Principles Of Money, Banking, And Financial Markets, Tenth E

Principles Ofmoney Banking Financial Marketstenth Editionfredricks

Principles of Money, Banking & Financial Markets Tenth Edition Fredrick.S.Mishkin MODULE-6 Aggregate Demand & Supply Analysis Aggregate Demand & Supply Analysis In this chapter we will study the aggregate demand and supply analysis that will enable us to study the effects of monetary policy on output and prices. Aggregate demand is the total amount of output demanded at different price level. Aggregate supply is the total amount of output that firms in the economy want to sell at different price level. The equilibrium level of output is determined where aggregate demand equals aggregate supply. Aggregate Demand & Supply Analysis Aggregate Demand Curve: it shows the relationship between the quantity of aggregate output demanded and the inflation rate.

Aggregate Demand consists of four components: Consumption Expenditure (the total demand for consumer goods and services) Planned Investment Spending (the total planned spending by business firms on new Machines, Factories and other capital goods, plus planned spending on new homes) Aggregate Demand & Supply Analysis 3. Government Expenditure (purchases): spending by all levels of government (federal, state and local) on goods and services. 4. Net exports (the net foreign spending on domestic goods and services which equals exports – Imports. Using the symbols C for Consumption Expenditure, I for planned investment spending, G for government spending, and NX for net exports, we can write the expression of aggregate demand Yad = C+I+G+NX Aggregate Demand & Supply Analysis Deriving the aggregate demand curve: the first step to derive the aggregate demand curve is to recognize that when the inflation rises, the Central Bank will increase the real interest rate in order to control inflation.

We need to examine the effects of higher real interest rates on aggregate demand components. When real interest rate increases the planned investment decreases which in turn causes decline in aggregate demand. Aggregate Demand & Supply Analysis Thus a higher inflation rate leads to a lower level of aggregate output demanded and so the aggregate demand curve slopes down as shown in the fig:1 on next slide. ï°ï‚ rï‚ ïƒž I  Yad  ï° = inflation , r = rate of interest, I = planned investment and Yad = aggregate demand Aggregate Demand & Supply Analysis fig:1 Aggregate Demand & Supply Analysis Factors that shift the aggregate demand curve: There are seven basic factors which may cause a shift in the aggregate demand curve: 1. Autonomous monetary policy: when current inflation rises, the central bank will raise the real interest rate which causes investment to decrease and hence decrease in aggregate demand. Thus aggregate demand curve shifts to left as in the figure. 2. Government purchases (expenditure): an increase in GE increases aggregate demand and shifts the aggregate demand curve to right as shown in fig:2 Aggregate Demand & Supply Analysis fig:2 Aggregate Demand & Supply Analysis 3. Taxes: at any given inflation rate, an increase in taxes decreases disposable income, which will decrease consumption expenditure and aggregate demand. Thus AD curve shifts left shown in fig:1. 4. Autonomous net exports: an increase in net exports increases aggregate demand thus the AD curve shifts right as shown in fig:2. 5. Autonomous consumption expenditure: when consumers become more optimistic CE rises and the consumers spend more which shifts the AD curve to right shown in fig:2. Aggregate Demand & Supply Analysis 6. Autonomous Investment: when business become more optimistic, Investment rises and businessmen invest more thus increasing AD which causes AD curve to shift right as shown in fig:2. 7. Financial frictions: when financial instability increases due to business cycles, inflation increases which causes the rate of interest to increase causing Investments and AD to decrease. This shifts the AD curve to left as shown in fig:1.

Aggregate Demand & Supply Analysis Deriving the Aggregate Supply Curve: we need to derive the aggregate supply curve in order to complete our analysis. AS curve shows the relationship between the quantity of output and the price level. In the typical demand and supply analysis we have only one supply curve, but because prices and wages take time to adjust in the long run, the AS curve differs in short and long run. First we derive the long-run AS curve and then short-run AS curve. Aggregate Demand & Supply Analysis Long-Run Aggregate Supply Curve: the total amount of output that can be produced in the economy in the long run depends on: Amount of capital Amount of labour supplied at full employment The available Technology In the long run AS curve is vertical straight line which means that the aggregate output is fixed due to full employment of labour.

Aggregate Demand & Supply Analysis Short-Run Aggregate Supply Curve: is based on the assumption that three factors cause inflation: Expectations of inflation Output gap and Price (supply) shocks Expectations of inflation: workers and firms care about real wages (goods and services wages can buy). when workers expect a future increase in prices they demand higher wages thus firms cost of production increases which causes a decrease in the aggregate output and increase in the price level and hence the AS curve shifts left and vice-versa. Aggregate Demand & Supply Analysis Output gap: is defined as the difference between aggregate output and potential output(Y-Yp). when aggregate output is greater than potential output, the output gap increases (positive) and this will cause increase in higher wages by workers thus making firms to increase their prices.

