AGGREGATE DEMAND AND SUPPLY

To determine which views of economic performance are valid, we need to examine the inner workings of the macro economy. All Figure 8.4 tells us is that macro outcomes depend on certain identifiable forces. But the figure doesn’t reveal how the determinants and outcomes are connected. What’s in the mysterious circle labeled “Macro Economy” at the center of Figure 8.4 ?

When economists peer into the mechanics of the macro economy they see the forces of supply and demand at work. All the macro outcomes depicted in Figure 8.4 are the result of market transactions—an interaction between supply and demand. Hence, any influence on macro outcomes must be transmitted through supply or demand.

By conceptualizing the inner workings of the macro economy in supply and demand terms, economists have developed a remarkably simple model of how the economy works.

Economists use the term aggregate demand to refer to the collective behavior of all buyers in the marketplace. Specifically, aggregate demand refers to the various quantities of output (real GDP) that all people, taken together, are willing and able to buy at alternative price levels in a given period. Our view here encompasses the collective demand for all goods and services rather than the demand for any single good.

To understand the concept of aggregate demand better, imagine that everyone is paid on the same day. With their incomes in hand, people then enter the product market. The question becomes: How much output will people buy?

aggregate demand: The total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus.

Aggregate Demand Aggregate Demand

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C H A P T E R 8 : T H E B U S I N E S S C Y C L E 153

To answer this question, we have to know something about prices. If goods and services are cheap, people will be able to buy more with their available income. On the other hand, high prices will limit both the ability and willingness to purchase goods and services. Note that we’re talking here about the average price level, not the price of any single good.

Figure 8.5 illustrates this simple relationship between average prices and real spending.

The horizontal axis depicts the various quantities of (real) output that might be purchased.

The vertical axis shows various price levels that might exist.

The aggregate demand curve illustrates how the real value of purchases varies with the average level of prices. The downward slope of the aggregate demand curve suggests that with a given (constant) level of income, people will buy more goods and services at lower price levels. Why would this be the case? Three separate reasons explain the down- ward slope of the aggregate demand curve:

• The real-balances effect.

• The foreign-trade effect.

• The interest-rate effect.

Real-Balances Effect. The most obvious explanation for the downward slope of the aggregate demand curve is that cheaper prices make dollars more valuable. Suppose you had

$1,000 in your savings account. How much output could you buy with that savings balance?

That depends on the price level. At current prices, you could buy $1,000 worth of output. But what if the price level rose? Then your $1,000 wouldn’t stretch as far. The real value of money is measured by how many goods and services each dollar will buy. When the real value of your savings declines, your ability to purchase goods and services declines as well.

Suppose inflation pushes the price level up by 25 percent in a year. What will happen to the real value of your savings balance? At the end of the year, you’ll have

Aggregate demand

REAL OUTPUT (quantity per year)

PRICE LEVEL (average price)

Slopes down because of

• Real-balances effect

• Foreign-trade effect

• Interest-rate effect

FIGURE 8.5

Aggregate Demand

Aggregate demand refers to the total output (real GDP) demanded at alternative price levels, ceteris paribus. The vertical axis measures the average level of all prices rather than the price of a single good.

Likewise, the horizontal axis refers to the real value of all goods and services, not the quantity of only one product.

The downward slope of the aggregate demand curve is due to the real-balances, foreign-trade, and interest-rate effects.

Real value of savings

at year-end savings balance price level at year-end price level at year-start

$1,000 125 100

$1,000 1.25 $800

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154 C Y C L I C A L I N S TA B I L I T Y

In effect, inflation has wiped out a chunk of your purchasing power. At year’s end, you can’t buy as many goods and services as you could have at the beginning of the year. The quantity of output you demand will decrease. In Figure 8.5 this would be illustrated by a move- ment up the aggregate demand curve.

A declining price level (deflation) has the opposite effect. Specifically, lower price levels make you “richer”: The cash balances you hold in your pocket, in your bank account, or under your pillow are worth more when the price level falls. As a result, you can buy more goods, even though your nominal income hasn’t changed.

Lower price levels increase the purchasing power of other dollar-denominated assets as well. Bonds, for example, rise in value when the price level falls. This may tempt consumers to sell some bonds and buy more goods and services. With greater real wealth, consumers might also decide to save less and spend more of their current income.

In either case, the quantity of goods and services demanded at any given income level will increase. These real-balances effects create an inverse relationship between the price level and the real value of output demanded—that is, a downward-sloping aggregate demand curve.

Foreign-Trade Effect. The downward slope of the aggregate demand curve is reinforced by changes in imports and exports. Consumers have the option of buying either domestic or foreign goods. A decisive factor in choosing between them is their relative price. If the average price of U.S.-produced goods is rising, Americans may buy more imported goods and fewer domestically produced products. Conversely, falling price levels in the United States may convince consumers to buy more “Made in the USA” output and fewer imports.

