Lecture 8
Economics 112

Classical Model of Aggregate Supply and Demand

I. Aggregate Demand:

Recall that the quantity of real GDP demanded is the sum of real consumption expenditure, (C), investment (I), government purchases (G), and exports (X) minus imports (M). We write it as follows

Recall that the quantity of real GDP demanded is the total amount of final goods and services produced in the United States that people, businesses, governments, and foreigners plan to buy.

A number of factors affect the quantity of real GDP demanded:

We are interested in deriving a relationship between the price level, P, and the quantity of real GDP demanded at that price level, holding all of the other variables which affect the quantity of real GDP demanded fixed. We would like to develop a model which can make predictions about the movements of the price level and the level of real GDP.

The AD curve is more complex than a market or industry demand curve. The AD curve is not a market demand curve and is not the sum of all market demand curves in the economy.

As we will see below the AD curve is downward sloping for different reasons than the demand curve of microeconomic theory and that the fundamental assumption of ceteris paribus is not applicable to the AD curve. For the market demand curve we assume that all other prices and incomes are fixed. For movements along a market demand curve, when the price of a good rises the quantity demanded of the good falls in part because the prices of other goods do not rise as well. The good becomes more expensive relative to other goods, so agents substitute other goods for the good whose price increased. Since income is held fixed, when the price of the good rises real income falls, which may lead to a lower quantity demanded as well.

Though it is true when we consider movements along the AD curve when P changes, some factors that affect AD are assumed constant, it is also the case that some other things do change for movements along the AD. When the overall price level rises not only prices but wage rates and incomes rise together. Thus, all other things do not remain the same. For the AD curve the ordinary substitution effect for a microeconmic demand curve of a rising price reducing the quantity demanded does not apply. As we shall see, the rising aggregate price level P reduces the equilibrium aggregate output demanded by tightening the money market, raising the interest rate, and thus reducing investment and consumption.

Why is AD Downward Sloping?

(1) Real Balance Effect (Pigou Effect): as the price level increases, household wealth and asset holdings lose purchasing power. Therefore fewer units of real output are purchased. We may write aggregate demand as follows

where M denotes the total supply of money and B denotes the supply of bonds. Assume for the sake of simplicity that people can put their wealth in either money or in bonds. What happens to the real value of their assets, , as the price level rises? From inspection we see that

Thus, as the price level rises the real value of assets falls, households lose purchasing power and their consumption falls.

(2) Interest Rate Effect: as the price level rises, interest rate also tends to rise. Keynes argued that people care about the purchasing power of the money that they hold, their real money balances. When the price level rises the same nominal quantity of money is no longer as valuable. It commands fewer goods and services than it did before the increase in the price level. To restore their holdings of money in real terms to its former value, economic agents must hold a larger amount of nominal money than before. This increases the amount that people need to borrow . At a higher price level borrowing needs are greater and the demand for loans rises increasing the price of money, i.
 
 

(3) Foreign Goods Substitution Effect: as the price level in the US rises people substitute into import consumption and exports fall. Thus, .

Summary: Downward slope of the AD schedule is due to different reasons than the downward slope of the demand curve in microeconomics.

II. Aggregate Supply (classical)

potential GDP: level of GDP which can be achieved and maintained given the following factors.

Determinants of Qp

(1) Availability of labor (L) and capital (K): increasing L or K will shift the Qp to the right.

(2) Productivity of labor and capital: increasing productivity of labor or capital will shift Qp to the right.

(3) Cost of labor and capital: e.g. increasing the price of oil can reduce Qp.

(4) Institutional arrangements: the more efficient are markets the greater is Qp. Note that government policy can affect Qp. For example, government policies increasing the efficiency of the financial sector increases the potential output of the economy.

Qp closely tied to labor market: potential GDP is the quantity of real GDP supplied when unemployment is at its natural rate and there is full employment.

Natural Rate of Unemployment: employment rate at which unemployed workers are primarily voluntarily out of work. It is frictional unemployment plus structural unemployment. It is the unemployment rate at full employment.

Recall, that we earlier described the business cycle as the fluctuations of employment around full employment and the fluctuations of real GDP around potential GDP. To explain the changes in employment over time and the changes in real GDP over time as compared to changes in the full employment level and potential GDP, we shall distinguish two time frames: the short-run and the long-run.

Qp is that level of output associatedwith the natural rate of unemployment. LN is the level of employment consistent with the natural rate of employment; DN is the natural duration of unemployment.

The natural rate is influenced by the structure of the labor force and public policy.

A short history of the natural rate of unemployment:

In the early 1960s the council of economic advisors argued that the full employment rate of unemployment was below 4%. By the early 1970s the number was 5%. By the early 1980s the number was though at the time to be at least 6% if not higher. As seen from the graph in Parkin (figure 8.10) the natural rate may well have been as high as 8.5% in the early 1980s. Why is there a difference?

Why was the natural rate in the US higher over the period from 1970 to 1996 and actually rising from early 1970 to early 1980? Some answers are given below.
 
1) labor force structure changes: young workers are more willing to change jobs (baby boom means more young workers which implies a higher natural rate). Increased labor-force participation of teenagers, minorities, and women. Over the period 1950-1983 the share of adult males in the total labor force declined from 66 to 53%. Young workers nearly doubled their share of the labor force. Since adult males usually have the lowest unemployment rate of any group, the changing composition of workers raised the overall natural unemployment level. The changing composition of the labor force toward high-turnover, high-unemployment workers increased the natural rate of unemployment.

(2) public policies:


 
 

Classical Model

features of the classical model:

(1) potential GNP: the economy tends to be at this point.

(2) flexible prices and wages move the economy to Qp via wage and price adjustments.
 

Example 1: permanent decrease in AD

if the price level stayed at p0, after AD falls, AD would be less than AS

How does the change in the price level affect the labor market?

the job search model is affected in the same way and gives conclusions that are consistent with the supply and demand model of the labor market.
 
 

Problems with the Classical Model