Download Additional Reading 11

University of Illinois
Macroeconomic Principles - Econ 103 - Spring 2013
TA: Zheng Zhang
Additional Reading 11–Aggregate Supply and Aggregate Demand
Chapter 13 presents our broadest framework in Keynesian economics – Aggregate Supply and
Aggregate Demand Model or AS-AD Model. This model aims to piece everything together we have
learned so far. Remember the goal of our economy is to achieve low inflation, high output growth
rate and low unemployment rate. Notice that high output implies low unemployment rate, so we
only need to device a model where we can find the relationship between the price level (CPI or
GDP deflator) and the aggregate output to see what policies we may use to achieve the desired
goals.
1. Aggregate Demand
To derive the aggregate demand curve, the first thing we have to know is that the value of
Aggregate Demand equals the value of Aggregate Expenditure in Keynesian Cross, the only
difference being that we say Aggregate Expenditure when prices are fixed while we prefer to
designate it as Aggregate Demand when prices are allowed to be changing.
(a) Real Wealth Effect: As the price level rises, the wealth held by households declines in
value because the purchasing power of money falls. As buyers become poorer, they reduce
their purchases of all goods and services which in turn reduce the aggregate expenditure
(AE curve makes a parallel shift down) and contract the economy (Y decreases). On
the other hand, as the price level falls, the purchasing power of money rises. Buyers
become wealthier and are able to purchase more goods and services than before.This
would lead to higher aggregate expenditure (AE curve makes a parallel shift up) and an
expansionary economy(Y increases) The wealth effect, therefore, provides one reason for
the inverse relationship between the price level and total output that is reflected in the
downward-sloping AD curve.Recall HW Chapter 12 Question 18 and 19.
(b) Interest Rate Effect:As the price level rises, households and firms require more money to
handle their transactions. However, the supply of money is fixed. The increased demand
for a fixed supply of money causes the price of holding money, the interest rate, to rise
in order for the equilibrium in money market to be restored. As the interest rate rises,
investment as part of AE that is sensitive to rate of interest will decline which will bring
down the total output. Hence, the interest rate effect provides another reason for the
inverse relationship between the price level and the demand for real GDP.
Both real wealth effect and interest rate effect imply an inverse relationship between the
price level P and aggregate demand for real output Y which gives rise to a downward sloping AD curve. This is shown in Figure 1 and as you can see, expansionary(contractionary)
fiscal or monetary policies shift AD curve out(in).
2. Aggregate Supply
(a) Simple Keynesian AS Curve As you can see in Figure 2, simple Keynesian AS curve
has two portions: short run Keynesian portion and long run Classical portion. In the
short run, Keynesians argue that prices are Fully Sticky so AS curve is perfectly elastic
which suggests that if the output is less than the full employment level i.e.when the
resources are not fully used (excess labor and savings), the firms can freely increase their
output by as much as they want at a fixed price level. This also indicates that the short
run aggregate output is determined by Aggregate Demand.However, in the long run when
the prices are allowed to be flexible, the AS curve is vertical which implies that the output
is equal to full employment level and resources are fully employed regardless of the price
level.
Suppose you were in a situation where the total output is less than full employment level,
for example, the economy is at Y1 . In the short run when prices are fully sticky, an
expansionary fiscal or monetary policy will shift the AD curve to the right and because
AD00
P
AD0
P
AD0
AS
AD
AD AD00
expansionary policies
P2
Classical Portion
Expansionary Policies
expansionary policies
P1
Contractionary Policies
Y
Figure 1: Aggregate Demand Curve
Keynesian Portion
Y
Y1 Full Employment Level
Figure 2: Simple Keynesian Supply Curve and Aggregate Demand
it intersects with the Keynesian portion of AS curve, the output will increase and so will
aggregate income which stimulates the economy. However, the same expansionary fiscal
or monetary policy will not be able to help increase the output but lead to higher price
level (P1 → P2 ) for AD curve now intersects with the classical portion of the AS curve.If
there is continuing increases in aggregate demand (for example, continuing expansions in
money supply), a sustained increase in price level will occur and this will become what
we call Demand Pull Inflation.
(b) Neo-Keynesian AS Curve Neo-Keynsian AS curve is a variant of simple Keynesian
Curve where it is assumed that prices are Partially Sticky in the short run meaning that
output prices(e.g. nominal wages) are flexible while input prices are sticky.In the long
run, both input and output prices are allowed to be floating. In other words, the change
in input prices lags behind the change in output prices.We claim that this assumption
gives rise to an upward sloping short run AS curve(SRAS).The argument is that the
firms will expand its production in the short run when the general price level is going up
because this means the output prices are increasing while the input prices stay the same,
hence the firms can make more profits by dong so. This suggest that there is a positive
relationship between the price level and total output. As shown in Figure 3, SRAS is
positively sloping. The long run AS curve(LRAS) is still vertical as is in the context of
Simple Keynesian Curve.
There are a bunch of factors that may shift the SRAS curve listed in slide 10 on page
91 of your course packet.For example, more labor or capital resource leads the SRAS
curve to the right. The item that is worth mentioning here is so called ”tax cuts”.This
tax is not the same as the one we discussed in our fiscal policy, the tax here specifically
refers to capital tax rather than the income tax the government used in its fiscal policy.
So fiscal policy only shifts the AD curve!. The cut in capital tax is one of the stimulus
supply side policies that shifts the SRAS curve to the right. Like we did for Simple
Keynesian Curve, we also distinguish between short run and long run when analyzing
economic policies. For example, suppose the economy is in a recession, i.e. the output
is at Y1 (Figure 4) when AD is less than what is needed to achieve full employment
level of output. In the short run, expansionary fiscal or monetary policy or both may be
effectively used to stimulate the economy, for example, shifting AD to AD0 and increasing
the output up to full employment level. However in the long run when input prices are
also allowed to be flexible, a sustained expansionary policy may push AD curve past
what is needed to generate long run output and lead to an overheating of the economy
(Y2 > full employment level) which contributes to nominal wage increases. This in turn
shifts the SRAS curve to the left (SRAS → SRAS 0 ) and hence reduces Y while further
increasing the price level.A continuing use of expansionary policies (Fiscal or Monetary
or both) will lead to Demand Push Inflation in this way.
Cost Push Inflation is initiated by an increase in the costs of production and this
would lead to so called stagflation where the price level keeps going up while the output
is declining. A good example is the oil criss in 1973 when the members of Organization
of Arab Petroleum Exporting Countries or the OAPEC (consisting of the Arab members
of OPEC, plus Egypt, Syria and Tunisia) proclaimed an oil embargo.
P
P
AD0
AD
AD00
LRAS
SRAS’
SRAS
AS 0
AS AS 00
P3
P2
lower cost; capital tax cuts;good weather
expansionary policies
P1
higher cost;over-regulation;natural disaster
Full Employment Level
Y
Figure 3: Neo-Keynesian Aggregate Supply Curve
Y1
Y2
Y
Figure 4: Simple Keynesian Supply Curve and Aggregate Demand