McConnell Economics, Chapter 11
Posted: Sat May 09, 2020 10:09 am
Discussion of the curriculum McConnell, Brue, Flynn Economics text, chapter 11.
Chapter 11 discusses the aggregate demand and aggregate supply models.
The first section discusses aggregate demand. Aggregate demand differs from aggregate expenditures in that it incorporates overall price level into the model (of how many goods are produced).
The aggregate demand curve slopes downward. This means that an increase in the overall price level will cause aggregate demand to drop. While this is the same as the individual demand curve the reasons are different. Instead of the downward slope caused by the income and substitution effects, the downward slope is caused by the real-balance, interest rate and foreign purchase effects.
A rise in overall prices means money is less valuable. If prices double a consumer holding $50,000 of purchasing power now has $25,000 in purchasing power, all else equal. This is the real-balance effect.
As prices increase the "demand for money" increases. This is because more actual money is needed to purchase the same goods. If the supply of money is fixed, the "price of money" increases. It is generally accepted that the "price of money" is the interest rate, so the interest rate increases. This causes a decrease in consumer borrowing and a decrease in firms borrowing for investment. Both of these cause the demand for goods (in the first case consumer and the second capital) to drop and thus aggregate demand drops as prices rise.
When domestic prices increase (and foreign prices remain the same), domestic consumers will buy more foreign goods and foreign consumers will buy fewer goods from the country with the price rise. Thus exports increase and imports decrease causing GDP to fall.
As discussed in previous chapters, aggregate demand is derived from aggregate expenditures. Aggregate demand is the relationship between GDP and aggregate price level. Expressed in graphical form, changes in aggregate price level (think CPI) move us along the aggregate demand curve, while other changes effecting aggregate demand shift the aggregate demand curve.
Changes to the components of aggregate expenditures shift the aggregate demand curve. An increase in consumer spending (caused by an increase in consumer wealth, positive changes in consumer expectations, a reduction in taxes, a decrease in past consumer debt or an increase in current consumer debt) will shift the aggregate demand curve to the right. An increase in investment spending (caused by a decrease in the real interest rate or an increase in expected returns) will shift the aggregate demand curve to the right. An increase in government spending* will cause the aggregate demand curve to shift to the right. An increase in net exports (caused by increased exports or decreased imports) will cause the aggregate demand curve to shift to the right.
*All of these changes assume "all else equal," that is, no feedback effects.
The next section focuses on aggregate supply. Aggregate supply has a positive relationship with price level, as price level increases the amount of goods supplied by producers will increase. When the economy is underemployed aggregate supply is horizontal, meaning that an increase in production will not result in an increase in the price level. Resources are significantly underused and can be put back to work without any upward pressure on price. As the economy reaches full employment the supply curve has an upsloping range. Once the labor capital ratio reaches the efficiency threshold any increase in production will necessarily be fueled by less efficient labor or capital usage. This will cause production costs to rise which in turn causes the price level to rise. As output reaches the full capacity of the economy the supply curve becomes vertical, that is, no matter what the price, more output cannot be produced.
As with demand, the supply curve captures the relationship between price level and domestic output supplied by producers. A change in price level moves us along the supply curve. An external ("exogenous") change shifts the supply curve. Some common supply curve shifters are: a change in input prices (caused by a change in resource prices or shifting market power) a change in productivity (caused by a change in technology) or a change in government legal policies (a change in taxes or regulations).
The final section is about equilibrium. Price and quantity will be set where aggregate supply meets aggregate demand. Any deviation from this would tend to pull producers and consumers back towards equilibrium. A shift in aggregate demand or aggregate supply may change equilibrium price and quantity. If the shift occurs in the horizontal part of the aggregate supply curve the equilibrium quantity but not the price will change, if the shift occurs with equilibrium in the upward sloping part of the supply curve it equilibrium price and quantity will change, if the shift occurs with the equilibrium in the vertical portion of the aggregate supply curve, price but not quantity produced will change.