Money and Banking Chapter 23 Aggregate Supply and Demand, the Growth Diamond and Financial Shocks

Chapter 23 Aggregate Supply and Demand , the Growth Diamond , and Financial Shocks CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Describe the aggregate demand ( AD ) curve and explain why it slopes downward . Describe what shifts the AD curve and explain why . Describe the aggregate supply ( AS ) curve and explain why it slopes upward . Describe what shifts the AS curve and explain why . Describe the aggregate supply ( curve , and explain why it is vertical and what shifts it . Explain the term long term and its importance for . Describe the growth diamond model of economic growth and its importance . Explain how financial shocks affect the real economy . URL books 468

Aggregate Demand LEARNING OBJECTIVES . What is the AD curve and why does it slope downward ?

What shifts the AD curve and why ?

We learned in Chapter 22 in Action that the model isn entirely agreeable to because it examines only the short term , and when pressed into service for the term , or changes in the price level , it suggests that policy initiatives are more likely to mess matters up than to improve them . In response , economists developed a new theory , aggregate demand and supply , that relates the price level to the total final goods and services demanded ( aggregate demand AD ) and the total supplied ( aggregate supply AS ) This new framework is attractive for several reasons ( it can be used to examine both the short and the long run ( it takes similar to the price theory model and demand , so it and ( it gives some grounds for implementing activist economic policies . To understand aggregate demand and supply theory , we need to understand how each of the curves is derived . The aggregate demand curve can be derived three ways , through the model as described at the end 22 in Action , with the quantity theory ofmoney , or its components . Remember that I . As the price level falls , real money balances are higher . That spells a lower interest rate , as we learned in Chapter The Economics of Fluctuations . A lower interest rate , in turn , means an increase in I ( and hence ) A lower interest rate also means a lower exchange rate and , as explained in Chapter 18 Foreign Exchange , more exports and fewer imports . So also increases . might be positively affected by lower i as well . As the price level increases , the opposite occurs . So the AD curve slopes downward . Figure ( URL books ' 469

Aggregate Price Level , 1996 ) Aggregate Output , trillions , 1996 ) The quantity theory of money also shows that curve should slope downward . Remember that the quantity theory ties money to prices and output via velocity , the average number of times annually a unit of currency is spent on goods and services , in the equation of exchange where money supply velocity of money price level aggregate output If 100 billion and , then must be 300 billion . If we set , the price level , equal to , must equal 300 billion ( If is , then Yis 150 billion ( If it is , then is 600 billion ( Plot those points and you get a downward sloping curve , as in Figure Aggregate demand curve . The AD curve shifts right if the increases and left if it decreases . URL books 470

Continuing the example above , if we hold constant at but double to 200 billion , then double to 600 billion ( 200 ) Recall that the theory suggests that changes only slowly . Cut in half ( 50 billion ) and will fall by half , to 150 billion ( 50 ) Figure Factors that shift the aggregate demand curve For a summary of the factors that shift the AD curve , review Figure Factors that shift the aggregate demand curve . KEY TAKEAWAYS The aggregate demand ( AD ) curve is the total quantity of final goods and services demanded at different price levels . It slopes downward because a lower price level , holding constant , means higher real money balances . Higher real money balances , in turn , mean lower interest rates , which means more investment ( I ) due to more projects and more net exports ( due to a weaker domestic currency ( exports increase and imports decrease ) The AD curve is positively related to changes in , I , and , and is negatively related to URL books

Those variables shift AD for the same reasons they shift , and the IS curve , as discussed in Chapter 21 and Chapter 22 in Action , because all of them except taxes add to output . An increase in the increases AD ( shifts the AD curve to the right ) through the quantity theory of money and the equation of exchange . Holding velocity and the price level constant , it is clear that increases in must lead to increases in URL books 472

Aggregate Supply LEARNING OBJECTIVES . What is the AS curve and why does it slope upward ?

What shifts the AS curve and why ?

