How can aggregate demand increase

This measurement is expressed as the total amount of money exchanged for those goods and services at a specific price level and point in time. Over the long-term, aggregate demand is equivalent to gross domestic product GDP. Price level is the average of current prices across the entire spectrum of goods and services produced in the economy. Of course, the general price level is purely hypothetical; there is obviously no uniform price for the many types of goods and services in the economy.

Price levels are one of the most-watched economic indicators in the world. This is because most economists agree that prices should stay relatively stable year-over-year in order to prevent high levels of inflation. Most price level estimates are calculated by tracking a set basket of goods and services. Using this approach, a collection of consumer-based goods and services is examined in aggregate; this makes it possible to identify changes in the broad price level over time.

When prices rise, this is referred to as inflation. When prices fall, this is referred to as deflation. The price level is also related to the purchasing power of consumers. In general, the higher the price level, the lower the purchasing power of money.

This is because purchasing power refers to how much money can buy. When prices go up, buying power goes down because a single unit of currency—for example, one dollar—can no longer acquire the same amount of goods and services as it once could. For this reason, the real price level is particularly useful because it compares the prices of goods and services against the purchasing power of money. In general, when the price of a good or service changes, consumer demand for that good or service is also impacted.

This is the basis for the law of demand , which states that any increase in prices tends to cause the demand for a good or service to decline. However, macroeconomists normally consider rising nominal prices as crucial for economic demand in the long-term. We address these problems in Appendix D. There we show that all our empirical results are robust to using an alternative proxy for product market tightness.

This alternative proxy is constructed from the operating rate in nonmanufacturing sectors measured by the ISM and published in their Semiannual Reports. The operating rate is the actual production level of firms as a share of their maximum production level given current capital and labor, so it exactly corresponds to our concept of labor utilization. Unfortunately, the time series for the operating rate only starts in Q4, so it is too brief to permit a thorough empirical analysis.

The empirical analysis also requires measures of output, employment, and labor market tightness for the United States from Q4 to Q2. We measure output and employment using seasonally adjusted quarterly indexes for real output and employment for the nonfarm business sector constructed by the MSPC program of the BLS.

We construct the labor market tightness as the ratio of vacancies to unemployment. We measure vacancies with the quarterly average of the monthly vacancy index constructed by Barnichon This index combines the online and print help-wanted indexes of the Conference Board. We measure unemployment with the quarterly average of the seasonally adjusted monthly unemployment level constructed by the BLS from the CPS.

We construct the cyclical components of these series by taking their log and removing the low-frequency trend produced by a HP filter with smoothing parameter The equilibria that we have studied can be sorted in two groups, based on their comparative statics.

The first group includes the fixprice equilibrium and the equilibrium with partially rigid price and real wage. Since shocks are not entirely absorbed by price and real wage and transmit to tightnesses, we say that these equilibria exhibit price and real-wage rigidity.

The second group includes the competitive equilibrium and the equilibrium with Nash bargaining. Since shocks are entirely absorbed by price and real wage and do not transmit to tightnesses, we say that these equilibria exhibit price and real-wage flexibility.

The two groups of equilibria have starkly different comparative statics, so the first step of the empirical analysis is to determine which group describes the data better. To do so, we observe the cyclical behavior of the product market and labor market tightnesses, and we exploit the property that the tightnesses respond to shocks only in equilibria with price and real-wage rigidity.

Figure VIII displays the cyclical components of the product market and labor market tightnesses. Panel A shows that the cyclical component of the product market tightness is subject to fluctuations. While the drop in labor market tightness in — was commensurate to the drops in previous recessions, the drop in product market tightness in — was unprecedented—it was three times as large as the drops in — and The cyclical fluctuations of the product market and labor market tightnesses suggest that the equilibria with price and real-wage rigidity are more appropriate to describe business cycles than the equilibria with price and real-wage flexibility.

