Chapter Eight: Lecture Notes -- Aggregate Demand and Aggregate Supply

The Circular Flow Diagram

Studying macroeconomics allows students to see how the individual pieces of the economy fit together. The economy is large and complex, but by breaking the economy into its individual components, we can understand how it works. To understand better how the macroeconomy functions, we examine a simple illustration called the circular flow diagram, graphed in Figure 1. The top half of the circle describes the demand for goods and services and the bottom half describes the production and income process. We will follow the circle going clock-wise, beginning with consumption.

Circular Flow
FIGURE 1

Consumers receive a certain amount of disposable income (DI), or income after taxes. (We will see where that income comes from shortly.) Consumers choose to either save (S) or consume (C) their disposable income. By definition, the portion of disposable income that is not consumed is saved. As the diagram illustrates, saving "leaks out" into the financial system. Consumption is the purchase of newly produced goods and services for current enjoyment. Going out to eat, buying the latest novel and purchasing a new pair of sneakers are examples of consumption. Unlike saving, the portion of disposable income that is consumed goes directly into the economy's circular flow.

The funds accumulated from saving are channeled through the financial system where they are lent out to investors through financial intermediaries such as banks or finance companies. For example, suppose that a consumer with $1,000 in disposable income spends $800 on consumption items and deposits the other $200 in a savings account. The bank lends the $200 to investors for investment (I). Investment is the total amount spent by firms on newly produced factories, machinery, and plant and equipment. Investment also includes the expenditures of households on new homes. Investment must expand the production capacity of the economy. In contrast to consumption, investment is not for current enjoyment. As with consumption, the amount invested goes directly into the circular flow.

The government also purchases newly produced goods and services. These purchases--called government spending (G)--go directly into the economy's circular flow. Examples of government spending include the purchase of education services from teachers and administrators, the purchase of national defense including expenditures for the military and its weapons, the purchase of highway construction and maintenance services, and so on. Government spending does not include government redistribution programs which are called transfer payments (TR). Social security, Medicare, Medicaid, welfare and unemployment benefits are examples of transfer payments.

Finally, demand for U.S. goods and services comes from consumers who reside outside the U.S. Exports (EX) are newly produced goods and services purchased by people from other countries. Examples include the purchase by a Canadian of a sport-utility-vehicle (SUV) produced in Detroit or the purchase by a Mexican of software from Microsoft. Of course, people in the U.S. also purchase products produced outside its borders. These purchases are called imports (IM). The difference between exports and imports is called net exports (NX), which goes directly into the circular flow.

The four components in the top half of the circular flow diagram--consumption, investment, government spending and net exports--generate the demand for goods and services in the economy. Together they compose Aggregate Demand (AD). Specifically, Aggregate Demand is the total amount that all consumers, firms, government, and foreigners wish to spend on final goods and services produced in the U.S. borders, given the price level. The equation for Aggregate Demand is:

AD = C + I + G + NX

In equilibrium, demand for final goods and services is equal to the supply of final goods and services. Firms produce the goods and services that are demanded. The total amount of newly produced goods and services is the Gross Domestic Product (Y). The production of GDP generates the economy's national income (NI). The values of GDP and national income are equal because all the revenue that is earned from selling a final good or service ultimately ends up as income to someone in the economy. For example, suppose that revenue from a software company is $100. The firm pays $60 in wages (which becomes income to the employees), $20 in rent (which becomes income to the owners of the building), and $10 in interest to pay off its capital equipment (which becomes income to the owners of the capital). This adds up to $90, so the firm makes $10 in profit. Where does the $10 go? It goes to the owners of the software company. The owners may choose to take the $10 as dividend income, or they may decide to reinvest the money in the company. Either way, $100 in total income is generated from the $100 in software sales. GDP equals the value of national income, or Y = NI.

