the Extending demand-supply
framework to the economy as a whole:
Aggregate Demand Aggregate
Supply Model
Through the so called wealth effect, recent stock market gains have
tended to foster increases in aggregate demand beyond the increases in
supply. It is this imbalance that contains the potential seeds of rising
inflationary pressures that could undermine the current expansion. Our
goal is to extend the expansion by containing its imbalances and avoiding
the very recession that would complete the business cycle.
-Alan Greenspan, January 13, 2000
Last two US recessions:
Recession of 2001: Decline in the Aggregate Demand
Recession of 2007-2010: Decline in the Aggregate Demand
Stock Market and the Wealth Effect
WFE - YTD Monthly
2008
Exchange
Americas
NASDAQ OMX
NYSE Euronext (US)
Total
May
3,483,629.7
15,071,483.3
56,911,591.1
June
3,174,512.3
14,413,303.1
52,519,954.9
July
3,230,774.5
13,418,169.4
50,338,918.6
August
3,300,155.9
13,567,084.6
48,634,575.2
September
2,903,915.5
13,045,902.7
42,559,050.2
How do such fluctuations in wealth effect the economy?
Can the effects be modeled and understood?
October
2,453,577.8
10,312,695.0
33,528,240.4
November
2,180,838.4
9,169,946.8
31,131,277.9
December
2,248,976.5
9,208,934.1
32,400,134.7
Aggregate Demand
Demand for domestically produced goods
and services aggregate across all sectors
of the economy (the demand for the Real
GDP)
AD = C + I + G + x m
U.S. Department of Commerce. Bureau of Economic Analysis - Real GDP
Constructing AD
Framework:
Any Demand
Aggregate Demand
Quantity = f (price, other factors)
Quantity of the product
Real Output (Real GDP)
Price of the product
Price Level
U.S. Department of Commerce. Bureau of Economic Analysis - Price Level
Constructing AD continued
Slope:
Any Demand
Aggregate Demand
Income Effect
Real Balances Effect
Price level changes effect the real
value of accumulated savings
> changes in Consumption
Substitution Effect
Open Economy Effect
Domestic price level changes
change the competitive position of
our export/import firms
>changes in exports/imports
Interest Rate Effect
Price level changes cause changes
in the interest rate (money supply is
assumed to be fixed)
> changes consumption/investment
Multiplier Effect
marginal propensity to consume
Determinants of AD
factors that shift AD
Anything (other than the price level) that
will cause changes in the expenditure
components of the GDP
Examples of Determinants of AD
Consumption Confidence (expectations)
Wealth
tax policy (current stimulus packages)
monetary policy
don't panic!
importance of housing and stock markets
give me money! (actually, let me keep my money)
make consumption cheaper
Investment
Expectations
monetary policy
improve future expected rate of return (stability, tech)
reduce the cost of capital
Government
fiscal policy
spend, spend, spend, who cares about tomorrow
Exports
exchange rate
foreign economic conditions
(recessions are contagious)
do we really need a strong currency?
can they afford our goods?
Canada and the US
Imports
exchange rate
trade policy
Why do we have a jobless recovery
today?
Need for non-residential investment in job
creation
U.S. Department of Commerce. Bureau of Economic Analysis - GDP growth
How can you explain what is going on with the
investment function?
How would you incorporate the minimum
wage increase into the model at this point?
Supply Side
Profit Function of a small perfectly competitive firm (self-employed) versus
a large firm with labor contracts.
Profit = Price x Output Wage x Labor
What is the real wage?
How does it change?
P=10
3
1
2
P=2
4 hr = 8 output
8 hr = 16 output
Short - Run
Long - Run
Nominal Wages slowly; move changes in
Nominal Wages fully match output price
output prices cause changes in real wages
adjustments
> Output price changes cause changes in
>Output price changes keep real wages
real wages
constant
>>Reductions in demand make workers
more expensive, and therefore not profitable
to keep
Wage rigidity may be due to labor contracts
(my wage is independent of your enrollment!)
>Input Prices are sticky
>>changes in output prices matter
> Input Prices are fully flexible
>> changes in output prices are
irrelevant
Inflation does not matter in the long run (do we take into consideration the inflation
rates of the 70s and 80s in our decisions today?)
In the long term, recessionary pressure translates into deflation
In the short term CPI inflation/deflation causes real output changes
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Sticky Input Prices
Fixed Output Level
capacity based
cyclical unemployment = zero
Short-Run Equilibrium
Long-Run Equilibrium
we are always in S-R equil.
Expansion path
corresponds to actual business cycle
Shifting Factors
input costs
economic development
availability of resources
competitiveness in resource markets
currency (if imported resources)
Productivity of inputs
Business Taxes/Subsidies
Every long-run equilibrium is a short-run equilibrium
Supply Driven Recession
The Oil Crisis of the 1970s
Supply side threat with the rising oil prices in
2008
Supply driven recessions are induced by rising
input costs or reduced productivity
Consequences:
Stagflation
Correction
Time cures all
Will redistribute wealth: shares of output value will shift
between the input suppliers
Rising price of fuel and Deltas labor negotiations in 2007.
Government Stabilization Policy
Demand Driven Recession
Recession of 2001: pull back in investment spending
Recession of 2007-2010: pull back in investment/consumption
spending
The recessions of 2001 and 2007-2010 underscore the importance
of asset bubbles
The wealth effect of a bubble burst
2008
Exchange
Americas
NASDAQ OMX
NYSE Euronext (US)
Total
May
3,483,629.7
15,071,483.3
56,911,591.1
June
3,174,512.3
14,413,303.1
52,519,954.9
July
3,230,774.5
13,418,169.4
50,338,918.6
August
3,300,155.9
13,567,084.6
48,634,575.2
September
2,903,915.5
13,045,902.7
42,559,050.2
October
2,453,577.8
10,312,695.0
33,528,240.4
November
2,180,838.4
9,169,946.8
31,131,277.9
December
2,248,976.5
9,208,934.1
32,400,134.7
WFE - YTD Monthly
Recessions can be contagious: Canada tends to follow the US business cycle
2000 2009: Correlation between the US and Canadian GDP is 0.55
Consequences: Deflation
Real GDP growth rate in 2000
World Bank Development Indicators 2003
Less than 0.6
-0.6 < . < 0.8
0.8 < / <2.1
2.1 < . < 4.2
Over 4.2
No data available
Real GDP growth rate in 2001
World Bank Development Indicators 2003
Less than 0.6
-0.6 < . < 0.8
0.8 < / <2.1
2.1 < . < 4.2
Over 4.2
No data available
Overheating
Short-run equilibrium above the capacity
level
Demand rise
Usually induced by a bubble
Aggregate Demand rise in 2000
Through the so called wealth effect, recent stock market gains have
tended to foster increases in aggregate demand beyond the increases in
supply. It is this imbalance that contains the potential seeds of rising
inflationary pressures that could undermine the current expansion. Our
goal is to extend the expansion by containing its imbalances and avoiding
the very recession that would complete the business cycle.
-Alan Greenspan, January 13, 2000
How will each of the following affect the AD-AS diagram?
Stock market growth
Fiscal expansionary policy
Increase in taxes
Capital investment