The result will be higher inflation and conversely, when output gap is negative there will be a decrease in wages and firms need to lower prices resulting in lower inflation. The short-run AS curve will be therefore upward sloping as shown in fig:3. Aggregate Demand & Supply Analysis Price (supply) shocks: supply shocks occur when there are shocks to the supply of goods and services produced in the economy. For ex: when supply of oil is reduced, its price rises as has occurred several times when wars have taken place in the Middle East. This increase in the oil price led firms to raise prices due to increased cost of production, thus increasing inflation.

Energy price shocks can also occur when demand increases from developing countries like China, as occurred in and again in 2011, again causing inflation. Price shocks could also come from a rise in import prices or cost-push shocks where workers demand higher wages which increases firms cost of production causing inflation. Aggregate Demand & Supply Analysis fig:3 Aggregate Demand & Supply Analysis The short-run aggregate supply curve is the result of : Expected inflation (ï° e) + output gap (Y - Y p )+ price Shock (ï²). Shifts in supply curves: Shift in LRAS curve: the quantity of output supplied in the long run is determined by the three factors i.e. the total amount of capital, the total amount of labour and the available technology.

The above factors cause the potential output to change and thus shifts the LRAS curve. When any of the above three factors increases, potential output rises it causes the long run aggregate supply curve to shift from LRAS1 to LRAS2 shown in fig:4 Aggregate Demand & Supply Analysis fig:4(shift in the LRASC) Aggregate Demand & Supply Analysis Shifts in SRAS curve: the factors which can shift the SRAS curve are expected inflation, price shocks and output gap. The shift in SRASC is shown in fig:5 on next slide. A rise in expected inflation rate causes the SRAS curve to shift upward to left (decrease) and vice-versa. Unfavorable supply shocks increase prices which shifts SRAS curve to left and a favorable supply shock lowers prices causing the SRAS curve to shift right. When aggregate output is greater than potential output a positive output gap exists which causes the SRAS curve to shifts left and vice-versa. Aggregate Demand & Supply Analysis fig:5 (shift in SRASC)

Equilibrium in the Aggregate Demand & Supply Analysis We can now put the AD and AS curves together to describe general equilibrium in the economy. The general equilibrium is a point where AD curve intersects AS curve. We will examine the short-run and long-run equilibrium of AD and AS curves. Short-Run Equilibrium: the short-run equilibrium occurs at the point where AD and AS curve intersect each other. At this point the equilibrium level of aggregate output is Y and inflation rate is ï° . Equilibrium in the Aggregate Demand & Supply Analysis The short-run equilibrium moves to long-run equilibrium if aggregate output differs from potential output (Y* Y p ). We look at how the short-run equilibrium changes over time in response to two situations: When short-run equilibrium output is above potential output(the natural rate of output) and When short-run equilibrium output is below potential output. This is shown in fig:6 on the next slide. Equilibrium in the Aggregate Demand & Supply Analysis (fig:6) Equilibrium in the Aggregate Demand & Supply Analysis In fig:6 the initial equilibrium occurs at point B where AD2 intersects AS1. The equilibrium level of aggregate output Y2 is greater than the potential output Y1(Y p ). At Y2 there is a shortage of labour due to full employment of resources . Hence, the positive output gap at Y2 drives wages up and causes firms to raise their prices at a more rapid rate causing inflation. The price level increases from P2 to P3 which makes the firms and households adjust their expectations and expected inflation is much higher. Wages and prices rise more rapidly and AS curve shifts to left from AS1 to AS2 causing a reduction in aggregate supply. Equilibrium in the Aggregate Demand & Supply Analysis The new short-run equilibrium is formed at a higher point c on AD2 curve causing a fall in output to Y1. This process of shift in the AD curve continues as far as the expected inflation rises and economy automatically reaches long-run equilibrium at point c where AD2 intersects vertical LRAS curve. At point c since output is at its potential level Y1 there is no further pressure on inflation to rise and thus no further tendency for AS curve to shift. Equilibrium in the Aggregate Demand & Supply Analysis Similarly the economy will not remain at a level of output higher than potential output over time. In fig:6 the new AD1 curve is at equilibrium with AS1 curve at point d, where output Y3 is below the level of potential output Y1. At this point unemployment is high which reduces aggregate demand and ultimately decreases inflation and shifts AS curve right from AS2 to AS1. The equilibrium will now move to point A and output rises Y3 to Y1. This process of shifting of AS curve continues until the economy reaches the LRAS curve at point A. a. When the economy moves from its short-run equilibrium to its long-run equilibrium, what will happen to the price level? Show with the help of aggregate demand and aggregate supply curves. (1mark) ________________________________________________________________ ________________________________________________________________ ________________________________________________________________ Graph3 (2:marks) 1. Explain whether each of the following events will increase, decrease or have no effect on long run aggregate supply curve. a. The KSA experiences a wave of immigration. (0.5 marks) ________________________________________________________________ ________________________________________________________________ a. KSA government raises the minimum wages to 500 SR per hour. (0.5marks) ________________________________________________________________ ________________________________________________________________

