Chapter 9 - AD/AS MODEL

In Ch 8, we focused on static, equilibrium conditions in the AD/AS model. We now look at dynamic changes in the macro model - e.g. acts of nature like droughts or earthquakes, important discoveries like the computer chip, shifts in consumer confidence, political disruptions, etc. We will still assume that fiscal and monetary policy are unchanged so that we can see how private markets react to dynamic change. Then we can later look at the potential and limitations of macro policy.

We distinguish between Anticipated and Unanticipated changes because dynamic adjustment differs depending on whether changes are expected or not. An anticipated change allows people time to adjust.

Example: inflation is 5% now and government announces that inflation will be 10% next year or that inflation will be 0% next year. That is different than inflation being 5% and unexpectedly going up to 10% or down to 0%.

Or researchers develop a new high yield drought-resistant hybrid seed that increases grain production by 10% (anticipated) vs. unusually favorable weather conditions resulting in a 10% increase in output. (unanticipated)

Unanticipated change is change that catches most people by surprise, so that decisions were already made that did not take the event into account. Much of the change is unexpected, at least by the majority of the people. That is where the role of the entrepreneur becomes important.

"Economics is largely about how people respond to change and how markets adjust to change."

FACTORS THAT SHIFT AD -

AD curve isolates the impact of price level on the Qd of Goods/Services (Real GDP). Factors besides price level changes also affect Real Output and those factors SHIFT the entire AD curve. Six factors:

1. Changes in Real Wealth - Changes in the price level affect real wealth by changing the real value of cash balances. Real wealth can also be affected by other factors. Example:Stock prices tripled between 92-98 - this represents an increase in real wealth of households holding stocks, mutual funds, pension funds, IRAs, etc. The stock market crashed in 87, a decrease in real wealth. The market has gone up by about 35% in the last year, DJIA almost 10,000, real wealth has increased. AD shifts out when AD increases from increase in wealth.

2. Changes in Real Int Rate - Int rates affect decisions of households and businesses in terms of their willingness to borrow. New Car and a Car Loan are like complimentary goods, goods that are consumed jointly. Our houses and mortgages, furniture and credit card debt. If the cost of financing a car or house or furniture goes down, the cost of the joint purchase goes down, and the demand increases. Lower int rates make the cost of buying a car/house cheaper, AD is stimulated, output increases. If real int rates increases, the joint cost of purchasing a car, home, etc goes up and the demand decreases. Same for business borrowing for expansion, property, plant, equipment, etc.

3. Business and Household Expectations about the Economy - Consumer/Business confidence about the future health of the economy. Optimism or pessimism about the economy. Increased optimism encourages consumption and production. Pessimism about the future makes consumers and businesses nervous about spending, the economy contracts.

4. Expected rate of inflation - Expected prices in the future. If inflation is expected to accelerate, people will have an incentive to "buy now, before prices go up." AD will increase now. Expectation of falling prices in the future will reduce AD now. Example: waiting to buy a computer.

5. Changes in Foreign Income - will influence our exports. If foreign incomes are rising, this will stimulate their demand for US products, exports will increase and AD will increase. About 10% of our domestic production is exported, many European countries it is closer to 50%. Think if the US were 50 countries and Michigan was a country exporting cars to 49 countries. Our economy would be affected by the "foreign" incomes of the other "countries."

6. Changes in Ex-rates - To buy US products, foreigners first have to buy US dollars. To buy foreign products, we have to first buy foreign currency. The relative value of dollars to other currencies will influence our exports (sales) to other countries and our imports (purchases) from other countries.

The relative value of dollars to Yen or pound or marks is the exchange rate. If the dollar is very strong, we can buy lots of yen or pounds or marks, and Japanese, British and German products seem cheap so our imports go up. If our dollar is strong, the foreign currencies are weak, so they find US goods expensive, our exports go down. If Exports go down and imports go up, net exports goes down, and AD decreases.

If the dollar is weak and foreign currencies are strong, our goods are cheap to foreigners. Weak dollar means foreign products are expensive to us. Exports will go up and imports will go down, net exports will go up and AD will increase.

See Summary on page 222.

Most of the time, the factors that shift the AD curve will be unexpected. For example, there will be unpredictable fluctuations in exchange rates and foreign incomes that will shift the AD curve. Consumer/business confidence fluctuates all the time, int rates are changing around all the time.

Unexpected changes will result in dynamic changes that will take place during an adjustment period. It will take time for producers to adjust.

For example - they see a strong increase in demand for their product. Is this just a random, one time occurrence or a real change/shift in demand for their product? Is it a temporary increase or a permanent increase in demand? Even if they are convinced that it is a permanent increase/decrease in the demand for their product, it takes time to adjust. Expansion/contraction, etc.

See page 223 for a diagram of the effects of an unanticipated increase in AD. We start at point E1/Y1. Suppose that there is a stock market boom (increase in wealth) or a burst of consumer optimism, AD shifts out. AD1 shifts to AD2.

The strong sales and increased demand puts upward pressure on retail prices. Profit margins increase and output expands along the SRAS to e2. (small e means SR, big E means LR).

