Chapter 23 Aggregate Supply and Demand, the Growth Diamond, and Financial Shocks

23.1 Aggregate Demand

We learned in Chapter 22 "IS-LM in Action" that the IS-LM model isn’t entirely agreeable to policymakers because it examines only the short term, and when pressed into service for the long-term, or changes in the price level, it suggests that policy initiatives are more likely to mess matters up than to improve them. In response, economists developed a new theory, aggregate demand and supply, that relates the price level to the total final goods and services demanded (aggregate demand [AD]) and the total supplied (aggregate supply [AS]). This new framework is attractive for several reasons: (1) it can be used to examine both the short and the long run; (2) it takes a form similar to the microeconomic price theory model of supply and demand, so it is familiar; and (3) it gives policymakers some grounds for implementing activist economic policies. To understand aggregate demand and supply theory, we need to understand how each of the curves is derived.

The aggregate demand curve can be derived three ways, through the IS-LM model as described at the end of Chapter 22 "IS-LM in Action", with help from the quantity theory of money, or directly from its components. Remember that Y = C + I + G + NX. As the price level falls, ceteris paribus, real money balances are higher. That spells a lower interest rate, as we learned in Chapter 5 "The Economics of Interest-Rate Fluctuations". A lower interest rate, in turn, means an increase in I (and hence Y). A lower interest rate also means a lower exchange rate and, as explained in Chapter 18 "Foreign Exchange", more exports and fewer imports. So NX also increases. (C might be positively affected by lower i as well.) As the price level increases, the opposite occurs. So the AD curve slopes downward.

Figure 23.1 Aggregate demand curve

The quantity theory of money also shows that the AD curve should slope downward. Remember that the quantity theory ties money to prices and output via velocity, the average number of times annually a unit of currency is spent on final goods and services, in the so-called equation of exchange:

where

M = money supply

V = velocity of money

P = price level

Y = aggregate output

If M = $100 billion and V = 3, then PY must be $300 billion. If we set P, the price level, equal to 1, Y must equal $300 billion (300/1). If P is 2, then Y is $150 billion (300/2). If it is .5, then Y is $600 billion (300/.5). Plot those points and you get a downward sloping curve, as in Figure 23.1 "Aggregate demand curve". The AD curve shifts right if the MS increases and left if it decreases. Continuing the example above, if we hold P constant at 1.0 but double M to $200 billion, then Y will double to $600 billion (200 × 3). (Recall that the theory suggests that V changes only slowly.) Cut M in half ($50 billion) and Y will fall by half, to $150 billion (50 × 3).

Figure 23.2 Factors that shift the aggregate demand curve

For a summary of the factors that shift the AD curve, review Figure 23.2 "Factors that shift the aggregate demand curve".

23.2 Aggregate Supply

The aggregate supply curve is a tad trickier because it is believed to change over time. In the long run, it is thought to be vertical at Y_nrl, the natural rate of output concept introduced in Chapter 22 "IS-LM in Action". In the long run, the economy can produce only so much given the state of technology, the natural rate of unemployment, and the amount of physical capital devoted to productive uses.

Figure 23.3 Short-run aggregate supply curve

In the short run, by contrast, the total value of goods and services supplied to the economy is a function of business profits, meant here simply as the price goods bear in the market minus all the costs of their production, including wages and raw material costs. Prices of final goods and services generally adjust faster than the cost of inputs like labor and raw materials, which are often “sticky” due to long-term contracts fixing their price. So as the price level rises, ceteris paribus, business profits are higher and hence businesses supply a higher quantity to the market. That is why the aggregate supply (AS) curve slopes upward in the short run, as in Figure 23.3 "Short-run aggregate supply curve".

The short-run AS curve shifts due to changes in costs and hence profits. When the labor market is tight, the wage bill rises, cutting into profits and shifting the AS curve to the left. Any so-called wage push from any source, like unionization, will have the same effect. If economic agents expect the price level to rise, that will also shift the AS curve left because they are going to demand higher wages or higher prices for their wares. Finally, changes in technology and raw materials supplies will shift the AS curve to the right or left, depending on the nature of the shock. Improved productivity (more output from the same input) is a positive shock that moves the AS curve to the right. A shortage due to bad weather, creation of a successful producer monopoly or cartel, and the like, is a negative shock that shifts the AS curve to the left.

