Aggregate Demand & Aggregate Supply

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Personally, I really enjoyed journalist Eric Wiener's course, The Good Fight, because it teaches how to fight constructively and creatively. His ideas are based on history, philosophy, and psychology. But he also gets practical as he gives advice on how to disagree and communicate effectively with the people we love, and those we don't care for so much. Really anyone with whom we might come into conflict. For a limited time, think like an economist listeners can go to Hema Leia.com and enter promo code Econ at checkout for a 14-day free trial. That's Hema Leia.com into the promo code Econ at checkout for a 14-day free trial. Hey, Nas, today's a huge day for our listeners. Why's 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 is going to be our last episode of the season on 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 macroeconomist. That's so cool. It's been a long road. In our first season, we worked 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 macroeconomy. 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, oranges, or jeans, or cars or houses. How can those ideas help us better understand the macroeconomy? What happens in the macroeconomy reflects all those individual microeconomic buying and selling decisions that each of us make every day. In today's episode, it's based on a bit more of a thought experiment. Now, instead of thinking about the economy, by thinking about thousands of different markets in the economy, like the market 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 going to do is think about the supply and 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 to remind, analyze the supply and demand for apples or for oranges, we can analyze the supply and 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 macroeconomy good we're calling stuff. So aggregate demand, we mean the demand for everything. Likewise, the supply of this aggregate stuff, well, we're going to 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 Justin Wolffers. We're here to give you the super tools to be economics, so that you can understand what's going on in the big and the small. Nestor and Tevacoli fires 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 using the Fed model. Today, we're going to turn to an alternative, but related approach using aggregate demand and aggregate supply. Okay, so when a microeconomist analyzes a 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 produce 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 in 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 that 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 microe 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 natinology between micro and macroe. But it's an imperfect analogy. So far, we've made it sound like the rules of microeconomics supply to the macroeconomy too. But really the similarities 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 the 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 reason 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 we should go get something else when we're talking about everything. There is an important trade-off or opportunity cost in macro. It's different to the one that guides micro. In macroe, 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, our opportunity cost is related to other products. In macroeconomics, it's 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. it demand an 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. Yes, 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 buy, 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-off in macroeconomics is the trade-off 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 year's inflation rate is higher, and that'll 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 dollar is 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 oversold, and it's difficult for anyone to keep up. Right, so if you're running a car company like Ford or General Motors, an economy is so strong that 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, the apprily 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 reason 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 rises 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 aggregate supply curve as 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 rims. 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 Betsy just said may sound weird, but it means that in the long run, the average price level has no effect on the amount of output that businesses produce. Stick with us because this is a really important idea. I have a crazy thought experiment for you. Just imagine that you have had this relaxing afternoon nap that has lasted for a decade. And you wake up 10 years later and every price in the economy has gone up by a factor of 10. The price of cars and meals and hotels are all 10 times higher. The price of your raw materials like electricity and rent are 10 times higher. Your wages are 10 times higher. The value of your investment are also 10 times higher. Ooh, so 10 years later, everything seems different, but is it? Well, people seem richer because their incomes are 10 times higher. But in reality, they're not richer at all because the prices of all the stuff that they can buy are also 10 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 10 times higher, that might be a big deal. But then the price of all his inputs are also going to be 10 times higher. So that cancels out much of the effect. And even if the profits that Ford earns 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 economy, 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, with the average prices at today's level, or 10 times higher, or 10 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 guy's thought a really long time ago, which means it comes from the classical economists whose insights apply 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 macro economy, 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 make 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 clearly. 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 of the musicians in a band create harmony, melody and highs and lows. With 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 curve, 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 catch 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 that's going to give you a really accurate view, not at the lead singer, but of what's going on with output and the price level. In the Fed model and 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 clear 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 are rock stars. Where are we going next? The first place is to say congratulations to our listeners. You've gone through all of macro economics. You have all of the great seats to watch the spectacular concert 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 MBA classroom. Thanks for listening. There's a lot more from this show and others like it on the Himalaya Learning Platform. 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