Aggregate Demand and Aggregate
Supply
ISLM aggregates the economy into a market for money
balances, a market for goods and services, and a residual
market that it ignores by invoking Walras' Law. Since part
of the residual market is the labor market, and because
adjustment in this market is slow, ISLM would be a better
model if it could capture what is happening in the resource
markets. Aggregate supply-aggregate demand analysis makes
this incorporation.
The aggregate demand curve is derived from the ISLM
model. In the illustration below, equilibrium income is Y1
when the price level is P1. Let the price level rise to a
higher level, from P1 to P2. At the higher level, with a
constant amount of money, purchasing power is cut. The fixed
number of dollars no longer buys as much. The effects on the
LM curve are identical to what happens when prices remain
fixed and the amount of money falls. The LM curve, in either
case, shifts left, interest rates rise, and income falls.
The output levels at both P1 and P2 are shown in the bottom
part of the illustration. The aggregate demand curve
connects them with points that other price levels
generate.
The aggregate supply curve comes from the resource
market. Though these markets may adjust slowly, when they
finally do fully adjust, price level should have little or
no effect on the amount of resources supplied. If a doubling
of all prices and wages results in more or less output,
someone is suffering from money illusion. The person
believes either that he is better off at a higher nominal
(but same real) wage, or that he is worse off with higher
prices that have been fully compensated with higher wages.
If people realize that money is merely an intermediary, and
ultimately goods trade for goods, price level should not
matter.
The point of the last paragraph is important enough to
explain in a more concrete manner. Suppose Edward has a
paper route and at the end of each week his income is
$25.00. He spends his entire income on 15 hamburgers that
cost $1.00 each and 20 soft drinks that cost $.50 each. One
day Edward wakes up and finds that his weekly income has
doubled to $50, but all prices have also doubled. Is he any
better or worse off? Clearly he is not. A week of delivering
newspapers still trades for 15 hamburgers and 20 soft
drinks. He has no reason to work either more or less.
If behavior does not change when price level does, output
will not depend on price level. The result will be the
perfectly vertical aggregate supply curve shown in the
illustration above. In the long run, when prices and wages
fully adjust to any change in total spending, resources and
output determine output.
In the short-run, however, an adjustment process that is
not instantaneous seems more appropriate. Prices can be
sticky, especially in
resource markets. Expected rates of inflation can affect the
way prices are set. Once we allow these possibilities, we
have a system in which it may take years to reach long-run
equilibrium. It is even possible that the system will never
reach equilibrium, but, as the business-cycle writers
thought, will fluctuate forever in the adjustment
process.
Once we add stickiness to prices and give a role to
expected inflation, a change in spending will not simply
move the economy up or down a vertical aggregate-supply
curve. The upward-sloping curve below shows what is likely
in the short run. A change in spending will move the
aggregate-demand curve. If the short-run aggregate-supply
curve is fairly flat, there will be a large change in output
and a small change in price level.
Aggregate supply and aggregate demand is an attractive
framework because it is simple, with the same structure as
supply and demand. However, the assumptions behind aggregate
supply and aggregate demand are totally different from those
behind supply and demand, that is, aggregate supply and
aggregate demand curves are not obtained by adding up all
the supply and demand curves in an economy. If they were,
one would expect that the long-run aggregate-supply curve
would be flatter than the short-run aggregate-supply curve,
as is the case with a normal supply curve. But the aggregate
supply curve grows steeper the longer the time for
adjustment.
Aggregate supply and aggregate demand is more general
than ISLM, and overcomes some of the limitations of ISLM. It
includes price level as a variable, and it shows that
resource markets matter. It also lets one consider cases in
which disturbances originate in a resource market, such as a
disruption of oil supplies, which ISLM cannot handle.
Aggregate supply and aggregate demand gives insight into
the adjustment process. Observation of the real world tells
us that when spending suddenly changes, output changes
initially more than prices, and only after considerable
delay do prices change more than output. Aggregate supply
and aggregate demand yields this pattern.
Aggregate demand and aggregate supply show an adjustment
process. It does this with a series of short-run equilibria.
Alfred Marshall originated this technique with regular
supply and demand. He had three periods: the market period
or the very short run, in which output was fixed; the short
run, in which capital was fixed but utilization of capital
was not; and the long run, in which nothing was fixed. So
far the expositions of aggregate supply and aggregate demand
have been fuzzy about what is fixed in the short run that is
not fixed in the long run. This fuzziness remains as a
problem of aggregate demand and aggregate supply.
Copyright
Robert Schenk
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