International consumers are also swayed by relative price levels. When U.S. price levels decline, overseas tourists flock to Disney World. Global consumers also buy more U.S.

wheat, airplanes, and computers when our price levels decline. Conversely, a rise in the relative price of U.S. products deters foreign buyers. These changes in import and export flows contribute to the downward slope of the aggregate demand curve.

Interest-Rate Effect. Changes in the price level also affect the amount of money people need to borrow. At lower price levels, consumer borrowing needs are smaller. As the demand for loans diminishes, interest rates tend to decline as well. This “cheaper”

money stimulates more borrowing and loan-financed purchases. These interest-rate effects reinforce the downward slope of the aggregate demand curve, as illustrated in Figure 8.5 .

Although lower price levels tend to increase the volume of output demanded, they have the opposite effect on the aggregate quantity supplied. As we observed, our production possi- bilities are defined by available resources and technology. Within those limits, however, producers must decide how much output they’re willing to supply. Their supply decisions are influenced by changes in the price level.

Profit Effect. The primary motivation for supplying goods and services is the chance to earn a profit. Producers can earn a profit so long as the prices they receive for their output exceed the costs they pay in production. Hence, changing price levels will affect the prof- itability of supplying goods.

If the price level declines, profits tend to drop. In the short run, producers are sad- dled with some relatively constant costs like rent, interest payments, negotiated wages, and inputs already contracted for. If output prices fall, producers will be hard-pressed to pay these costs, much less earn a profit. Their response will be to reduce the rate of output.

Higher output prices have the opposite effect. Because many costs are relatively constant in the short run, higher prices for goods and services tend to widen profit margins. As profit margins widen, producers will want to produce and sell more goods. Thus, we expect the rate of output to increase when the price level rises. This expectation is reflected in the Aggregate Supply

Aggregate Supply

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C H A P T E R 8 : T H E B U S I N E S S C Y C L E 155

upward slope of the aggregate supply curve in Figure 8.6 . Aggregate supply reflects the various quantities of real output that firms are willing and able to produce at alternative price levels, in a given time period.

Cost Effect. The upward slope of the aggregate supply curve is also explained by rising costs. The profit effect depends on some costs remaining constant when the average price level rises. Not all costs will remain constant, however. Producers may have to pay overtime wages, for example, to increase output, even if base wages are constant. Tight supplies of other inputs may also unleash cost increases. Such cost pressures tend to multiply as the rate of output increases. As time passes, even costs that initially stayed constant may start creeping upward.

All these cost pressures will make producing output more expensive. Producers will be willing to supply additional output only if prices rise at least as fast as costs.

The upward slope of the aggregate supply curve in Figure 8.6 illustrates this cost effect. Notice how the aggregate supply curve is practically horizontal at low rates of aggregate output and then gets increasingly steeper. At high output levels the aggregate supply curve almost turns straight up. This changing slope reflects the fact that cost pressures are minimal at low rates of output but intense as the economy approaches capacity.

When all is said and done, what we end up with here is two rather conventional-looking supply and demand curves. But these particular curves have special significance. Instead of describing the behavior of buyers and sellers in a single product market, aggregate sup- ply and demand curves summarize the market activity of the whole (macro) economy.

These curves tell us what total amount of goods and services will be supplied or demanded at various price levels.

These graphic summaries of buyer and seller behavior provide some important clues about the economy’s performance. The most important clue is point E in Figure 8.7 , where the aggregate demand and supply curves intersect. This is the only point at which the behavior of buyers and sellers is compatible. We know from the aggregate demand curve that people are willing and able to buy the quantity Q E when the price level is at P E . From the aggregate supply curve we know that businesses are prepared to sell quantity Q E at the price level P E . Hence, buyers and sellers are willing to trade exactly the same quantity ( Q E ) at that price level. We call this situation macro equilibrium —the unique combination of prices and output compatible with both buyers and sellers’ intentions.

aggregate supply: The total quantity of output (real GDP) producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

Macro Equilibrium Macro Equilibrium

equilibrium (macro): The combination of price level and real output that is compatible with both aggregate demand and aggregate supply.

REAL OUTPUT (quantity per year)

PRICE LEVEL (average price)

Aggregate supply

Slopes up because of:

• Profit effect

• Cost effect

FIGURE 8.6 Aggregate Supply

Aggregate supply is the real value of output (real GDP) producers are willing and able to bring to the market at alternative price levels, ceteris paribus. The upward slope of the aggregate supply curve reflects both profit effects (the lure of wid- ening profit margins) and cost effects (increasing cost pressures).

The slope of the aggregate supply curve depends in part on what producers pay for their inputs. Find out about producer prices at www.

bls.gov/ppi

webnote

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156 C Y C L I C A L I N S TA B I L I T Y

To appreciate the significance of macro equilibrium, suppose that another price or output level existed. Imagine, for example, that prices were higher, at the level P1 in Figure 8.7 . How much output would people want to buy at that price level? How much would business want to produce and sell?