Figure 23.4 Factors that shift the short-run aggregate supply curve

Also, whenever Y exceeds Y_nrl, the AS curve shifts left. That is because when Y exceeds Ynrl, the labor market gets tighter and expectations of inflation grow. Reversing that reasoning, the AS curve shifts right whenever Y_nrl exceeds Y. Figure 23.4 "Factors that shift the short-run aggregate supply curve" summarizes the discussion of the short-run AS curve.

23.3 Equilibrium Analysis

Of course, this is all just a prelude to the main event: slapping these three curves—AD, AS, and ASL—on the same graph at the same time. Let’s start, as in Figure 23.5 "Short-run equilibrium in the macroeconomy", with just the short-run AS and AD curves. Their intersection indicates both the price level P* (not to be confused with the microeconomic price theory model’s p*) and Y* (again not to be confused with q*). Equilibrium is achieved because at any P > P*, there will be a glut (excess supply), so prices (of all goods and services) will fall toward P*. At any P < P*, there will be excess demand, many bidders for each automobile, sandwich, haircut, and what not, who will bid prices up to P*. We can also now examine what happens to P* and Y* in the short run by moving the curves to and fro.

Figure 23.5 Short-run equilibrium in the macroeconomy

To study long-run changes in the economy, we need to add the vertical long-run aggregate supply curve (ASL), to the graph. As discussed above, if Y* is > or < Y_nrl, the AS curve will shift (via the labor market and/or inflation expectations) until it Y* = Y_nrl, as in Figure 23.6 "Long-run equilibrium in the macroeconomy". So attempts to increase output above its natural rate will cause inflation and recession. Attempts to keep it below its natural rate will lead to deflation and expansion.

Figure 23.6 Long-run equilibrium in the macroeconomy

The so-called self-correcting mechanism described above makes many policymakers uneasy, so the most activist among them argue that the long-run analysis holds only over very long periods. In fact, the great granddaddy, intellectually speaking, of today’s activist policymakers, John Maynard Keynes,http://en.wikipedia.org/wiki/John_Maynard_Keynes once remarked, “[The l]ong run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.”http://www.bartleby.com/66/8/32508.html Other economists (nonactivists, including monetarists like Milton Friedman) think that the short run is short indeed and the long run is right around the corner. Figuring out how short and long the short and long runs are is important because if the nonactivists are correct, policymakers are wasting their time trying to increase output by shifting AD to the right: the AS curve will soon shift left, leaving the economy with a higher price level but the same level of output. Similarly, policymakers need do nothing in response to a negative supply shock (which, as noted above, shifts AS to the left) because the AS curve will soon shift back to the right on its own, restoring both the price level and output. If the activists are right, on the other hand, policymakers can improve people’s lives by regularly shifting AD to the right and countering the effects of negative supply shocks by helping the AS curve to return to its original position or beyond.

The holy grail of economic growthReal per capita GDP. theory is to figure out how to shift Y_nrl to the right because, if policymakers can do that, it doesn’t matter how short the long term is. Policymakers can make a difference—and for the better. The real business cycle theory of Edward Prescott suggests that real aggregate supply shocks can affect Y_nrl.http://www.minneapolisfed.org/research/prescott/ This is an active area of research, and not just because Prescott took home the Nobel Prize in 2004 for his contributions to “dynamic macroeconomics: the time consistency of economic policy and the driving forces behind business cycles.”http://nobelprize.org/nobel_prizes/economics/laureates/2004/prescott-autobio.html Other economists believe that activist policies designed to shift AD to the right can influence Y_nrl through a process called hysteresis.http://economics.about.com/library/glossary/bldef-hysteresis.htm It’s still all very confusing and complicated, so the authors of this book and numerous others prefer bringing an institutional analysis to Y_nrl, one that concentrates on providing economic actors with incentives to labor, to develop and implement new technologies, and to build new plant and infrastructure.

