Supply and Demand graphs- The Basics
Price
Supply
Pe
Demand
Qe
Q
The purpose of this graph is to look at markets.
Free Market Price and Quantity
The Aggregate Market- The Basics
Long Run Aggregate Supply (LRAS)
Aggregate- all together (total)
Price Level
Aggregate Supply (AS)
Measure
of
Inflation
The purpose of this graph is to look at countries.
Total supply and demand at full employment
Pe
Aggregate Demand (AD)
Qe
G.D.P real
Qy
employment
Qy= Quantity at full employment
The law of demand is the same.
There is an inverse relationship- PL up, AD down, PL down AD up
The law of supply is the same
There is a direct relationship- PL up, AS up, PL down AS down
AD= Aggregate Demand
AD= GDP= C + I G + NX
You may find it amazing how a fairly simple
graph can be interpreted in so many different
ways.
Learning the basics of the graph will provide you
an opportunity to learn fiscal and monetary
policy in different ways.
Conflicting Views
Classical Views
F.A. Hayek
Less Government
Equilibrium of market
Neo-Classical
Austrian
Increase consumer or
Monetarist
Investments
Supply-siders
SAVINGS!!!!!
1. Prices and Wages are flexible – markets quickly and
efficiently achieve equilibrium. When applied to the
resource market full employment is maintainedunemployment is not a long term problem
2. Say’s Law- supply creates it own demand- aggregate
product of goods and service produces enough income to
exactly purchase all output
3.
Savings-investment equality-any decrease in output
because of savings is offset an increase in the demand
for investment
Keynesian Views
John M. Keynes
Keynesians
Neo-Keynesians
Demand-siders
More Government
Micro not Macro
Increase Gov’t
spending!!!!!!!!
Fiscal Policy
1. Prices and Wages are Sticky- Prices and wages respond
slowly to changes in supply and demand and this results in
shortages and surplus- especially with labor.
2. Increase Aggregate Demand to increase GDP- is
influenced by a host of economic decisions both public and
private.- savings hurt The paradox of thrift
3. “In the Long Run we are all dead”- care more about
Short run and not so much about the long run. Changes in
AD have greater short run effect on real GDP and
employment but not as much on price. What is true in the
short run isn’t always true in the long run
This creates a different market – the money market
Investment is demand
Savings is Supply
Interest rates create equilibrium- Monetarist
4. Individualism
4. The multiplier- increases in spending will increase
consumption and increase output- which will lead to more
spending
5. Steer the Market- advocated stabilization policies such
as tax, government spending, laws, and regulation in order
to defend against the sudden and unpredictable changes in
the business cycle
Keynesian’s Paradox of thrift
A Prisoner’s Dilemma for Savings
A Prisoners Dilemma between individuals in a society who want to save.
It is smart to save during the good times , but if everybody saves than Aggregate demand
drops and GDP drops now we are in a recession.
How does the government attempt to avoid this?
AS/AD/LRAS graphs- Classical vs Keynesian models
Labor Market
Wages
(AS)
We
W1
(AD) 1
Q2 Q1
Q
(AD)
Employment
Classical (Monetarist)- believe that when demand for employment decreases- wages will fall and the market will clear
(return to equilibrium). Some people will choose not to work but most will eventually lower their wages.
Keynesians- say- no when demand for employment falls- wages and prices are sticky. We simply get a new quantity at
the same wage. This creates a surplus of supply of workers which will remain until demand increases.
Quantity demanded is less than the quantity supplied.
Aggregate Supply (The classical model)
The whole purpose of these graphs is to find
the Price level, GDP, and unemployment
(AS) much like the LRAS
P.L.
AS is vertical and at the same point of full
employment
Classical economist believe that resources
prices and wages are flexible
This model says that the government
doesn’t need to get involved because the
market will fix itself.
Pe
What will happen to price as AD falls?
P1
(AD) 1
Qy
(AD)
G.D.P real
The classical model suggest that the
economy fixes itself and that prices and
resources price will fall to create a new
equilibrium.
When Aggregate demand falls what
happens to. . .
Price?
Employment?
Wage (remember wages are price)?
GDP real?
Aggregate Supply (The classical model)
If there is a decrease in AD
There will be a reduction in price
level and higher unemployment
LRAS
P.L.
