Microfoundations of Macroeconomic Policy
|
|
|
Microfoundations of Macroeconomic Policy
The Common Sense of Aggregate Demand and Aggregate Supply
Mark E. Schaefer,
and C. Richard Long,
A) What are the AD and AS
curves?
The aggregate demand curve AD, asserts the existence of a stable meaningful inverse comparative static relation between the average price level, AP, of final goods and services and the total or aggregate quantity demanded, AQd, of final goods and services per unit of time. The aggregate supply curve, AS, makes the symmetrical assertion that the flow of total quantity supplied, AQs, is directly (rather than inversely) related to AP.
Why is the AQd inversely related to AP? Given the money supply, M, and given the velocity, V, at which money moves from hand to hand in exchange for final output, then the equation of exchange tells us that the product of AP and AQd is a constant or that AQd is inversely related to AP. In other words, a larger demand for a quantity flow of final sales, AQd, can be transacted with the current stock of money only at lower average prices bid by the demanders, APd, when the velocity of money is stable. Of course, when AQd is relatively large and money is relatively scarce, then loans will be relatively hard to get, the interest rate will be relatively high and transactors will economize on "barren" cash by using it more intensively and moving faster, i.e., by increasing the velocity of cash, which partly migrates the initial scarcity.
Why is the AQs directly related to AP? The lower marginal productivity of labor associated with a larger aggregate quantity flow of final output supplied, AQs, can be absorbed only at a lower real wage, which implies a higher average price level offered by suppliers, APs, when the nominal wage is fixed.
B) Of what use are the AD and AS curves?
Inflation and unemployment always top the list of citizens' concerns in public opinion polls on the macro economy. The AD and AS curves are useful for analyzing the effect on equilibrium AP and AQ either of a shift in AD and the implied movement along AD. Thus, AD and AS help us to understand the two main macro economic issues of inflation, which is the percentage rate of increase of issues of inflation, which is the percentage rate of increase of AP over time, and unemployment, which is related through Okun's law to the percent by which AQ falls short of its potential.
What are the limitations of the use of the AD and AS curves? 1) We actually have only fuzzy curves at best, rather then clear-cut ones, so AP and AQ are only imprecisely "determined" as a result. 2) We are repeatedly tempted to use the curves to analyze dynamical situations when they were derived under statical assumptions. In other words, knowledge of the starting and ending positions of the system does not tell us the intervening pathway over time. 3) The dynamical path may be destabilizing, thus preventing the system from ever achieving the ending position implied by comparative statical analysis. The very existence of motion in an economic system may stir up momentum effects that were quiescent in the calm world of statical equilibrium, where the future will be like the present. My present demand depends on the future price as well as the present price. When the future price may be higher (or lower) then the present price, then a new speculative component of demand is introduced which was absent before. When the economy is launched on a pathway of change, participants who formerly knew what to expect must now guess about an uncertain future. In turn, these guesses influence behavior which influences the pathway which influences guesses and so on in a feedback process that gets so entangled as to appear chaotic to the imperfectly informed observer. In fact, the newly developing mathematical theory of "Chaos" attempts to sort out this seemingly unpatterned random complexity into its underlying deterministic simplicity.
C)
How are the AD and AS curves different from their microeconomic
counterparts DD and SS?
Total income of the economic system is taken as a fixed parameter in the microeconomic "partial equilibrium" analysis of a particular market, so individual price can be determined (which explains why micro economics used to be called the theory of price). But when we look at the whole economic system, total income is no given, but is precisely the thing whose equilibrium value we want to discover. So aggregate income (which cannot differ, for the system as a whole, from total real output, AQe explains why whole-system or "macro" economics used to be called the theory of income determination).
AD differs from DD because the macro view sees the entire circular flow which feeds back any initial change of spending to create additional re-spending of income. This multiplies the total effect over time of any initial change of spending by capturing the secondary, tertiary and later effects in the circular flow, thus magnifying the horizontal shift of AD. Increasing the money stock increases the ability of buyers to bid over one another for goods, thus driving up APd at any AQd and shifting AD upwards, i.e., vertically rather than horizontally.
