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Frank & Bernanke
Ch. 13: Aggregate Demand and
Output in the Short Run
(Neo) Classical Theory

Markets always clear.
 When Supply does not equal to Demand,
price changes to equate the two.
 Labor market works the same way, too.
 In the 19th century, general price levels
sometimes went up and sometimes down
but there hasn’t been any trend.
The Great Depression

Living through the Great Depression,
people rightfully questioned the received
wisdom of economists.
– If markets tended to clear, why did the labor
market show up to 25% unemployment?

The 1936 publication of The General
Theory of Employment, Interest and Money
by John Maynard Keynes provided an
explanation for markets not to clear in the
short run.
The Model by Keynes

Prices (including the price of labor - wages) do
not change in the short run.
 Firms respond to demand changes by adjusting
their production and keeping the price constant.
 Demand changes occur all the time and the
structure of the economy changes as the
demand for say, horse carriages fell and trains
and cars rose. This would not affect labor.
The Model by Keynes

If the total spending (aggregate demand) fell,
then almost all markets would feel the drop in
demand.
 Production in general would fall.
 Recession (and depression) would be felt.
 To avoid this aggregate demand shortfall, the
government should step in and by the use of
monetary and fiscal policies, should stimulate
total spending.
Why Are Prices Constant in
the Short Run?

Menu costs.
 Fear of uncertainty.
 Contracts.
 Information lag.
Constant Price Means Wide
Output Fluctuations
P
S
Q1
Q2
Q
Circular Flow Explanation
Consumption Expenditures
Firms
Households
Wages, profits, rent, interest
If the upper flow (C+I+G+NX) is LESS THAN the lower flow
(Income = Value of Output), inventories will pile up (I>Ip) and the
firms will cut back in production. If the upper flow is MORE THAN
the lower flow, inventories will fall below the desired level (I<Ip) and
the firms will increase production.
Circular Flow Explanation
Consumption Expenditures
Firms
Households
Wages, profits, rent, interest
The upper flow is the aggregate demand: C+I+G+NX. The lower flow
is Output: Y. When Aggregate Demand is <Y and also Y* there is a
positive output gap (Y*-Y>0) and the economy has slowed down.
When I<Ip, C+I+G+NX is greater than Y, or Y>Y* and there is
an expansionary (negative) output gap.
Aggregate Demand
Fluctuations

Consumption expenditures fluctuate.
– Confidence, fear levels, demography, wealth,
taxes, etc. change.

Investment expenditures fluctuate.
– Optimism/pessimism about the future; interest rate
changes.

Government expenditures change.
– Budget items, wars…

Net Exports change.
– Demand for our exports or exchange rates change.
Algebraic Short Run
Equilibrium
Y = C + I + G + NX (Output=Aggregate Demand)
C = a +c (Y-T)
(Consumption=Autonomous+c*Disposable Income)
c = MPC = Change in Consumption/Change in Disposable Income
Y = a +cY -cT + I + G + NX
Y = (a + I +G + NX - cT) + cY
Aggregate Demand Function is comprised of autonomous
and induced parts.
Y = [1/(1-c)][a+I+G+NX-cT]
Equilibrium income is multiplier times autonomous expenditures.
Numerical Short Run Equilibrium
a=400; c=0.8; I=300; G=250; NX=10; T=200
Y
0
500
1000
1500
2000
2500
3000
3500
4000
4500
5000
5500
6000
AggregateDemand
800
1200
1600
2000
2400
2800
3200
3600
4000
4400
4800
5200
5600
Graphical Short Run Equilibrium
AD
AD
C
Slope=3200/4000=0.8
800
240
4000
Y
1990-91 Recession
Iraq’s invasion of Kuwait forced oil prices
to shoot up and dampened consumer
confidence.
 The Savings and Loan Debacle forced many
banks to bankruptcy and created a credit
crunch.
 Both C and I dropped.

2001 Recession

Both NASDAQ and NYSE dropped
precipitously.
 During 1999-2000, the Fed increased
interest rates by 50%.
 Wealth loss => C drop.
 Stock market drop => I drop.
 Interest rate rise => I drop.
Multiplier

If a and I drops, what will happen to Y?
 Y = [1/(1-c)][a+I+G+NX-cT]
 One can plug in the new values and find Y.
 One can take the “Change in Y” to be equal
to [1/(1-c)]*Change in a+I.
 One can show the effect graphically by
shifting AD downward.
Multiplier

Suppose a dropped from 400 to 350, and I
dropped from 300 to 250. Find the new
equilibrium Y.
 Y = [1/(1-c)][a+I+G+NX-cT]
 Y = 5 (700) = 3500
 DY = 5 (-100) = -500
Graphical Short Run Equilibrium
AD
AD
800
700
3500
4000
Y
Role of Fiscal Policy

In the Keynesian system, it is obvious that
in response to changes in C, I, and NX,
government can counter them by changing
G or T.
 If a+I fell by 100, how much G should
change to keep Y=4000?
 If a+I fell by 100, how much T should
change to keep Y=4000?
Limitations of Fiscal Policy

Lags.
 Political considerations.
 Effects on potential output.
– Savings changes
– Investment changes.
Automatic Stabilizers

Without any act by the Congress, fiscal
measures kick in to keep Y close to Y*.
– Income taxes.
– Unemployment insurance.
– Welfare payments.
– Recession aid transfers.