Stop and Think Box

People often believe that wars induce long-term economic growth; however, they are quite wrong. Use Figure 23.7 "Inflation and output during and after two major U.S. wars, the Civil War (1861–1865) and World War I (1917–1918)" and the AS-AD model to explain why people think wars induce growth and why they are wrong.

Figure 23.7 Inflation and output during and after two major U.S. wars, the Civil War (1861–1865) and World War I (1917–1918)

Y* often increases during wars because AD shifts right because of increases in G (tanks, guns, ships, etc.) and I (new or improved factories to produce tanks, guns, ships, etc.) that exceed decreases in C (wartime rationing) and possibly NX (trade level decreases and/or subsidies provided to or by allies). Due to the right shift in AD, P* also rises, perhaps giving the illusion of wealth. After the war, however, two things occur: AD shifts back left as war production ceases and, to the extent that the long run comes home to roost, AS shifts left. Both lower Y* and the AD leftward shift decreases the price level. Empirically, wars are indeed often followed by recessions and deflation. Figure 23.7 "Inflation and output during and after two major U.S. wars, the Civil War (1861–1865) and World War I (1917–1918)" shows what happened to prices and output in the United States during and after the Civil War (1861–1865) and World War I (1914–1918; direct U.S. involvement, 1917–1918), respectively. The last bastion of the warmongers is the claim that, by inducing technological development, wars cause Y_nrl to shift right. Wars do indeed speed research and development, but getting a few new gizmos a few years sooner is not worth the wartime destruction of great masses of human and physical capital.

23.4 The Growth Diamond

Over the last two decades or so, many scholars, including one of the authors of this textbook (Wright), have examined the link between financial development and economic growth. They have found that financial repression, severe underdevelopment of financial intermediaries and markets, can stymie growth and that financial development paves the way for growth. The reason is clear: by reducing asymmetric information and tapping economies of scale (and scope), the financial system efficiently links investors to entrepreneurs, ensuring that society’s scarce resources are allocated to their highest valued uses and that innovative ideas get a fair trial.

The research agenda of some of those scholars, including the author of this textbook, has recently broadened to include more of the institutional factors that enhance or reduce economic growth, sustained rightward movements of Y_nrl. A leading model, set forth by three economic historians who teach economics at New York University’s Stern School of Business,http://w4.stern.nyu.edu/economics/facultystaff.cfm?doc_id=1019 is called the growth diamond or diamond of sustainable growth.http://w4.stern.nyu.edu/sternbusiness/spring_2007/sustainableGrowth.html Imagine a baseball or softball diamond. At the bottom of the diamond is home plate, the most important base in the game, where the player both begins and, if successful, ends his or her journey. Looking out from home, first base is at the right corner; second base is at the top of the diamond, dead ahead; and third base is at the diamond’s left corner. To score a run, a player must return to home plate after touching first, second, and third base, in that order. Countries are no different than ballplayers in this regard. For a country to get rich, it needs to progress from base to base in the proper order.

In the growth diamond, home plate is represented by government, first base by the financial system, second base by entrepreneurs, and third base by management. To succeed economically, as depicted in Figure 23.8 "The growth diamond", a country must first possess a solid home plate, a government that at a minimum protects the lives, liberty, and property of its citizens. Next, it must develop an efficient financial system capable of linking savers/investors to people with good business ideas, the entrepreneurs at second base. The managers at third take over after a product has emerged and matured.

Figure 23.8 The growth diamond

The growth diamond is a powerful model because it can be applied to almost every country on earth. The poorest countries never left home plate because their governments killed and robbed their citizens. Poor but not destitute countries never made it to first base, often because their governments, while not outright predatory, restricted economic liberty to the point that financiers and entrepreneurs could not thrive. In many such countries, the financial system is the tool of the government (indeed many banks in poor countries are owned by the state outright), so they allocate resources to political cronies rather than to the best entrepreneurs. Countries with middling income rounded the bases once or twice but found that managers, entrepreneurs, and financiers co-opted the government and implemented self-serving policies that rendered it difficult to score runs frequently. Meanwhile the rich countries continue to rack up the runs, growing stronger as players circle the bases in a virtuous or self-reinforcing cycle.

