Wednesday, October 14, 2009

AD & AS: 1st AD then AS and finally in concert

1st of a three part series. 1st we consider the AD & AS model. Then the AD curve is explored in depth. Then the AS curve is explored in depth. Finally, we use them in concert to explain the economy.

More models... this one is different from the rest. When we view this chart we can see the equilibrium between price and output. That is to say, the AS curve represents the total quantity of goods and services firms are willing to provide at each point along the price level continuum. The AD line shows how much people, businesses, the government and foreigners would wish to buy at each price point. The equilibrium clears this market. As I said this is different from a microview graph because there cannot be a substitution to another good, this is the economy on a whole. So if ice cream prices rises one cannot just substitute frozen yogurt.

The AD curve slopes downward. Consider the equation

Y = C + I + G + NX

So that each factor will affect how much output is created by an economy. We can consider C + G together because both are consumption expenditures the only difference is one is for the public and the other is the government. Say for instance that the entire economy only make ice cream. You make two dollars and the government taxes you a dollar. The cost of ice cream is a dollar. So that you and the government can each have one cone. If the price of ice cream were to fall to 25 cents you would still have your dollar but now you could purchase 4 ice cream cones. So when the price level falls you have more purchasing power, as does the government. Now in a real economy the price level dropping will entice you to consume more, in our hypothetical economy you might tire of more ice cream quickly or develop diabetes and thus an aversion to sweets. The converse is true, when the price level rises, the value of the dollar falls which will reduce your wealth, consumption and the quantity of goods and services demanded.

Here we can see the chart of price level. As the price level drops from P1 to P2 the quantity of goods and services increases from Q1 to Q2.

The price level will also affect interest rates and thus investment. The effect is because imagine you are a household from above in the ice cream economy. Maybe you desire to only purchase one cone of Ice cream a year, thus the drop in price of ice cream from a dollar to 25 cents frees up 75 cents. Since more ice cream wouldn't give you any more marginal satisfaction you instead lend out your 75 cents. You might put it in a certificate of deposit, buy a bond or place it in a savings account with the bank. These three choices are all the same you would be lending the money out or giving the money to a bank to lend out for you. This, in aggregate, will drive interest rates lower. This then has a secondary effect in which because the interest rate is lowered more firms and households will borrow to purchase assets, plants & equipment for businesses and cars & houses for households. Again price level rising would have the opposite effect of raising the interest rate (less deposits), reducing investment and spending.

Since the interest rate is lowered by the mechanisms described above this will cause investors to seek higher returns from abroad. As these investors buy foreign currency to purchase investments in yuan, euros and Australian dollars this will increase the supply of US dollars in the exchange market. The increase supply will drive down the exchange rate against this basket of currencies. Since the dollar will now purchase less foreign currency than it follows that the US dollar will buy less foreign goods as well. As a corollary this will make US goods less expensive compared to comparable goods delivered by foreign countries, so net exports will increase. This will increase the demand for US goods and services. In reverse, a higher price level increase the interest rate, the dollar increases in value and the appreciated dollar will lower net exports (increase imports and decrease exports) which decreases the demand for US goods and services.

These are three reasons why the AD curve slopes downward but it can shift too.

We can also look at the variables C, I, G and NX to show why the AD curve would shift.

C - Consumption - consumption patterns could change. For instance, household wealth could fall because of a falling stock market and housing prices falling more in line with what a rental market could support. This would cause consumers as a whole to demand less services and goods at any price level, thus shifting the curve leftward.

I - Investment - if firms become pessimistic about future business conditions this will cause them collectively to invest less in plant and equipment. This also would shift the AD curve leftward. The government does have two tools in which to affect businesses' collective decision, it can employ fiscal or monetary stimulus. On the fiscal side it could lower taxes, of course in the current situation lowering taxes will not do as much because businesses will be employing NOLs (net operating losses) over the next few years and thus their tax burden will be less or zero anyways thus negating the positive effect this might have. The other tool is monetary policy, the Federal Reserve can increase the money supply thus lowering the rate of interest, which will encourage households and firms to invest, thus shifting the curve to the right combating the leftward shift of the gloomy outlook.

G - Government - any shift in purchasing plans of the US government will shift the curve. If the government decides to spend less this will shift the curve leftward, if it decides to spend more it will shift the curve rightward. There are two ways the government can spend, it can either lower taxes while keeping it spending the same running a deficit. Or it can keep taxes the same and spend more, both have the same effect. Unfortunately, Republicans only like the former and Democrats only the latter even though while in office both do the same, that is run deficits.

NX - Net Exports - NX is tricky because it has two variables affecting: the desire of the rest of the world to purchase US goods and also people and firms moving their wealth into and out of the US economy. On the first if China grows at 10% this year, all things else being equal, it will import more goods from the US. This will cause NX to shift outward. Because of this people and firms may sell their US dollar assets and use US dollars to purchase Yuan. This will depress the US dollar and cause NX to shift outward even further. However, should a recession occur in China the reverse would occur, the NX curve would shift inward because of less demand and the flight of capital from China to the US would strengthen the US dollar making imports less expensive and shifting the AD curve further inward.

Next we consider AS.

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