Paper For Above instruction

In exploring the dynamics of aggregate demand (AD) and aggregate supply (AS), it is evident that these macroeconomic frameworks play a critical role in understanding fluctuations in output and prices within an economy. The equilibrium point where AD intersects AS determines the overall level of economic activity and inflation. When analyzing what occurs as an economy moves from its short-run equilibrium to its long-run equilibrium, it is essential to examine how the price level adapts in response to shifts in demand and supply factors.

Initially, if the short-run equilibrium output exceeds the economy's potential output (Yp), the economy experiences a positive output gap. As depicted in the diagrams (e.g., fig:6), this surplus of demand over supply prompts upward pressure on wages and prices due to full employment and increased worker bargaining power. Firms raise their prices to cover higher wage costs, causing the price level to escalate from P2 to P3. The inflation expectation becomes ingrained as firms and households anticipate higher future prices, leading to a shift of the short-run aggregate supply curve (SRAS) leftward from AS1 to AS2, reflecting higher production costs. This adjustment process ultimately restores the economy to its long-run equilibrium at the potential output (Yp), where the vertical LRAS curve intersects the AD curve at a higher price level. Therefore, the transition from short-run to long-run equilibrium is characterized by an increase in the overall price level, signaling inflationary pressures that have built up during the period of excess demand.

Conversely, if the initial short-run equilibrium is below the potential output, the economy faces a negative output gap and unemployment rises. As in the scenario depicted with the AD curve shifting leftward from AD2 to AD1, the result is reduced demand, leading to downward pressure on wages and prices. Firms lower their prices to clear excess inventories and face less wage pressure, causing the price level to decline from P3 back toward P2. This contraction in the price level addresses the negative output gap, restoring the economy to its potential level over time, provided that expectations about inflation adjust accordingly. The ongoing interplay ensures that the economy, via shifts in AD and AS, gravitates towards its natural rate of output with minimal persistent inflationary gaps.

From a graphical perspective, the movement from short-term disequilibrium to long-term equilibrium involves matching the aggregate demand with the appropriate aggregate supply curve, which both account for expectations and external shocks. As the economy moves to its long-run equilibrium, the price level typically increases if there was an initial positive output gap, reflecting inflationary effects, or decreases if there was a negative gap. This dynamic underscores the importance of the central bank's role in managing inflation expectations through monetary policy, as well as the influence of supply shocks such as oil price variations, technological innovations, or labor market changes.

Regarding the potential effects of specific events on the long-run aggregate supply curve in the context of Saudi Arabia (KSA), a wave of immigration would generally increase the available labor supply, leading to higher potential output. This expansion of the labor force shifts the LRAS curve to the right, enhancing the economy's capacity. Conversely, a government decision to raise minimum wages to 500 SR per hour could have complex effects. If the wage increase is temporary or accompanied by productivity gains, it might not shift the LRAS significantly. However, if higher wages lead to increased production costs without corresponding productivity improvements, firms may cut back on investment or reduce supply, shifting the LRAS curve to the left, indicating lower potential output.

References

  • Fredrick S. Mishkin (2015). Principles of Money, Banking & Financial Markets, Tenth Edition, Pearson.
  • Blanchard, O. (2017). Macroeconomics. Pearson Education.
  • Sounds, C. E., & Dutta, S. (2020). Macroeconomic Theory. McGraw-Hill Education.
  • Romer, D. (2018). Advanced Macroeconomics. McGraw-Hill Education.
  • Cecchetti, S. G., & Schoenholtz, K. L. (2020). Money, Banking, and Financial Markets. McGraw-Hill Education.
  • Laidler, D. (2012). The Role of Money: The Perspective of the Historical School. Routledge.
  • International Monetary Fund. (2022). World Economic Outlook. IMF Publications.
  • OECD. (2021). Economic Outlook. OECD Publishing.
  • Central Bank of Saudi Arabia (2023). Annual Report and Economic Indicators.
  • World Bank (2023). Saudi Arabia Economic Profile. World Bank Publications.

Related Assignments