Aggregate Supply and Demand

1
Aggregate Supply and Demand

• F. Gerard Adams
• Northeastern University

2
Macroeconomic Measurement
3
GDPValue of the nations total productThree
approaches to measuring GDP

• Final Demand
• Gross Income Flows
• Sum of Value Added

4
Income and Product Side of GDP

• Outlays Receipts
• Compensation of Employees (2-1) Personal
  Consumption Expend. (2-7)
• Proprietors' Income (2-2) Gross Private Domestic
  Invest. (5-5)
• Rental Income of Persons (2-3) Net Exports of
  Goods and Services
• Corporate Profits Exports (4-4)
• Dividends (2-4) less Imports (4-1)
• Undistributed Profits (5-2)
• Corporate Profits Taxes (3-2)
• Net Interest (2-5) Government consumption
  (3-1)
• Indirect Business Taxes (3-3) Government
  investment (3-2)
• Consumption of Fixed Capital (5-3)
• less Net Income Receipts from RoW (4-2)
• Gross Domestic Product Gross Domestic Product

5
Real GDP

• Real GDP GDP / GDP Deflator

6
Price Index Number formulas

• I t ?i wi (Pit / Pi0 ) 100
• ILit ? ((Pi0 Qi0)/ (?i
  (Pi0 Qi0)) (Pit / Pi0 ) 100)

ILit ?i(Pit Qi0) / ?i(Pi0 Qi0)
100 IPi ?i (Pit Qit ) / ?i(Pi0 Qit)
100
7
Index number problems

• What kind of problems?
• Do they make a difference?

8
What Measures for Business?
9
Aggregate Supply and Demand

• How Do We Forecast the Economy?
• Demand Side
• The demand components
• Keeping up with the latest information
• Supply Side
• Short run -- Labor Markets and Inflation
  (Phillips curve)
• Long run -- Productivity growth

10
Circular FlowGDP Income side GDP Demand side
Receipt and Allocation
Production
Demand
Income
Income
Spending
11
Leakages
Injections
In equilibrium, Injections Leakages
12
Leakages and Injections

• Leakages Injections
• Saving Investment
• Imports Exports
• Taxes Government Spend.

13
Theory of Aggregate Demand

• Output is determined by aggregate demand
• Y AD C I G

14
How do we use this to forecast?Whats exogenous
and whats endogenous?

• Outlook for Consumption
• Durables (autos)
• Non durables
• services
• Outlook for Investment (including software)
• Business Equipment
• Structures
• Government
• Inventory change
• Residential construction
• Government Consumption
• Exports
• Imports

15
A Simple Aggregate Demand System
I
G
Y GDP
C
16
Production and Income Flows
P I outlay
NIPA
Gov
S-I
17
Theory of Aggregate Demand

• Y C I G
• C cY
• Y cY I G
• Y 1/(1-c) (I G)

18
The Multiplier (Numerical Example)

• Assume mpc .8 multiplier 5
• Y C I G AD
• 100 80 10 10 100
• 100 80 10 20 110
• 110 88 10 20 118
• 118 94.4 10 20 124.4
• 150 120 10 20 150

Equilibrium
19
The Multiplier

• multiplier dY/d(GI) 1/(1-c)
• if c is .7 Multiplier is 1/.3 3.33
• but note there are leakages (imports)

20
The Keynesian Cross
45 degree line
Expenditure
C I G
C I
Equilibrium GDP
C
Income
Equilibrium Y
Equilibrium Y Equilibrium GDP
C a bY where b is the MPC
21
More complex multiplier

• Y C I G X M
• C c (Y-T)
• T t (Y)
• M m (Y)
• Y c (Y (tY)) I GX mY where I , G, X,
  are exogenous
• Y(1 c ct m) I G X
• dY/d(IGX) 1/(1-c ct m)

22
Whats a reasonable value for the multiplier?

• Assume
• c 0.8
• t 0.3
• m 0.2 Mult 1/(1-c ct m)
• Mult 1/(1-.8.24.2) Mult 1/.641.5625

23
A simple graduate student econometric model model

• Y C I G X-M where I, G, X, M are
  exogenous
• C .85 Y where the coefficient .85 is
  estimated from data
• Put in exogenous data for each year and solve for
  Y and C

24
Result What Happened?
Oil Crisis
GDP
Estimated GDP
Actual GDP
1970
Years
1960
1980
25
Components of Consumption

• What factors influence consumption spending
• Long term income versus current income
• Liquidity
• Assets
• Consumer Sentiment

26

• Smoothing consumption over the life cycle

Y, C
Income ( Y )
Consumption ( C )
LIFE (years)
27
Theory of consumptionConsumption spending is
tied to long run (life cycle) income

• Life cycle hypothesis

Income
wealth
Consumption
income and consumption
b
a
saving
f
e
dissaving
d
c
g
Years
Total life
Working life
28
Life cycle hypothesis and consumption

• 1. In a stable population
• Income Working life Consumption Total
  Life or saving working life
  dissaving during retirement.
• i. e. YWL CTL or SWL C (TL-WL)
• C/Y WL/TL
• The share of consumption in income depends on the
  working life relative to total life
• 2. In an aging population, you need to save more
  to cover future retirement of a growing share of
  the populationthats our problem.