SRAS
SRAS 1
Pe
P1
This will give you a new quantity
demanded back at full
employment
(AD) 1
Q1
Qy
Q2
(AD)
G.D.P real
Whether or not the market will clear will also depend on the worker’s
wage expectations.
Rational Expectations
According to classical economist
the SRAS will eventually increase
as wages decrease and the price of
resources decrease
Adapted Expectations
This will occur as long as wages
can adjust. What can keep wages
artificially elevated? Or in other
words what can keep the market
from clearing?
Unions
Min. Wage laws
Workers will revise their
expectations instantaneously
It may take workers weeks,
months, or years but eventually
they will adapt their wage
expectations.
Unemployment benefits
Aggregate Supply (The Keynesian Model)
LRAS
P.L.
Pe
(AD) 1
Y1
(AD)
Qy
full
G.D.P real
According to Keynes, it is possible for the economy to be in a recession permanently. Prices/wages won’t
change and output will remain low.
When output is below full employment, the price level doesn’t fall because wages/resource prices don’t
fall (wages are sticky)
Aggregate Supply (The Keynesian Model)
LRAS
P.L.
Pe
(AD) 5
(AD) 3 (AD) 4
(AD) 1
(AD) 2
Y1
Qy
full
G.D.P real
According to Keynes, only with the help of the help of the government can Aggregate demand increase.
Demand side economics- focus on demand
Fiscal approach- government spending and taxation
Monetarist approach is to increase investments
Any aid past Qy- is purely inflationary
Aggregate Supply – So what Model is correct?
They Both have some
valid points
LRAS
P.L.
Classical
Phase
When in the Classical Phase
The economy is operating at full employment
Pe
Any and all increase in AD will result in an
increase in price and in increase in inflation
Intermediate
Phase
Keynesian
Phase
AD
AD
AD
Qy
full
G.D.P real
When in the Keynesian Phase
When in the Intermediate Phase
Output can increase with no change in price.
No increase in price level, no inflationary
pressure, spare room to grow.
As AD approaches the curve
An increase in AD and decrease in
unemployment
Result in a gradual increase of price and
some inflationary pressure
AS/AD/LRAS graphs- how it works during Expansion
(LRAS)
P.L.
P2
Both Prices and GDP will increase.
(AS)
C
P1
Pe
If Aggregate Demand increases
(AS) 1
In the long run – an increase in price will
not lead to an increase in output.
B
Why?
A
(AD) 1
Because as prices increase so does the price
of resources including labor, wages, and
materials.
(AD)
Qe
Qy
Q1
G.D.P real
As a result the Aggregate supply will shift to
the left (decrease) and we will find
ourselves back at full employment.
AS/AD/LRAS graphs- how it works during Recession
If Aggregate Demand decreases.
(LRAS)
P.L.
(AS)
Both Price Level and output will decrease.
(AS 1)
P1
Why?
A
Pe
B
Because as prices decrease so does the
price of resources including labor, wages,
and materials.
C
P2
(AD) 1
Q1
Qe
Qy
In the long-run a decrease in price will not
lead to a decrease in output.
(AD)
G.D.P real
As a result the Aggregate supply will shift to
the right (increase) and we will find
ourselves back at full employment.
Inflationary and Recessionary Gaps- Steering the Market
Economic
Activity
Potential
GDP
Inflationary Gap
Recessionary Gap
Time (years)
The Government can steer the economy in different ways
1. Laws and Regulations- stabilizers
2. Fiscal Policy- changes in government spending or taxation to influence the economy
3. Monetary policy- changes in monetary supply to influence the economy
AS/AD/LRAS graphs- Inflationary Gap
Price
Level
Actual GDP > Potential GDP
Output is beyond full
employment
LRAS
AS
Unemployment very low
Prices very high
P1
Government wants to limit
inflation by reducing demand
P2
How do they do it?
AD 2
Qy
FE
Fiscal Policy:
Q1
AD 1
GDP real
Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE
Monetary Policy: Federal Reserve can decrease money supply or increase interest rates.
AD = C + I + G + NE
AS/AD/LRAS graphs- Recessionary Gap
Price
Level
Actual GDP < Potential GDP
Output is below full employment
LRAS
High unemployment
AS
Government wants to limit
unemployment by increasing
demand
P2
P1
How do they do it?
