Economic Analysis for Business

1. Economic Analysis for Business Chapter 13 Aggregate Demand and Aggregate Supply

2. Central point • an economy has only so much capacity • if you try to push an economy beyond its productive capabilities, it will “overheat” creating an inflationary environment • if there is not enough demand, then the economy will slow and unemployment will rise • worried about inflationary effects of too much demand and worried about the employment effects of too little RMIT University

3. Historical interlude • The 45-degree line model, known as the “Keynesian cross diagram” was the core of macroeconomic teaching from the 1940s through to the early 1970s • It was all aggregate demand and nothing else • But as there were no major recessions, although a few minor downturns, the model continued to be taught in this way because events in the real world had not yet shown it to be dangerously incomplete RMIT University

4. Stagflation of the 1970s • it was in the 1970s that the first major post-World War II economic downturn occurred • the causes were very far from having occurred on the demand side • it demonstrated that a demand-side understanding of economic events provided no insight into many of the most important problems an economy might face • Vietnam War • push for much greater spending on social welfare RMIT University

5. Oil Shock and Wage Explosion • economies began to wilt. What was worse there was continuing upwards pressure on the price level • and then came: • the oil shock • a worldwide wage explosion • became immediately evident that the Keynesian-cross model could not explain what was taking place RMIT University

6. Aggregate Demand and Aggregate Supply • Keynesian-cross was therefore replaced • replaced with aggregate demand and aggregate supply curves • AD-AS brought to attention: • the supply side of the economy affected the level of activity • the forces causing inflation RMIT University

7. Understanding AD and AS • along the curve there are no changes in the underlying conditions of aggregate demand or supply, and most importantly, in the level of wages • schedules of different possible combinations of prices and output over a period of time, say a month or a quarter • nothing much changes in a month or in most quarters RMIT University

8. Shape of the AD-AS Curves • wages are fixed but along both the AD and AS curves the price level is rising • the result is: • higher prices have a negative effect on demand – the higher the price level the less will be demanded • higher prices will have a positive effect on supply – higher prices and more supplied RMIT University

9. Price Level AD Y Aggregate Demand • Wages (and incomes generally) held constant so lower prices means more is purchased RMIT University

10. Aggregate Supply • the higher the price level, that is the more that can be received for each unit of output, the more that businesses will be willing to produce • since costs are assumed not to change during the period, if price are higher more will be produced RMIT University

11. Price Level SRAS Y Short Run Aggregate Supply(SRAS) • Labour costs held constant so as prices rise more is produced RMIT University

12. Price Level SRAS Pe AD Y Ye Equilibrium where AD = AS AD=SRAS RMIT University

13. Factors that cause AD to shift • behind the AD curve are the usual elements of aggregate demand, C, I, G and NX • whatever pushes them up, will push the AD curve to the right • if these underlying factors fall, then AD moves to the left RMIT University

14. Factors that cause AS to shift • the position of the AS curve is dependent on production costs • anything that reduces unit production costs will move the curve to the right, eg technological improvements • anything that raises unit production costs, will move the curve to the left, eg higher wages RMIT University

15. Types of Unemployment and the Natural Rate • To understand modern macroeconomic policy, it is first necessary to understand the modern classification of unemployment • broadly speaking, three types of unemployment: • frictional • structural • cyclical • each type has the same immediate consequence but are very different for policy purposes RMIT University

16. Frictional Unemployment • frictional unemployment is the naturally occurring unemployment that cannot be escaped in even the best managed economies • it is the unemployment that exists because economies are dynamic, so that some businesses are shutting down while others are opening up • part of the adjustment process • this kind of unemployment is actually healthy for an economy RMIT University

17. Structural Unemployment • structural unemployment comes about because not only do people lose their jobs, but the very skills they have are no longer sought by the labour market • those who are structurally unemployed are willing to work but no jobs are available that match the kinds of things they can do RMIT University

18. Cyclical Unemployment • cyclical unemployment is the kind of unemployment associated with downturns in the economy • most notable characteristic of an economy in recession is the large and often rapid rise in unemployment • when the economy has returned to full employment level, all cyclical forms of unemployment will have disappeared RMIT University

19. Defining full employment • how full employment is defined • there will always be frictional and structural unemployment in even the best of economies • cyclical occurs only when the economy is performing below its potential RMIT University

20. The central policy dilemma • inflation creates massive problems on its own, and must also be avoided • dilemma is that many of the actions that lower unemployment also tend to raise inflation and vice versa RMIT University

