Chapter 6: Aggregate Demand-Aggregate Supply Analysis and Economic Stability

Introduction

One of the most important issues in macroeconomics is the determination of the general price level in the economy. There was an assumption that we accepted up to this chapter: General price level in the economy is constant. Now, by changing this assumption on prices, we can go on to examine how the general level of prices in the economy is determined. The analytical technique we use for this purpose is an extremely robust analytical technique called aggregate demand – aggregate supply (AD – AS analysis in brief). The advantage of the method is not only because it allows us to explain how the general level of prices is determined and why it changes, but also because we have synthesized goods market equilibrium, money market equilibrium and firms’ production / pricing decisions that we have discussed in the previous chapters separately. Briefly, in the AD – AS analysis, we aim to reach a synthesis of the topics that we have covered so far in macroeconomics.

Aggregate Demand

Aggregate demand is the total amount of goods and services demanded at various price levels by all sectors in an economy (households, firms, government, and external world). The total amount of these goods and services is measured by real income or real GDP. As you will recall, the general level of prices is expressed by the average weighted index of prices of all goods and services in the economy. For example, the consumer price index (CPI) we are familiar with from our daily lives is an index that measures the change in the general level of prices. In this sense, aggregate demand explains the relationship between the general level of prices and the real income.

The aggregate demand curve is the curve showing the relationship between the general price level and the level of production. In order to obtain the aggregate demand curve, we should examine how the quantity of production responds to the price level changes. The economic process shows us that there is an inverse relationship between prices and production (real income). The inverse relationship between total production (real income) and the general level of prices is called the aggregate demand curve (AD). Here, we should mention two important features related to the aggregate demand curve. First of all, both the real sector and the monetary sector are at the equilibrium on the AD curve. The process starting with analyzing the effect of changing prices on money market equilibrium results in analyzing how the equilibrium changes in goods market (real part of the economy). The second feature of AD curve is related with the meaning of aggregate demand curve. AD curve has a more complex meaning than the individual or market demand curves you have learned in microeconomics. We should note that AD curve is neither a market demand curve nor the total of market demand curves in the economy. Contrary to individual demand curve, aggregate demand curve is drawn by considering all the prices in the economy and, therefore, these two curves differentiate. In order to explain the negative slope of AD curve, we cannot use the logic that we used to explain the negative slope of individual demand curve. To understand what aggregate demand curve tells us, we should understand the interaction between real and financial sectors of the economy.

The aggregate expenditures in the economy are the sum of consumption (C), investment (I), government expenditure (G) and net exports (NX). These expenditures planned by households, firms, government and foreigners are called aggregate expenditures (AE). The equilibrium condition for the economy was that aggregate planned expenditures are equal to output:

Y = AE

Y = C + I + G + NX

Since both the monetary sector and the real sector are in equilibrium at each point on the aggregate demand curve, the aggregate demand is equal to aggregate planned expenditures.

In obtaining the aggregate demand curve, we have assumed that the variables of the economic policy that the government use are fixed. Changes resulting from government expenditure (G), taxation (T) and money supply (MS) due to monetary and fiscal policy decisions cause the aggregate demand curve to shift.

We can see this by examining the effects of an increase in money supply. When the prices are at a certain level, the central bank increases the money supply, causing the interest rate to fall in the money market. The decline in interest rates increases planned investment expenditures and therefore aggregate expenditures. Depending on the aggregate expenditures, production will also increase. The final result of the increase in money supply is the increase in production at a certain price level. An increase in government expenditure or a reduction in taxes leads to an increase in production (real income) at each price level. The increase in government expenditures directly leads to an increase in the amount of production by increasing aggregate expenditures. A decrease in taxes leads to an increase in disposable income and an increase in consumption expenditures, leading to an increase in aggregate expenditures and an increase in production. Therefore, the increase in government expenditures or the decline in tax rates causes the AD curve to shift to the right.

Aggregate Supply

Aggregate supply shows the total output of goods and services produced in the economy, at a certain price level in a given period. The total output is the amount of goods and services measured by real GDP and produced by all sectors in the economy.

Aggregate supply curve is the curve showing the relationship between the total amount of production supplied and prices offered by all firms in an economy. In economic theory it is necessary to make a distinction between short term and long term aggregate supply curves. Today most of the economists accept that long term aggregate supply curve is vertical at the potential GDP level. Therefore, monetary and fiscal policies do not have any effect on production in the long-run. Since we are interested in stabilization policies in this chapter by using monetary and fiscal policies, we are going to investigate only the short-run aggregate supply curve unless otherwise cited.