Households and firms have to pay taxes (T) on that national income. The taxes flow to the middle of the circular flow diagram to the government. But the government also takes some of the tax revenue and redistributes it back to households in the form of transfer payments (Tr). After accounting for taxes and transfer payments, national income is turned into disposable income (DI), or DI = Y - T + TR. The disposable income is available for consumers to save or consume, and the circular flow starts all over again.






Saving and investment mean different things; they are not interchangeable. 		   

Investment vs. Saving

In common usage, the terms saving and investment are often interchangeable. For example, we speak of making the proper stock investment, or we invest our money in a mutual fund. In economics, the terms saving and investment are very distinct and they are not interchangeable. Recall that saving (S) is disposable income not consumed. It is not a component of Aggregate Demand. In contrast, Investment (I) expands the productive capacity of the economy. When an individual purchases a mutual fund or stock with her excess income, she is saving because that purchase is not directly expanding the productive capacity of the economy. It may be the case that the company who issued the stock takes the funds and uses them for investment. In this case, the company is investing while the stock purchaser is simply saving. Alternatively, a farmer who purchases a new tractor is investing. The same farmer who purchases a bank certificate of deposit after harvest is saving. To understand clearly macroeconomics, the distinction between saving and investment must be understood well.






The Aggregate Demand Curve is downward sloping because of the wealth effect and the international trade effect. 		  

The Aggregate Demand Curve and its Slope

Aggregate Demand Curve

The Aggregate Demand curve plots the level of Aggregate Demand at various price levels. As the price level rises, the level of Aggregate Demand falls. The reverse is also true. As the price level falls, Aggregate Demand increases. Thus an inverse relationship exists between the price level and Aggregate Demand. The negative slope in the image labeled "Aggregate Demand Curve" illustrates this inverse relationship.

At first glance, the downward slope of the Aggregate Demand curve seems perfectly intuitive. The law of demand seems to explain the negative relationship between price and Aggregate Demand. Upon further reflection, however, this reasoning is incorrect. The law of demand applies to individual markets because when the price of a particular good or service rises, consumers substitute other products in place of the more expensive item. So the law of demand deals with changes in relative prices--the price of one good relative to another good. In macroeconomics, the price plotted on the vertical axis is the price level, the average level of all prices in the economy. If the price level increases, all prices in the economy are rising, on average, and there are no goods or services for which the consumer can substitute. The microeconomic demand curve and the law of demand do not strictly apply.

Two explanations exist to account for the negative relationship between Aggregate Demand and the price level. These explanations are called the wealth effect and the international trade effect.

  
Wealth Effect

   The wealth effect occurs because certain financial assets have returns stated in nominal dollars. If the price level rises unexpectedly, the real return on these assets falls. For example, suppose that a person purchases a $100 bond that will pay a 10 percent return, so the bondholder will receive $110 in one year. The bondholder forecasts no inflation over the year, but the inflation rate turns out to be 5 percent. When the bondholder receives the $110 payment, the real return is less than the bondholder expected because the purchasing power of the $110 is less than it was a year ago. In effect, the rising price level reduces the bondholder's wealth. If the value of a person's financial assets declines, she will reduce consumption, and Aggregate Demand will decline.

  
International Trade Effect
  

The international trade effect occurs because an increase in the price level can reduce net exports. If the nominal exchange rate is fixed, an increase in the U.S. price level means that, in real terms, the U.S. dollar is appreciating. For example, suppose that one U.S. dollar equals one British pound and a toaster costs $20 and 20 pounds to produce in both the U.S. and England, respectively. Suppose then that the price level in the U.S. increases so that prices of domestically produced goods and services are higher than before. Assume that the price of a domestically produced toaster rises to $22. If the price level in England is unchanged, then the toaster still costs just 20 pounds to produce and it can be imported and sold in the U.S. for $20 because of the one-to-one exchange rate. The fixed exchange rate gives U.S. consumers more import purchasing power. In other words, a rising U.S. price level, all else equal, lowers the cost of foreign goods relative to domestic goods. The relatively cheaper imports will be demanded at the expense of domestically produced goods, decreasing net exports and hence, Aggregate Demand.