AD 2
AD 1
Q1
Fiscal Policy:
Qy
FE
GDP real
Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE
Monetary Policy: Federal Reserve can increase money supply or decrease interest rates.
AD = C + I + G + NE
How Much is Too Much?
Fiscal Policy (Demand side)
Keynesians and Democrats
Keynesian economics
President sets the budget, Congress develops programs- they can tax and borrow
Commerce clause – etc.
Raising Revenue- Tax or Borrow
Spending- increase of Decrease (discretionary and nondiscretionary)
Leading advocates- Monetarist
Monetary Policy (Demand side)
Milton Friedman showed that people’s annual consumption is a
function of their “permanent income,” a term he introduced as a
measure of the average income people expect over a few years.
Monetarist believe that price level depends on money supply
Friedman stated that in the long run, increased monetary growth increases prices but has little
or no effect on output. In the short run, he argued, increases in money supply growth cause
employment and output to increase, and decreases in money supply growth have the opposite
effect.
Friedman’s solution to the problems of INFLATION and short-run fluctuations in employment and
real GDP was a so-called money-supply rule. If the Federal Reserve Board were required to
increase the money supply at the same rate as real GDP increased, he argued, inflation would
disappear.
He argued that the Great Depression was caused by the Federal Reserves poor management of
money. Most monetarist do not support the idea of using money supply to fix the economy- too
much lag
To keep unemployment permanently lower, he said, would require not just a higher, but a
permanently accelerating inflation rate – increase with rate of increase of real GDP
Supply and Demand of Money
Price
Interest Rate
I2
I1
I3
AD
Q2
Q1
Q3
Q
Interest rate at supply
Decreasing the supply of money will increase the interest rate
Increasing the supply of money will decrease the interest rate
Open Market Operations:
The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of
excess reserves that banks have available to make loans and to create money. This is the primary
monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more
reserves which they use to make more loans at lower interest rates and increase the money
supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make
fewer loans at higher interest rates and decrease the money supply.
If the Fed. Easy money policy
Results:
Reserves increase
Excesses reserves
increase
Loans increase
$$ and Treasury Securities
$$ and Treasury Securities
If the Federal Reserve buys Treasury Securities from banks or market
The banks will have more in their reserves
and they will be able to lead at a lower interest rate
Money Supply
increases
Interest rates
decrease
More consumer and
investment
spending
Open Market Operations:
The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of
excess reserves that banks have available to make loans and to create money. This is the primary
monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more
reserves which they use to make more loans at lower interest rates and increase the money
supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make
fewer loans at higher interest rates and decrease the money supply.
If the Fed. Tight money policy
Results:
Reserves decrease
Excesses reserves
decrease
Loans decrease
$$ and Treasury Securities
$$ and Treasury Securities
Money Supply
decreases
If the Federal Reserve sell Treasury Securities to banks or market
Interest rates
increase
The banks will have less in their reserves
Less inflation
and they will have to lead at a higher interest rate
Discount Rate:
The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or
lower rates affect the amount of excess reserves that banks have available to make loans and
create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which
they can use to make more loans at lower interest rates, which then increases the money
supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use
to make fewer loans at higher interest rates, which then decreases the money supply. Changes
in the discount rate are most often used as a signal for monetary policy actions.
Easy money policy
3.0%
3.0%
3.0%
3.0%
3.0%
Fed Reserve lowers discount rate (interest rate it charges banks)
Banks Borrow more reserves
There is an increase in the money supply
There is a lower interest rates because banks can compete with other banks
There is an increase in spending by consumers and investors
Discount Rate:
The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or
lower rates affect the amount of excess reserves that banks have available to make loans and
create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which
they can use to make more loans at lower interest rates, which then increases the money
supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use
to make fewer loans at higher interest rates, which then decreases the money supply. Changes
in the discount rate are most often used as a signal for monetary policy actions.