There are different approaches among economists regarding the shape of the short-run aggregate supply curve, in other words, the slope of the short-run aggregate supply curve. Classical economists argue that the shortrun supply curve is completely vertical or rather steep because the economy is always at full of employment as a result of dynamics of the market mechanism. According to this view, since the economy is in full employment, it is not possible to increase the total output even in the shortrun. Keynesian economists argue that the supply curve is horizontal because the economy is underemployment GDP level. According to this view, it is possible to increase the total production without changing the general price level. When the economy moves from underemployment to full employment due to the increase in production, the general price level will start to rise. In this region where the elasticity of the short-run aggregate supply curve begins to decrease, the supply curve will have a positive slope.

Economic growth causes the aggregate supply curve to shift to the right. We have already stated that the AS curve is vertical when the economy is at full employment level. Full employment is determined by current production factors and technology. Accordingly, if the labor force (or the productivity of the labor force) and capital stock (or the productivity of the capital) increase, the AS curve will shift to the right. The capital goods used in the production process are worn over time and gradually disappear if not properly maintained. If an economy is not adequately supplemented with capital stock, the capital stock will decrease. The decrease in the capital stock will cause the AS curve to shift to the left. This is called the investment gap. Changes in weather conditions can also cause the AS curve to shift. For example, a severe drought will reduce the supply of agricultural products, while favorable weather conditions will increase the fertility of the soil and increase the supply of agricultural products. However, in the event of disasters such as natural disasters or war, production in the economy will decrease and the AS curve will shift to the left.

The Equilibrium Price Level

In an economy, the equilibrium price level is the general level of prices at which the aggregate demand is equal to the aggregate supply. This also corresponds to the intersection of AD and AS curves.

AD-AS Analysis and Economic Stabilization Policies

In terms of economic stability, two main objectives emerge in today’s economic policy. These are the stability in prices and the stability in production. Price stability is the situation in which the general price level in the economy either changes very slowly or does not change at all. In today’s world it is generally accepted that a two percent annual increase in price level means prices are stable in the economy. Stability in production (output stability) is the reduction of periodic fluctuations in GDP and maintaining economic growth rate close to the longterm average.

The economic policy is influential on aggregate demand, as it is contractionary or expansionary. When the fiscal policy is applied, the tools used are the government expenditure (G) and the taxes (T), while the money supply (MS) used in the monetary policy. An expanding economic policy is to stimulate the economy by increasing the aggregate demand. We have shown that this goal can be achieved with an increase in government spending or with an increase in money supply and a reduction in taxation. The goal of a contractionary economic policy is to reduce aggregate demand and slow down economic activity.

Our goal is to assess the impact of economic policies. When analyzing these effects, we should pay attention to two points about AS curve. First of all we assume that the AS curve does not change. Secondly, we have to pay attention to what region the economy is on the AS curve because the price and production reaction of the economy will be different accordingly.

Inflation and Its Causes

Inflation is the increase in the general level of prices. According to this definition, every factor that shifts the AD curve to the right and the AS curve to the left causes inflation. However, we should clarify the difference between one-time price increase and continuous increases in prices. Inflation is the continuous increases in the general price level for a long time. Most of the economists today accept that the main factor that drives prices to increase continuously is continuously increasing money supply. This shows that whatever the initial reason to increase price level is, inflation occurs only when increasing money supply accompanies. Therefore, it is generally accepted in economics that inflation is always a monetary phenomenon. After distinguishing one-time price increase and inflation, we can analyze the causes of inflation depending on its basic types. Demand-pull inflation is the inflation caused by aggregate demand increases. Inflation, which is caused by cost increases, is called cost-push inflation. For example, increases in oil and raw material prices are an important cost-enhancing factor for producers. This process in which prices and unemployment increase at the same time is known as stagflation (inflation in stagnation).

The increase in the money supply plays an important role in the emergence of demand-pull inflation as well as the consistent inflation. For example, let’s assume that an expansionary fiscal policy has been followed by an increase in government expenditure while money supply is constant. The fact that the money supply remains constant in the face of the increase in government expenditures suggests that the central bank does not accommodate to the expansionary fiscal policy. The increase in government expenditures will cause the aggregate demand curve to shift to the right and the prices will increase.