Equilibirum of Aaggregate Supply and Demand

Macroeconomics VIII:
Equilibrium of Aggregate Supply

and Demand
Gavin Cameron
Lady Margaret Hall
Hilary Term 2004
aggregate demand revisited
• Aggregate demand comprises four components:
• consumption
• investment
• primary government spending (i.e. net of transfers)
• net exports
• The level of income (both current and expected) is a major
determinant of consumption, government spending and net exports.
• The real exchange rate is a major influence on net exports.
• The interest rate is also an influence on consumption and investment
(with the latter being also dependent upon output expectations and
‘animal spirits’).
why does the AD curve slope down?
• Three reasons why the aggregate demand curve slopes downwards:
• The first is the Real Balance Effect. When prices rise unexpectedly, the
real value of assets whose prices are fixed in nominal terms (such as
some government bonds, money, and gold) falls. This leads to less
consumer spending.
• The second is the real exchange rate. When prices rise unexpectedly,
the real exchange rate appreciates (if the nominal exchange rate is
fixed). This leads to an deterioration in the primary current account.
• The third is the Keynes effect. When prices rise unexpectedly, people
need more money for day to day transactions and so try to switch their
money balances from bonds and shares. This raises the interest rate
and hence reduces interest-sensitive spending, such as investment.
the aggregate demand curve
prices
the level of output given by any point on

the AD curve is such that if that level of
output is produced, planned expenditure at
the given relative price will exactly equal
P1 actual expenditure
P0 AD
Y1 Y0
income, output
long-run aggregate supply revisited
• We say that the labour market is in equilibrium when
inflation is stable.
• At the equilibrium unemployment rate, there will be both
voluntary unemployment (workers who do not wish to
work at the current real wage) and involuntary
unemployment (workers who would like to work but
cannot find jobs at the current real wage).
• If there is a unique and stable level of equilibrium
unemployment, then there is also a unique and stable
equilibrium rate of output.
• In the long-run, the economy should return to its
equilibrium rate of output, ‘money is neutral’.
short-run aggregate supply revisited
• In the short-run, there is no reason to expect actual output
to equal its equilibrium rate.
• Here are four reasons why changes in nominal variables
may lead to temporary changes in real output:
• sticky-wages
• worker-misperception
• imperfect information
• sticky-prices
• All of these lead to a ‘surprise-supply’ function.
Y = Y * +α (P − Pe)
AS-AD in long-run equilibrium
LRAS
prices
SRAS1 (Pe=P1)
P1
AD1
Y* output (Y)
AS-AD in dis-equilibrium
LRAS
prices
SRAS (Pe=P0)
SRAS (Pe=P2)
P0
P1
In the short-run, the economy can
P2 be in dis-equilibrium with expected
prices too high
AD
Y1 Y* output (Y)
shocks to the economy
• Why might the economy get ‘shocked’ away from equilibrium?
• Aggregate demand shocks
• an investment boom;
• a pre-election government spending spree;
• a sudden rise in the real exchange rate;
• a consumer boom abroad;
• a boom in the housing market;
• an unexpected cut in interest rates;
• a slump in share prices.
• Aggregate supply shocks
• a sudden rise in oil prices;
• the invention and diffusion of a new technology.
an investment boom
LRAS
prices
SRAS (Pe=P3)
SRAS (Pe=P1)
P3
An investment boom shifts the
P2 AD curve outwards. At first,
expectations lag behind events, so
P1 output and relative prices rise
AD2 (‘unexpected inflation’). Once
prices and wages are renegotiated,
equilibrium is restored with a
AD1 higher relative price level.
Y* output (Y)
an ‘oil price shock’ & labour
Labour productivity falls since production has to
switch to less energy-intensive techniques.
real wage
Hence, the marginal product of labour falls and

demand for labour shifts inwards. The
equilibrium real wage and employment falls
LS
W1/P1
W2/P2
LD1
LD2
L2 L1 employment
an ‘oil price shock’ and AS-AD
LRAS2 LRAS1
prices
SRAS (Pe=P2)
SRAS (Pe=P1)
P2
In short-run, nominal wages

P1 fixed; as relative prices rise,
output falls (‘stagflation’).
Eventually, wages are
renegotiated and output
AD settles at new equilibrium.
Y2* Y1* output (Y)

Log Real Oil Price and US Price Level (1995=1)
1959 to 1999
2.5
1.5
0.5
0
1959 1964 1969 1974 1979 1984 1989 1994 1999
-0.5
-1
Real Oil Price GDP Deflator

fiscal policy
• ‘If the Treasury were to fill old bottles with bank notes, bury them at
suitable depths in disused coal mines which are then filled up with
town rubbish, and leave them to private enterprise… to dig them up
again, there need be no more unemployment. It would, indeed, be
more sensible to build houses and the like, but if there are political and
practical difficulties in the way of this, the above would be better than
nothing’ J.M. Keynes, 1936.
• Changes in the government’s fiscal stance (that is, the difference
between government spending and taxation) will shift the aggregate
demand curve.
• If economy is at equilibrium output, increases in spending (or tax cuts)
will lead to an inflationary boom, which eventually will lead only to
higher prices.
• If economy is below equilibrium output, increases in spending (or tax
cuts) will tend to raise output (as well as prices) and shift the economy
back to equilibrium.
the limits to fiscal policy
• But there are problems with the use of fiscal policy:
• Measurement of output: where are we? where are we going? how
fast? will we know when we get there?
• Lags in the fiscal policy process: implementation (recognition &
administrative lags) and operational;
• What kind of fiscal policy? Spending (on what?) or tax cuts (for
whom?);
• Will spending ‘crowd-out’ other spending, either directly or
indirectly?
• Will consumers pierce the veil? Will they attempt to offset the
actions of the government (Ricardian Equivalence)?.
monetary policy
• ‘Having regard to human nature and our institutions, it can only be a
foolish person who would prefer a flexible wage policy to a flexible
money policy, unless he can point to advantages from the former that
are not obtainable from the latter’ J.M.Keynes, 1936.
• Monetary policy can be implemented through either changes in the
money supply or interest rate. A cut in the interest rate leads to a rise
in the money supply.
• Changes in the interest rate will shift the aggregate demand curve.
• If economy is at equilibrium output, interest rate cuts will lead to an
inflationary boom, which eventually will lead only to higher prices.
• If economy is below equilibrium output, interest rate cuts will tend to
raise output (as well as prices) and shift the economy back towards
equilibrium.
the theory of short-run fluctuations
Keynesian Cross IS Curve
IS-LM model AD curve
AS-AD model
Money Market LM Curve
AS curve
summary
• “But this long run is a misleading guide to current affairs. In
the long run we are all dead. Economists set themselves too
easy, too useless a task if in tempestuous seasons they can
only tell us that when the storm is long past the ocean is
flat again.” J.M. Keynes, 1936.

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Macroeconomics VIII:

Equilibrium of Aggregate Supply

the level of output given by any point on

Hence, the marginal product of labour falls and

In short-run, nominal wages

Y2* Y1* output (Y)

Real Oil Price GDP Deflator

Keynesian Cross IS Curve

IS-LM model AD curve

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