Economics 314 Coursebook, 2008 Jeffrey Parker 2 AGGREGATE SUPPLY AND DEMAND: A SIMPLE FRAMEWORK FOR ANALYSIS Chapter 2 Contents A. Topics and Tools ..................................................................................2 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...........................................................................................11 Shocks to aggregate demand ............................................................................12 Shocks to aggregate supply...............................................................................13 D. Dynamic Equilibrium in the AS/AD Model ......................................14 Why the AS shifts over time............................................................................15 Why the AD 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 Aggregate Supply/Demand.......................................................................................20 Growth models................................................................................................20 Real business cycles ..........................................................................................20 The IS/LM and Mundell-Fleming models.......................................................21 Neoclassical and new Keynesian models ............................................................22 F. Suggestions for Further Reading........................................................22 G. Works Cited in Text ..........................................................................232 - 2 A. Topics and Tools Nearly every introductory and intermediate textbook on macroeconomics uses the framework of aggregate supply and aggregate demand to model the macroeconomy. Romer’s text refers to this model occasionally, but never de-scribes 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. This makes the AS/AD model resemble the familiar supply/demand model of perfect competition and, in some ways, they are similar. However, it is extremely important not to confuse the aggregate macro model with the simple micro model; some properties of the curves and models are very different. Although the variables on the axes of the AS/AD model sound very much like the familiar quantity and price variables of microeconomic fame, there are subtle but important differences. 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 specific commodity. This leads to important differ-ences in the interpretation of the curves. For example, the demand curve for zuc-chini slopes downward because consumers will substitute other foods as zucchini get expensive. In the macro model, GDP is all goods, so there is nothing to sub-stitute for GDP if it gets expensive.1 Thus, in the macro context we cannot rely on the familiar logic of substitution to motivate the shape 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 1 Future goods and foreign goods are possible substitutes. We’ll have much more to say about such issues later on.2 - 3 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 increase in all prices need not have any effect on either supply or de-mand behavior, as long as nominal wages and nominal stocks of assets such as money all increase along with prices. This is the familiar principle that the econ-omy exhibits no money illusion–people care only about the real value of things, not about the number of dollars attached to them. Levels or growth rates? The simplest form of the AS/AD model puts the level of GDP on the hori-zontal axis and the level of prices on the vertical axis. Putting the model in terms of levels has the advantage of simplicity: the point of equilibrium corresponds to a well-defined level of output and prices. This is the most common form of the model and works very well in situations where output is not growing over time and there is no ongoing inflation. However, year-to-year growth of real output and inflation of the price level are the normal state in modern economies. In order to capture this behavior, the “equilibrium point” in the levels version of the AS/AD model must be moving upward and to the right over time. We can keep the model in terms of levels only if we are willing to discard the notion of a fixed point of long-run equilib-rium and depict the long run as an equilibrium growth/inflation path involving a sequence of points of momentary equilibrium. An alternative is to model aggregate supply and aggregate demand in terms of percentage changes of output and/or prices, putting the growth rate of output on the horizontal axis