One important implication of the growth diamond is that emerging (from eons of poverty) or transitioning (from communism) economies that are currently hot, like those of China and India, may begin to falter if they do not strengthen their governance, financial, entrepreneurial, and management systems. Some of today’s basket-case economies, including that of Argentina, were once high fliers that ran into an economic brick wall because they inadequately protected property rights, impeded financial development, and squelched entrepreneurship.

Although currently less analytically rigorous than the AS-AD model, the growth diamond is more historically grounded than the AS-AD model or any other macro model and that is important. As storied economist Will Baumol once put it,

23.5 Financial Shocks

Another important implication of the growth diamond is that financial crises can have extremely negative consequences for economic growth. Five shocksIn economics, sudden, unexpected changes. They usually have adverse consequences, but some shocks can be salutary. The ones discussed here are all bad for the financial system and hence the economy., alone or in combination, have a strong propensity to initiate financial crises:

Increases in uncertainty. When companies cannot plan for the future and when investors feel they cannot estimate future corporate earnings or interest, inflation, or default rates, they tend to play it safe. They hold cash instead of investing in a new factory or equipment. That, of course, reduces aggregate economic activity.

Increases in interest rates. Higher interest rates make business projects less profitable and hence less likely to be completed, a direct blow to gross domestic product (GDP). Also, higher interest rates tend to exacerbate adverse selection by discouraging better borrowers but having little or no effect on the borrowing decisions of riskier companies and individuals. As a result, lenders are saddled with higher default rates in high interest-rate environments. So, contrary to what one would think, high rates reduce their desire to lend. To the extent that businesses own government or other bonds, higher interest rates decrease their net worth, leading to balance sheet deterioration, of which we will learn more below. Finally, higher interest rates hurt cash flow (receipts minus expenditures), rendering firms more likely to default.

Government fiscal problems. Governments that expend more than they take in via taxes and other revenues have to borrow. The more they borrow, the harder it is for them to service their loans, raising fears of a default, which decreases the market price of their bonds. That hurts the balance sheets of firms that invest in government bonds and may lead to an exchange rate crisis as investors sell assets denominated in the local currency in a flight to safety. Precipitous declines in the value of local currency causes enormous difficulties for firms that have borrowed in foreign currencies, like dollars, sterling, euro, or yen, because they have to pay more units of local currency than expected for each unit of foreign currency. Many are unable to do so and they default, increasing uncertainty and asymmetric information.

Balance sheet deterioration. Whenever a firm’s balance sheet deteriorates, which is to say, whenever its net worth falls because the value of its assets decreases and/or the value of its liabilities increases, or because stock market participants value the firm less highly, the Cerberus of asymmetric information rears its trio of ugly, fang-infested faces. The company now has less at stake, so it might engage in riskier activities, exacerbating adverse selection. As its net worth declines, moral hazard increases because it grows more likely to default on existing obligations, in turn because it has less at stake. Finally, agency problems become more prevalent as employee bonuses shrink and stock options become valueless. As employees begin to shirk, steal, and look for other work on company time, productivity plummets, and further declines in profitability cannot be far behind. The same negative cycle can also be jump-started by an unanticipated deflation, a decrease in the aggregate price level, because that will make the firm’s liabilities (debts) more onerous in real terms (i.e., adjusted for lower prices).