The aggregate demand curve tells us that people would want to buy only the quantity D 1 at the higher price level P 1. In contrast, business firms would want to sell a larger quantity, S 1 . This is a dis equilibrium situation in which the intentions of buyers and sellers are incompatible. The aggregate quantity supplied ( S 1 ) exceeds the aggregate quantity demanded ( D 1 ). Accordingly, a lot of goods will remain unsold at price level P 1.

To sell these goods, producers will have to reduce their prices. As prices drop, producers will decrease the volume of goods sent to market. At the same time, the quantities that consumers seek to purchase will increase. This adjustment process will continue until point E is reached and the quantities demanded and supplied are equal. At that point, the lower price level P E will prevail.

The same kind of adjustment process would occur if a lower price level first existed. At lower prices, the aggregate quantity demanded would exceed the aggregate quantity supplied. The resulting shortages would permit sellers to raise their prices. As they did so, the aggregate quantity demanded would decrease, and the aggregate quantity supplied would increase. Eventually, we would return to point E , where the aggregate quantities demanded and supplied are equal.

Equilibrium is unique; it’s the only price-level-output combination that is mutually compatible with aggregate supply and demand. In terms of graphs, it’s the only place the aggregate supply and demand curves intersect. At point E there’s no reason for the level of output or prices to change. The behavior of buyers and sellers is compatible. By contrast, any other level of output or prices creates a dis equilibrium that requires market adjust- ments. All other price and output combinations, therefore, are unstable. They won’t last.

Eventually, the economy will return to point E.

There are two potential problems with the macro equilibrium depicted in Figure 8.7 . The two potential problems with macro equilibrium are

• Undesirability: The equilibrium price or output level may not satisfy our macroeco- nomic goals.

• Instability: Even if the designated macro equilibrium is optimal, it may not last long.

Macro Failures Macro Failures FIGURE 8.7

Macro Equilibrium

The aggregate demand and supply curves intersect at only one point (E). At that point, the price level (PE) and output (QE) combination is compatible with both buyers’ and sellers’ intentions. The economy will gravitate to those equilibrium price (PE) and output (QE) levels. At any other price level (e.g., P1), the behavior of buyers and sellers is incompatible.

Macro equilibrium E

D1 QE S1

REAL OUTPUT (quantity per year)

PRICE LEVEL (average price)

Aggregate supply

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C H A P T E R 8 : T H E B U S I N E S S C Y C L E 157

Undesirability. The macro equilibrium depicted in Figure 8.7 is simply the intersection of two curves. All we know for sure is that people want to buy the same quantity of output that businesses want to sell at the price level P E . This quantity ( Q E ) may be more or less than our full-employment capacity. This contingency is illustrated in Figure 8.8 . The output level Q F represents our full-employment GDP potential. In this case, the equilibrium rate of output ( Q E ) falls far short of capacity production. We’ve failed to achieve our goal of full employment.

Similar problems may arise from the equilibrium price level. Suppose that P * represents the most desired price level. In Figure 8.8 , we see that the equilibrium price level P E exceeds P *. If market behavior determines prices, the price level will rise above the desired level.

The resulting increase in the average level of prices is what we call inflation.

It could be argued, of course, that our apparent macro failures are simply an artifact. We could have drawn the aggregate supply and demand curves to intersect at point F in Fig- ure 8.8 . At that intersection we’d have both price stability and full employment. Why didn’t we draw them there, instead of intersecting at point E ?

On the graph we can draw curves anywhere we want. In the real world, however, only one set of aggregate supply and demand curves will correctly express buyers’ and sellers’

behavior. We must emphasize here that these “correct” curves may not intersect at point F , thus denying us price stability or full employment, or both. That is the kind of economic outcome illustrated in Figure 8.8 .

Instability. Figure 8.8 is only the beginning of our macro worries. Suppose, just suppose, that the AS and AD curves actually intersected in the perfect spot. That is, imagine that macro equilibrium yielded the optimal levels of both employment and prices. If this hap- pened, could we stop fretting about the state of the economy?

Unhappily, even a “perfect” macro equilibrium doesn’t ensure a happy ending. The AS and AD curves aren’t permanently locked into their respective positions. They can shift — and they will, whenever the behavior of buyers and sellers changes.

AS Shifts. Suppose the Organization of Petroleum Exporting Countries (OPEC) increased the price of oil, as it did in early 2006. These oil price hikes directly increased the cost of production in a wide range of U.S. industries, making producers less willing and able to

full-employment GDP: The total market value of final goods and services that could be produced in a given time period at full employment; potential GDP.

inflation: An increase in the average level of prices of goods and services.

E F

Aggregate demand Aggregate

supply

QE QF PE

REAL OUTPUT (quantity per year)

PRICE LEVEL (average price)

Full-employment output Equilibrium

output

FIGURE 8.8

An Undesired Equilibrium Equilibrium establishes only the level of prices and output that are compatible with both buyers’ and sellers’ intentions. These outcomes may not satisfy our policy goals. In this case, the equilibrium price level is too high (above P*) and the equilibrium output rate falls short of full employment (QF).

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WHAT ECONOMICS IS ALL ABOUT

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