A change in the price level will cause movement along the Aggregate Demand Curve.



A change in anything but the price level that affects Aggregate Demand will cause a shift in the Aggregate Demand Curve. 		  

Movements Along vs. Shifts in the Aggregate Demand Curve

Move Along AD Curve

A change in the level of Aggregate Demand that is caused by a change in the price level is referred to as a movement along the Aggregate Demand curve. The figure titled "Movement Along AD Curve" illustrates a movement from point A to point B. As the price level rises, consumption and net exports decline because of the wealth and international trade effects, respectively. The economy moves along the Aggregate Demand curve.

A change in any factor other than a change in the price level that changes the level of Aggregate Demand results in a shift of the Aggregate Demand curve. The figure titled "Shift of Aggregate Demand Curve" illustrates a rightward shift. Factors that Shift the Aggregate Demand curve include changes in autonomous consumption, investment, government expenditures and net exports.


Shift of Aggregate Demand Curve

An increase in autonomous consumption--the portion of consumption that is independent of disposable income--shifts the Aggregate Demand curve to the right because for a given price level, the level of Aggregate Demand is higher than before. For example, an increase in consumer confidence shifts the Aggregate Demand curve to the right. An increase in expected future income also shifts the Aggregate Demand curve rightward because consumers believe that their incomes will increase over time. A decrease in taxes shifts the Aggregate Demand curve to the right because for each price level, disposable income and, hence, consumption are higher than before.

A change in investment expenditures is another factor that shifts the Aggregate Demand curve. An increase in plant and equipment expenditures, for example, shifts the Aggregate Demand curve to the right because the level of Aggregate Demand is higher at each price level. Investment could also increase due to an increase in business confidence or a fall in interest rates. As we will explore in a later chapter, the Federal Reserve may lower interest rates to stimulate investment.

A change in government expenditures is a third factor that shifts the Aggregate Demand curve. A decrease in government spending to cut back on defense spending at the end of the Cold War, for example, shifted the Aggregate Demand curve to the left.

Finally, changes in net exports shift the Aggregate Demand curve. If net exports rise, the Aggregate Demand curve shifts to the right. Net exports increase when there is a weakening of the domestic currency or when there is an increase in foreign income relative to domestic income. If the U.S. enters a recession at the time Canada is in a high growth mode, U.S. net exports will increase because Canadians will purchase more U.S. exports but Americans will purchase fewer Canadian imports.



The Aggregate Supply curve graphs the total amount of output produced at various price levels.





The short run Aggregate Supply Curve is upward sloping.















The long run Aggregate Supply Curve is vertical. 		  

Aggregate Supply

Short Run Aggregate Supply is Upward Sloping

The Aggregate Supply curve graphs the total amount of output (Y) produced at various price levels. A significant difference exists between the short-run Aggregate Supply curve and the long-run Aggregate Supply curve. In the short run the Aggregate Supply curve is upward sloping. In the long run the Aggregate Supply curve is vertical.

In the context of the Aggregate Supply curve, the short run is a time period in which the costs of production--wages, raw materials, energy, and so on--are held constant; only output prices vary. When prices rise, the level of Aggregate Supply also rises because firms seek to take advantage of the profit opportunities. A firm's profit is the difference between its revenues and costs over a given time period, say one year. Suppose that a firm produces picture frames and it uses only one input, labor. Each picture frame requires one labor hour to produce, and wages are $8 per hour. The firm sells each picture frame for $10 so the profit per picture frame is $2 ($10 - $8). If the firm sells 2,000 picture frames in the first year, its total profit is $4,000 (2,000 x $2). In the second year, the firm increases the price per picture frame to $11. By assumption, wages are unchanged at $8 per hour. The firm's profit per frame produced is $3. The chance for the firm to increase its profits provides an incentive for the firm to increase production. By producing and selling 2,500 picture frames in the second year, the firm's profits rise to $7,500 (2,500 x $3). An increase in the price level, therefore, leads to a short run increase in Aggregate Supply. The Figure labeled "Short Run Aggregate Supply Curve" is upward sloping, which illustrates the positive relationship between the price level and Aggregate Supply.


