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Aggregate Supply _amp; Demand

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					Aggregate Supply
   & Demand



   Chapter 7
Aggregate Supply/Demand


     P    MRS


    P1           SRS

                 D

         Y1=Yn       Y
                          2
               Aggregate
             Demand / Supply

   Negatively sloped demand curve
   Supply side - prices (P) adjust in the medium
    run, but not the short run (Keynesian)
     Medium run supply curve (MRS) is vertical at the
      natural rate (Yn )
       • Natural rate depends on labor force, physical
         capital, technology, raw materials, energy
     Short run supply curve (SRS) is horizontal & is
      based on expected demand
                                                       3
Limits to the Effectiveness
 of Demand Side Policies

   P        MRS
              3
   P3                      SRS3

        0        1          2     SRS1
   P1
            D0        D1        D2
                 Yn                  Y
                                         4
     Limits to the Effectiveness
      of Demand Side Policies

   Expansionary monetary (M ) or fiscal policy
    (G  or T ) can help us reach the natural rate.
    (Go from 0 to 1)
   However, once we reach the natural rate (at
    1), further expansions are no longer effective
    or useful
     Cannot permanently raise output
     Only create inflation


                                                  5
    Limits to the Effectiveness
     of Demand Side Policies

   At 1, we are in a short run and medium run
    equilibrium
   Overly expansionary policy moves us to 2.
   At 2, labor costs are rising and eventually we
    get inflation (P)
   As P  we return to the natural rate (move
    from 2 to 3) and experience stagflation
    (rising P, falling Y, and rising unemployment)
                                                 6
                     Stagflation

   “Naive” Keynesian Economics (pre 1980) –
    believed expansionary monetary & fiscal policy
    had no limits
       Evidence - in the 1940’s expansionary fiscal policy
        pulled us out of the great depression w/ little or no
        inflation
   1960’s & 1970’s – The US under Kennedy,
    Johnson, Nixon, Ford, and Carter pursued
    overly expansionary policies
                                                           7
                  Stagflation

   Eventually (in the 1970’s) we got stagflation –
    stagnation combined w/ high inflation (P &
    Y)
   Under Nixon, we tried to prevent inflation with
    price controls
   PBS (Commanding Heights) Why don’t price
    controls work?

                                                  8
               The Natural Rate


   Naïve Keynesians did not believe in the
    natural rate or limits to demand side policy
   Concept was developed Milton Friedman, the
    leading critic of Keynesian economics
       Argued there was a medium run equilibrium level
        of output (or unemployment or growth) consistent
        with price stability
   Idea was eventually incorporated in Keynesian
    models
                                                       9
           Ineffectiveness of
            Monetary Policy

   What happens to interest rates and the
    components of demand during this monetary
    expansion?
   What happens as we go from 1 to 2 to 3?




                                            10
     Monetary Expansion -
          Short Run


 i          LM1         P
       1
i1                LM2
                               1     2
i2          2           P1
                                          D2
                  IS                D1
     Y1=Yn Y2      Y         Y1 = Yn Y2    Y

                                           11
         Monetary Expansion -
              Short Run

   Output is initially at the natural rate (Y = Yn)
   The Fed buys bonds which  the money
    supply & pushes interest rates (i) 
   The  in borrowing costs causes an  in the
    demand for investment goods (I), the
    aggregate demand for goods (D), & Y 


                                                   12
       Monetary Expansion
          Medium Run


 i           LM1,3       P MRS
       1,3
                               3
i1&3             LM2     P3         SRS3
i2           2                 1        2
                         P1                  SRS1
                 IS                D1       D2
       Y1,3 Y2       Y        Yn               Y

                                                13
          Monetary Expansion
             Medium Run

   Since Y2 > Yn, costs rise & firms  prices (P).
   An  in the aggregate price level (P) will
      nominal money demand (or  in real money
      supply)
     The public will sell bonds to get money
     Bond prices will  & interest rates (i) will 
     The demand for investment goods (I), aggregate
      demand (D), and output (Y) will 
                                                  14
            Ineffectiveness of
             Monetary Policy

   In the medium run, money is neutral.
     Cannot change output (Y)
     Cannot change interest rates (i)
     Cannot change investment (I)

   The only permanent effect of a monetary
    expansion at the natural rate is higher prices


                                                15
              Increased
         Government Spending

   Economy is initially at the natural rate &
    government spending is increased
   Which is worse, overly expansionary monetary
    policy or overly expansionary fiscal policy.




                                             16
17
18
                  Long Run

   Yn can change due to changes in
     Labor
     Physical capital
     Technology
     Energy and raw materials




                                      19
             New Economy

                      US
                     1980 – 1995 1996 - 1999
Av. Inflation Rate      3.9%        1.6%
Av. GDP Growth          2.7%        4.4%

   How can GDP growth be so high when
    inflation is so low?
   CNN, December 1999
                                           20
21
                Oil Price Shocks

   In the 1970’s the US experienced two dramatic
    oil price shocks
       In 1974 and again in 1979 OPEC gained political
        strength & restricted the supply of oil to drive
        prices up




                                                      22
                       Oil Prices (per Barrel)

100.00

 80.00

 60.00                                                            2004 $'s
 40.00                                                            $'s

 20.00

  0.00
         1970
                1975
                        1980
                               1985
                                      1990
                                             1995
                                                    2000
                                                           2005        23
                     Oil Prices

   $’s - prices in $’s (not adjusted for inflation)
   2004 $’s – price in 2004 $’s (adjusted for
    inflation)
       For example, prices in general have quadrupled
        since 1974. So an oil price of $10 in 1974 is the
        equivalent of $40 today



                                                        24
             Oil Price Shocks

   What were the economic effects of the oil price
    shocks of the 1970’s?




                                               25
26
              Oil Price Shocks

   Is history repeating itself today?




                                         27

				
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