Economics 314 Coursebook, 2009 Jeffrey Parker 2 AGGREGATE SUPPLY AND DEMAND: A SIMPLE FRAMEWORK FOR ANALYSIS Chapter 2 Contents A. Topics and Tools ............................................................................. 1 B. Output and Prices ............................................................................ 2 Levels or growth rates? .................................................................................................. 3 C. Aggregate Supply and Demand ........................................................... 4 Aggregate supply and the natural level of output .............................................................. 4 Upward-sloping aggregate supply ................................................................................... 6 A fixed point on the short-run AS curve .......................................................................... 7 Aggregate demand ........................................................................................................ 8 Does the aggregate-demand curve slope downward? ......................................................... 9 Static equilibrium ....................................................................................................... 10 Shocks to aggregate demand ........................................................................................ 11 Shocks to aggregate supply .......................................................................................... 13 D. Dynamic Equilibrium in the AS/AD Model .......................................... 14 Why the AS curve shifts over time ................................................................................ 14 Why the AD curve shifts over time ............................................................................... 15 Equilibrium with growth and inflation ......................................................................... 16 A “growth recession” .................................................................................................. 18 E. A Preview of Romer’s Text from the Perspective of AS/AD ..................... 19 Growth models ........................................................................................................... 19 Real business cycles ..................................................................................................... 20 The IS/LM and Mundell-Fleming models ................................................................... 20 Neoclassical and new Keynesian models ....................................................................... 21 F. Suggestions for Further Reading ......................................................... 22 G. Works Cited in Text ....................................................................... 22 A. Topics and Tools Nearly every introductory and intermediate textbook on macroeconomics uses the framework of aggregate supply and aggregate demand to model the macroecon-2 - 2 omy. Romer’s text refers to this model occasionally, but never describes it in detail. This chapter presents a simple version of aggregate supply and aggregate demand that summarizes what most undergraduates learn about macroeconomics. The goal is not to cram a basic macroeconomics course into one chapter, but rather to describe a simple analytical framework that can be used to provide context for the detailed models we will study. B. Output and Prices The central endogenous variables in aggregate supply-demand analysis are real output and the general price level. With the assignment of quantity to the horizontal axis and price to the vertical axis, the AS/AD model resembles the familiar supply-demand model of perfect competition. Indeed they are very similar in some ways, however it is extremely important not to push the parallels too far; some properties of the curves and models are very different. The variables on the axes of the AS/AD model sound very much like the famili-ar quantity and price variables of microeconomics, but there are important differenc-es. The quantity variable on the horizontal axis of the AS/AD model measures the total output of the economy (real GDP) rather than the physical output of some spe-cific commodity. This leads to important differences in the interpretation of the curves. For example, the demand curve for zucchini slopes downward because con-sumers will substitute other foods as zucchini get expensive. In the macro model, GDP is all goods, so there is nothing obvious to substitute for GDP if it gets expen-sive.1 Thus, in the macro context we cannot rely on the familiar logic of substitution to motivate the negative slope of the demand curve. The price variable on the vertical axis is also fundamentally different. In the AS/AD model, price refers to the aggregate price of all goods and services—a price index like the GDP deflator—rather than the relative price of zucchini as in the micro model. Again, this has important implications for the behavior of the curves. An in-crease in all prices may not have any effect on either quantity supplied or quantity demanded if, along with the increase in prices, nominal wages and nominal stocks of assets such as money all increase in equal proportion. This is the familiar principle that the economy exhibits no money illusion—people care only about the real value of things, not about the number of dollars attached to them. If all dollar labels are rede-fined in a proportional way, nothing is more or less expensive than before and there is no reason for real purchases or sales to change. 1 Future goods and foreign goods are possible substitutes. We’ll have much more to say about such issues later on.2 - 3 Levels or growth rates? The simplest form of the AS/AD model puts the level of GDP on the horizontal axis and the level of prices on the vertical axis. Putting the model in terms of levels has the advantage of simplicity: the unique point of intersection defines a unique equilibrium level of output and prices. This is the most common form of the model and is adequate as a momentary snapshot of the macroeconomy. However, year-to-year growth of real output and inflation in the price level are the normal state in modern economies. We are often more interested in these rates of change than in the absolute level of GDP and prices. In order to capture this beha-vior, the “equilibrium point” in the levels version of the AS/AD model must be mov-ing