Relatedly, Shimer and Hall observe that the labor market tightness is subject to large fluctuations in the United States, and they conclude that real wages must be somewhat rigid. In the rest of the analysis, we therefore use the predictions of the equilibria with price and real-wage rigidity. We evaluate whether labor market fluctuations are caused by labor demand, labor supply, or mismatch shocks. Labor demand shocks encompass aggregate demand and technology shocks. Our model with price and real-wage rigidity predicts that the effects of labor demand shocks are different from those of labor supply and mismatch shocks.

Labor demand shocks produce a positive correlation between labor market tightness and employment. In contrast, labor supply and mismatch shocks produce a negative correlation between labor market tightness and employment.

To assess the prevalence of labor demand, labor supply, and mismatch shocks, we therefore measure the correlation between the cyclical components of labor market tightness and employment. This correlation is displayed in Figure IX. In Panel A the cyclical components of labor market tightness and employment appear strongly positively correlated. Panel B formalizes this observation by reporting the cross-correlogram of labor market tightness and employment: labor market tightness leads employment by one lag; at one lag, the correlation is large, 0.

Employment, l t , is the seasonally adjusted quarterly index for employment in the nonfarm business sector constructed by the BLS MSPC program. The horizontal dashed lines are the 2-standard-deviation confidence bounds. In the context of our model, these positive correlations imply that it is labor demand shocks and not labor supply shocks or mismatch shocks that generate labor market fluctuations.

Relatedly, Blanchard and Diamond b observe that the vacancy and unemployment rates are negatively correlated in U. Having found that labor demand shocks are the prevalent source of labor market fluctuations, we determine whether these labor demand shocks are aggregate demand shocks or technology shocks. Our model with price and real-wage rigidity predicts that the effects of aggregate demand shocks are different from those of technology shocks.

Aggregate demand shocks produce a positive correlation between product market tightness and output. In contrast, technology shocks produce a negative correlation between product market tightness and output.

To determine the nature of labor demand shocks, we therefore measure the correlation between the cyclical components of product market tightness and output. This correlation is displayed in Figure X. In Panel A the cyclical components of product market tightness and output appear positively correlated. Particularly, large drops in product market tightness followed the output drops of —, , and —, suggesting that these recessions were caused by a negative aggregate demand shock.

There are some exceptions, however. From to , output was increasing while product market tightness was falling. This observation suggests a positive technology shock in the — period. Panel B reports the cross-correlogram of product market tightness and output: product market tightness leads output by one lag; at one lag, the correlation is quite large, 0.

Panel A displays the proxy for the cyclical component of the product market tightness, x t c , and the cyclical component of output, y t c. Output, y t , is the seasonally adjusted quarterly index for real output in the nonfarm business sector constructed by the BLS MSPC program. Panel B displays the cross-correlogram between x t c and y t c.

In the context of our model, these positive correlations imply that it is aggregate demand shocks and not technology shocks that are the main source of labor market fluctuations.

We use a simple model and direct empirical evidence to explore the sources of the unemployment fluctuations observed in the United States. The model makes predictions about the comovements of product market tightness, labor market tightness, output, and employment for a broad set of shocks that could potentially explain the fluctuations. We compare these predictions with the comovements observed in U.

The comparison suggests that aggregate demand shocks are the main source of unemployment fluctuations, whereas technology, labor supply, and mismatch shocks are not an important source of fluctuations. Our analysis also confirms the prevalence of price and real-wage rigidities in the data; the rigidities allow aggregate demand shocks to propagate to the labor market.

In our model, aggregate demand arises from a choice between consumption and holding money. Usually, we think that aggregate demand arises from a choice between consumption, holding money, and saving with interest-bearing assets. In Michaillat and Saez , we extend the model in that direction and show that the properties of the aggregate demand and equilibrium are robust. We also use the extended model to study the roles and limitations of conventional and unconventional fiscal and monetary policies in stabilizing unemployment fluctuations.

