Economics - Macroeconomics - DEMAND AND SUPPLY ANALYSIS

	TOTAL DEMAND AND SUPPLY ANALYSIS
	The Keynesian IS-LM model developed earlier is a model of only demand behavior. It tells us how the equilibrium between planned aggregate demand and output is achieved. It describes demand behavior but says absolutely nothing about supply behavior. Total supply and demand analysis breaks that implicit assumption and introduces the possibility of supply constraints or economic issues that can affect supply behavior. The total demand curve shows how the Keynesian equilibrium changes for different values of the price level. The total demand curve shows how changes in the price level affect the IS-LM or demand side equilibrium. Total Demand Curve The price level determines the real value, or purchasing power, of the nominal money supply, thus positioning the LM curve and determining the aggregate demand equilibrium. The total demand curve is a locus of Keynesian aggregate demand equilibrium for different price levels. If the price level changes while everything else (including the nominal money supply, M) remains the same, then the resulting change in the real money supply ( ) causes the IS-LM equilibrium to change Total Supply Curve It describes the amount of output that producers are willing and able to supply to the goods market. Keynesian Supply Curve: The total supply curve implicit in the Keynesian IS-LM model is based on the notion that there are no supply constraints and that prices are pre-determined in the short-run (one year or less). Thus, whatever output level is demanded will be produced and the total supply curve is a horizontal line.There is sufficient excess capacity so that an increase in demand leads to more production without increasing production costs and prices. Long-run or Classical Supply Curve: At the opposite extreme to the Keynesian short-run horizontal supply curve lies the supply curve implicit in the long-run equilibrium or classical view of the Macroeconomic world. The classical view implies a vertical supply curve, The classical vertical total supply curve and the Keynesian horizontal total supply curve represent two theoretical extremes, neither of which is a satisfactory representation of behavior in the real world. The traditional Keynesian approach leaves us without a theory of price determination. The classical approach introduces a theory of price determination, but at the cost of eliminating an explanation of fluctuations in real output. By assuming that competitive markets at all times generate equilibrium levels of output, the model cavalierly does away with fluctuations in output. Some More Reasons Why Prices are Sticky: Labor Contracts: Implicit labor contracts are a term that refers to the type of agreements that are often made between employers and employees. Career Labor Markets: The idea here is that employers adopt policies that promote the long-run attachment of workers to the firm. This is important to employers because finding able workers and providing training can be expensive. In addition, employees find it in their interest to agree to such arrangements. A Demand Shock: In the short run. The monetary policy expansion leads to a fall in interest rates which gets the multiplier process under way and output increases. Over time, the multiplier process that leads to an increase in output also leads to increases in prices. Quantity adjustments become less common and price adjustments become more common. Nevertheless, additional output is forthcoming, and after a period of several years, there are both output and price increases. Expansionary monetary policy: A major theoretical point of our discussion is the tendency to return to a long-run equilibrium—the normal, natural, or long-run equilibrium level of output termed Y*. It is an output level associated with balance in the macroeconomics; in particular, there is an absence of inflationary or deflationary pressures at this output level. It is very important to add that this output need not be one where all resources are fully employed. The long-run equilibrium is “natural” because the economy tends to move toward it. The term does not convey a value judgment that this equilibrium is desirable or good. There may be more unemployment at Y* than a democratic society would like to endure. INFLATION Since the inflation rate is probably the most closely followed macroeconomic phenomenon, it will be helpful to have a theoretical framework that concentrates on the determination of the inflation rate directly. Our inflation equation will also help us understand one of the most unusual characteristics of inflation—its persistence. That is, we will discuss the momentum to inflation. Price Adjustment Function: where π = is the inflation rate. An important implication of this specification of equation is that when Y =Y* , there are not inflationary pressures. Phillips Curve: The term Phillips curve refers to the empirical relationship between wage or price inflation and the unemployment rate. Since Phillips’ early econometric studies in the 1950s, the relationship has been extended and developed into an important analytic tool for understanding the inflation process. An expansionary policy could reduce the unemployment rate at the cost of only a small increase in the inflation rate. Expectations of Inflation The influence of market supply and demand on the inflation rate that emerges will depend as well on the expected inflation rate. A given degree of slack will result in a higher or lower overall inflation rate depending on how much inflation the price-setting agents expect to occur. Augmented Price Adjustment The effect of an increase in expectations of inflation on the actual rate of inflation can be seen by envisioning a particular price or wage negotiation. The parties in a particular negotiating session will be influenced by supply and demand conditions in the market and also by their expectations of aggregate inflation. The price or wage agreement that emerges from the negotiations will be higher if both parties expect more inflation to take place in the overall economy. Expectations-augmented price adjustment equation Where the expected rate of inflation and the coefficient b is measures the impact of expectations on the inflation rate. Rational Expectations Formation of expectations have indicated that expectations adjust slowly when inflation changes. This has often turned out to be an accurate description of reality, but it is not necessarily true. Starting in the early 1970s an alternative hypothesis about the formation of expectations had a very profound effect on economic thinking. The rational expectations hypothesis states that expectations are knowledgeable and informed predictions of the actual outcome. That is, expectations are formed by individuals with an understanding of the workings of the economy and with available information on all relevant phenomena. Expectations of inflation are thus based on all available information that relates to price determination and with an understanding of how prices are in fact determined. With rational expectations, the expected inflation rate can be expressed as the actual inflation rate (π) plus a random error term: New Classical Macroeconomics The natural rate Phillips curve model implies that the unemployment rate differs from the natural rate hen inflation is unanticipated. With rational expectations, unanticipated inflation is always a random or unpredictable phenomenon. Therefore, all deviations, including short-run deviations, of the unemployment rate from the natural rate are random events. Sources of Inflation The distinction among the different sources of inflation is somewhat artificial because they can all be present and are often related to one another. However , different inflationary episodes can be often be ascribed to a particular dominant causal factor. Monetary Growth Excess Demand Relative Price Shocks Wage Price Spiral Inflation Expectations