Aggregate Supply and Demand

00:01 Hello and welcome back to your online presentation of macroeconomics.

00:04 My name is James DeNicco, and this presentation, we're going to be putting a lot of things together that we've looked at in other presentations, looking at the bigger picture of aggregate supply and aggregate demand.

00:16 So first, we're going to look at business cycles when we talk about movements and shifts in aggregate supply and aggregate demand.

00:23 A lot of what we're talking about is in the short run, in the business cycles.

00:27 So briefly, we'll go back and look what business cycles are.

00:30 Again, we're going to look at why aggregate demand is downward sloping, why short run aggregate supply is upward sloping.

00:38 We're going to look at why long run aggregate supply is vertical and what long run aggregate supply is made up of.

00:46 We're going to look at factors that shift our supply and demand curves.

00:49 And finally, we're going to look at how the free market restores long run equilibrium.

00:54 If you go into a recession, how is the free market supposed to restore us back to our potential GDP? So first, our business cycles.

01:03 We have this long explanation over here.

01:06 All right. This long definition.

01:08 Business cycles are a type of fluctuation in aggregate economic activity of nations that organize their work mainly in business cycles.

01:16 So we're going to have these expansions in these contractions.

01:20 This is a graph that we've seen before.

01:21 In some of our presentations.

01:23 We see the long run here.

01:25 That's our normal growth path.

01:27 But the long run is made up of business cycles, of the short runs, the ups and downs. So at the bottoms we have our troughs from our troughs to our peaks, we expand. Then we hit our peak, and that's the beginning of a contraction.

01:40 So we're going to be looking at those increases and decreases around our long run trend.

01:48 So here's our big graph.

01:49 These are our big supply and demand graph.

01:51 So on a vertical axis, we're going to have price here, not the price of any individual good. But you can think of this as the price index.

01:58 So this is the price level relative to other periods of time as opposed to, say, just one product.

02:05 All right. So along our vertical axis that we're going to have prices on our horizontal axis, we're going to have output or GDP.

02:12 Now we have three curves here, right? The vertical curve, that's our long run aggregate supply curve.

02:19 That's where our potential GDP is.

02:21 That's where our long run GDP is.

02:24 That's the long run growth path.

02:26 All right. It's vertical because it doesn't depend on prices.

02:29 It's a real variable.

02:31 It depends on quantities.

02:32 It depends on total factor productivity, capital, which is K or total factor productivity. Was there A, L which is labor H, which is human capital and R, which is natural resources.

02:44 You probably recognize that equation from the growth presentation because that's what our long run aggregate supply is.

02:50 It's our real long run growth potential.

02:53 So then we have our short run aggregate supply.

02:56 So that depends on long run aggregate supply, and it also depends on prices and price expectations.

03:03 It's upward sloping.

03:04 We see our demand curve is downward sloping.

03:07 So you should recognize that equation as well.

03:10 Our downward sloping aggregate demand curve, we have our expenditure equation for GDP here.

03:15 So it's consumption, investment, government spending and net exports.

03:20 That's what the downward sloping demand curve is comprised of.

03:24 So now let's talk a little bit more about each of those curves.

03:28 First, our aggregate demand curve.

03:30 Why is it downward sloping? We're going to go over three reasons why it's downward sloping.

03:35 So the aggregate demand curve that shows the quantity of goods and services that households, firms and government demand at each price level, the curve is downward sloping due to what we're about to talk about.

03:47 The first is the wealth effect.

03:49 So as prices go down, you want to consume more.

03:54 So if you go to the mall and you want to buy a pair of shoes and you find that shoes are half off, you might just buy yourself two pairs of shoes or hats or whatever you like to purchase.

04:05 So that's our wealth effect.

04:07 We're essentially richer as prices go down because we can buy more stuff in real terms. We're wealthier, we can purchase more, so we do so.

04:15 As prices go down, aggregate demand increases.

04:18 Because consumption goes up, we buy more.

04:22 The second reason is what we call the interest rate effect.

04:25 Now this is a little more intricate, so let's talk about it.

04:28 So the interest rate effect, a lower price level is going to reduce the demand for money. That's our first graph here, our nominal interest rate on the vertical axis and money on the horizontal axis.