Un rate temporarily falls below the nat rate, Y temporarily > full employment level of output. The strong demand puts upward pressure on prices in the resource markets (labor, materials) and the loanable funds markets. Input prices and int rates rise, which shifts the SRAS curve back to Yf.

LR equilibrium is re-established at Yf and P=110. Economy is only temporarily above Yf. As soon as all factor/input prices adjust, economy is back at LRAS. Un returns to nat rate. Since the increase in AD does not permanently affect any of the factors that influence the LRAS, it cannot expand output above Yf permanently.

REDUCTIONS IN AD

Suppose that there is increased pessimism or a decline in income abroad. AD shifts back from AD1 to AD2 on page 225. Weak demand will reduce prices and output to P95 and Y2. Workers will be laid off, un > nat rate temporarily. Input prices/labor costs are fixed, so that profits will decrease.

The weak demand, weak economy will put downward pressure on input/resource prices, including labor and other resources. Once the input prices have fallen, the SRAS will shift out to SRAS2 and the economy will recover and be back at Yf.

However, workers and unions will be reluctant to accept wage cuts. Wages are sticky downward, unlike other prices like stock prices. Prices go up easier than they fall!

SHIFTS IN AGGREGATE SUPPLY -

What if AD stays the same and there is change in AS? Depends on whether the change is permanent or temporary. If the change is permanent, the LRAS and the SRAS both move, usually out.

If the change is temporary, only the SRAS shifts. An example of a temporary change: a drought in CA. Output temporarily drops, but will return to long run potential after the drought.

Changes in LRAS - same factors that shift the PPF. What will increase LRAS?

1. An increase in resources will increase LRAS.

Examples: net investment in the economy results in more and better machines and equipment, more educated, higher skilled workforce, increases in the labor force or labor force participation, increased supply of materials (oil exploration), etc.
All of these increases in the quantity and quality of resources will allow the economy to produce a permanently higher level of output.

2. Improvements in technology increase the productivity of the labor force, which allow us to produce permanently higher levels of output.

Research, development and discovery lead to more efficient methods of production. Machine Age developments - steam engine, internal combustion engine, electricity, nuclear power, etc. Information Age developments - computer and electric technology, fax machines, Internet, VCRs, calculators, etc.

3. Institutional/legal factors can influence the LRAS.

Having an efficient legal system with enforcement of property rights, including intellectual prop rights can inc LRAS. Patents, copyrights, trademarks, etc. increase LRAS.

Can be negative influence - trade protection reduces standard of living/LRAS, farm subsidies result in inefficiencies, min wage laws reduce employment and training, rent controls result in deterioration of real estate, etc.

LRAS in US has increased at 3%/year on average, curve is shifting out, some periods faster than 3 and some periods less than 3 percent.

CHANGES IN THE SRAS -

Factors that will increase the SRAS:

1. Temporary decrease in resource prices and production costs. If the price decrease is from a permanent increase in supply, the LRAS will shift. If the price change is temporary, only the SRAS will change.

Example: temporary favorable ex-rate for buying foreign resources, like oil. Temporary strong dollar.

2. Favorable, but temporary, "supply shocks."

Supply shocks are unexpected favorable or unfavorable events that either increase or decrease AS.

Example: good weather resulting in large amount of corn/soybeans. Unfavorable supply shock: OPEC in the 70s restricting the supply of oil and raising the price.

3. Changes in the expected rate of inflation.

Changes in expected future inflation influence SRAS. If producers expect prices to rise in the future, their willingness to supply them today is reduced. They can wait and get a higher price in the future. An increase in expected inflation will reduce SRAS now. A decrease in expected inflation will increase SRAS now. Sell now before prices fall. (assuming deflation)

Changes in LRAS graphically - see page 230. Starting at equilibrium - E1, P1 and Yf1, we have an increase in LRAS and SRAS2 - E2, P2 and Yf2. If MS is fixed, the increase in output will be deflationary, price level falls to P2.

The long run trend has been a 3% increase in LRAS and the price level has risen, NOT fallen because of increases in the MS.

UNANTICIPATED INCREASES IN SRAS -

Suppose there is a temporary, favorable supply condition that will not be permanent - good weather or a temporary price decline for a foreign input - oil. The LRAS will not change, but the SRAS will shift out/increase.

See page 231. Output will temporarily expand to Y2. The inc in supply will put downward pressure on prices to P95. As the economy returns to normal weather, normal oil prices, the SRAS will return to its original position.

Another effect of the temporarily high income - increased savings which will lower the int rate temporarily.

Reason: Consumption depends on long-run expected future income, rather than current income. Much of the temporary income from the favorable supply shock will be saved, not spent, and int rates will decline.

Example: you get a one time bonus of $1000 during a good period for your company. You might spend some of it, but many people would save for future periods - put in bank or stock market. We smooth our consumption behavior.

Example: you work on commission sales, so your income varies from month to month. You would smooth out your consumption based on your long run permanent income, not your monthly income. Point: temporary increases in income get saved, not spent. Int rates fall.

