Aggregate Demand & Aggregate Supply

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For a limited time, think like an economist. Listeners can
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a fourteen day free trial. Hey Naz, today's a huge
day for our listeners. Why is that justin Well, we've
been working our way through macroeconomics over recent weeks, talking
about the big issues like inflation and unemployment, economic growth,
and monetary and fiscal policy.
And today it's going to be our last episode of
this season our macroeconomics.
So I want to congratulate our listeners because by the
end of today's episode, you'll get to say that you've learned.
To think like a macro economist.
That's so cool. It's been a long road. In our
first season, we work through the big ideas of microeconomics,
and now we're near the end of macroeconomics, that's.
Right, and so in today's episode, I want to draw
on some of the ideas we learn from microeconomics about
supply and demand to better understand the macro economy.
Yeah, I know that microeconomics is about individual markets, and
often it's about the supply and demand of a specific good,
like the market for apples or oranges, or jeans, or
cars or houses. How can those ideas help us better
understand the macroeconomy.
What happens in the macro economy reflects all those individual
microeconomic buying and selling decisions that each of us make
every day.
In today's episode is based on a bit more of
a thought experiment. Now, as instead of thinking about the
economy by thinking about thousands of different markets in the economy,
like the mark for apples, the market for oranges, and
other things, we're going to think about the economy as
if it were just one big market.
What we're gonna do is think about the supplying demand
for all the goods and services in the economy. And
one way that economists like to do this is just
to imagine the economy as one big market with just
one product. Think about it as the market for stuff,
where stuff represents all the goods and services you might buy.
And so just as we might analyze this supplying demand
for apples or for oranges, were going to analyze the
supplying demand for this composite good that we're calling stuff.
To keep things straight, so that you know when we're
talking about macro versus micro, we're going to be careful
to use the word aggregate demand to describe the demand
for this aggregate macroeconomic good we're calling stuff. So aggregate
demand we mean the demand for everything.
Likewise, the supply of this aggregate stuff, well we're gonna
call it aggregate supply.
An aggregate demand and aggregate supplier are topics on today's
episode of Think Like an Economist with me Betsy Stevenson.
And I'm just a Wolvers. We're here to give you
the super tools of economics so you can understand what's
going on in the big and the small. NaSTA and
ta acolifiers with us.
So this idea of returning to supply and demand to
analyze the macroeconomy, well, I've got to admit I didn't
see that coming.
Economics is full of exciting plot twists. We've talked about
one way to think about business cycles used in the
FED model. Today, we're going to turn to an alternative
but related approach using aggregate demand and aggregate supply.
Okay, so one of microeconomist analyzes the market like the
market for apples. They'll forecast the quantity of apples that
will be produced and the price of those apples. How
can we apply this to the macroeconomy.
Think about the quantity of all the stuff we produce.
That quantity is measured by GDP.
And to think about the price of stuff, think about
the price of a basket that's packed with the sorts
of goods and services we produce, including food and clothes
and doctors visits, and cars and houses and so on.
This basket has more of the goods we'll produced more of,
so it represents all the stuff we produce.
Add up the price of everything in that basket, and
you've got a snapshot of the price of stuff. And
tracking the price of that basket full of stuff allows
us to track how the average price level on the
economy is changing over time.
I think I'm remembering some of this from our earlier
episode on inflation. Our measures of inflation track the price
of a representative basket of goods over time.
Yeah, it's the same idea, only this time we're tracking
the price of the output we produce, which is why
the price of that basket is called the GDP deflator.
It's a bit like the consumer Price index, which is
often used to measure inflation, except the GDP deflator tracks
the price of the stuff we make rather than the
stuff we consume.
Okay, so we have the quantity of stuff, which is
GDP and the price of stuff, which is the GDP deflator.
Those really do sound like big macroeconomic concepts.
Yeah, and they're going to be determined by aggregate demand
and aggregate supply.
Remember, aggregate demand is the amount of stuff that people
want to buy. And just as we demand fewer apples
when the price of apples is higher, we demand less
stuff when the average price of stuff is higher.