Upjohn Institute for Employment Research. On mismatch, see Sahin et al. On aggregate demand, see Farmer and Mian and Sufi See for instance Pissarides and Shimer General disequilibrium generated a vast amount of research. For book-length treatments, see Barro and Grossman and Malinvaud See Pissarides for an exhaustive treatment. See Blanchard and Kiyotaki for a classical model of product market with monopolistic competition.

See Rendahl for an alternative model built around the zero lower bound on nominal interest rates. Hall , den Haan , and Petrosky-Nadeau and Wasmer also take a matching approach to the product and labor markets, but they do not explicitly represent and study aggregate demand.

The matching function is borrowed from den Haan, Ramey, and Watson This representation is slightly unconventional.

The matching literature usually emphasizes the role of visits or, on the labor market, of vacancies. Pissarides pioneered the concept of matching function on the labor market. Pissarides and Blanchard and Diamond a first explored the empirical properties of the matching function on the labor market. See Petrongolo and Pissarides for a survey of this literature. Note that the classification of occupations evolves over time so comparisons across years are not meaningful.

There is another equilibrium at the intersection with zero consumption. In that equilibrium, the tightness is x m. We do not study that equilibrium because it is uninteresting. Here the productive capacity of household i is fixed to k i , but the model could be extended to have household i choose k i.

The indeterminacy of the solution to the bilateral monopoly problem has been known since Edgeworth The indeterminacy is discussed by Howitt and McAfee and Hall in the context of matching models.

In matching models of the labor market, several researchers have assumed that the wage is a parameter or a function of the parameters.

Nash bargaining was first used in the seminal work of Diamond b , Mortensen , and Pissarides In the literature, firms usually pay the cost of posting vacancies in output. Here, firms pay the cost of posting vacancies in labor as they need to employ recruiters to fill vacancies. We make this assumption because it greatly simplifies the analysis and seems more realistic. Farmer and Shimer make the same assumption.

Assume that workers receiving unemployment insurance search for a job with effort 0 or 1. A change to the generosity of unemployment insurance affects the share of workers searching with effort 1.

But only workers searching with effort 1 are part of h because only these workers contribute to the matching process. Hence, changing the generosity of unemployment insurance affects h. Note that our classification of the workers receiving unemployment insurance is consistent with the definitions used in official statistics. In the statistics constructed by the BLS from the CPS, job seekers are counted as unemployed if they search with effort 1 and as out of the labor force if they search with effort 0, irrespective of their receipt of unemployment insurance.

See Shimer and Sahin et al. Another possible parameterization of mismatch shocks is a decrease in matching efficacy with no change in recruiting cost. Such a parameterization leads to less clearcut results because the mismatch shock affects both labor demand and labor supply. New Keynesian models feature monopolistic firms that can only change their prices at intermittent intervals.

When its price is fixed, a firm faces a demand constraint as the firms in the Keynesian unemployment regime of the Barro-Grossman model. This explains why some new Keynesian models have inherited the property of the Barro-Grossman model.

We confine our analysis to the case in which price and real wage have the same rigidity. This case shows that the comparative statics of the fixprice equilibrium may also be valid when price and real wage are only partially rigid. Although a firm and its workers are engaged in multilateral intrafirm bargaining, we abstract from possible strategic behavior.

Such behavior is analyzed in Stole and Zwiebel Instead, we assume that a firm bargains with each of its workers individually, taking each worker as marginal. Using BLS data on contractual arrangements between firms trading intermediate goods, Goldberg and Hellerstein find that one-third of all transactions are conducted under contract.

This survey is described in Eyster, Madarasz, and Michaillat Introducing positive inflation ensures that households consume some produced good even when they become infinitely patient at the limit without time discounting. Without inflation, infinitely patient households would use all their income to increase their money balances, and aggregate demand would be zero. The assumption underlying our analysis is that the comparative statics provide a good approximation to the actual dynamic effects of shocks.

