Macroeconomic Concepts: Understanding Aggregate Demand, Supply, and Policy

Posted on Jun 6, 2024 in Economy

1. Wage-Setting Relation

This describes the relationship between the real wage (nominal wage adjusted for inflation) and the unemployment rate. It reflects the balance between worker demands for higher wages and employer willingness to pay based on economic conditions. Higher unemployment puts downward pressure on wages, while lower unemployment allows workers to negotiate for higher wages.

2. Price-Setting Relation

This describes the relationship between the price level and the unemployment rate. Firms set prices based on their production costs (including wages) and desired profit margins. Higher unemployment leads to lower wages, potentially allowing firms to lower prices. However, firms may also raise prices to maintain profit margins if other factors like inflation are high.

3. Wage Determination

Wages are determined through interaction between supply and demand in the labor market. Workers (supply) offer their labor at a certain wage expectation, while firms (demand) seek to hire workers at a wage that maximizes their profit. This interaction can be influenced by unions, minimum wage laws, and overall economic conditions.

4. Natural Rate of Unemployment

This is the unemployment rate that exists in the long run when the real wage matches the price level set by firms. It reflects frictional and structural unemployment, not caused by a lack of aggregate demand.

5. Shifts in Wage-Setting & Price-Setting

These relations can shift due to changes in factors like:

  • Productivity: Increased productivity allows firms to offer higher wages without raising prices (wage-setting) or lowering prices even with higher wages (price-setting).
  • Unions: Stronger unions can push for higher wages (wage-setting).
  • Inflation Expectations: If workers expect higher inflation, they might demand higher wages to maintain purchasing power (wage-setting).
  • Markups: Firms with more power to set prices (monopolies) can maintain higher profit margins even with higher wages (price-setting).

6. AD Curve (Aggregate Demand Curve)

This shows the relationship between the price level and the total quantity of goods and services demanded in the economy. Generally, a higher price level leads to lower demand. The AD curve is influenced by factors like consumer spending, investment, government spending, and net exports.

7. Aggregate Supply Curve

This shows the relationship between the price level and the total quantity of goods and services supplied in the economy. Generally, a higher price level incentivizes firms to produce more. The aggregate supply curve can be short-run (steeper) or long-run (flatter) depending on production adjustments.

8. Shifts in the AD Curve

The AD curve can shift due to changes in:

  • Consumer Spending: Higher consumer confidence and wealth can lead to increased spending (rightward shift).
  • Investment: Increased business confidence or lower interest rates can lead to higher investment (rightward shift).
  • Government Spending: Higher government spending injects money into the economy, increasing demand (rightward shift).
  • Net Exports: A stronger currency or weaker foreign economies can decrease net exports (leftward shift).

9. Impact of Fiscal and Monetary Policy on AD

  • Increase in Government Spending & Decrease in Nominal Money: This is a combination of expansionary fiscal policy (increased spending) and contractionary monetary policy (decreased money supply). The impact on the AD curve depends on the relative strengths of these policies. A strong spending increase might outweigh the money supply decrease, shifting the AD curve right.

10. Short-Run vs. Medium-Run Equilibrium

  • Short-Run: In the short run, prices may be sticky (slow to adjust). Changes in aggregate demand can lead to changes in output in the short-run.
  • Medium-Run: In the medium-run, prices adjust more fully. Changes in aggregate demand primarily affect the price level, not output, in the medium-run.

11. Monetary Contraction/Expansion

  • Short-Run: In the short-run, contraction (higher interest rates, less money supply) can decrease output and prices. Expansion (lower interest rates, more money supply) can increase output and prices.
  • Medium-Run: In the medium-run, monetary policy primarily affects the price level, not output.

12. Fiscal Contraction/Expansion

Fiscal policy directly affects aggregate demand. Expansion (increased spending or tax cuts) increases output and prices. Contraction (decreased spending or tax increases) decreases output and prices.

13. Neutrality of Money

This concept suggests that money has no real effect on the economy in the long run, only impacting prices. In the long run, changes in the money supply only affect the price level, not output.