04:40 As prices go down, we demand less money.

04:44 As we demand less money, we're going to save more money.

04:47 So these are graphs we've seen before the graph on the right now, that's our savings and investment graph.

04:53 The real interest rate is on the vertical axis and on the horizontal axis we have savings and investment.

04:59 So as savings increases, there's more of a supply of loanable funds that drives down the price for loanable funds or the real interest rate.

05:08 As the real interest rate comes down, you have a lower opportunity cost of investment. So we're going to move along the investment demand curve to the right level lower real interest rate at equilibrium and a higher equilibrium level of savings and investment or supply and demand.

05:25 Now that increase in investment, that's another reason that the aggregate demand curve is downward sloping.

05:33 As prices go down, there's less demand for money, there's more savings driving down the real interest rate and increasing investment aggregate demand.

05:42 Part of that is investment.

05:44 So as that goes up, there's an increase in aggregate demand.

05:48 That's our second reason that it's downward sloping.

05:50 Let's get to our third reason.

05:52 It's what we call the exchange rate effect.

05:54 So both the grass we just talked about also apply.

05:58 So that step one, step two.

06:00 Now this is the the third step for the exchange rate effect as that real interest rate goes down, there's going to be less demand for our domestic assets, net capital outflows again.

06:13 And you're probably sick of hearing this.

06:15 It's the net change in domestic ownership of foreign assets, minus the net change in foreign ownership of domestic assets as the real interest rate on domestic assets go down. Foreigners want to hold less domestic assets.

06:29 That drives net capital outflows up.

06:31 That increases the supply of money of the domestic currency out in the foreign exchange market.

06:38 So as there's more currency that lowers the price of that currency, that lowers the real exchange rate as the real exchange rate goes.

06:46 Damn. That means domestic goods become relatively cheaper compared to foreign goods, which drives up net exports.

06:54 As net exports go up, there's an increase in aggregate demand as prices go down. Aggregate demand increases also because net exports go up.

07:03 That's the third reason that aggregate demand is downward sloping.

07:07 All right. So now what can shift the demand curve? Well, we saw prices move us along the demand curve.

07:13 Anything else that changes consumption, investment, government purchases or net exports, those things will shift that demand curve.

07:22 So if consumption changes in current or future income taxes or wealth changes investment from changes in the marginal product of capital or maybe the user cost of capital and changes to net exports, they come up with a new product here in the United States that people want and that drives demand.

07:39 All those things are going to shift the demand curve.

07:42 Anything that doesn't come from a change in prices that affects the demand curve will be a shift in that curve.

07:49 So now let's take a look at long run aggregate supply.

07:51 We talked a little bit about this.

07:53 When we're looking at the graph, let's talk about it again.

07:55 It's vertical.

07:57 Why is it vertical? Because it's a real variable.

07:59 It doesn't depend on prices.

08:01 It's determined by the available inputs and technology.

08:05 All right. So look at the equation Y or long run potential.

08:09 You can think of that as our trend line in the business cycle graph.

08:12 It depends on total factor productivity, which is driven mainly by technology. That's the large driver of total factor productivity.

08:20 It's also driven by K capital, L, labor, h, human capital, R, natural resources, all of those things that we talked about and growth that make us more productive as an economy.

08:32 So as those things increase, the long run aggregate supply curve will shift to the right. All right.

08:38 Now let's talk about our third curve, our short run aggregate supply curve.

08:42 We're going to talk about why it is upward sloping.

08:45 Again, we'll go over three reasons why it's upward sloping.

08:49 The first is what we're going to call sticky wages.

08:52 So as prices go down, we can't immediately lower our wages.

08:58 So in real terms, wages are going to get more expensive for firms.

09:03 So real wages equal nominal wages adjusted for prices. So as prices come down and nominal wages stay the same, real wages are going to go up.

09:16 It gets more costly to employ people.

09:19 So we're going to want to employ less people.

09:22 As we employ less people, we will be supplying less.

09:26 So again, let's say that again, because it might not jump off the page at you as a parent. So why is it upward sloping? So let's think about a decrease in prices.

09:36 So we call wages sticky.

09:38 That means you can't adjust wages right away.

09:42 Sometimes when prices change so you have contractual obligations, maybe you get to reset your contract every quarter or maybe you're lucky.

