Download short run

Chapter 11 Homework
• Number 1, 4, 8, and 14
Chapter 12
The Role
of Aggregate
Demand in
the Short Run
Emergence of the
Keynesian Short-Run Model
• Classical economists thought that an
economy will self-adjust to any problems.

Economy will always be at or near
full employment.

Called the Long Run Economic Model
• The Great Depression set the stage for a
new short-run economic model.
The Great Depression’s
Challenge to the Long-Run Model
• Most severe economic trauma in U.S. history.

From 1929 to 1933, the unemployment rate
increased from about 3% to almost 25%.

By 1933, real GDP had fallen by almost 27%.

Marriage and birth rates fell.

Participation in radical political movements
increased.

Fear was fostered by not knowing what was
happening or how to fix it.
The Great Depression’s
Challenge to the Long-Run Model (cont’d)
• Following the long-run economic model, the
belief was that the economy would eventually
cure itself.

However, during the1930s it didn’t seem to be
working
• The nation’s short-run suffering required
immediate action.
The Keynesian
Short-Run Model Emerges
• John Maynard Keynes was a professor of
economics at Cambridge University in
England.
The Keynesian
Short-Run Model Emerges (cont’d)
• Keynes’ book, The General
Theory of Employment,
Interest and Money, was
published in 1936.

Arguably the most important
economics book of the 20th
century

It challenged the accepted longrun macroeconomic model.
The Keynesian Challenge to the
Long-Run Model
• The Keynesian model is a short-run model of
the behavior of the macroeconomy that:

Emphasizes the role of aggregate demand and
government action in the macroeconomy

Questions the validity of the long-run model as an
effective guide for macroeconomic policy
The Keynesian Challenge to the
Long-Run Model (cont’d)
• Compared to the Classical long-run model, the
Keynesian model:

Is concerned with the short run
• “In the long run, we’re all dead.”

Focuses on aggregate demand
• Can be shaped by policy

Suggests that the economy could remain below full
employment for prolonged periods
• Because markets don’t adjust quickly

Promotes government stabilization policy
The Keynesian Model and
Economic Policy
• In 1933, President Roosevelt proposed—and
Congress passed—a wide variety of economic
legislation designed to stabilize the economy
and put people back to work.

Roosevelt was unwilling for the economy to “fix
itself”.
Characteristics of the Short-Run Model
• Major belief is that full employment is the
exception rather than the rule.

Advocates an aggressive approach to economic
policy that attacks and cures short-run problems
quickly and effectively.
Characteristics
of the Short-Run Model (cont’d)
• Three pillars of the model

Each is a contradiction of a characteristic of the longrun model.
• Challenges:

Say’s Law

The loanable funds market

Flexible prices and wages
Challenge to Say’s Law
• Say’s Law = “supply creates its own
demand.”
• Keynes taught that demand creates its
own supply.

Aggregate demand motivates firms
• Produce a good only if there is a demand for it.

If something is wrong with the economy, it’s
due to a problem with aggregate demand.
Challenge to the Loanable Funds Market
• Long-run model interest rate adjusted so that the
quantity supplied of funds equals the quantity
demanded of funds.

Saving was channeled into investment spending.
• Short-run model no mechanism converts saving to
investment spending.
• Factors other than the interest rate can also influence
saving and investment:

Disposable income has a major impact on saving.

Expected return on investment affects the decision to invest.
Challenge to Price and Wage Flexibility
• Long-run model  freely adjusting prices
and wages.

Based on an economy comprised of small,
competitive firms, workers negotiating their own
wages, and minimal government.
• Short-run model  prices and wages are
“sticky downward.”

Based on an economy characterized by:
• Large firms with some control over the prices
they charge
• Workers represented by strong unions with the power to
negotiate wages and other benefits
Price Inflexibility
• Long-run model  AD decline leads to
lower prices as the short-run aggregate supply
curve shifts to the right.

Firms are not required to reduce output
or employment.
• Short-run model little pressure for firms to cut
prices.


AD declines  firms cut output and employment.
Unless and until prices adjust, the economy will
remain below full employment.
Wage Inflexibility
• long-run model  decline AD workers accept
lower nominal wages to keep their jobs.
• short-run model  workers resist accepting
lower wages.

Wage stickiness doesn’t allow the economy to selfadjust to a decline in aggregate demand.
• Employers will ultimately have to lay off some workers.