29
Reality about consumption

• consumer anticipations,
• inflation,
• interest rates
• Permanent income hypothesisconsumption adjusts
  to long term income expectations and does not
  link to short term ups and downs of income

30
Components of demand

• Investment
• What factors influence Investment

31
Theory of Investment

• At the margin the Internal Rate of Return
  Interest Rate
• PDV - C NRt1/(1r)NRt2 /(1r)2 NRt3
  /(1r)3 . NRtn /(1r)n
• Where r is the interest rate
• IRR 0 - C NRt1/(1IRR)NRt2 /(1IRR)2
  NRt3 /(1IRR)3 . NRtn /(1IRR)n

IRR and r
1
Hurdle rate
2
Investment function
3
Investment
32
Investment Criteria

• Invest Do
  not Invest
• If PDV lt 0 lt 0
• If IRR lt rate gt rate

33
Illustration of Accelerator (Each machine can
produce 100 widgets)

• Sales Production Machines Required Machines
  Available Investment 500 5 5 0
• 600
  6
  5 1
• 900 9 6 3
• 500
  5
  9 0

34
Accelerator Effect

• Investment is a function of change in output
• Required K a Y
• I K - K-1
• I aY K-1
• I a (Y Y-1)
• Notethe faster the economy grows there more
  capital investment it needs. When it slows down,
  investment will fall.

35
Investment and the Business Cycle(Investment
depends on the rate of change of GDP)
Peak Investment
Peak Investment
GDP
36
Various investment functions and animal spirits

• Boom
• Recession
• In a boom investment is sensitive to interest
  rates. It may not be when investors are
  discouraged or have excess capacity

Interest rate
investment
37
Interest Rates

• The role of interest rates--where do they impact?

38
Aggregate Demand Stabilization Policy

• Fiscal Policy
• Expenditures
• The role of tax cuts
• The role of monetary policy

39
Aggregate Demand Stabilization Policy

• The role of monetary policy

40
What is money

• Medium of Exchange
• Store of Value

41
Various types of money

• M1 demand deposits and currency
• M2 demand deposits and currency and savings
  deposits

42
Yield curve
Jan 2001
rate
nov.2002
4-
3-
2-
1-
Maturity
3 months
1 year
5 years
10 years
43
Actual Yield Curve
44
Demand and Supply of Money

• Demand for Money
• Transactions Demand f(y)
• Asset demand--Speculative, Precautionary Demand
  f()
• Supply of Money
• Basically a supply of bank reserves
• Supplied by open market operations

45
Commercial Banks and the Creation of Money

• O The use of a fractional-reserve banking system
  allows the money supply to grow as a multiple of
  the reserves In How does the Fed influence
  interest rates

46
Required reserves and excess reserves

• Required Reserves
• Required Reserve Ratio Demand deposits
• Excess Reserves Actual Reserves Required
  Reserves
• Money Multiplier 1/Required Reserve Ratio

47
Fractional Reserve Banking (1)

• Consolidated Balance Sheet of Commercial Banks
• Assets Liabilities
• Reserves 1000 Demand
  Deposits 1000
• Note this is the initial position. Banks put
  their reserves into the Federal Reserve (a
  bankers bank).
• Suppose reserve requirements are 10 percent, the
  banks have excess reserves (900) and can make
  loans that will increase the money supply

48
Fractional Reserve Banking (2)

• Consolidated Balance Sheet of the Commercial
  Banks
• Assets Liabilities
• Reserves 1000 Demand deposits
  1900
• Loans 900
• .
• Banks lent out 900 and borrowers spent money and
  it was redeposited elsewhere in the banking
  system.
• There are still excess reserves.

49
Fractional Reserve Banking (3)

• This slide shows the equilibrium when banks are
  fully loaned up. Remember the required reserve
  ratio is still 10.
• Consolidated Balance Sheet of the Commercial
  Banks
• Assets
  Liabilities
• Reserves 1000
  Demand Deposits 10,000
• Loans 9000
  .

50
Fractional Reserve Banking (4)

• Federal Reserve open market operations. Fed sells
  100 short term paper on open market. Banks pay
  from reserves. To meet reserve requirement,
  loans must be called and money supply (demand
  deposits) declines.
• Consolidated Commercial Bank Balance Sheet
• Assets Liabilities
• Reserves 900 Demand Deposits
  9000
• Loans 8000
  .
• Short term paper 100

51
Fractional Reserve Banking(5)

• Now suppose the Fed wants to stimulate the
  economy by open market operations. Beginning with
  the equilibrium Fractional Reserve Banking (3),
  the Fed buys 100 short term paper. (assume some
  banks were holding short term paper.) Note the
  banks now have some excess reserves, but they may
  not lend them out.
• You can lead a horse to water, but you cant
  make him drink!
• Consolidated Commercial Bank Balance Sheet
• Assets
  Liabilities
• Reserves 1100 Demand
  Deposits 10000
• Short term paper -100
  .
• Loans 9000
  .

