PRINCIPLES OF MACROECONOMICS
Ranjit Dighe
WEEK 11 (LECTURES 27 - 29)
Nov. 8-12, 1999

[Last revised on Sun., Nov. 14, at 9 pm.]

LECTURE 27
Mon., Nov. 8, 1999

O.   IMPEDIMENTA

Today: Aggregate Demand (AD) and Aggregate Supply (AS)
I.    Aggregate demand (finish)
II.  Aggregate supply

* Get Problem Set 7

* POP QUIZ (on account of low attendance)
 

I.    AGGREGATE DEMAND (finish)

Determinants of AD / Factors that shift the AD curve

(1) Changes in consumer spending
-- consumer wealth (wealthier consumers will consume more. Rising household wealth because of, say, rising stock prices, will cause consumption to increase.)
-- consumer expectations (a.k.a. "consumer confidence," which measures consumers' willingness to buy big new durable goods, based on their expectations of what their individual financial situations will be in the future)
-- household indebtedness (puts pressure on households to cut back their consumption, so this is bad for consumption)
-- taxes (higher taxes lower disposable income and thus lower consumption)
-- interest rates (affect durable-goods consumption in particular)

(2) Investment spending (firms' expenditures on new plant and equipment)
-- interest rates (lower interest rates raise the level of investment spending, by making the cost of borrowing cheaper and by lowering the opportunity cost of investment projects -- an investment with an expected return of 6% is not worth pursuing if you can earn 8% by holding bonds, but it is worth pursuing if you can only earn 4% by holding bonds.)
-- expected returns on investment projects (the higher the expected return on investing, the more likely firms are to invest. Expected returns will be higher when the economy appears strong and growing and when the political situation appears stable. Changes in business psychology -- what Keynes called "animal spirits" -- can also strongly affect expectations of future returns.)
-- business taxes (higher business taxes lower the after-tax return on any investment, so they are bad for investment)
-- technology (the availability of good new technology will tend to induce firms to invest in new, state-of-the-art plant and equipment)
-- degree of excess capacity (the higher this is, the less need there is for investment, since firms with a lot of excess capacity -- such as the typical firm in a recession -- can expand just by utilizing more of their existing capacity.)
-- stock prices (when stock prices are low, a company that is looking to expand can often do so most cheaply by buying up another firm in the same industry. When stock prices are high, acquiring other firms becomes more costly, and it is often cheaper to expand "from scratch," by building new plant and equipment on one's own.)

(3) Government spending
-- The determinants of government spending are mostly political.
-- A few types of government spending, such as unemployment insurance and anti-poverty spending like food stamps and welfare, depend on the state of the economy because they are higher in recessions, when many people are thrown out of work and into poverty. Such programs are called automatic stabilizers; we will learn more about them in our unit on fiscal policy.

(4) Net export spending
-- national income abroad (prosperity in foreign countries, especially among our biggest trading partners, means greater spending by their citizens on U.S. exports, and recessions in foreign countries lower spending on U.S. exports)
-- exchange rates (when the dollar depreciates, becoming less expensive in terms of foreign currency, U.S. exports rise, because they have become cheaper relative to foreign products, and Americans buy fewer foreign imports, because those have become more expensive relative to American products. Both of those effects cause U.S. net exports to rise).
-- tariffs (taxes on foreign imports) -- Other things equal, if a country imposes higher tariffs on imports, that country's spending on imports will fall, raising its net exports. (Other things, however, are often not equal, since higher tariffs in one country often invite retaliation in the form of higher tariffs in other countries, which hurt the first country's exports and may make the net change in net exports a wash.)

When the AD curve shifts outward or rightward (AD increases), it means that people are willing to buy more goods and services at any given price level than they were before.
When the AD curve shifts inward or leftward (AD decreases), it means that people are willing to buy fewer goods and services at any given price level than they were before.
-- [See McConnell's Figure 11-3, on page 225, for examples of AD shifts.]

Recall from the multiplier model that the levels of consumption and aggregate demand depend not only on those above, autonomous factors but also on the level of real GDP. When real GDP is higher, then (typically) real disposable, or after-tax, income is higher, too, and consumption and AD both increase. Then, through the multiplier process, that induced increase in consumption spending leads to still more consumption spending, because anyone who receives payment for providing goods and services will spend most of the income he receives on his own consumption, and so on. It's still true that an initial increase in autonomous spending will ultimately result in a total increase in spending (or, equivalently, an increase in AD) that is much larger.
--> One could think of an initial shift in the AD curve as touching off a cascade of progressively smaller shifts, until the cumulative shift is many times as large as the initial shift. In other words, the multiplier process is a series of increases in AD. But for the sake of simplicity, we draw just one big AD shift, the cumulative shift, which includes both the initial change in autonomous spending and the induced change in spending that occurs through the multiplier process. In other words,

horizontal amount of shift in AD curve = (change in autonomous spending)*(multiplier)

[This lecture left off with the aggregate supply (AS) curve. For the sake of neatness and compactness, I've moved those notes into the next lecture.]

