Remember the three macroeconomic goals -- price stability, low unemployment, and high & sustained
economic growth?
Is there a tool that we can use to allow us to understand how price level (P), unemployment
(U), and real GDP, or quantity of goods and services (Q) are determined?
Well, we already have a tool, sort of: we’ll just need to adapt it.
It's the market tool: the supply and demand diagram.
Think about the supply and demand in a particular market determine the price and quantity in
that market.
The issue is that the supply and demand in a particular market help you find the price
of one product, not the price level of all products, and the quantity of one product,
not the quantity of all goods and services (also known as GDP).
The single market supply and demand diagram is actually pretty simple to modify into a
macroeconomic model.
Instead of looking at the demand for one product or service, we look at the aggregate demand
for all products and services; and rather than the supply of a single commodity or service,
let's use the aggregate supply of all commodities and services.
Then the equilibrium will represent the macroeconomic equilibrium; rather than the equilibrium price
of a single product or service, it yields the equilibrium price level of the prices
for all goods and services.
And instead of the equilibrium quantity of a single commodity, the equilibrium quantity
of all goods and services, i.e., the real GDP, is yielded.
So let's take a closer look at our modified market model, starting with the aggregate
demand.
Whereas demand for single product is a collection of all the quantities demanded for that product
at various prices, and exhibiting an inverse relationship, the aggregate demand for all
goods and services is an inverse relationship between price level in the economy and the
quantity of all goods and services demanded, or a collection of all the aggregate quantities
demanded for all goods and services at various price levels in the economy.
Why is there an inverse relationship?
That is, why are fewer goods and services demanded when price levels are higher?
Well, for a number of reasons really; if the overall price level for all goods and services
is increasing, other things remaining equal, the existing income cannot buy as much as
it used to.
Another reason is that as the domestic price level rises, foreign goods start to look much
more attractive; households, businesses, and the foreign sector shy away from buying our
more expensive goods.
Also, higher prices tend to drive interest rates up (more on that later, when we discuss
credit markets), but that also depresses the amount of goods and services that the four
sectors can buy, or want to buy.
Just like demand for single product, a change in the price level will not shift aggregate
demand, but only cause a movement along it.
Is there anything that can shift aggregate demand?
Sure -- at a given price level, anything that changes total expenditures will change the
overall aggregate demand.
Do you remember who makes expenditures on goods and services?
The household sector, the business sector, the government sector, and the foreign sector.
This means that anything other than the price level that affects household consumption (C),
business investment (I), government spending (G), or net exports (X) will shift aggregate
demand.
For example, in the 1990s, the US stock market really boomed, and many households found themselves,
as the market climbed, with increased wealth.
This led to increased spending, or a rightward shift of aggregate demand.
TIME TO THINK: for discussion in our next class, what kinds of things, other than prices,
could cause a change in 1) consumption, 2) investment, 3) government spending, or 4)
net exports?
Now what about aggregate supply?
The aggregate supply is the direct relationship between price level in the economy and the
aggregate quantity of goods and services supplied.
The aggregate supply curve, then, is just the collection of all price level/aggregate
quantity supplied combinations.
Why is aggregate supply upward-sloping?
Well, for pretty much the same reasons that a single product supply curve is upward sloping
– cost and profit.
As the price level rises in an economy, other things staying the same, more producers -- even
inefficient, high-cost producers -- can produce and survive.
At a lower price levels, only the lowest-cost producers can continue.
On the profit side, at higher price levels, other things staying the same, profits are
higher, giving greater incentive to produce.
TIME TO THINK: for our next class, what can shift aggregate supply?
Again, changes in price level will only cause movement along aggregate supply; what types
of changes could occur that would have a broad effect on all types of production throughout
the economy?
Where aggregate demand and aggregate supply meet, we find our macroeconomic equilibrium.
The price level, the quantity of goods and services, or GDP, and even an implied unemployment
level (more GDP means more jobs and lower unemployment, lower GDP means fewer jobs and
higher unemployment).
How will changes in aggregate demand and aggregate supply affect prices, GDP, and unemployment?
NEXT TIME: Does the economy self-adjust?
TRANSCRIPT0 (MACRO) EPISODE 24: AGGREGATE DEMAND & AGGREGATE SUPPLY