Long Run Aggregate Supply Curve is Vertical

We define the long run as a time period in which all prices and costs are variable. An increase in the price level will have no impact on Aggregate Supply in the long run because all firms' costs (e.g. wages and resource costs) will rise proportionally with the price level. Recall that the picture frame company increased profits by increasing the price of picture frames from $10 to $11. Over time, workers adjust their wage demands upward because goods and services are more expensive and because good workers are harder to find as employment rises with the level of production. Suppose that workers increase their wage demands to $9 per hour. Now the firm earns the same $2 profit per frame as it did before the price level increase and the level of output returns to 2,000, the same level of production as in the first year. In the long run, the Aggregate Supply curve is vertical as illustrated in the Figure labeled "Long Run Aggregate Supply Curve." When resources such as labor and capital are fully employed, the economy's production is at the potential level of output, Yp. When the economy is on the Long Run Aggregate Supply curve, GDP is equal to potential output.


Movements Along vs. Shifts of the Short-Run Aggregate Supply curve

Movement Along the AS Curve

Short-run Aggregate Supply is influenced by a number of factors. One factor that we have discussed is a change in the price level. When the price level changes but resource costs are held constant, there is a movement along the Aggregate Supply curve. The figure titled "Movement Along AS Curve" graphs this scenario. As the price level rises from PLA to PLB, Aggregate Supply rises from ASA to ASB.

A change in any factor other than a change in the price level that changes the level of Aggregate Supply shifts the Aggregate Supply curve. Three nonprice factors that shift the Aggregate Supply curve are changes in resource costs, technology and inflation expectations.

An increase in the cost of a resource will shift the Aggregate Supply curve to the left. Resource costs include wages, capital, energy, and so on. Recall that the picture frame firm increased production when it had a chance to earn higher profits and reduced production when wages increased, reducing profits. If resource costs increase a firm's incentive to produce decreases as its profits decline. When oil costs increase, for example, profits decrease because energy costs increase as utility bills and fuel expenses rise. For a given price level, firms respond to rising resource costs by decreasing Aggregate Supply.


Shift of the AS Curve A second factor that shifts the Aggregate Supply curve is a change in technology. As the Figure titled "Shift of Aggregate Supply Curve" illustrates, an increase in technology shifts the Aggregate Supply curve to the right. Technological progress influences the economy in a variety of ways. One channel is the introduction of entirely new goods and services. Just a few years ago an on-line textbook was not possible. Advances in the Internet, however, have enabled information to be delivered in a new way. Another way that technology influences the economy is through quality enhancements of products. In contrast to automobiles produced in the 1970s, today's cars are more dependable thanks to fuel injection systems and other automated components. Newer automobiles are also more fuel-efficient, and they have air bags and other safety features that older cars lack. A third way that technology is integrated into the economy is through cost-reducing innovations. The same product can be produced at a lower cost. First-generation computers used to take up areas the size of football fields. Today some hand-held calculators are just as powerful as those computer but the cost of producing a calculator is far less than the cost of producing an old-generation computer. Given the price level, cost-reducing technological advancements allow firms to increase production and boost profits.

Changes in inflation expectations also shift the Aggregate Supply curve. If workers believe that inflation will increase in the future, they will bid up wages to compensate for the coming inflation. For a given price level, the increase in wages shifts the Aggregate Supply curve to the left.