***

PRINCIPLES OF MACROECONOMICS
WEEK 11, LECTURE 28
Wed., Nov. 10, 1999

[Much of today's class was devoted to going over the second exam (see solution sheet).]

AGGREGATE SUPPLY (AS) AND THE PRICE LEVEL

Aggregate supply (AS) is roughly the same thing as GDP. Both differ from aggregate demand (AD) because they include all goods or services that are produced, not just all the ones that are sold. Unsold goods are counted in GDP as inventory investment (unintended inventory investment if sales fall short of producers' expectations). Only in equilibrium does AD=GDP, and only in equilibrium does AD=AS (more on this later. Also note that in equilibrium there is no unintended inventory investment.)

The aggregate supply (AS) curve is a schedule or curve showing the level of real domestic output that will be produced at each aggregate price level.

We draw the AS curve in (Q,P) space, with three ranges [see Figure 11-5 on McConnell's page 228]:
(1)  horizontal (when the economy is very depressed);
(2)  upward-sloping (intermediate; where the economy is almost all of the time);
(3)  vertical (at capacity GDP, the economy's uppermost limit).

The intermediate or upward-sloping part of the AS curve closely corresponds to the Phillips Curve. Recall that the Phillips Curve shows the tradeoff between unemployment and inflation, whereas the upward-sloping part of the AS curve shows how real output (Q) and the price level (P) move in the same direction.
-- Start with a Phillips Curve [drawn on board. For diagram, see Figure 16-7 (p. 337) in McConnell's book].
-- Recall that low rates of unemployment and high levels of real GDP go hand in hand (Okun's Law, which we learned earlier, says that every one-percentage-point decrease in the unemployment rate corresponds to a two-percentage-point increase in real GDP relative to potential GDP). Combining the Phillips Curve tradeoff between unemployment and inflation with the inverse relationship between unemployment and real GDP, we note that higher levels of real GDP (relative to potential GDP) are associated with higher rates of inflation.
-- Since higher inflation rates mean higher price levels, it's a short step to note that higher levels of real GDP (relative to potential GDP) are associated with higher price levels. So we can now draw an AS curve that is upward-sloping. (Potential GDP is assumed fixed in the short run, which is what these diagrams represent.)

For the record, a shift of the aggregate demand (AD) curve corresponds to a movement along the Phillips Curve.
-- An outward (rightward) shift of the AD curve corresponds to a northwest movement along the Phillips Curve, toward lower unemployment and higher inflation.
-- An inward (leftward) shift of the AD curve corresponds to a southeast movement along the Phillips Curve, toward higher unemployment and lower inflation.

A shift of the aggregate supply (AS) curve corresponds to a shift of the Phillips Curve.

Determinants of AS / Factors that shift the AS curve:

(1) changes in input prices
-- domestic resource availability-- land, labor, capital, entrepreneurial ability
-- prices of imported resources (oil, foreign exchange)
-- market power / degree of monopoly (monopolies raise prices and restrict output, so greater industrial concentration means a leftward or inward shift of the AS curve)

(2) changes in productivity

(3) changes in the legal and institutional environment (government)
-- business taxes and subsidies
-- government regulation
---- bad for AS: constraints on what businesses can and can't do; "red tape"
---- good for AS: police and property-rights protection

***

PRINCIPLES OF MACROECONOMICS
WEEK 11, LECTURE 29
Fri., Nov. 12, 1999

O.    IMPEDIMENTA

Today: The AD-AS model [what you need to do the PS]
I.    Factors that shift the AS curve (finish) [I included these in Wednesday's notes]
II.  AD-AS equilibrium
III. Changes in the AD-AS equilibrium

* QUIZ
 

I.    [FACTORS THAT SHIFT THE AS CURVE -- SEE WEDNESDAY'S NOTES]
 

II.   AD-AS EQUILIBRIUM

... corresponds to the point where the AS and AD curves intersect. At that point, AD=AS and there is no unintended inventory accumulation, just like in the multiplier-model equilibrium. Since the graph has two dimensions, P and Q, the AS-AD equilibrium determines the equilibrium levels of Q (real GDP) and P (the price level).
-- [Drawn on blackboard. See the graphs at the top of McConnell's page 233.]
 

III. CHANGES IN THE AD-AS EQUILIBRIUM

[This depends what regions of the AS curve the economy is on. If it's on the flat region, shifts of the AD curve affect real GDP but not the price level, just as in the multiplier model. If it's on the vertical region, GDP is already equal to capacity GDP and a higher level of AD cannot raise real GDP but will only raise the price level.]

[Usually only one curve shifts at a time. We looked at the four possible shifts and the resulting changes in the economy's equilibrium:
(1) increase in AD --> Q increases, P increases (demand-pull inflation)
(2) decrease in AD --> Q decreases, P decreases (deflation; caveat: in real life, deflation is almost nonexistent -- what more likely happens is merely a decline in the inflation rate)
(3) increase in AS --> Q increases, P decreases
(4) decrease in AS --> Q decreases, P increases (stagflation; cost-push inflation)]

[I will add examples, like I did in class, later. Right now, it's getting late.  Further refinements will have to wait.]