The aggregate supply curve is a tad trickier because it is believed to change over time . In the long run , it is thought to be vertical at i , the natural rate of output concept introduced in Chapter 22 in Action i In the long run , the economy can produce only so much given the state of technology , the natural rate of unemployment , and the amount of physical capital devoted to productive uses . Figure ( I ' supply ( llI ( Aggregate Price Level , 1996 ) Aggregate Output , trillions , 1996 ) In the short run , by contrast , the total value of goods and services supplied to the economy is a function of business profits , meant here simply as the price goods bear in the market minus all the costs of their production , including wages and raw material costs . Prices of goods and services generally adjust faster than the cost of inputs like labor and raw materials , which are often sticky due to contracts their price . So as the price level rises , business URL books 473

are higher and hence businesses supply a higher quantity to the market . That is why the aggregate supply ( AS ) curve slopes upward in the short run , as in Figure aggregate supply curve . The AS curve shifts due to changes in costs and hence . When the labor market is tight , the wage bill rises , cutting into and shifting the AS curve to the left . Any wage push from any source , like unionization , will have the same effect . If economic agents expect the price level to rise , that will also shift the AS curve left because they are going to demand higher wages or higher prices for their wares . Finally , changes in technology and raw materials supplies will shift the AS curve to the right or left , depending on the nature of the shock . Improved productivity ( more output from the same input ) is a positive shock that moves the AS curve to the right . A shortage due to bad weather , creation of a successful producer monopoly or cartel , and the like , is a negative shock that shifts the AS curve to the left . Figure that Sill the ( supply curve URL books 474

Also , whenever Yuri , the AS curve shifts left . That is because when , the labor market gets tighter and expectations of grow . Reversing that reasoning , the AS curve shifts right whenever i exceeds . Figure Factors that shift the aggregate supply curve summarizes the discussion of the AS curve . KEY TAKEAWAYS The aggregate supply ( AS ) curve is the total quantity of final goods and services supplied at different price levels . It slopes upward because wages and other costs are sticky in the short run , so higher prices mean more profits ( prices minus costs ) which means a higher quantity supplied . The curve shifts left when exceeds , and it shifts right when is less than . In other words , is achieved via shifts in the AS curve , particularly through labor market tightness and inflation expectations . books 475

When is , the labor market is tight , pushing wages up and strengthening inflation expectations when , is , the labor market is loose , keeping wages low and inflation expectations weak . Supply shocks , both positive and negative , also shift the AS curve . Anything ( like a wage push or higher raw materials prices ) that decreases business profits shifts AS to the left , while anything that increases business profits moves it to the right . URL books , 475

Equilibrium Analysis LEARNING OBJECTIVES . What is the curve ?

Why is it vertical , and what shifts it ?

How long is the long term and why is the answer important for ?

Ofcourse , this is alljust a prelude to the main event slapping these three , AS , the same graph at the same time . Lets start , as in Figure equilibrium in the , with just the AS and AD curves . Their intersection indicates both the price level ( not to be confused with the price theory model ) and ( again not to be confused with ) Equilibrium is achieved because at any , there will be a glut ( excess supply ) so prices ( of all goods and services ) will fall toward . At any , there will be excess demand , many bidders for each automobile , sandwich , haircut , and what not , who will bid prices up to . We can also now examine what happens to and in the short run by moving the curves to and fro . Figure ( i ) I in flit ( I ' Aggregate Price Level , Aggregate Output , URL books 477

To study changes in the economy , we need to add the vertical aggregate supply curve ( to the graph . As discussed above , if is or i , the AS curve will shift ( via the labor market expectations ) until it , as in Figure equilibrium in the . So attempts to increase output above its natural rate will cause and recession Attempts to keep it below its natural rate will lead to and expansion . Figure I ' in the In ( URL books 478

Aggregate Price Level , Aggregate Output , a ) Initial equilibrium in which , Aggregate Price Level , Aggregate Output , Initial equilibrium in which , The mechanism described above makes many uneasy , so the most activist among them argue that the analysis holds only over very long periods . In fact , the great granddaddy , intellectually speaking , of today activist , John Maynard URL books 103 , 479

