. 26.4).
This relationship produces a schedule of real GDP demanded and different levels
of prices. In turn this schedule can be graphed as the Aggregate Demand Curve
(downward sloping to the left reflecting the Law of Demand: the higher the
price, the lower the demand; the lower the price, the higher the demand).
As in microeconomics, there are income and substitution
effects associated with changes in prices. These effects serve to explain
the downward sloping nature of the Aggregate Demand Curve. In macroeconomics, the income effect is called 'the wealth
effect'. If prices rise, wealth falls because financial assets such as
bank accounts, stocks and bonds now buy less. In macroeconomics, a basic assumption about the substitution
effect (shifting from more to less expensive commodities) is that future prices
(expectations) and foreign prices (imports) do not change. If prices
go up today but future prices remain constant, people will buy less today
deferring purchases till tomorrow (when prices are, relatively speaking lower,
because future prices remain constant and current prices go up).
Similarly, if Canadian prices go up but foreign prices remain constant then
foreign prices (imports) become relatively less expensive and Canadian will tend
to buy more foreign and fewer Canadian goods and services.
ii - Expectations
It is primarily expectations about future income, prices and
profits that affect aggregate demand today. The expectation of an increase
in future income leads consumers to increase aggregate demand today (and vice
versa for an expectation of lower future income). The expectation of
increase future profits will lead firms to increase their purchases of new plant
and equipment today (and vice versa for an expectation of lower future
profits). Similarly, the expectation of higher prices tomorrow (inflation)
will lead households and firms to increase purchases today (and vice versa for
an expectation of lower future prices).
iii - Fiscal, Taxation & Monetary Policy
Fiscal policy involves government spending including
transfers of monies to households and firms. If government spending goes
up, aggregate demand goes up (and vice versa for spending cuts). Taxation
policy involves taxes raised to pay for government spending. If taxes go
down, 'disposable' income goes up and, all things being equal, aggregate demand
goes up (and vice versa for tax increases).
Monetary policy involves changes in the interest rate (the
cost of money) and the quantity of money. If interest rates go down the
cost of money declines and aggregate demand goes up (and vice versa for an
interest rate increase). Similarly, if the quantity of money increases
aggregate demand goes up (and vice versa for a decrease in the money supply).
iv - World Economy
The two principal aspects of the world economy affecting
domestic aggregate demand are exchange rates and foreign
income. The foreign exchange rate measures the value of the
domestic currency relative to foreign currencies. If the exchange rate
goes down, that is, the dollar buys less foreign currency then domestic
commodities become less expensive to foreign buyers and exports tend to rise
increasing domestic aggregate demand (and vice versa for an increase in the
exchange rate).
Similarly,
if foreign income goes up, that is, foreign countries become wealthier, then
they can afford to buy more domestic goods increasing exports (and vice versa
for a decline in foreign income).
v - Shifts in the Aggregate Demand Curve
The aggregate demand curve will shift in line with changes in (a) - (d) (P&B
4th Ed
Fig.
24.7;
7th Ed Fig. 26.5).
3.2 Aggregate Supply (AS)
AS is the sum total of all final goods &
services produced by an economy at various price levels (P&B
4th Ed
Fig. 24.2;
7th Ed Fig. 26.1). It is graphed on the x-axis
as real GDP and
the price level on the y-axis. It is based on the production function of a
country. In symbolic logic, Ys = f (K, L, N, .....) where:
Ys = aggregate supply;
f = technology
or 'know-how'
K = capital plant &
equipment
L = labour;
N = natural resources; and,
... = all other imaginable factors
of production.
a)
Long-Run AS (LRAS)
LRAS
corresponds to when all available factors of production (K, L, N, T, etc) are
fully employed (P&B 4th Ed Fig 24.1;
7th Ed Fig. 26.1). LRAS is vertical meaning
there is no increase
possible given available factors of production. LRAS thus corresponds to potential real
GDP, that is, the maximum output attainable by the economy given the existing
supply of factors of production. Movement up or down
LRAS is caused by changes in two sets of prices – the overall or aggregate price level for
final goods and services and
factor prices.
If final prices go up then factor prices will rise at the same rate meaning
that 'real' wage rates and other factor prices remain constant as does real GDP.
LRAS
can shift if there are increases in available factors of production,
e.g. the quantity of labour (population growth or increase in the labour
force); changes in the quantity of capital (investment) or technological
progress.
b)
Short-Run Aggregate Supply (SRAS)
The SRAS
curve is plotted using the schedule of increasing price levels and real GDP (P&B
4th Fig. 24.2;
7th Ed Fig. 26.1) assuming monetary factor prices remain constant. This
means that if the overall price level rises then real factor prices decline
resulting in increased production. Why? Revenue goes up (PQ) while
cost remains the same, i.e, profits increase. Because real production grows as prices rise
(assuming constant money factor prices) the SRAS curve is upward sloping, that
is, it has a positive sloped. Higher prices for goods and services
with lower real factor prices increases profits and encourages firms to produce
more.
The key,
in this model, for movement along the SRAS curve is the labour market. Movement up
along the SRAS means real GDP rises as the price level rises because
unemployment falls as the real wage rate falls with rising prices. This
will continue until SRAS measured by real GDP attains LRAS or potential GDP at which point the natural rate of Ue or 'full employment' is
achieved. This 'natural rate of Ue' is not zero but rather reflects
'frictional' Ue about which more will be said in a future lecture.