Similarly, AS differs from SS in that AS includes a multiplied effect compared to SS because reinvestment of part of the flow of output multiplies the capacity to produce over time, thus magnifying the rightward shift of AS. Moreover, strong (weak) AD over time raises (lowers) the reservation wage of labor, thus raising (lowering) the bargaining floor and shifting AS upward (downward). For a given AD, this drives APe upward (downward) and AQe leftward (rightward).
Michael Kuehlwein,
There are lots of good
examples of how a combination of an increase in the number of producers and
technological innovation can shift the supply curve out, leading to
dramatically lower prices and higher sales.
When ballpoint pens were first introduced in 1945, Gimbel’s started selling
them for $12. In today's prices that
would be around $80. Macy's soon
introduced their own version for $19.95.
Competition and probably advances in production lowered prices steadily
until by 1948 you could buy one for 38 cents.
Sales boomed. In 1973 hand-held calculators that could merely do the
dour basic arithmetic operations cost over $100. By the late 1980s, solar-powered calculators
that could do more could be purchased for less than $5 and were
commonplace. In 1979 the average cost of
a VCR was $1300. By 1990, you could buy
a much more sophisticated model for less than $300 and over half the households
in the
Illustration of an Aggregate Supply Curve of Labor
Peter Hess,
I begin the series of lectures on factor markets with a classroom illustration of a supply curve of labor. Suppose the college is offering part‑time employment to students during the next term. For each wage called out, the students are asked to indicate how many hours of labor (0, 5, 10, or 20 ) they would be willing to supply each week. The table for the entire class is then filled in to derive the class supply of labor.
Number of Students Supplying Labor
wage
per hour 5 hours 10 hours 20 hours Total
$2 ___ ___ ___ ___
$4 ___ ___ ___ ___
$6 ___ ___ ___ ___
$8 ___ ___ ___ ___
$10 ___ ___ ___ ___
The class or aggregate supply curve could then be plotted. The expectation would be an upward sloping curve indicating the rising opportunity cost of leisure although for higher wages you may find a backward bending curve if the income effect outweighs the substitution effect. At this point the instructor can return to indifference curve analysis and the labor/leisure trade‑off's or discuss the following:
1. the elasticity of supply, reservation wages, transfer earnings, and economic rent.
2. shifts in the supply curve due first to the type of employment, e.g., fringe benefits and non‑monetary considerations which affect the quantity of labor supplied at any wage and, second, to incentives, e.g., the effect of an increase in the tax rate on labor income, or an increase in student aid, or an increase in the expected inflation rate, or the willingness to work at any nominal wage rate. This could easily lead into a discussion of supply‑side economics.
I find that not only does this simple derivation of an aggregate supply curve of labor interest the students by bringing home a number of important concepts, but it leads nicely to the demand curve for labor and equilibrium in the labor market, including the effects of labor unions and minimum wage laws, and sets the stage for later analysis with the aggregate supply curve for national output.
Supply‑Side vs. Demand Side Exercises
Ralph T. Byrns
We have integrated much of modern discussions of fiscal policies from a supply‑side perspective. Discuss with students whether the following monetary and fiscal policies will stimulate or detract from Aggregate Demand or Aggregate Supply, if they do anything.
Policy Aggregate Aggregate
Demand Supply
a. Raise tax rates
b. Raise government spending
c. Raise transfer payments
d. Make income taxes more progressive
e. Lower corporate income taxes
f. Extend unemployment compensation
g. Increase investment tax credits
h. Accelerate depreciation allowances
i. Allow investment as a deduction
from income taxation
j. Allow saving as a deduction
from income taxation
k. Eliminate mortgage interest
payments as a deduction from
income taxation.
l. Raise the discount rate
m. The FED sells Treasury bonds
n. Raise the reserve requirement ratio
o. Threaten to audit banks that borrow
too much or too often from the FED
p. Raise margins required to buy stock
Diane Cunningham,
To explain the idea of cost‑push inflation I introduce the new field of laser‑frisbee technology, which consists of three firms employing a total labor force of 10 engineers. Each of the engineers works up to her fullest capacity, contributing $50,000 worth of labor services to industry output, for which she receives $50,000 income. It is physically impossible for any of the engineers to be more productive, and it will be at least two years before any new firms or engineers will be available to expand the industry.