UNANTICIPATED DECREASES IN SRAS -

Unfavorable supply shocks - 1973/1979 oil shocks for example. 1988 severe drought conditions resulted in very poor harvest. 1990 - Iraq invaded Kuwait, oil prices doubled from $15 to $30/bbl.

See page 232. SRAS1 shifts back to SRAS2. Output falls to Y2, prices rise to P110. If the shift is temporary, resource prices will start to fall and output will increase back to Yf.

If the supply shock was permanent - long term increase in price of oil - the LRAS would shift back to a permanently lower output level.

DOES A MKT ECONOMY HAVE SELF-CORRECTING MECHANISMS?

Answer is YES, it has several, the debate is over how quickly they operate. Economy as an ecosystem - economy has feedback loops and at least three self- correcting mechanisms.....

1. Consumption demand (PCE) is relatively stable over the bus cycle. Consumption spending is 2/3 of AD. Consumption spending tends to be relatively stable over the business cycle, which stabilizes the economy. Permanent Income Hypothesis of Friedman. Current consumption depends more on long-run expected lifetime income rather than current income. We "smooth out" consumption.

Example: when economy is expanding and incomes are temporarily high, people save more and consume at a steady level. This stability of C helps dampen the growth of AD and keep inflation under control.

During a contraction, incomes fall, but consumers smooth out consumption and keep it stable buy drawing on savings. Even if your income falls, or your hours are reduced, or even if your are laid off, you still buy diapers for your children.

Point: Income varies more than consumption, so consumption stabilizes the economy without any formal policy.

2. Changes in real int rates stabilize the economy. Assume that businesses and consumers are pessimistic about the economy and confidence falls and AD falls, economy slows down and we start to go into a contraction or recession. There is a general reduction in the demand for credit, reflecting the increased pessimism.

The reduced demand for credit will put downward pressure on int rates. At some point, int rates will fall enough that businesses and consumers will start to borrow again and the economy will recover by itself. Falling int rates during a recession will eventually stimulate the economy.

On the other hand, when there is an economic expansion, there is increased demand for credit/borrowing by consumers/businesses, putting upward pressure on int rates. Eventually the higher int rates will automatically slow the economy down. Int rates act like a shock absorber and provide a self- correcting mechanism for the economy.....

3. Changes in resource prices will stabilize the economy. During an econ expansion, output will be greater than full-employment capacity and there will be upward pressure on resource prices including wages, raw materials, supplies, commodities, etc. At some point, these higher prices will help slow the economy down and full-employment output will be re-established.

During a recession, output will be less than the full employment level, demand will weaken for resources inc labor, and resource prices will fall. The lower prices for wages and resources will eventually help to stimulate the economy, output will expand back to full-employment level.

See graph page 235. LRAS

Graph of self-correcting mechanisms, see page 236. In (a), we start at SRAS1, e1, P100 and Y1. Output is greater than long run potential, putting upward pressure on int rates, prices and wages. AD1 shifts back to AD2. SRAS1 shift back to SRAS2.

Page 247b, we start at e1, Y1, SRAS1 and p100. Output is less than full capacity. Resource prices, wages, and int rates decline and eventually stimulate the economy back to Yf. AD1 to AD2 and SRAS1 to SRAS2.

BUSINESS CYCLE REVISITED -

Using AD/AS, we can understand the business cycle. In a dynamic world of changing AD and supply shocks, there will be alternating periods of economic expansion and contraction. Macro markets do not adjust instantly and this leads to the business cycle. Part of the business cycle is due to the sluggishness of adjustment that has to do with living in a physical universe. The faster that info flows through the economy, the faster the adjustment and the shorter the fluctuations. Info Age economy should be more stable than Machine Age.

Also, decision makers do not always correctly anticipate changes in the price level - this can lead to economic fluctuations, periods of expansion and contraction.

See page 238. We see the LR trend of real GDP, and un rate. We see alternating periods of econ expansion and contraction - business cycle.

Recessions were in 69-70, 74-75, 79-82, 90-91, in blue.

Expansions were in 66-68, 71-73, 76-79, 83-89, 92-96.

Panel b shows the actual un rate compared to the estimated nat rate. During recessions of 74-75, 79-82 especially, the actual rate was well above the nat rate.

If the economy is self-correcting, we would expect real interest rates and real wages to rise during an expansion and fall during a recession. See page 239. We see evidence that real int rates fall during recessions and rise during expansions. We also see the same pattern for real wages.

GREAT DEBATE: HOW QUICKLY DOES ECONOMY SELF-CORRECT?

After the Great Depression, many economists lost faith in the ability of the economy to self correct. We had a ten year recession with un as high as 25%. The consensus view was that activist, discretionary fiscal and monetary policy was required to stabilize and guide the economy to full employment. This view was predominant for the next forty years until the 1970s, until we had stagflation - high inf and high un at the same time. This was not supposed to happen.

The trend is now back to a faith in the economy to self-correct and many economists now advocate a fixed, passive, rule-based approach to fiscal and monetary policy. The feeling is that activist attempts to fine-tune the economy are actually disruptive and de-stabilizing. Rule based policies are advocated like: balanced budgets and fixed money growth. We come back to this debate later.

Problems 1, 2, 4, 6, 8, 9, 12.

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