09:50 And it's more often than that.

09:51 Sometimes it's every year.

09:52 So that's the amount of money you're paid.

09:55 Your nominal wage, your real wage is adjusted for inflation or adjusted for prices.

10:01 So your real wage equals your nominal wage divided by prices.

10:06 So as prices come down, real wages are going to increase.

10:10 So you become more costly as a worker, labor becomes more expensive. So as prices come down, you're going to decrease your supply because you're going to have to let people go.

10:23 You're going to have to get rid of some workers because they're too costly and you're there to maximize your profits, your real terms.

10:30 Your marginal cost has increased.

10:33 As your marginal cost increases, you need to decrease your supply of your production to get your marginal benefit in line with your marginal cost. Our second reason is what we call sticky prices. Firms can't necessarily change their prices right away.

10:50 There's a few reasons for that.

10:52 One is what we call menu cost.

10:54 It's just expensive to change your prices.

10:57 You think about a fine dining establishment that has really fancy menus as the general price level goes down in the economy and people are less willing to buy goods and services at high prices, you may not be able to adjust your prices right away because it's costly to adjust those prices to change your fancy menu.

11:16 So that's going to decrease your supply.

11:18 You're not going to be able to supply as much at your higher prices because the general price level in the economy has come down.

11:26 Also, sometimes it sends a signal that there's a lower quality if you lower your prices. So if you have a really fancy steakhouse and the general price level in the economy is coming down, you might not want to lower your prices.

11:38 You don't want to send the signal that our meat's not as good as it was before.

11:42 Our steaks just don't taste as good anymore.

11:44 So you might be.

11:45 Rather, you might.

11:46 Rather want to decrease your supply.

11:49 You might rather decrease your production than lower your prices for some sort of long run strategy of high quality.

11:57 You want to send that signal that you want to come to this steakhouse because we have the best steaks. You don't want to lower your prices.

12:03 So is the general price level comes down.

12:06 You'll decrease your supply in the short run as opposed to changing the price of your goods. Our third reason is what we call the misconceptions theory. So now as prices go up, sometimes firms misinterpret that signal.

12:21 When we talked about inflation, we talked about this that noisy signal.

12:24 Sometimes as there's an increase in the price level, firms can mistake that increase for an increase in demand when it's just inflation.

12:33 So as there's an increase in the price level, firms are going to go ahead and they're going to increase their production.

12:39 They're going to increase their supply because they can think they can sell more because they think there's a higher demand.

12:45 So it's about misconception of relative prices.

12:49 So they respond to these higher price levels by increasing the quantity of goods and services produced.

12:55 So again, think of that noisy signal that misconceptions theory, that that higher price means higher demand.

13:01 If it's higher demand, you want to increase your supply.

13:04 If it's not, you're making a mistake.

13:06 But that's what firms see.

13:08 So they see that higher price, they increase their supply.

13:11 So those are the three main reasons that we see are upward sloping, short run aggregate supply curve.

13:19 All right. So now we know what moves along the short or in aggregate supply curve.

13:22 Those are changes in prices.

13:24 Let's take a look at what can shift short run aggregate supply.

13:28 Well, anything that can shift long run aggregate supply will also shift short run aggregate supply.

13:34 Short run aggregate supply will always move along with long run aggregate supply.

13:38 It's not necessarily the other way around them.

13:41 So every time there's something that shifts long run aggregate supply, labor capital, human capital, natural resources, total factor productivity that will also shift short run aggregate supply, but also changes in price expectations will shift short run aggregate supply.

13:57 So we can take a look over here.

13:59 All right. This Y here, that's our actual output.

14:02 Our y star that's our long run aggregate supply.

14:05 That's our potential output.

14:09 Now, the difference is going to be a times the prices minus the price expectations.

14:14 This A that A is just the sensitivity to output of output to a deviation in price.

14:21 All right. You can assume that to be whatever you want.

14:23 If you were going to write a paper for the literature about that, you probably go out and empirically estimate that.

14:29 But that A, it just monitors the sensitivity of output to price deviation. So if prices are above price expectations, you're going to see actual output or the short run aggregate supply or the short run GDP. If prices are above price expectations, you're going to see that's above the long run aggregate supply.