And the total amount of stuff that businesses want to
produce and sell is called aggregate supply. And just as
apple farmers try to produce more apples when the price
is higher, across the whole economy, businesses produce more stuff
when the price of stuff is higher.
And if I'm guessing right, the total amount of stuff
we produce is determined in equilibrium when aggregate demand is
equal to aggregate supply.
Exactly, And that equilibrium determines both the quantity of stuff
we buy and sell, which is our GDP, as well
as the average price level in the economy.
And they'll tells you why this framework can be so helpful.
You can use it to forecast total output or GDP,
as well as the average price level, which we measure
as a GDP deflator.
All this talk of demand and supply sounds familiar from
our episodes looking at microeconomics.
That's right, And just as microeconomists draw supply and demand graphs,
macroeconomists draw aggregate supply and aggregate demand graphs.
Yeah.
In microeconomics, the supply curve is all about the law
of supply. This says that businesses want to supply more
stuff when the price is higher. Applying this idea to
the whole economy means that an aggregate supply curve shows
that the quantity of goods and services that businesses produce
rises with the average price level.
You bet, nas, You've just described the supply side of
the economy.
And on the demand side. In micro the demand curve
is all about the law of demand, which says that
people want to buy more stuff when the price is lower. Again,
applying this to the whole economy tells us that you
can think of an aggregate demand curve, illustrating the idea
that the quantity of stuff that people want to buy
falls when the average price level is higher.
Yeah, there's a really pretty neat analogy between micro and macro, but.
It's an imperfect analogy. So far, we've made it sound
like the rules of microeconomics apply to the macro economy too,
but really the similarity to end here.
That's because we're dealing with a different set of trade
offs or opportunity costs. When we look at supply and
demand in a micro context, the key opportunity cost of
buying something like an apple is that money you can't
spend buying something else like an orange.
So nas one we use in people buy fewer apples
when the price is high is that they can go
and buy oranges instead.
But in macroeconomics, we're looking at spending on all goods
and services. We're talking about the supply and demand for
all the stuff the economy produces. It's not so easy
to go get something else. When we're talking about everything.
There is an important trade off or opportunity costs in macro.
It's different to the one that guides micro In macro,
one of the most important choices people face is whether
to spend money buying stuff today versus spending money in
the future.
So in microeconomics are opportunity costs is related to other products.
In macroeconomics is related to another time period.
That's right. And all of this means that while aggregate
demand and aggregate supply sound a lot like microeconomic demand
and supply, they actually represent a really different set of ideas, so.
Different in fact, that we're going to have to spend
the rest of the episode digging into just what drives
aggregate demand and aggregate supply.
Okay, let's start with aggregate demand, which is the total
quantity of stuff that people want to buy. We've already
talked about this in our recent episodes where we went
into aggregate expenditure.
Yeah, so this is the total amount of goods and
services that people want to buy across the entire economy.
That means the stuff that households by we call that consumption,
the stuff that businesses buy we call that investment. The
stuff that government buys we call that government purchases, and
the net amount of stuff the rest of the world buys,
which we call net exports. So aggregate demand includes all
these things added together.
Betsy, we said earlier that the higher the price level,
the lower the quantity of aggregate demand. Why is that.
Remember that the big trade up in macroeconomics is the
trade up across time, and the price that matters for
deciding whether to spend today or in the future is
the interest rate.
That's why central banks like the FED or the Bank
of England or the European Central Bank play a really
big role here. Remember, the FED tends to raise the
interest rate when inflation is higher. So a higher price
level this year means that this is inflation rate is higher,
not on lead the Fed to set a higher interest rate.
Higher interest rates are going to lead to overall less spending.
People are going to buy fewer things, businesses are going
to invest less in new machinery, and the dollars going
to appreciate, which causes exports to fall. All of this
means less demand for stuff.
Put the pieces together and we see that a higher
price level leads to higher interest rates and hence less
demand for stuff. That's the story of aggregate demand.