Tight money policy
11.0%
11.0%
11.0%
11.0%
Fed Reserve increases discount rate (interest rate it charges banks)
Banks Borrow less reserves
There is an decrease in the money supply
There is a higher interest rate
There is an decrease in spending which will slow down inflation
11.0%
Reserve Requirements:
The Fed can further adjust the proportion of reserves that banks must keep to back outstanding
deposits (the reserve ratio). Higher and lower rates affect the deposit multiplier and the
amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve
requirements, then banks can use existing reserves to make more loans and thus increase the
money supply. If the Fed raises reserve requirements, then banks can use existing reserves to
fewer more loans and thus decrease the money supply. This tool is seldom used as a means of
controlling the money supply.
A depository institution's reserve requirements vary by the dollar amount of net transaction
accounts held at that institution. Effective December 30, 2010, institutions with net transactions
accounts:
Of less than $10.7 million have no minimum reserve requirement;
Between $10.7 million and $58.8 million must have a liquidity ratio of 3%;
Exceeding $58.8 million must have a liquidity ratio of 10%.
Monetary Policy (Demand side)
Who- the Federal Reserve
What- increasing or decreasing the amount of money in circulation
Goal- full employment, stability, and growth
Easy Money Supply- increasing money supply and decreasing interest rates
Open Market OperationsDiscount RatesReserve Requirements-
buy securities
lower discount rate
lessen requirements
Decrease interest rates
Tight Money Supply – decreasing the money supply and increasing interest rates
Open Market operationsDiscount RatesReserve Requirements-
sell securities
increase discount rates
increase requirements
Prisoner’s Dilemma between Monetary and Fiscal Policy.
Normally, high expenditures and is a dominate strategy for Congress and tight money for the
Fed. When each selects its preferred strategy will be deficit spending with tight money.
It is important that both the Fed and Congress aligned their ideas, but they are independent of
each other and have different goals. The goal’s of the Fed can vary but the goals representatives
in Congress is the same- get reelected.
If the Fed and Congress oppose follow their dominate strategies they will find themselves in a
prisoner’s dilemma- this happen a lot in the 1980’s
Payoffs (Utility) 1-10
Congress
High
Expenditures
1 being least desirable
10 being most desirable
Low
Expenditures
Tight Money
4, 4
10, 0
Easy Money
0, 10
6, 6
The Fed.
Supply-side theory in AS/AD/LRAS
LRAS 1
v
v
LRAS 2
LRAS 3
v
Supply side economics
1. Supports any action by the government that enables business to lower cost, boost efficiency, and
competitiveness.
2. This increases potential output
3. There are a number of methods
a. Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment
benefits
b. Invest in education
c. Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)
d. Lower corporate tax rates
e. Invest in infrastructure
f. reduce regulations and oversight
4. Eliminate safety nets and allow for profit and loss
How to fix the economy? According to . . .
Fiscal Policy
Increase Government
Spending
During a
Recession
Decrease Taxes
With high
unemployment
Decrease Government
Spending
During
Expansion Increase Tax
With high
inflation
Monetary Policy
Supply Side Policy
Buy Securities from banks Cut tax on Business
or dealers
Reduce Regulation
Decrease Discount Rate
Give business a chance to
Reduce Reserve
expand and hire
requirements
No capital gains tax or
All ideas intended to
marginal (progressive
lower interest rate
income tax)
Sell securities to banks
Eliminate tax cuts
Increase Discount Rate
Increase regulation and
oversight
Increase Reserve
Requirements
All ideas intended to
increase interest rates
Expand minimum wage
and unemployment
benefits
Capital gain tax
The Problem with Lag.
Knowledge lag- knowledge and recognition lag, it takes time to recognize and correctly
understand the problem.
Procedure or Action Lag- In the United States our legislative process can take long and there
can be many hold ups.
Change or impact Lag- By the time change has taken place or the impacts are felt we may have
been past the initial phase of the business cycle
Progressive Tax
Laffer Curve
http://econstories.tv/
http://www.econedlink.org/lessons/index.php?lid=593&type=educator
Practice Quiz
1. List the top 3 indicators of economic health
2. GDP= ______+______+______+_____= GDP
3. Aggregate Market
A
E
D
C
F
B
4. List and explain 2 ideas of classical economist
List and explain 2 ideas of Keynesian economist
5. Draw the AS for classical economist, Keynesian economist, current model
6. Fiscal policy and monetary policy for a recession and inflationary period