Equilibrium and Disequilibrium in the Aggregate Demand/Aggregate Supply Model

Equilibrium in the macroeconomic sense occurs when the demand for final goods and services equals the supply of final goods and services. A short-run equilibrium, however, differs from a long-run equilibrium because in the long run the economy must be producing at the potential level of output so that all factors of production are fully employed.

Short-Run Equilibrium

Intersection of AD and SRAS Determine Short Run Equilibirum The short-run equilibrium occurs where the Aggregate Demand curve crosses the short-run Aggregate Supply curve. The intersection of Aggregate Demand and Aggregate Supply in the figure labeled "Short Run Equilibrium" determines both the price level and the equilibrium level of GDP in the economy. The level of output can be above or below potential output. For example, suppose that the economy produces $9 trillion of goods and services in the year 2005 and potential output is $8.5 trillion. As long as the demand for final goods and services is also $9 trillion, the economy is at a short-run equilibrium. Because supply and demand are equal, firms do not overproduce, which would lead to an unintended accumulation of inventories. Nor do firms underproduce, which would lead to an unintended depletion of inventories.

Long-Run Equilibrium

Intersection of AD and LRAS Determine Long Run Equilibirum The long-run equilibrium can only occur where the Aggregate Demand curve crosses the vertical Long Run Aggregate Supply curve because in the long run, equilibrium output must equal potential output where all resources are fully employed. This condition holds because in the short run, production input costs are held constant, but in the long run, input costs can vary. When output is above the potential level of output, there is pressure on wages to increase because workers are relatively scarce and employers bid up wages competing for the workers. As wages are bid up, the short-run Aggregate Supply curve shifts to the left until the equilibrium output is equal to potential output. This scenario is graphed in the figure labeled "Long Run Equilibrium."

Conversely, the Aggregate Demand curve could intersect the short-run Aggregate Supply curve at a level of output below potential output. In this scenario, unemployment would be above the natural rate of unemployment and there would be pressure on wages to decline, shifting the Aggregate Supply curve to the right. This process would continue until the Aggregate Demand curve intersected Aggregate Supply at the potential level of output. Note that in both short-run and long-run equilibriums, Aggregate Demand and Aggregate Supply are equal. The difference between the two is that the long run equilibrium requires the additional condition that output be at the potential level of output.


Disequilibrium

Excess Demand Due to Price Level Below Equilibrium Suppose the economy is in disequilibrium. Let us consider first the case in which Aggregate Demand exceeds Aggregate Supply, or AD > AS. Demand for goods and services is greater than the production of goods and services. As demand outpaces supply, firms see inventories declining unexpectedly and they respond by increasing output and prices until equilibrium is reached. As the price level rises, aggregate demand declines due to the wealth and international trade effects, and aggregate supply rises due to firms' potential for larger profits. This scenario is illustrated in the figure titled "Aggregate Demand Exceeds Aggregate Supply."


Excess Supply Due to Price Level Above Equilibrium The alternative scenario, illustrated in the figure titled "Aggregate Supply Exceeds Aggregate Demand," occurs when the price level is too high such that Aggregate Demand is less than Aggregate Supply, or AD < AS. Demand for goods and services is less than production of goods and services, and firms see inventories increasing unexpectedly. They respond by decreasing production and prices. As the price level falls, Aggregate Demand increases and Aggregate Supply decreases. Again, the economy tends towards equilibrium.

Aggregate Demand, Aggregate Supply, and the Business Cycle

Demand Driven Business Cycle

Having explained the theoretical framework, we are now ready to explain business cycle behavior using the Aggregate Demand/Aggregate Supply model. Generally, economic expansions and contractions are driven by shifts in the Aggregate Demand or Aggregate Supply curves. In more "typical" business cycles, fluctuations in Aggregate Demand generate movements in output and price. As the figure labeled "Demand-Driven Business Cycle" illustrates, rightward shifts in the Aggregate Demand curve increase both the price level and the level of output. In other words, in a typical business cycle expansion, economic growth is accompanied by rising prices. Conversely, leftward shifts in the Aggregate Demand curve decrease both the price level and the level of output. Demand-driven contractions, therefore, lead to declining levels of output and prices. In the real world, the price level does not actually fall but inflation decreases. Recessions and lower inflation rates tend to go together.