Let's move on to aggregate supply. Now, this is all
about how much businesses will produce depending on the price level,
and higher prices tend to go with higher output.
It's going to be easiest to think about how output
affects prices rather than the other way around.
Okay, so let's say the economy is strong and so
GDP is high. With a strong economy, that means that
nearly every business is producing a lot of stuff. Restaurants
are full, factories are running over time, hotels are over sold,
and it's difficult for anyone to keep up.
Right. So, if you're running a car company like Ford
or General Motors, and the economy is so strong you've
got your production lines running all day and all night
and you still can't keep up, you might think, why
not raise my prices? After all, I'll probably still sell
all the cars I can produce, but I'll sell them
at a higher price, which is going to be more profitable.
And don't forget that you're probably paying higher overtime rates
to keep your production levels this high. So the marginal
cost of producing output is much higher. The higher marginal
cost is another, and to charge a higher price when
the economy is hot.
It's not just Ford that's going to think like this.
If the economy is booming so that your local restaurant
has queues of customers out the door, they'll pretty quickly
work out that they can still raise the prices on
their menu and still be booked out.
Hotels that are always sold out will also figure out
that they can raise their prices, and millions of businesses
across the country do similar calculations, coming to similar conclusions,
which is that when the economy is really hot with
a high level of output, they can raise their prices
and make more money.
Put the pieces together and you'll discover that a really
high level of output will lead the average price level
across the whole economy to be higher.
That's a key idea behind aggregate supply. From the supplier's perspective,
more output is associated with a higher average price level.
You know, the aggregate supply curve seems to have some
similarities with the Phillips curve. In both cases, the price
level rise as output rises.
That's right. In fact, they're describing exactly the same ideas.
When the economy is producing too much, bottlenecks emerge and
that can lead businesses to charge higher prices.
So the Phillips curve is about inflation and the aggregate
supply curve is about the price level. But it's the
same idea because anything that pushes up this year's price
level will also push up this year's inflation rate. So
you can think about the aggurate supply curve. It's being
pretty similar to the Phillips curve.
And like the Phillips curve, the story of what happens
in the short run, well, it's not the whole story.
So far, we've only been focused on the short run.
And the problem that businesses face in the short run
is that they only have so much production capacity, right.
But in the long run, you can expand your production capacity.
Ford can build more production plants, and a popular restaurant
can expand its seating area or open the second location.
Hotels can add more rooms.
So in the long run, which to be clear, might
be a period of many years, businesses will adjust their
production capacity.
This means that in the long run, businesses respond to
a stronger economy by expanding their production capacity rather than
raising their price, So in the long run, aggregate supply
will no longer be related to the price level.
What bitch you to sid might sound weed, but it
means that in the long run, the average price level
has no effect on the amount of output that businesses produced.
Stick with us, because this is a really important idea.
I have a crazy thought experiment for you. Okay, just
imagine that you have had this relaxing afternoon nap that
has lasted for a decade, and you wake up ten
years later, and every price in the economy has gone
up by a factor of ten. The price of cars
and meals and hotels are all ten times higher. The
price of you raw materials like electricity and rent are
ten times higher. Your wages are ten times high, where
the value of your investment are also ten times higher.
Ooh, so ten years later, everything seems different, but is it.
Well, people seem richer because their incomes are ten times higher,
but in reality they're not richer at all because the
prices of all the stuff that they can buy are
also ten times higher, so they can't buy any more
goods and services than before.
And a similar thing happens on the supply side.
Yeah, So let's look at a car company. For example.
If the price that Ford can charge for a car
is ten times higher, that might be a big deal,
But then the price of all its inputs are also
going to be ten times higher, so that cancels out
much of the effect. And even if the profits that
Ford earns a higher, if the price of the stuff
you might spend your profits on are also higher, then
it's not really more profitable either.
The economy's exactly like it was before you fell asleep.
It's the same, except there's an extra zero on the
end of everything.