14:49 Now, if prices are below price expectations, you're going to see actual output is going to be below long run output.

14:56 So now let's take a look a little bit more why that might be.

15:00 All right. Let's take a look at a specific case of why when prices are greater than price expectations, actual output is above long run output, above low run output. And why? When prices are below price expectations, actual output will be below long run output. So here we're going to take a look at an example of when the short run or actual output is away from the long run output.

15:25 We're going to look at it through the sticky wages theory.

15:28 Now, we could do this with the misconceptions theory or the sticky prices theory, but we're going to do it through the sticky wages theory here.

15:35 So let's assume we're at pointy here and we're grooving along at our long run output or our long run potential GDP, and all of a sudden we hit a recession.

15:44 So the aggregate demand decreases.

15:47 We're going to see a leftward shift in aggregate demand, which is going to drive down prices.

15:52 Prices are going to be below price expectations.

15:55 You thought prices were going to be right here when you're sitting at point E, but now you're at point F, but you already set your wages based on these price expectations, your nominal wages, what you're going to pay to your workers.

16:08 Now, again, your real wage, your real wage equals your nominal wage divided by prices.

16:14 We see that right here.

16:16 So you're going to set your nominal wages based on your price expectations.

16:20 But now the price is lower than you thought it was going to be.

16:24 So your real wages have gone up.

16:26 As your real wages go up, the marginal cost of your workers go up.

16:31 And as we know from previous presentations, as there's an increase in the marginal cost of your workers, you're going to have to decrease the number of workers that you're hiring. So as you decrease the number of workers that you're hiring, you're going to move along that supply curve to the left.

16:47 So as those prices go down, your real wages go up, you move along the supply curve to the left, you lower your supply.

16:56 Now, over time, you can adjust your price expectations.

16:59 So as you adjust your price expectations to meet that recession, to meet the reality of what's out there, you can also lower your wages.

17:07 You lower those nominal wages to get your real wages back to where they were before the recession.

17:13 As you start to do that, you can hire people back.

17:17 That's our shift from F to G.

17:19 That's our decrease in our price expectation that restores our long run equilibrium.

17:25 That's through the sticky wages theory.

17:28 So again, you're at pointy, you go through a recession that shifts aggregate demand to the left.

17:34 So now prices are below price expectations.

17:37 You set your nominal wage based on your price expectations, but the prices are below that price expectation.

17:43 So the real wage now is to high.

17:45 Your marginal cost of employment is too high, so you have to decrease employment.

17:50 That's that movement along the curve from E to F on the short run aggregate supply curve. As you adjust your price expectations to meet the reality, you can adjust your nominal wages down to get your real wages back to where they were.

18:05 As you adjust your price expectation and your nominal wages, you're going to see that rightward shift in the short run aggregate supply curve from F to G that restores our long run equilibrium at a lower price level.

18:19 So that's how an economy through the free market will recover through the sticky wages theory from a recession.

18:26 Now let's take a look at shifts in the long run aggregate supply curve.

18:30 It's a little more straightforward here.

18:32 So say there's some sort of technological boom that allows us to be more productive, allows us to increase our potential output.

18:40 Well, you see that rightward shift of the long run aggregate supply curve.

18:44 Well, remember what we said every time the long run aggregate supply curve shifts, that short run is going to shift right along with it.

18:51 So it's more straightforward here.

18:53 We'll see the rightward shift in the long run aggregate supply curve, and we'll see the short run aggregate supply curve shift to meet it at our demand curve.

19:01 And F is our new long run potential where all three curves are intersecting.

19:05 So that one's a little more straightforward.

19:08 So remember the short run aggregate supply curve always moves with the long run aggregate supply curve, but not necessarily the other way around.

19:17 So now what have we learned here? Well, now we know why.

19:20 Short run, aggregate supplies, upward sloping.

19:22 We know why aggregate demand is downward sloping.

19:25 We know what longer in aggregate supply is comprised of and why it's vertical.

19:29 Why it's vertical because it's a real variable.

19:31 We know the factors that shift aggregate supply and aggregate demand curves, and we now know how free markets restore our long run equilibrium.

19:40 So that's our aggregate supply and aggregate demand presentation.

19:44 Thank you.