Tuesday, October 27, 2009

AD & AS in concert and in dischord

Shifts in Aggregate Demand
First, we begin with a chart.

This chart shows the Aggregate Demand (AD) curve, the Aggregate Supply (AS) curve and the Long Run Aggregate Supply (LRAS) curve. Currently, it is in equilibrium with the price level at the natural rate of output of the economy. From our previous posts, we know that the AS and AD curves can shift, which will cause short term fluctuations in the economy. Now we can use this model to explore why things happen, like they did in 2007 and 2008.

So let's examine the recent crisis, more closely. In a nutshell, loans were given to bad credit risks with little to no documentation because in the originate to distribute model, the borrower would only need to meet a minimum amount of payments before the loans could be sold to investors. Investors, relying on the advice of credit rating agencies, believed that the securitized pools offered superior returns for the high credit ratings and bought these investments. After, it was revealed that most of these investments were, when the tide rolled out swimming naked. This caused people to stop consuming and start saving as their financial asset portfolio and housing investments were no longer worth as much as was believed. Thus, the chart.

Here you can see that AD curve shifts downward [to the left] to a new equilibrium in the short run but that there is an output gap between what the economy can normally produce. We saw this when looking at the CBO's GDP projections, shown here.

You can picture that the gap between the actual GDP in black and the thinner natural output line is the same in the chart above where it is shown the gap between short run equilibrium and its gap from the darker red line which indicates the natural output of the economy. Eventually, [shown below] the gap will close again just like in the CBO's projections.

Here the output gap is closed by the short term AS curve adjusting to the new pricing paradigm as the veil of prices is lifted. Stated another way, as the costs of goods/services decline workers will not need as great a wage to maintain their standard of living. The workers will then return to work at the new lower wage and capacity in the economy will return to normal.

All of the above assumes that policymakers do nothing. That is, if they followed an Austrian School of Thought, that any policy will invariably make matters worse and instead the free market should be allowed to work to clear prices. Instead, what usually happens, is that policymakers tend to use fiscal and monetary stimulus to stop the process at price equilibrium 2 and return it to price equilibrium 1.

Again, usually, the Federal Reserve will act first to loosen the money supply, which through the financial system will drop interest rates making it more attractive to buy capital goods via financing and will make business opportunities more attractive. If this does not work, then in concert, the fiscal authorities can undertake stimulus by borrowing when the private sector will not, to invest in capital goods. This should have a multiplier effect in that companies hired by the government will then give money to their employees who then spend it on consumption ... until economic growth ensues.

Shifts in Aggregate Supply
This usually comes about in changes in the cost of production to firms. There is some interesting work done by Professor Jim Hamilton in this area with regards to oil and the global economy, a post is here, so we will run with it. In his post, he uses econometrics to describe the global economy and its growth from 2004 to 2008. He shows that the price of oil could have risen to 142 dollars per barrel on fundamentals alone. This cost shock affects many areas of the economy because oil is not only used to transport so many goods around the globe but it literally makes up goods as well.

Some examples,
products that contain petroleum that could be affected by oil prices: Antiseptics, Baby strollers, Balloons, Bandages, Cameras, Candles, Clothing, CDs and DVDs, Computers, Crayons, Dentures, Deodorant, Diapers, Food preservatives, Garbage bags, Glue, Hair dryers, Ink, Insecticides, Medical equipment, Nylon rope, Pacemakers, Photographs, Roofing, Shampoo, Shaving cream, Soft contact lenses, Telephones, Toothpaste, Toys, Vitamin capsules. Source: Ohio Petroleum Council

So the tripling of oil prices would shift the AS curve to the left, which is to state that the cost of production is higher at any price level. This causes an output gap and perhaps even more perversely, prices rise. As shown in the chart below.

We can see this in actual practice by looking at a chart from Dr. Hamilton.

Here the natural rate of output is the green dotted line and the back line is the actual. You can see that the professor's model does an accurate job of describing the oil shock and its affect on GDP.

So now what happens. Well a couple of things can happen:

The natural rate of output of the economy could fall permanently, this would shift the dark red LR AS curve to the left to meet the new price point.

Alternatively, the government can stoke AD curve [via the same mechanisms described above] so that the equilibrium rises to the natural rate of output again but at the cost of permanently higher cost of goods/services.

Finally, the sticky wage theory would propose a scenario like this: because the economy is stagnating but at the same time shows inflation, herein called stagflation, the workers will see their cost of living declining and demand higher wages to compensate them. Firms will lose more money as the cost of goods/services (inputs) continue to rise, called the wage-price spiral. Eventually, the under-utilization (output gap) though will cause more workers to be unemployed. Unemployed workers will work for less thus dropping the costs to firms and make it more profitable to produce more goods. Eventually you return to the original price equilibrium 1.

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