If
SRAS moves beyond LRAS or potential GDP, that is, after
full employment has been achieved, factor prices including the real wage rate
will increase due to competition. Rather than increased real GDP (which has reached its limit), money factor prices will
rise and movement will shift up
along the LRAS curve rather than out and up along the SRAS curve (P&B 4th Ed Fig 24.3;
7th Ed not displayed).
c)
Shifts in AS (SR/LR)
Shifts
in the SRAS curve occur because of changes in real factor prices thereby
affecting a firm’s costs of production.
Furthermore, changes in the quantity of capital and advances in technology also
cause shifts in both the SRAS and LRAS curve (P&B
4th Ed
Fig. 24.4;
7th Ed Fig. 26.2).
3.3
AD-AS Equilibrium
The purpose of the AD/AS model is to understand and predict changes in real GDP and
the price level.
It represents another application of the Marshallian scissors
of microeconomics. There are both short-run (SR) and long-run (LR) points
of equilibrium, that is points to which the model will return after any
short-term changes in the underlying variables of the model
a)
SR Real GDP & Prices
SR equilibrium occurs when SRAD = SRAS. If the economy is not in
equilibrium forces will tend to bring the economy back into equilibrium (P&B
4th Fig 24.8;
7th Ed Fig. 26.6). For example, if real GDP is higher than equilibrium, final
and factor prices tend to be higher than consumers are willing to pay and firms will cut
production, lower prices and factor prices will tend to fall. If, on
the other hand, real GDP is less than equilibrium, the quantity of final goods producers
supply is less than consumer demand forcing up all prices until equilibrium is
achieved.
b)
SR Equilibrium & Full Employment (FE)
SR equilibrium is not necessarily at potential real GDP or full employment.
If it is less there is a recessionary gap; if it is more there is an
inflationary gap (P&B
4th Ed
Fig. 24.8
&
24.11;
7th Ed
Fig. 26.6 &
26.9 ). Overtime the economy will tend to
adjust in response to the forces at play and return the economy to LR
equilibrium. For example in a recession, factor prices are depressed
causing the cost of production to fall and output to increase over time.
During inflation, factor prices are elevated causing the cost of production to
rise and output to fall.
c)
LR Growth & Inflation
LR growth results from the persistent increase in LRAS, i.e., in
potential. The rate at which
LRAS shifts is measured by growth rate of potential GDP. Inflation results
when the rate of growth of LRAD is greater than LRAS. The major factor
affecting the rate of growth of LRAD is the quantity of money. If the
money supply grows faster than LRAS inflation results. If growth of
the money supply is low, so is inflation. None of these growth rates are
steady and there results a persistent fluctuation around an ever increasing potential
GDP.
d)
AD & AS Fluctuations
Let us assume that the world economy grows faster than the domestic
economy. Demand for exports increases shifting the AD curve (P&B
4th Ed
Fig. 24.12;
7th Ed Fig. 26.10). This shifts the domestic economy out of equilibrium with LRAS.
Initially movement occurs along the SRAS curve on which it is assumed that money
factor costs are constant. Eventually, however, factor prices must rise as
firms compete for a fixed quantity of factors of production. This raise
prices and causes the SRAS curve to shift to the left back to LR equilibrium at
full employment but at a higher price level.
Similarly, let us assume that the price of a significant factor of production
like oil increases. This will cause the SRAS curve to shift as production
costs rise to the left out of equilibrium will potential GDP (P&B
7th Ed. Fig. 26.11). A
recessionary gap is created but at a higher level of prices. This
combination of recession and inflation is called stagflation. The final
outcome depends on what happens to AD. If AD does not increase the demand
for oil is decreased and production falls and other factor prices fall eventually
returning the SRAS curve to its starting point and the economy returns to LR
equilibrium
d) Equilibrium Real GDP & Price Level
The economy can be in three possible states: a recessionary gap, full
employment or an inflationary gap (P&B
4th Ed Fig 25.12
&
Fig 25.13; 7th Ed Fig.
27.10 &
27.11). Automatic
forces will tend to eliminate an inflationary gap and restore full employment. There are, however, no automatic forces which will
eliminate a recessionary gap.
Assume, in the short-run, potential real GDP of $750 billion
is greater than actual $600 billion (P&B
4th Ed
Fig. 25.12;
7th Ed Fig.
27.10). If
autonomous spending increases by $100 billion then AE0 shifts to AE1
and AE increases more than $100 billion due to the multiplier. However,
prices increase as AE rises eating into the shift and AE1 drops to AE2.
The effect of the price increase is visible in
P&B
4th
Fig. 25.12;
7th Ed Fig.
27.10.
If instead we assume the economy is at long run potential and autonomous
expenditure increases AE0 will shift up to AE1 by more than the increase
in autonomous spending due to the multiplier (P&B
Fig. 25.13). However,
because the economy is at full potential this increase in AE will be translated
as a shift in AD to the right and in a price increase shifting the SRAS to the
left (P&B
4th Ed
Fig. 25.13; 7th Ed Fig.
27.11). The result is a return to equilibrium
potential GDP but at a higher price level.
The shifting from below long-run
equilibrium to equilibrium and then above characterizes the business
cycle (P&B
7th Ed Fig. 26.9). |
