Download Aggregate Demand, Aggregate Supply, and Modern Macroeconomics

Aggregate Demand, Aggregate
Supply, and Modern
Macroeconomics
Chapter 9
Keynes and the Classics


During the Depression, output fell by 30
percent and unemployment rose to 25
percent.
Each had very different explanation of the
same facts
Unemployment Rate
WW II
30
20
10
0
1910 1920 1930
McGraw-Hill/Irwin
1940 1950 1960 1970
1980 1990 2000
2010
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Basic Philosophy of Economics


Classical: laissez-faire (leave the market
alone and it will self-adjust).
Keynes: leave the market alone and we will
return to the Great Depression
Cause of the great depression




Classics: Unemployment caused by high real
wages
Lowering profitability-> lower investment
-> lower capital -> lower growth
Keynes: Unemployment caused by lack of
effective demand or spending
Classical labor market
Unemployment
Supply
Real wage rate
$5.00
Demand
LD
Employment
LS
Keynesian labor market
Unemployment
Real wage rate
Demand
Supply
LD
LFull
Employment
Keynesian output market
price
Demand
Supply
Q
Qppf
output
Long v. short run


Classics: short-run imbalances in supply and
demand work themselves out in the long-run.
Keynes: “In the long run we are all dead.’’
Speed of adjustment


Classicals flexible wages and prices adjust
reasonably quickly
Keynes: wages and prices are sticky slow
adjustment
Output (supply)


Classics depends mostly on factors (labor
and capital) of production
Keynes: depends on demand (short side of
the market)
Output (con’t)

Both believed Y=p Q(K,L) = C + I + G
+ X-M

Classics: supply, Q(K,L) most
important
Keynes demand C,I,G, X, M most
important

Growth


Classics: Believed that savings drives
investment which increases capital stock per
worker
Keynesian: growth of factors of production
less important the utilization of factors
Savings



Classicals depends on interest rate first and
then income from factors production
Keynesian depends on income from demand
(interest rate irrelevant)
Data says that the relationship between
interest rate and savings is nonexistent.
Y = C + I + G + X- M


Both Keynes and the Classics agree with
Different on what determines each term on
the RHS
C = Consumption


Classical: demand depends on price
Keynes: main determinant of demand is
income (price irrelevant)
I = Investment


Classical: depends on savings
Keynes: depends on the interest rate and
animal spirts (does not depend on savings)
G = govt


Classical: should only repair market failures
such as externalities and public goods.
Keynes: must be used to manage aggregate
demand
T = taxes


Classical: should always be adjusted so that
budget is balanced or in surplus (never a
deficit).
Keynes: in recession run deficit; inflation run
a surplus
Keynes could not deny the truth of
classical economics



InThe General Theory of Employment,
Interest and Money
General means: with both fast and slow
adjustment
Classical system was a special case of a
more general model
The Layperson's Explanation for
Unemployment


Laypeople believed that the depression was
caused by an oversupply of goods that
glutted the market.
They wanted the government to hire the
unemployed even if the work was not
needed.
The Layperson's Explanation for
Unemployment

Classical economists opposed deficit
spending, arguing that the money to create
jobs had to be borrowed.

This money would have financed private
economic activity and jobs, so everything would
cancel out.
The Essence of Keynesian
Economics

Keynes thought that the economy could get
stuck in a rut as wages and price level
adjusted to sudden changes in expenditures.
The Essence of Keynesian
Economics

According to Keynes:
a decrease in investment demand 
job layoffs  fall in consumer demand 
firms decrease production 
more job layoffs 
further fall in consumer demand, and so forth
The Essence of Keynesian
Economics

Keynes argued that, in times of recession,
spending is a public good that benefits
everyone.