Banking problems and panics. If anything hurts banks’ balance sheets (like higher than expected default rates on loans they have made), banks will reduce their lending to avoid going bankrupt and/or incurring the wrath of regulators. As we have seen, banks are the most important source of external finance in most countries, so their decision to curtail will negatively affect the economy by reducing the flow of funds between investors and entrepreneurs. If bank balance sheets are hurt badly enough, some may fail. That may trigger the failure of yet more banks for two reasons. First, banks often owe each other considerable sums. If a big one that owes much to many smaller banks were to fail, it could endanger the solvency of the creditor banks. Second, the failure of a few banks may induce the holders of banks’ monetary liabilities (today mostly deposits, but in the past, as we’ve seen, also bank notes) to run on the bank, to pull their funds out en masse because they can’t tell if their bank is a good one or not. The tragic thing about this is that, because all banks engage in fractional reserve banking (which is to say, that no bank keeps enough cash on hand to meet all of its monetary liabilities), runs often become self-fulfilling prophecies, destroying even solvent institutions in a matter of days or even hours. Banking panics and the dead banks they leave in their wake causes uncertainty, higher interest rates, and balance sheet deterioration, all of which, as we’ve seen, hurt aggregate economic activity.

A downward spiral often ensues. Interest rate increases, stock market declines, uncertainty, balance sheet deterioration, and fiscal imbalances, as detailed above, all tend to increase asymmetric information. That, in turn, causes economic activity to decline, triggering more crises, including bank panics and/or foreign exchange crises, which increase asymmetric information yet further. Economic activity again declines, perhaps triggering more crises or an unanticipated decline in the price level. That is the point, traditionally, where recessions turn into depressions, unusually long and steep economic downturns.

Assuming the growth diamond has not been destroyed by the depression, economies will eventually reverse themselves after many companies have gone bankrupt; the balance sheets of surviving firms improve; and uncertainty, asymmetric information, and interest rates decrease (see Chapter 5 "The Economics of Interest-Rate Fluctuations"). It is better for everyone, however, if financial crises can be nipped in the bud before they turn ugly. This, as we learned in Chapter 17 "Monetary Policy Targets and Goals", is one of the major functions of central banks like the European Central Bank (ECB) and the Fed. Generally, all that the central bank needs to do at the outset of a crisis is to restore confidence, reduce uncertainty, and keep interest rates in line by adding liquidity (cash) to the economy by acting as a lender of last resort, helping out banks and other financial intermediaries with loans and buying government bonds in the open market. As we learned in Chapter 12 "The Financial Crisis of 2007–2008", however, sometimes a bailout becomes necessary. Figure 23.9 "Anatomy of a financial crisis and economic decline" summarizes this discussion of the ill consequences of financial shocks.

Figure 23.9 Anatomy of a financial crisis and economic decline

Note: At any point the downward spiral can be stopped by adequate central bank intervention.

Source: Text.

But in case you didn’t get the memo, nothing is ever really free. (Well, except for free goods.)http://en.wikipedia.org/wiki/Free_good When central banks stop financial panics, especially when they do so by bailing out failed companies, they risk creating moral hazard by teaching market participants that they will shield them from risks. That is why some economists, like Allan Meltzer, said “Let ’Em Fail,” in the op-ed pages of the Wall Street JournalJuly 21, 2007. http://online.wsj.com/article/SB118498744630073854.html when some hedge funds ran into trouble due to the unexpected deterioration of the subprime mortgage market in 2007. Hamilton’s Law (née Bagehot’s Law which, as described in Chapter 16 "Monetary Policy Tools", urges lenders of last resort to lend at a penalty rate on good security) is so powerful precisely because it minimizes moral hazard by providing relief only to the more prudent and solvent firms while allowing the riskiest ones to go under.

23.6 Suggested Reading

Baumol, William, Robert Litan, and Carl Schramm. Good Capitalism, Bad Capitalism, and the Economics of Growth and Prosperity. New Haven, CT: Yale University Press, 2007.

Haber, Stephen, Douglass North, and Barry Weingast. Political Institutions and Financial Development. Stanford, CA: Stanford University Press, 2008.

Powell, Benjamin. Making Poor Nations Rich: Entrepreneurship and the Process of Economic Development. Stanford, CA: Stanford University Press, 2008.

Wright, Robert E. One Nation Under Debt: Hamilton, Jefferson, and the History of What We Owe. New York: McGraw-Hill, 2008.