21. Inflation defined • inflation is a continuous ongoing reduction in the value of money • when inflation occurs, the purchasing power of a unit of currency continues to fall • as time passes, each unit of currency buys less than it did in the time period before • creates many problems RMIT University

22. Forms of inflation • inflation comes in many forms: • creeping 2-3% growth in prices that most economies now tolerate as an acceptable price to pay for economic growth • to the many thousands of percent annual growth rates that are found during hyperinflations that have catastrophic effects RMIT University

23. Problems with inflation • Money no longer secure as store of value • Savings are eroded and can be entirely lost • Forward planning within business becomes more difficult • Businesses become more tentative in terms of investment • Investments become less productive as the aim becomes to protect wealth from inflation RMIT University

24. More problems with inflation • Wage increases accelerate and industrial disputation is certain to increase • Lenders are robbed while borrowers receive an unearned return • Debtors receive a windfall return • Interest rates rise to quite high levels • Additional unemployment is created RMIT University

25. Potential GDP and the Natural Rate of Unemployment • the level of economic growth when economic activity is at its equilibrium level is described as potential GDP • the unemployment rate when GDP growth is at its potential growth rate is described as the natural rate of unemployment – there is only frictional and structural unemployment • the natural rate of unemployment is different in every economy and is determined by those responsible for economic management RMIT University

26. Natural Rate of Unemployment and Long Run Aggregate Supply (LRAS) • the natural rate has a very important additional characteristic • if the actual unemployment rate falls below the natural rate, the assumption is that inflation will begin to rise • the rise in inflation will itself set off a series of responses RMIT University

27. Responding to higher inflation • various groups attempt to defend standard of living by pushing for higher incomes because of the higher prices they face • the higher incomes will push the SRAS curve to the left • the economy cannot for very long break past the barrier imposed by the natural rate of unemployment • it is the upwards limit imposed by technology, existing capital and labour force skills RMIT University

28. Price Level LRAS SRAS3 SRAS2 P3 SRAS1 P2 P1 AD3 AD2 AD 1 Y Yn Long Run Aggregate Supply (LRAS) Natural rate of unemployment at Yn RMIT University

29. Tracing out Long Run Aggregate Supply • The sequence is: • Aggregate demand goes up - AD curve moves right • Sets off inflationary pressures, in particular increases in wages, which push the SRAS curve to the left • The continuous shifting of SRAS in response to upwards movements of AD traces out a series of points which becomes the Long Run Aggregate Supply curve (LRAS) RMIT University

30. Phillips Curve • according to the Phillips Curve relationship, the lower the level of unemployment, the higher would the level of inflation become • the higher the level of unemployment, the lower the rate of inflation • Phillips Curve analysis remains at the heart of the inflationary control policies of central banks RMIT University

31. Inflation ∆P1 ∆Pn Unemployment U1 Un Phillips Curve Diagram Un is natural rate of unemployment RMIT University

32. Source of anti-inflation policy • there is a choice, a trade off, between higher inflation but lower unemployment on the one hand, and lower inflation but higher unemployment on the other • the theory suggests that: • lower unemployment creates pressure for wage increases and price movements in general • higher unemployment reduces the pressure on wages and prices • anti-inflationary policy has been designed to limit the growth in prices through adjustments to the rate of unemployment RMIT University

33. Optimum inflation rate • in every economy those in charge of economic management calculate the natural rate of unemployment in their own economy • this is the rate of unemployment at which the “optimum” rate of inflation will occur • what is this “optimum”? – it is the rate of inflation those in charge are prepared to live with over the longer term RMIT University

34. Shifts in the Phillips Curve • the natural rate of unemployment will rise and fall over time depending on various factors that affect how prone an economy is to inflation • the unemployment rate associated with the optimal rate of inflation will change • with the Phillips Curve having shifted to the left, it is now possible to achieve the same desired inflation rate, but with a lower rate of unemployment • such changes take time RMIT University

35. Inflation ∆P1 ∆Pn Unemployment U1 Un2 Un Shift in the Phillips Curve Economy is less inflation prone RMIT University

36. Economic Utopia • productivity rises as technology advances, capital is increased and labour force skills improve • the LRAS curve will move to the right and higher output occurs but with no additional inflationary pressures • at the same time wages and other incomes rise so the AD curve moves from AD1 to AD2 • in an ideal world the SRAS2, AD2 and LRAS2 all meet at the same point RMIT University

37. Price Level LRAS1 LRAS2 SRAS1 SRAS2 P1 AD2 AD1 Y Y1 Y2 Long Run Non Inflationary Growth No inflation and higher output RMIT University