52
Demand for money supply of money

• Transactions demand asset demand supply
  (controlled by Fed)

53
Interest rate determination
rate
M supply
5-
3-
Mdspeculative
1-
S and D for money
Mdtrans
54
How does the Fed influence interest rates

• Open Market Operations
• Discount rate
• Reserve requirements
• Moral suasion
• The Federal Reserve and the 1998-2000 stock
  market bubble

55
Interest rate policy and the Fed
56
The equation of exchange

• MV PY
• Money of times each dollar is used prices
  total income(spending)

57
Monetarism

• Weak Monetarism
• Assumes v is fixed
• Effect of M on growth of pY
• Strong Monetarism
• Assumes v and y are fixed
• Effect of M only on prices (inflation)

58
Do we have monetarist policy?

• Possible targets
• Money growth
• Inflation
• Real growth and business cycle stability

59
Disintermediation and Credit Availability
60
Limits of monetary policy

• Liquidity trap
• You can lead a horse to water.
• Operation Twist

61
Back to the Real economy

• In this section we are concerned with real
  aggregate supply and demand. We will consider
  Fiscal and Monetary policy again below.

62
Where do the supply limits come in?

• What do we mean by supply limits
• Capacity Utilization
• Is the supply schedule flat, steep, or both flat
  and steep?

63
Aggregate Supply

• Where is full employment?
• Is the supply schedule horizontal below full
  employment?

64
Aggregate Demand and Supply 1
Price Level
AS
AD
GDP
65
Aggregate Demand and Supply 2
P
AS1
AD2
AD1
GDP
66
Aggregate Demand and Supply 3
AS1
Price level
AD1
AD2
Aggregate supply and demand
67
The Classical / Keynesian Controversy

• Short run price and wage rigidity
• Long run price and wage flexibility
• A tempest in a teapot--in the long run we are
  all dead (J. M. Keynes)

68
Can we reconcile Classical and Keynesian?

• over business cycle Keynesian
• over longer run Classical

69
Aggregate Demand and Supply 4
P
AS1
AD2
AD1
AS2
GDP
70
Aggregate Supply and Demand in the Short and Long
Run

• Supply (long run)

Prices
Supply (long run)
Demand
P short run
Supply (short run)
P long run
Y short run
Y (full Empl Long run
Output
71
Fiscal Policy

• Reagans Supply side vs demand stimulus
• Do we need a tax cut now?
• Does the deficit have an impact?

72
Inflation and the Phillips Curve

• What determines the rate of inflation

73
Inflation and the Phillips Curve
inflation
.
.
.
.
.
.
.
.
Unemployment u/lf
74
The Phillips Curve

• change P a b (1/U)
• change P a b (1/U) c P-1 or Pe

75
Inflation and the Phillips Curve with various
assumptions about price expectations
inflation
.
.
.
.
.
P2
.
.
.
P1
Po
Unemployment u/lf
76
Is the Phillips Curve Stable?

• The Phillips curve in the 1970s, the 1990s, and
  today

77
The Phillips Curve and the New Economy
78
How are prices determined?

• Markup theory on
• labor cost (ULC)
• materials (oil) prices (Pm

79
Labor cost reflects

• Wages
• Productivity
• change Prices depends on change of ULC
• where change ULC change W - change
  productivity

80
The Makings of a Wage Price Spiral

• change W a b (1/U) change P-1
• change P e m ( change W - change
  Productivity) q change Pm

81
What to expect for economic policy now!

• Monetary Policy
• Fiscal Policy

82
Tools of macro policy

• Fiscal Policy stimulus
• Spending
• Transfer Payments
• Tax cuts
• Monetary Policy stimulus
• Open Market operations
• Other Monetary policy tools

83
Effectiveness of Policy tools

• Fiscal tax cuts versus expenditure increases
• Monetary policy (liquidity trap, and you can lead
  a horse to water)
• In recession Fiscal Stimulus works
  long inside lag, short outside lag
• Monetary Stimulus may not
  work short inside lag, long outside lag
• In boom Fiscal cutbacks works
• Money tightening works
  

84
What differences between a Liberal and a
Conservative (Democratic and Republican??)
policy 1

• Macroeconomic objectives?
• Microeconomic views?
• Organization of industry
• Role of government
• Time Horizon?

85
What differences between a Liberal and a
Conservative (Democratic and Republican??)
policy? 2

• Traditional Democratic and Republican policies
• Democrats were considered the big spenders
• Republicans were budget balancers
• Democrats were concerned with business cycle
  stabilization
• Republicans were opposed to intervention
• Democrats were in favor of big government
  projects (dams, roads, etc.)
• Republicans were opposed to big government
  projects
• Democrats concerned with income inequality
• Republicans with reducing taxes so as to maintain
  unimpeded markets

86
What about Republican and Democratic Economic
Policy today?