14. Crowding-Out Effect

This occurs when government borrowing to finance spending drives up interest rates, making borrowing less attractive for businesses. This can crowd out private investment, reducing overall economic growth.

15. IS/LM Curve

This is a graphical framework that shows the simultaneous equilibrium in the goods market (IS curve) and the money market (LM curve). The IS curve represents combinations of interest rates and output levels that achieve equilibrium in the goods market. The LM curve represents combinations of interest rates and money supply that achieve equilibrium in the money market. The intersection of these curves determines the equilibrium interest rate and output level.

16. Fiscal Policy

Fiscal policy uses government spending and taxation to influence the economy. It is most effective when the economy is in a recession (to stimulate demand) and least effective at full employment when the crowding-out effect might be strong.

17. Multiplier

The multiplier is a concept in fiscal policy that shows the magnified effect of government spending on aggregate demand. An increase in government spending leads to a more than proportional increase in output.

18. Fiscal Policy Effects

  • Full Effect: Fiscal policy has its full effect in the medium-run when prices fully adjust.
  • Ineffective: Fiscal policy can be ineffective if it crowds out private investment completely or if Ricardian equivalence applies (consumers anticipate future tax increases to finance spending, reducing their current spending).

19. Crowding-Out Effect (Further Explained)

The crowding-out effect is strongest when the government borrows heavily to finance spending, driving up interest rates significantly and discouraging private investment.

20. Fiscal Policy Measures

These include:

  • Government Spending: Increasing spending directly injects money into the economy, stimulating demand.
  • Tax Cut: Reducing taxes leaves more money in people’s pockets, potentially increasing consumption and investment.
  • Investment Subsidy: The government can directly subsidize investment to encourage businesses to invest more.
  • Accommodating Monetary Policy and Monetizing the Deficit

21. Accommodating Monetary Policy

This occurs when the central bank expands the money supply to offset potential interest rate increases caused by government borrowing.

22. Monetizing the Deficit

This is a form of accommodating monetary policy where the central bank directly purchases government bonds, essentially financing the deficit through money creation.

23. Benefit of Monetary Accommodation

It can help to lower interest rates and prevent crowding out private investment, potentially leading to a larger overall economic stimulus from fiscal expansion.

24. IS Curve Shifts

The IS curve shifts due to changes in factors like:

  • Autonomous Investment: An increase in autonomous investment (investment independent of interest rates) shifts the IS curve right, increasing equilibrium output at each interest rate level.
  • Government Spending: An increase in government spending shifts the IS curve right, similar to an increase in autonomous investment.

25. LM Curve Shifts

The LM curve shows the relationship between the interest rate and the money supply.

  • Horizontal LM Curve (h=0): This occurs when the money supply is fixed (h=0), and the LM curve becomes a horizontal line. Changes in interest rates do not affect the money supply in this case.
  • Vertical LM Curve (h=∞): This occurs when liquidity preference is infinitely high (h=∞), and the LM curve becomes a vertical line. Changes in the money supply have no effect on the interest rate in this case.

26. LM Curve Determination

The position of the LM curve is determined by the money supply and the level of liquidity preference (demand for money to hold).

27. Deriving the AD Curve from IS/LM

We can derive the AD curve by tracing the equilibrium points at different price levels in the IS/LM framework. A higher price level generally corresponds to a lower equilibrium output level, forming the downward-sloping AD curve.

28. Impact of Government Spending on AD

An increase in government spending shifts the IS curve right, leading to a higher equilibrium output level at each price level. This translates to a rightward shift of the AD curve.

29. Impact of Money Supply on AD

An increase in money supply shifts the LM curve down, leading to a lower equilibrium interest rate at each price level. This encourages borrowing and spending, shifting the AD curve right.

30. Monetary Policy

Monetary policy is most effective when the economy is facing a recession (to stimulate borrowing and spending) and least effective at full employment when inflation might be a bigger concern.