And because it's the same, the amount of stuff that
businesses want to produce is the same, and what consumers
can buy is the same, but nothing's different.
In the long run, aggregate supply will be the same
whether average prices are at today's level or ten times
higher or ten times lower, oh well, pretty much anywhere
in between.
The idea here is that in the long run, aggregate
supply is unrelated to the price level, which is an
idea called the classical dichotomy.
This is the idea that what's happening in the real economy,
which is about the amount of stuff that businesses actually
really produce is unrelated to nominal variables like the price level.
The truth is, I actually hate this term classical dichotomy,
but let me break it down for you. It's a
dichotomy because it keeps real and nominal separated, and it's
classical because it refers to some stuff some old white
I thought a really long time ago, which means it
comes from the classical economists whose insights a best to
the long run.
What we're saying is that in the long run, the
economy will produce at its potential, which is determined by
long run factors like the quantity of machines, workers, skills,
and technology. It's determined by these real factors rather than
the price level.
The point here is that the aggregate demand and aggregate
supply framework that we've been discussing is really useful for
thinking about how the economy shifts around from year to year.
That's why we use it to analyze business cycles. But
over the long run, like how the economy is going
to perform over the next decade or so, this model
becomes a lot less relevant. This season, we've been looking
at the macroeconomy, which can be a little hard to
get our heads around, as we've been talking about big
scales and concepts that can sometimes seem abstract.
To makes sense of all this, we've talked about a
bunch of different models and frameworks that you can use
to see and understand the economy a bit more.
Clar With macroeconomics, we need to bring in all the
various players consumers, investors, foreigners, the government. Let's step back
and think about the economy as a concert with a singer,
a guitarist, a keyboard player, someone on the drums, a
bunch of other musicians, each adding a different instrument. Now,
what I want you to do is swap all the
musicians in the concert for consumers, investors, government, exporters, and importers.
Just like the interactions to the musicians in a band
create harmony and melody and highs and lows, well, the
interactions between all these different parties in the economy also
create harmony and melody and economic highs and lows what
we call business cycles.
Okay, I hear that. But today we've talked about one
model of the economy emphasizing aggregate demand and aggregate supply.
But in early episodes we looked at the ISMP model,
the phillips Cu and how these come together in the
fad model. So how can we fit all of these
pieces together?
Well, it's all about where you sit as an economist
during that concert.
You could be standing in the stars, which gives you
a great view of the lead guitarist, or.
Maybe you have a seat in the upper circle to
the left of the stage, which will give you a
different perspective. You'll have a really great view of the
drummer and the lead singer.
You could get a good view from both positions, and
it's really simply a matter of preference which vantage point
you prefer.
The point is the concert and the music being performed
don't change whether you're sitting in the stalls or sitting
to the left of the stage.
And that's also the keys of the macro economy. You
can examine the macro economy from different angles, but the
facts of the economy don't change.
Today's perspective was about aggregate demand and aggregate supply. It's
like sitting to the left of the stage. This is
the perspective. It's going to give you a really accurate
view not at the lead singer, but of what's going
on with our in the price level.
In the FED model, in the ISMP model, which we
talked about in earlier episodes, focus on what's happening with
the real interest rate, output and inflation. With these models,
you're sitting in the seats which give you a clearer
view of what's going on there.
So which model I use really depends on which parts
of the macroeconomic concert I most want to.
See you Bet.
Okay, Betsy, justin learning about macro with you guys has
been really awesome. You guys have rock stars. Where are
we going next?
The first place is to say congratulations to our listeners.
You've gone through all of macroeconomics. You have all of
the great seats to watch the spectacular concept playing out
in front of you, and hopefully you're going to see
it and hear it a little more clearly.
So what we're going to do next when we return
in season three is dig a little bit more into
business economics and business strategy.
And how it is that CEOs make the big decisions
that really.
Matter for their workers and their customers and their shareholders.
We're looking to bring you some of the secrets that
you might only hear in an NBA classroom.
Thanks for listening.
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