Aggregate demand management –
government’s attempt to control the aggregate
level of spending in the economy.
Equilibrium Income Fluctuates
–

Income is not fixed at the economy's long-run
potential income – it fluctuates.
For Keynes there was a difference between
equilibrium income and potential income.
Equilibrium Income Fluctuates

Equilibrium income – the level toward
which the economy gravitates in the short run
because of the cumulative cycles of declining
or increasing production.
Equilibrium Income Fluctuates

Potential income – the level of income that
the economy technically is capable of
producing without generating accelerating
inflation.
Equilibrium Income Fluctuates

Keynes felt that at certain times the economy
needed help to reach its potential income.

He believed that market forces would not work
fast enough and not be strong enough to get the
economy out of a recession
The Paradox of Thrift

If a large number of people in the economy
suddenly decided to save more and
consume less, total spending would fall and
unemployment would rise.
The Paradox of Thrift

Incomes would fall as people lost their jobs
causing both consumption and saving to fall
as well.

The economy would reach a new equilibrium
which could be at an almost permanent
recession.
The Paradox of Thrift

This paradox of thrift is important to the
Keynesian story.

Paradox of thrift – an increase in savings can
lead to a decrease in expenditures, decreasing
output and causing a recession.
The AS/AD Model

The AS/AD model consists of three curves:
–
–
–
The short-run aggregate supply curve.
The aggregate demand curve.
The long-run aggregate supply curve.
The AS/AD Model

The AS/AD model is fundamentally different
from the microeconomic supply/demand
model.
The AS/AD Model

–
–
Microeconomic supply/demand curves
concern the price and quantity of a single
good.
Price is measured on the vertical axis and quantity is
measured on the horizontal axis.
The shapes are based on the concepts of substitution
and opportunity cost.
The AS/AD Model

In the AS/AD model the price of everything is
on the vertical axis and aggregate output is
on the horizontal axis.
The AS/AD Model

The AS/AD model is an historical model that
starts at a point in time and says what will
happen when changes affect the economy.
The Aggregate Demand Curve


The aggregate demand (AD) curve shows
how a change in the price level changes
aggregate expenditures on all goods and
services in an economy.
It shows the level of expenditures that would
take place at every price level in the
economy.
The Slope of the AD Curve


The AD is a downward sloping curve.
Aggregate demand is composed of the sum
of aggregate expenditures.
Expenditures = C + I + G +(X - M)
The Slope of the AD Curve

The slope of the AD curve is determined by
the wealth effect, the interest rate effect, the
international effect, and the multiplier effect.
The Wealth Effect


Wealth effect – a fall in the price level will
make the holders of money and other
financial assets richer, so they buy more.
Most economists accept the logic of the
wealth effect, however, they do not see the
effect as strong.
The Interest Rate Effect

Interest rate effect – the effect a lower price
level has on investment expenditures
through the effect that a change in the price
level has on interest rates.
The Interest Rate Effect

The interest rate effect works as follows:
a decrease in the price level 
increase of real cash 
banks have more money to lend 
interest rates fall 
investment expenditures increase
The International Effect

International effect – as the price level falls
(assuming exchange rates do not change),
net exports will rise.

Real exchange rate = e p*/p
e = nominal exchange rate, p* foreign price
and p is the domestic price

The International Effect

The international effect works as follows:
a decrease in the price level in the U.S.
the fall in price of U.S. goods relative to foreign
goods 
U.S. goods become more competitive
internationally 
U.S. exports rise and U.S. imports fall
The Multiplier Effect


Initial changes in expenditures set in motion
a process in the economy that amplifies the
initial effects.
Multiplier effect – the amplification of initial
changes in expenditures.
The Multiplier Effect

The multiplier effect works as follows:
an increase in the price level in the U.S.
U.S. exports fall and U.S. imports rise 
U.S. firms lose sales and cut output 
U.S. incomes fall 
U.S. households buy less 
U.S. firms cut back again  and so on
The Multiplier Effect