Keynes , once remarked , The ong run is a misleading guide to current affairs . In the long run we are all dead . Economists set themselves too easy , too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is Other economists ( including like Milton ) think that the short run is short indeed and the long run is right around the corner . Figuring out how short and long the short and long runs are is important because if the are correct , are wasting their time trying to increase output by shifting AD to the right the AS curve will soon shift left , leaving the economy with a higher price level but the same level of output . Similarly , need do nothing in response to a negative supply shock ( which , as noted above , shifts AS to the left ) because the AS curve will soon shift back to the right on its own , restoring both the price level and output . If the activists are right , on the other hand , can improve people lives by regularly shifting AD to the right and countering the effects of negative supply shocks by helping the AS curve to return to its original position or beyond . The holy grail of economic growth theory is to figure out how to shift , to the right because , if can do that , it doesn matter how short the long term is . can make a for the better . The real business cycle theory of Edward Prescott suggests that real aggregate supply shocks can affect , This is an active area of research , and not just because Prescott took home the Nobel Prize in 2004 for his contributions to dynamic the time consistency of economic policy and the driving forces behind business Other economists believe that activist policies designed to shift AD to the right can , through a process called hysteresis . It still all very confusing and complicated , so the authors of this book and numerous others prefer bringing an institutional analysis to , one that concentrates on providing economic actors with incentives to labor , to develop and implement new technologies , and to build new plant and infrastructure . Stop and Think Box People often believe that wars induce economic growth however , they are quite wrong . Use Figure and output during and after two major wars , the Civil War ( URL books 480

and World War I ( and the model to explain why people think wars induce growth and why they are wrong . Figure and output during and after two major wars , the Civil War ( and World War I ( URL books ' 481 often increases during wars because AD shifts right because of increases in ( tanks , guns , ships , etc . and I ( new or improved factories to produce tanks , guns , ships , etc . that exceed decreases in ( wartime rationing ) and possibly ( trade level decreases or subsidies provided to or by allies ) Due to the right shift in AD , also rises , perhaps giving the illusion of wealth . After the war , however , two things occur AD shifts back left as war production ceases and , to the extent that the long run comes home to roost , AS shifts left . Both lower and the AD leftward shift decreases the price level . Empirically , wars are indeed often followed by and . Figure and output during and after two major wars , the Civil War ( and World War I ( shows what happened to prices and output in the United States during and after the Civil War ( and World War I ( direct involvement , respectively . The last bastion of the warmongers is the claim that , by inducing technological development , wars cause shift right . Wars do indeed speed research and development , but getting a few new gizmos a few years sooner is not worth the wartime destruction of great masses of human and physical capital . KEY TAKEAWAYS The is the amount of output that is obtainable in the long run given the available labor , technology , and physical capital set . It is vertical because it is insensitive to changes in the price level . Economists are not entirely certain why shifts . Some point to hysteresis , others to real business cycles , still others to institutional improvements like the growth diamond . Nobody knows how long the long term is , but the answer is important for one attitude toward economic . Those who favor activist policies think the long term is a long way off indeed , so can benefit the economy by shifting AD and AS to the right . Those who are suspicious of interventionist policies think that the long run will soon be upon us , so interventionist policies can not help the economy for long because output must soon return to , i . Maynard Keynes 66 URL books 482

URL books ( 483 The Growth Diamond LEARNING OBJECTIVE . What is the growth diamond and why is it important ?

Over the last two decades or so , many scholars , including one of the authors of this textbook ( Wright ) have examined the link between financial development and economic growth . They have found that repression , severe underdevelopment intermediaries and markets , can stymie growth and the growth . The reason is clear by reducing asymmetric information and tapping economies of scale ( and scope ) the financial system efficiently links investors to entrepreneurs , ensuring that society scarce resources are allocated to their highest valued uses and that innovative ideas get a fair trial . The research agenda of some of those scholars , including the author of this textbook , has recently broadened to include more of the institutional factors that enhance or reduce economic growth , sustained rightward movements of . A leading model , set forth by three economic historians who teach economics at New York University Stern School of Business , is called the growth diamond or diamond of sustainable growth . Imagine a baseball or softball diamond . At the bottom of the diamond is home plate , the most important base in the game , where the player both begins and , if successful , ends his or her journey . Looking out from home , first base is at the right corner second base is at the top of the diamond , dead ahead and third base is at the diamonds left corner . To score a run , a player must return to home plate after touching , second , and third base , in that order . Countries are no than ballplayers in this regard . For a country to get rich , it needs to base to base in the proper order . In the growth diamond , home plate is represented by government , first base by the financial system , second base by entrepreneurs , and third base by management . To succeed economically , as depicted in Figure The growth diamond , a country must first possess a solid home plate , a government that at a minimum protects the lives , liberty , and property of its citizens . Next , it must develop an efficient system capable of linking to people with good business ideas , the entrepreneurs at second base . The managers at third take over after a product has emerged and matured . URL books , 484