Supply Driven Business Cycle

Supply-driven business cycles are caused by shifts in the Aggregate Supply curve. Aggregate supply shifts have played an increasingly important role since the 1970s. As the figure titled "Supply-Driven Business Cycle" illustrates, leftward shifts in the Aggregate Supply curve lead to both a rising price level and a contraction in output. These so-called supply shocks result in stagflation, the unfortunate combination of higher inflation and negative economic growth. The 1974-75 recession, the 1980 recession and the recession in 1990-91 were all precipitated by higher oil prices. Conversely, rightward shifts in the Aggregate Supply curve caused by, say, technological advances, decrease the price level and increase the level of output. Supply-side economics (see Chapter 12) is an attempt to shift the Aggregate Supply curve to the right, resulting in lower prices and higher levels of output. Supply-driven business cycles result in opposite movements in the price level and output.


The Paradox of Thrift states that an increase in the desire of the economy as a whole to save more may lead to a decrease in output and employment.   

The Paradox of Thrift

Is it good for the economy to save income or to consume? The United States has persistently low saving rates and high consumption rates, while Japan, for example, has high saving rates and relatively low consumption rates. A common economic hypothesis asserts that United States growth rates between the 1950s and the 1980s were less than Japan's growth rates because of the U.S.' desire to consume. Since the U.S. invests a smaller percentage of its GDP than does Japan, Japan's capital accumulation has grown relatively faster than that of the U.S.; hence, Japan has nearly caught up to the U.S. standard of living.

Paradox of Thrift

Based on what we have learned thus far of the Aggregate Demand/Aggregate Supply model, the argument that higher living standards result from less consumption and more saving should seem strange. The Household Identity states that all disposable income must be consumed or saved, DI = C + S. If saving goes up, consumption declines. Our model tells us that consumption is a key component of Aggregate Demand. If consumption falls, output and income fall as well. Thus, we arrive at the Paradox of Thrift.

The Paradox of Thrift states that an increase in the desire of the economy as a whole to save more may lead to a decrease in output and employment, thus thwarting the attempt to save more. The figure titled "Paradox of Thrift" shows this scenario. The drop in consumption brought on by the desire to increase saving shifts the Aggregate Demand curve to the left and decreases output. It appears, then, that more consumption is better. Yet we also observe that high-saving countries tend to be high-growth countries. So we return to the original question: are high levels of saving good or bad for an economy?







The Paradox of Thrift assumes that investment does not respond to the increased saving. 		  

To Consume or to Save?

The answer of whether an economy should have high or low saving rates depends on two factors. The first factor is the response of investment to saving. In the macroeconomy (assuming no taxes or government spending), saving (S) is equal to investment (I). From the following equations, we see that Y = C + S and Y = C + I. Setting the two equations equal to each other, we obtain C + S = C + I, or S = I.

As consumers attempt to increase saving, consumption falls. The Paradox of Thrift assumes that investment does not increase with the increased saving. Instead, output and income fall and bring saving down to its original level such that S and I are unchanged. If Investment did increase with saving, the Paradox of Thrift would not hold and high saving rates would indeed benefit the economy over the short-term and long-term by increasing economic growth rates.

The answer to whether high saving rates are "good" also depends on whether one has a short-term or long-term view of the economy. The Paradox of Thrift is more likely to hold in the short run than in the long run. In that sense higher saving rates may be bad because they may lead to a recession. On the other hand, long-run economic growth ultimately results from investment. Higher saving and, consequently, higher investment increases economic growth rates, which ultimately determine living standards in the long run.

In sum, high levels of saving are beneficial when the additional saving is invested and when the high saving is maintained over a long period of time.

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