Tuesday, February 24, 2015

Dynamics of Aggregate Demand

Money may be thought of as the life blood of any economy. Possession of money by an agent empowers that agent to coordinate resources and even other agents. It is a mistake to look at money only as one good among money. This perspective may aid analysis of changes in the value of money and its allocation, but they only partly capture money’s influence. Money is the universal numeraire. It is the measuring rod that aids economic calculation. In every exchange that occurs in a monetary economy, money is one side of transaction – the other side being the good or service offered in exchange for money. Given this feature, a dichotomy arises between the demand side and the supply side of the economy. The demand side is represented by the money that is available to be used for the purchase of goods and services. The supply side is comprised of the flow of existing goods over some time period and the stocks already on hand. To avoid shortages or surpluses, sellers of goods must adjust prices to accommodate changes in demand for goods. Markets also experience fluctuations in aggregate demand as 1) the money stock fluctuates and 2) general demand to hold money changes. That is, the tendency of agents to collectively decrease or increase consumption over a period is reflected by fluctuations in total expenditures of all agents.

Those of you who are familiar with macroeconomics or have been engaging the previous posts in thorough dialectic will, I hope, see what this implies for macroeconomic analysis. The equation of exchange helps us to identify the aggregate demand and aggregate supply. Recall that MV = Py. Total expenditures on final goods and services is equal to the nominal value total income. For the exercise, let us assume that the economy is static so as to avoid analytical problems that arise from innovation. For now, we will assume that prices adjust to accommodate changes in the supply of and demand for money. Of course, the store owner would likely never imagine that he is accommodating these changes. She instead adjusts price of the good based on changes in available stocks of the good itself as well as changes in the price inputs. She also accounts for expected changes in demand for the good at the given price. Remember, as Hayek (1945) argues, that suppliers need not know the source of a price change. They only need to correctly interpret an appropriate cue or cues that helps them adjust prices to prevailing conditions. In this early analysis, we shall make the grandiose assumption that prices adjust instantaneously. In the future, we shall consider situations where the given array of prices produce excess supplies of goods. For now, we will consider the nature of changes in the aggregate demand curve both at the instance of the change and the equilibrium outcome results.
               
Now we have appropriately identified our objects of analysis and the objects that comprise them, we may move forward in employing the aggregate variable M, V, P, and y. Aggregate demand and aggregate supply are both described in P-y space. As mentioned above, the aggregate demand curve is defined by total outlays, MV. The curve intersects the long-run aggregate supply (LRAS) curve at some price level comprising the equilibrium state. The value y* at this point is the value of real income in the long-run. At this level, the economy is said to be at full employment.
                




Figure 1
The aggregate demand curve falls as a result of an decrease in either the money stock, M, or an increase in demand for money (equivalently a fall in velocity). In Figure 1, the AD curve falls, but the reason is not indicated. For the sake of analysis, let us assume that this change was either entirely the result of a fall in the money stock or an increase in demand, but not a combination of both. Possible changes in the composition of total expenditures, MV, that yield this result are shown below in Figures 2 and 3.
Figure 2

                    
Figure 3
The effect of changes in total expenditures is dependent upon the nature of subsequent price changes. If adjustment of prices is instantaneous, than there will be no change in y. Iif agents perfectly predict changes in prices given a change in the money stock or a change in demand for money, there will be no temporary change in output. This is the long run effect of changes in these variables, given that complications do not arise within the capital structure. (Say a wave of bankruptcies results from an increased rate of insolvency. Contracts are typically set in nominal, not real terms. In that case, nominal changes can, therefore have real effects.)

If prices do not instantly adjust, then we are left with an excess demand for money and an excess supply of goods. The excesses perfectly offset one another. The value of the excess demand for money [Figure 4] is equivalent to the value of the excess supply of goods [Figure 5]. This can only be alleviated by an adjustment in the price level – i.e., adjustment of all prices to cohere with the new allocation of money. The process of the opposite adjustment works in reverse. An increase in AD brought about by a fall in demand for money or an increase in the money stock will create excess demand for goods and an excess supply of money. As with the previous example, this will eventually be offset by changes in prices. (You  may want to refer back to this paragraph in the coming discussion of Say’s Principle.)
 Figure 4
Figure 5

A final warning. The process of adjustment in a real economy is not as smooth as aggregate analysis might suggest. Remember that this is a tool for conceptualizing aggregate changes in a monetary economy. A change in the price level tells us little about changes in relative prices (price ratios). These will be considered in the section on monetary policy under the heading of the non-neutrality of money.

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