Figure Open Access Entrepreneurship Effective Modern Management Financial System Home plate government The growth diamond is a powerful model because it can be applied to almost every country on earth . The poorest countries never left home plate because their governments killed and robbed their citizens . Poor but not destitute countries never made it to base , often because their governments , while not outright predatory , restricted economic liberty to the point that and entrepreneurs could not thrive . In many such countries , the system is the tool of the government ( indeed many banks in poor countries are owned by the state outright ) so they allocate resources to political cronies rather than to the best entrepreneurs . Countries with middling income rounded the bases once or twice but found that managers , entrepreneurs , and the government and implemented policies that rendered it to score runs frequently . Meanwhile the rich countries continue to rack up the runs , growing stronger as players circle the bases in a virtuous or cycle . Stop and Think Box URL books 485

In the early nineteenth century , Canada ( then a colony of Great Britain ) and New York State ( then part of a but independent United States ) enjoyed ( perhaps hated is a better word here ! a very similar climate , soil type , and and fauna ( plants and animals ) Yet the population density in New York was much higher , farms ( were worth four times more there than on the north side of Lake , and per capita incomes in New York dwarfed those of . What explains those differences ?

The growth diamond does . By the early , the United States , of which New York State was a part , had put in place a nonpredatory government and a system that , given the technology of the day , was quite efficient at linking investors to entrepreneurs , the activities of whom received governmental sanction and societal support . A nascent management class was even forming . by contrast , was a colony ruled by a distant monarch . Canadians had little incentive to work hard or smart , so they didn , and the economy languished , largely devoid of banks and other intermediaries and securities markets . As late as the , New York was sometimes a better market for the sale of Canada exchange on London than Canada Only after they shed their imperial overlords and reformed their domestic governments did Canadians develop an effective system and rid themselves of entrepreneurial laws and sentiments . The Canadian economy then grew with rapidity , making Canada one of the world richest countries . A narrower and more technical explanation of the higher value of New York farms comparable to Canadian farms in size , soil quality , rainfall , and so forth is that interest rates were much lower in New York . Valuing a farm is like valuing any asset . All it takes is to discount the farm expected future income stream . Holding expected income constant , the key to the equation becomes the interest rate , which was about four times lower in New York ( say , percent per year versus 24 percent ) Recall that ( i ) If ( next year income ) in both instances is 100 , buti in Canada and in New York , an investor would be willing to lease the New York farm for a year for , but the Canadian farm for only . The longer the time frame , the more the higher Canadian interest rate will bite . In the limit , we could price the farms as using the equation from Chapter Interest Rates . That means the New York farm would be worth , while the Canadian farm would be worth a mere ( which , of URL books 0797 ?

486 course , times equals the New York farm price ) Canadian land values increased when Canadian interest rates decreased after about 1850 . One important implication ofthe growth diamond is that emerging ( from eons ) or transitioning ( from communism ) economies that are currently hot , like those and India , may begin ifthey do not strengthen their governance , entrepreneurial , and management systems . Some of today economies , including that of Argentina , were once high that ran into an economic brick wall because they inadequately protected property rights , impeded financial development , and entrepreneurship . Although currently less analytically rigorous than the model , the growth diamond is more historically grounded than the model or any other macro model and that is important . As storied economist Will once put it , We can not understand . without systematic examination events which the present and will continue to exercise profound tomorrow . he long run is important because it is not sensible for economists and to attempt to discern trends and their developments , which may be dominated by transient conditions . KEY TAKEAWAYS The growth diamond is a model of economic growth ( increases in real per capita aggregate output ) being developed by economic historians at the Stern School of Business . It posits that sustained , economic growth is predicated on the existence of a nonpredatory government ( home plate ) an efficient financial system ( first base ) entrepreneurs ( second base ) and modern management ( third base ) It is important because it explains why some countries are very rich and others are desperately poor . It also explains why some countries , like Argentina , grew rich , only to fall back into poverty . Finally , it warns investors that the growth trends of current high fliers like China could reverse if they do not continue to strengthen their governance , financial , entrepreneurial , and management systems . URL books 487

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doc ( Preston , Three Years Residence in Canada , from 1837 to 1839 , London Richard Bentley 1840 ) 185 ) Will , Productivity Growth , Convergence , and Welfare What the Data Show , American Economic Review 76 ( December 1986 ) as quoted in Peter , Against the Gods The Remarkable Story ( New York John Wiley Sons , 1996 ) 181 . URL books 488

Financial Shocks LEARNING OBJECTIVE . How do financial shocks and crises affect the real economy ?

Another important implication of the growth diamond is that crises can have extremely negative consequences for economic growth . Five shocks , alone or in combination , have a strong propensity to crises Increases in uncertainty . When companies can not plan for the future and when investors feel they can not estimate future corporate earnings or interest , or default rates , they tend to play it safe . They hold cash instead of investing in a new factory or equipment . That , of course , reduces aggregate economic activity . Increases in interest rates . Higher interest rates make business projects less profitable and hence less likely to be completed , a direct blow to gross domestic product ( Also , higher interest rates tend to exacerbate adverse selection by discouraging better borrowers but having little or no effect on the borrowing decisions of riskier companies and individuals . As a result , lenders are saddled with higher default rates in high environments . So , contrary to what one would think , high rates reduce their desire to lend . To the extent that businesses own government or other bonds , higher interest rates decrease their net worth , leading to balance sheet deterioration , of which we will learn more below . Finally , higher interest rates hurt cash ( receipts minus expenditures ) rendering more likely to default . Government problems . Governments that expend more than they take in via taxes and other revenues have to borrow . The more they borrow , the harder it is for them to service their loans , raising fears of a default , which decreases the market price of their bonds . That hurts the balance sheets of that invest in government bonds and may lead to an exchange rate crisis as investors sell assets in the local currency in a to safety . Precipitous declines in the value of local currency causes enormous difficulties for firms that have borrowed in foreign currencies , like dollars , sterling , euro , or yen , because they have to pay more units of local currency than expected for URL books 489

each unit of foreign currency . Many are unable to do so and they default , increasing uncertainty and asymmetric information . Balance sheet deterioration . Whenever a balance sheet deteriorates , which is to say , whenever its net worth falls because the value of its assets decreases or the value of its liabilities increases , or because stock market participants value the less highly , the of asymmetric information rears its trio of ugly , faces . The company now has less at stake , so it might engage in riskier activities , exacerbating adverse selection . As its net worth declines , moral hazard increases because it grows more likely to default on existing obligations , in turn because it has less at stake . Finally , agency problems become more prevalent as employee bonuses shrink and stock options become valueless . As employees begin to shirk , steal , and look for other work on company time , productivity plummets , and further declines in profitability can not be far behind . The same negative cycle can also be by an unanticipated , a decrease in the aggregate price level , because that will make the liabilities ( debts ) more onerous in real terms ( adjusted for lower prices ) Banking problems and panics . If anything hurts banks balance sheets ( like higher than expected default rates on loans they have made ) banks will reduce their lending to avoid going bankrupt incurring the wrath of regulators . As we have seen , banks are the most important source of external in most countries , so their decision to curtail will negatively affect the economy by reducing the of funds between investors and entrepreneurs . If bank balance sheets are hurt badly enough , some may fail . That may trigger the failure of yet more banks for two reasons . First , banks often owe each other considerable sums . If a big one that owes much to many smaller banks were to fail , it could endanger the solvency of the creditor banks . Second , the failure of a few banks may induce the holders of banks monetary liabilities ( today mostly deposits , but in the past , as we ve seen , also bank notes ) to run on the bank , to pull their funds out en masse because they can tell if their bank is a good one or not . The tragic thing about this is that , because all banks engage in fractional reserve banking ( which is to say , that no bank keeps enough cash on hand to meet all of its monetary liabilities ) runs often become prophecies , destroying even solvent institutions in a matter of days or even hours . Banking panics and the dead banks they leave in their URL books 490

wake causes uncertainty , higher interest rates , and balance sheet deterioration , all of which , as we ve seen , hurt aggregate economic activity . A downward spiral often ensues . Interest rate increases , stock market declines , uncertainty , balance sheet deterioration , and imbalances , as detailed above , all tend to increase asymmetric information . That , in turn , causes economic activity to decline , triggering more crises , including bank panics exchange crises , which increase asymmetric information . Economic activity again declines , perhaps triggering more crises or an unanticipated decline in the price level . That is the point , traditionally , where turn into depressions , unusually long and steep economic . Stop and Think Box In early 1792 , banks curtailed their lending . That caused a securities speculator and shyster by the name of William Duer to go bankrupt owing large sums of money to hundreds of investors . The uncertainty caused by Duer sudden failure caused people to panic , inducing them to sell securities , even government bonds , for cash . By , though , the economy was again humming along nicely . In 1819 , banks again curtailed lending , leading to a rash of mercantile failures . People again panicked , this time running on banks ( but clutching their government bonds for dear life ) Many banks failed and unemployment soared . Economic activity shrank , and it took years to recover . Why did the economy right itself quickly in 1792 but only slowly in 1819 ?

In 1792 , America central bank ( then the Secretary of the Treasury , Alexander Hamilton , working in conjunction with the Bank of the United States ) acted as a lender of last resort . By adding liquidity to the economy , the central bank calmed fears , reduced uncertainty and asymmetric information , and kept interest rates from spiking and balance sheets from deteriorating further . In 1819 , the central bank ( with a new Treasury secretary and a new bank , the Second Bank of the United States ) crawled under a rock , allowing the initial crisis to increase asymmetric information , reduce aggregate output , and ultimately cause an unexpected debt . Since 1819 , America has suffered from crises on numerous occasions . Sometimes they have ended quickly and quietly , as when Alan stymied the stock URL books 491

market crash of 1987 . Other times , like after the stock market crash of 1929 , the economy did not fare well at all . Assuming the growth diamond has not been destroyed by the depression , economies will eventually reverse themselves after many companies have gone bankrupt the balance sheets of surviving firms improve and uncertainty , asymmetric information , and interest rates decrease ( see Chapter The Economics of Fluctuations ) It is better for everyone , however , if crises can be nipped in the bud before they turn ugly . This , as we learned in Chapter 17 Monetary Policy Targets and Goals , is one of the major functions of central banks like the European Central Bank ( and the Fed . Generally , all that the central bank needs to do at the outset of a crisis is to restore , reduce uncertainty , and keep interest rates in line by adding liquidity ( cash ) to the economy by acting as a lender of last resort , helping out banks and other intermediaries with loans and buying government bonds in the open market . As we learned in Chapter 12 The Financial Crisis of , however , sometimes a bailout becomes necessary . Figure Anatomy of a financial crisis and economic decline this discussion of the ill consequences of financial shocks . Figure ( crisis and URL books 492

Note At any point the downward spiral can be stopped by adequate central bank intervention . Source Text . URL books 493 But in case you didn get the memo , nothing is ever really free . Well , except for free goods . When central banks stop panics , especially when they do so by bailing out failed companies , they risk creating moral hazard by teaching market participants that they will shield them from risks . That is why some economists , like Allan , said Let Em Fail , in the pages of the Wall Street Journal when some hedge funds ran into trouble due to the unexpected deterioration of the subprime mortgage market in 2007 . Hamilton Law ( nee Law which , as described in Chapter 16 Monetary Policy Tools , urges lenders of last resort to lend at a penalty rate on good security ) is so powerful precisely because it minimizes moral hazard by providing relief only to the more prudent and solvent while allowing the riskiest ones to go under . KEY TAKEAWAYS Financial shocks and crises affect the real economy by increasing asymmetric information . That , in turn , reduces the amount of funds channeled from investors to entrepreneurs . Starved of external finance , businesses cut back production , decreasing aggregate economic activity . The conduits include rapidly rising interest rates , foreign exchange crises , and bank panics . wiki Free July 21 , URL books 494

Suggested Reading , William , Robert , and Carl . Good Capitalism , Bad Capitalism , and the Economics of Growth and Prosperity . New Haven , Yale University Press , 2007 . Stephen , North , and Barry . Political Institutions and Financial Development . Stanford , CA Stanford University Press , 2008 . Powell , Benjamin . Making Poor Nations Rich Entrepreneurship and the Process Development . Stanford , CA Stanford University Press , 2008 . Wright , Robert One Nation Under Debt Hamilton , and the History of What We Owe . New York , books 495