This assumption is justified if the labor and product markets quickly reach their steady states. Shimer and Pissarides argue that this assumption is justified for the labor market because the rates of inflow to and outflow from unemployment are large.

Michaillat uses numerical simulations to validate this assumption for the labor market. There is little evidence on the size of customer flows, making it difficult to validate the assumption for the product market. For a measure of the tightness on the capital market, see Ottonello The cyclical fluctuations of the product market tightness have never been analyzed before.

Yet the observation that the product market tightness fluctuates a lot is not very surprising: everybody knows that queues at restaurants systematically vary depending on the time of the day or the day of the week, which indicates that prices do not adjust sufficiently to absorb variations in demand. See, for instance, the empirical work of Blanchard and Diamond b and Shimer Google Scholar.

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Sign In or Create an Account. Sign In. Advanced Search. Search Menu. Article Navigation. Close mobile search navigation Article Navigation. Volume Article Contents Abstract. Pascal Michaillat , Pascal Michaillat. Oxford Academic. Emmanuel Saez. Select Format Select format. Permissions Icon Permissions.

Abstract This article develops a model of unemployment fluctuations. The productive capacity of each household is k ; that is, a household is able to produce k services. Each household visits v other households to purchase their services. The number of trades y on the product market is given by a matching function with constant returns to scale. The product market tightness is an aggregate variable taken as given by households.

We model the matching cost as follows. Figure I. Open in new tab Download slide. The Matching Frictions on the Product Market. The representative household derives utility from consuming services and holding real money balances. There are many actions that will cause the aggregate demand curve to shift. When the aggregate demand curve shifts to the left, the total quantity of goods and services demanded at any given price level falls. This can be thought of as the economy contracting. To understand what causes the economy to contract, let's start with the basic equation for the demand curve.

Recall that the price level is not directly in the equation for aggregate demand. Rather, it is implicit in each of the terms in the equation. Thus, a decrease in any one of these terms will lead to a shift in the aggregate demand curve to the left. The first term that will lead to a shift in the aggregate demand curve is C Y - T. This term states that consumption is a function of disposable income.

If disposable income decreases, consumption will also decrease. German GDP grows 0. Export increase lifts economy; OECD raises estimate of growth rate. May 30, a. The German economy, Europe's biggest, expanded by 3. The quarter-over-quarter growth rate matched the 0. Economists now predict full-year growth of more than 3 percent. In the first quarter, exports grew Gross investment in plant and equipment increased 5. The pace of growth in private consumption weakened to 0.

OPEC wants to reverse the glut of oil on the market. However, this would hit consumers hard, perhaps rekindling inflation. Is an increase in exports good for an economy?

Most students will quickly answer "yes" to this question, as would most newspaper writers. But WE know better. It depends. Currently the economy of the United States is operating at the full employment level of output as shown in the graph below:. An increase in exports will do what to the graph above? An increase in exports will increase AD. Then, an increase in exports would increase AD and move the economy closer to the full employment level of output with only a little inflation.

See graph:. This would of course be good for the economy. So is an increase in exports good for an economy?

Now you try it. Read this short article from cnn. Send your answers to me using the form below. Type your answers here: A.

Now that we have this handy tool, let's use it to discuss government policies NOTE: when I use the term "policies", I always mean "government policies". What is the role of the government in a market economy? In a market economy capitalist economy the government has a limited role, but some people believe that the government should try to help the economy maintain full employment and low inflation.

We have discussed in the 5 Es lesson that unemployment results in greater scarcity since some resources are not being used so less will be produced. Government policies may be able to help the economy achieve full employment and therefore reduce scarcity.

Tools -- Some of the determinants of AD can be manipulated by the government to achieve these goals. The goal of expansionary fiscal policy is to reduce unemployment. This would shift the AD curve to the right increasing real GDP and decreasing unemployment, but it may also cause some inflation.