Once the engineers become aware of their position as a resource oligopoly they demand more pay by threatening to move to one of the other firms. This is an effective ploy, since other firms might well be willing to offer more money in an attempt to capture a dominant position in the market by acquiring control of most of the available engineering resources. At the end of the ensuing bidding/negotiation process, the average pay of engineers in the industry is $62,000. The competitive value of industry output is still $500,000 ($50,000 worth of engineers' services x 10 engineers) but costs have risen to $620,000 ($62,000 per engineer x 10 engineers). This cost increase will be reflected in a higher product price overall for the same amount of product.
Super Bowl Tickets and Why the LM Curve Slopes Upward
William C. Lee, St. Mary's
One of the more difficult concepts for Macroeconomics students to grasp is why the LM curve slopes upwards. Because the demand for money is inversely related to the interest rate, they somehow feel that LM must slope downward as well. I find it helpful to suggest an analogy in a market with which they are familiar - for example, super bowl tickets (or any market where supply is fixed).
First I draw a fixed supply curve (suggesting 80,000 tickets) intersecting a normal downward sloping demand curve for super bowl tickets (Figure 1a). I ask them to remember back to Economics 1 and tell me what factors other than price will determine how many super bowl tickets buyers will demand. Eventually someone says "income". I then label the demand curve representing an average income of $50,000, and show the equilibrium price to be $100. I then ask how Figure 1a would change if buyers' average income rose to $75,000. The students realize that at a price of $100 a shortage would occur and the now richer buyers would bid up the price of the 80,000 tickets to say, $150.
Now I suggest to them that even though we have never been concerned with anything like this before, we have all the information necessary to easily graph the relationship between different income levels and equilibrium prices holding the supply of tickets fixed. I then take the information from Figure 16-1a and plot the two points on Figure 16-1b with price on the vertical axis and income on the horizontal axis. I call the curve that connects the two points a PINC curve. This upward sloping PINC curve shows the different income levels and prices where the demand for super bowl tickets equals the 80,000 supply. When income was $50,000, equilibrium price was $100 while when income was $75,000 equilibrium price rose to $150. Because supply is fixed, as income increases, so must the equilibrium price.
I then remind them that the interest rate is the price that equilibrates money demand and money supply. Because money demand is positively related to income (transactions demand), they now see that for a given money supply a higher income must result in a higher equilibrium interest rate. I then draw the conventional money supply equal money demand relationship (Figure 16-2a) and translate the information to an LM curve (Figure 16-2b). For example, with a money supply of 1000 and an income of $5,000, the equilibrium interest rate would be 10%. If income increases to $7,500 money demand will shift outward raising the equilibrium interest rate to 15%. Students see that these curves are similar to the curves in the super bowl example.
Eventually I demonstrate that if the fixed supply of tickets increases, the PINC would shift outward. They then realize that when the money supply increases, the LM curve shifts outward in a similar way.
Figure 16-1
Figure 16-2
Loren Guffey,
I like to use IS-LM models to illustrate phases in the development of macroeconomic theory. This IS schedule is derived from the investment demand function and the LM Schedule is derived from the liquidity preference schedule. Students need a gimmick to help them remember what is being measured on the axes and what the slopes of the lines should be. At the end of a rather extensive lecture I end up with the graphical models shown below. There is a way to check to see if the student has depicted the relationship correctly. I explain that they can remember that the LM model should remind them of the wake of a boat speeding away from them. The IS model should remind them of the wake of a boat speeding across their bow from starboard to port. Those in the class who are familiar with nautical terms delight in explaining what they see to the others. They end up remembering what each model should look like and learn some nautical terms as a bonus!
Figure 16-3
Notes: