macroeconomic equilibrium and monetary policy€¦ · macroeconomic equilibrium where both...

College of Education

School of Continuing and Distance Education2014/2015 – 2016/2017

MACROECONOMIC EQUILIBRIUM AND MONETARY POLICY

Lecturer: Dr. Priscilla Twumasi Baffour, Department of Economics Contact Information: [email protected]

Session Overview

• In this session students are introduced to the concept ofmacroeconomic equilibrium where both Aggregate Demandand Aggregate Supply are used to determine the general pricelevel and output. The session goes further discuss the impactaggregate demand and supply shocks have on equilibriumoutput and the general price level. Specifically on demandshocks, it is shown that price and output move in the samedirection at the shock, whether positive or negative whileswith a supply shock, price and output move in oppositedirections. The session concludes with a discussion onmonetary policy in addressing fluctuations in the businesscycle.

Priscilla T. Baffour Slide 2

Session Outline

The key topics to be covered in the session are as follows:

• The key topics to be covered in the session are as follows:

• Macroeconomic Equilibrium

• Changes in GDP and the Price Level

• Aggregate Demand Shocks

• Aggregate Supply Shocks

• Monetary policy

• Expansionary monetary policy

• Contractionary monetary policy


Learning Outcome

• After completing this session, you should be able to;

– Determine equilibrium level of GDP and the price level.

– Illustrate how an exogenous change in autonomous spending (ademand shock) shifts the aggregate demand curve and causeequilibrium output and price level to move in the same direction.

– Indicate how an exogenous change in input prices or technology (asupply shock) shifts the short-run aggregate supply curve andcauses both output and the price level move in opposite direction.

– Identify the tools of monetary policy

– Discuss how expansionary monetary policy is used to boost theeconomy under a recession

– Explain how contractionary monetary policy is used to controlinflationary pressure


Reading List

• Chapter 19 of R. G. Lipsey & K. A. Chrystal, Economics,Eleventh Edition, 2004, Oxford University Press

• Session Slides

• Watch video on session 11 ……………………..

• Any Other Economics text books available to students


Macroeconomic Equilibrium

• Within the aggregate demand and supply framework, equilibriumincome is obtained at the point where aggregate demand of goodsand services is equal to the aggregate supply of goods and services.

• In other words, macroeconomic equilibrium occurs at theintersection of the AD and SRAS curves and determines theequilibrium values for GDP (income) and the price level.

• From figure 1 below,

– Equilibrium occurs at E0 with GDP equal to Y0 and the price level P0.– If the price level were P1 as in figure 2 below P0, the desired output of

firms as given by the SRAS curve would be Y1 which is less that thedesired demand at that level of GDP. The excess desired demand willcause prices to bid up, and output will increase along the SRAS curve.

– Hence there can be no macroeconomic equilibrium when the price levelis below P0

– Only at E0 are desired plans of producers and consumers consistent.

Priscilla T. Baffour

Y0

P0

SRAS

Macroeconomic Equilibrium (Figure 1)

AD

E0

0Real GDP


Y0

P0

SRAS

AD

E0

Y2Y1

P1

0 Real GDP

Macroeconomic Equilibrium (Figure 2)


Macroeconomic Equilibrium

– Similarly, if the price level is above Po, producers will wish tosupply more than the output that is demanded at that pricelevel. Desired demand will not be large enough to purchaseeverything that firms wish to produce at that price level

– Therefore only at the combination of GDP and price level givenby the intersection of the SRAS and AD curves are desireddemand and desired production activities consistent.

• Macroeconomic equilibrium thus requires that two conditions besatisfied.

• First, at the prevailing price level, desired demand must beequal to national output. Simply means that economicagents are just willing to buy all that is produced.

• The second, that at the prevailing price level, firms must wishto produce the prevailing level of national output.


Changes in GDP/Output and the Price Level

• Aggregate demand and aggregate supply curves are used to explainhow various shocks to the economy change both real GDP and theprice level.

• A shift in the AD curve is called an aggregate demand shock.

– A rightward shift in the AD curve results from an increase inaggregate demand(Positive Aggregate Demand Shock)

– A leftward shift in the AD curve indicates a decrease in aggregatedemand(Negative Aggregate demand shock)

• A shift in the SRAS curve is called an aggregate supply shock.

– A rightward shift in the SRAS curve represents an increase inaggregate supply. That at any given price level more real output issupplied

– A leftward shift in the SRAS curve is a decrease in aggregate supply.That is less real output is supplied at an given price level.


Aggregate Demand Shocks

• The aggregate demand curves plots demand determined GDP as afunction of the price level, therefore anything that alters thisoutcome for GDP at any specific price level must shift the AD curve.

• A change in the price level causes a movement along the AD curve .

• It is only changes in exogenous spending which cause the Aggregateexpenditure curve to shift that causes the AD curve to shift(Aggregate demand shock)

Aggregate Demand shocks could originate from

– Changes in spending by the private sector(Investment)

– Changes in Autonomous Private Consumption

– Changes in monetary(money supply) and fiscal policy (Government spending and taxes)


Aggregate Demand Shocks

• AD shocks cause the price level and real GDP to change in the same direction.

– A positive AD shock leads to an increase in both real GDP and the Price Level

– Real GDP and the Price Level decline with a negative AD shock.


Positive Aggregate Demand Shock

• Positive Aggregate demand shock results from:

– Increase in Autonomous Consumption

• A tax cut for instance increases the disposable income ofhouseholds thereby increasing consumption.

– Increase in private sector spending(Investment)

• Optimism about the future, a fall in interest rate makes firms invest more at a given price level.

– Increase in money supply

• A fall in the discount rate, open market purchase and a reduction in the reserve required ratio increases money supply

– Increase in Government Spending or decrease in taxes


Positive Aggregate Demand Shock

• An increase in autonomous consumption, private spending, moneysupply and government spending will increase aggregate demand ata given price level and therefore shift the aggregate demand curveto the right.

• From figure 3 below, a rightward shift of the AD curve from 𝐴𝐷0 to𝐴𝐷1 causes the price level to move in the same direction (increase).Macroeconomic Equilibrium moves from 𝐸0 to 𝐸1. The price levelincreases from 𝑃0 to 𝑃1 and real GDP/Output increases from 𝑌0 to𝑌1 reflecting a movement along the SRAS curve.


P0

Real GDPY1

AD0

AD1

P1

SRAS0

E0

E1

Y*

Inflationary

Gap Opens

Price Level

Rises

Autonomous increase in aggregate demand

Positive Demand-Shock (Figure 3)

Negative Aggregate Demand Shock

• A leftward shift in the AD curve results from a decrease in aggregatedemand (Negative Aggregate Demand Shock)

• Negative Aggregate demand shock results from:

– Decrease in Autonomous Consumption

– Decrease in private sector spending(Investment)

• A rise in interest rate, pessimism about the future will lead to a decreasein investment.

– Decrease in money supply

• An increase in the discount rate, open market sale and a rise in thereserve required ratio increases money supply

– Decrease in Government Spending or Increase in taxes


Negative Aggregate Demand Shock

• A decrease in Autonomous Consumption, private spending, money supply,government spending and an increase in taxes will shift the aggregatedemand curve to the left.

• A decrease in aggregate demand, holding SRAS curve constant will resultin a decrease in both real GDP/Output and prices.

• As shown in figure below, a negative aggregate demand shock shifts theAD curve to the left thereby causing the price level and output to move inthe same direction.

• A Decrease in aggregate demand shifts the AD curve to the left from 𝐴𝐷0to 𝐴𝐷1. Macroeconomic Equilibrium moves from 𝐸0 to 𝐸1. The price levelfalls from 𝑃0 to 𝑃1 and real GDP/Output falls from 𝑌0 to 𝑌1 reflecting amovement along the SRAS curve.


P0

Real GDP

[i]. Autonomous Fall in Aggregate Demand

AD0

AD1

SRAS0

E0

Y0

1

Negative Demand-Shock (Figure 4)

E1

Y1

Aggregate Supply Shocks

• The SRAS curve shows the quantity of output firms would like toproduce and to sell at each price level on the assumption thatprices of all inputs remain constant.

• An aggregate supply shock means a shift in the SRAS curve.Meaning at the same price level, firms are willing to supply more(positive shock) or less (negative shock).

• Adjustment to a new equilibrium following a shock in aggregatesupply involves a movement along the AD curve causing the pricelevel and output to move in opposite direction.

• There are two main sources of aggregate supply shocks which areof particular importance:– Changes in the prices of inputs

– Increases in productivity



– An increase in AS (downward shift of AS curve) will cause afall in general price level and an increase in output.

– A decrease in AS (upward shift of AS curve) will cause a risein general price level and a decrease in output.

• Examples of AS shocks

– Oil Price Increases during 1973-74, 1979-80, during Gulf warin 1990, and during the late 2000s (i.e. 2007/08)

– Productivity gains from an upsurge of new technologies inlate 1990s

– In Ghana during the droughts in 1982/83, energy crises inearly 1980s, mid 2000s and 2011-2015.



• Changes in Input Prices

– The profitability of firms current production is reducedwith increases in input prices. Due mainly to increased costof production

– As a result, if output prices do not rise, firms will react byreducing production. This means that there will be lessoutput at each price level than before.

– Thus if input prises rise, the SRAS curve shifts upwardindicating a decrease in aggregate supply. That is a fall inoutput but higher prices



• Changes in Productivity

– Labour Productivity has to do with output per worker.

– If Labour productivity rises, meaning that each worker canproduce more per hour, the unit cost of production will fallas long as wage rate and other input prices remainconstant.

– If cost falls, firms will be willing to sell more at the sameprice which causes a rightward or downward shift in theaggregate supply curve.

• Figure 4 below shows the impact of both positive andnegative supply shocks on output and the price level.


Graphical Illustration of Supply Shocks (Figure 4)


MONETARY POLICY

Topic Two


Monetary Policy Tools

• Monetary policy is management of the quantity of money incirculation(Money supply) and/or the interest rates for thepurpose of reducing a business cycle fluctuations.

• Although different tools can be employed to conductmonetary policy, the specific objective at any point in timemay be different.

• In a period of recession, the aim of monetary policy is toincrease aggregate demand and output. On the other hand, ininflationary periods, monetary policy is used to reduceaggregate demand and reduce the inflationary pressures inthe economy.

• This means monetary policy can be expansionary orrestrictive(Contractionary)


Types of Monetary Policy

• There are two main types of monetary policy.

– Expansionary Monetary Policy

– Contractionary Monetary Policy

• Another form of monetary policy is Discretionary Monetary Policy.


Expansionary Monetary Policy

• Expansionary Monetary policy is an increase in the quantity ofmoney in circulation(Money supply) with corresponding reductionsin interest rates for the purpose of stimulating aggregate demandand output and to address the problem of low demand andunemployment.

• Thus, the goal of expansionary monetary policy is to increaseaggregate demand and output and to reduce unemployment.

• Expansionary monetary policy includes:

– Buying government bonds(Open market purchase)

– Lower discount rate (the rate of interest charged on loans tocommercial banks by the central bank)

– Lower required reserve ratio (increases excess reserves availableto commercial banks to create money).


Expansionary Monetary Policy

• Figure 5 below shows the increase in money supply by using openmarket operation.

• The increase in the money supply is shown by a rightward shift inthe supply of money curve from 𝑀𝑠1 to 𝑀𝑠2. This given the moneydemand function, leads to a reduction in the interest rate from 𝑟1 to𝑟2. When the interest rate falls from 𝑟1 to 𝑟2, investment increasesfrom 𝐼1to 𝐼2. Using the macroeconomic equilibrium, increase ininvestment shifts the aggregate demand curve from 𝐴𝐷0 to𝐴𝐷1.this increase real GDP/output.

• This implies in recessionary periods where output and employmentin the economy are below their potential levels. Money supply maybe increased to stimulate investment and aggregate demand in theeconomy.


Graphical Illustration (Figure 5)


Contractionary Monetary Policy

• Contractionary monetary policy on the other hand is areduction in the quantity of money in circulation(Money supply)with corresponding increase in interest rates for the purpose ofreducing a business cycle expansion to address the problem ofinflation (too much demand)

• The primary goal of contractionary monetary policy is to reduce inflation.

• Contractionary monetary policy includes:

– Sale of government bond/securities(open market sale

– Raising the discount rate

– Raising the required reserve ratio


Questions

1. Show what would happen to the SRAS if

a. Investment in transport infrastructure lowers costs of shipping goods andraw materials

b. Oil prices rise

c. Workers agree to work for lower wages

d. There is a technical innovation in manufacturing industry

2. Outline how the interaction of the AD and the SRAS curves determinesequilibrium GDP and the price level in response to

a. A rise in wage rates

b. An increase in investment

c. A reduction on government consumption

d. A boom in demand in neighboring economies


macroeconomic equilibrium and monetary policy€¦ · macroeconomic equilibrium where both...

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