The multiplier effect amplifies the initial
wealth, interest rate, and international
effects, making the AD curve flatter than it
would have been.
The AD Curve
Price
level
Wealth, interest rate, and
international effects
P0
Multiplier effect
P1
Aggregate
demand
Y0 Y1
Ye
Real output
How Steep Is the AD Curve


Most economists agree that small changes in
the price level result in relatively small
changes in expenditures.
This gives the AD curve a very steep slope.
Shifts in the AD Curve

Except for a change in the price level,
anything that changes aggregate
expenditures shifts the AD curve.
Shifts in the AD Curve

The main shift factors of aggregate demand
are:
–
–
–
–
–
Foreign income.
Expectations about future output or prices.
Exchange rate fluctuations.
The distribution of income.
Government policies.
Foreign Income


When U.S. trading partners go into a
recession, the demand for U.S. goods
(exports) will fall.
The U.S. AD curve shifts to the left.
Foreign Income

A rise in foreign income leads to an increase
in U.S. exports and a rightward shift of the
U.S. AD curve.
Exchange Rates

When a currency loses value relative to other
currencies:
–
–
Export goods produced in that country become
less expensive.
Imports into that country become more expensive.
Exchange Rates

Foreign demand for its goods increases.

Its demand for foreign goods decreases.
The AD curve will shift to the right.
When a currency gains value, the AD curve
shifts to the left.


Expectations About Future Output



If businesses expect demand to be high in
the future, they will want to increase their
capacity to produce.
The demand for investment will increase.
The AD curve will shift to the right.
Expectations About Future Output

When consumers expect the economy to do
well in the future, they will spend more now.

The AD curve shifts to the right.
Expectations of Future Prices



It pays to buy now if you expect prices to rise
in the future.
The AD curve will shift to the right.
The is most acutely felt in a hyperinflation.
Distribution of Income


Wage earners tend to spend a greater
percentage of their income than earners of
profit income.
It is likely that AD will shift to the right if the
distribution of income moves from earners of
profit to wage earners.
Monetary and Fiscal Policy



Macro policy makers think they can control
the AD curve to some extent.
If the federal government spends lots of
money, AD shifts to the right.
If it raises taxes, household incomes will fall,
they will spend less, AD shifts to the left.
Monetary and Fiscal Policy

When the Federal Reserve Bank expands
the money supply, it can often lower interest
rates.

AD will shift to the right.
Monetary and Fiscal Policy

Macro policy – deliberate shifting of the AD
curve.
–
–
Expansionary macro policy shifts the curve to the
right.
Contractionary macro policy shifts it to the left.
Multiplier Effects of Shift Factors

Because of the multiplier effect, a change in
a shift factor of the AD curve moves the
curve by more than the initial shift.
Effect of a Shift Factor on the AD
Curve
Price
level
Initial effect
100
200
Multiplier
effect
P0
Change in total
expenditures
AD0
300
AD1
Initial effect
Real output
Effect of a Shift Factor on the AD
Curve
Multiplier effect
Price level
P0
Initial
effect
100
200
AD0
Change in total expenditures = 300
AD1
Real output
The Short-Run Aggregate Supply
Curve

The short-run aggregate supply (SAS)
curve specifies how a shift in the aggregate
demand curve affects the price level and real
output in the short run, other things constant.
Price level
The Short-Run Aggregate Supply
Curve
SAS
Real output
The Slope of the SAS Curve


The SAS curve is upward-sloping.
The SAS curve reflects two different types of
microeconomic markets in our economy.
–
–
Auction markets – markets represented by the
supply/demand model.
Posted-price markets – prices are set by the
producers and change only infrequently.
The Slope of the SAS Curve

Posted-price markets are often called
quantity-adjusting markets.

Quantity-adjusting markets – markets in which
firms respond to changes in demand primarily by
modifying their output instead of changing their
prices.
The Slope of the SAS Curve

Prices change in quantity-adjusting markets
for two reasons.
–
–
Markups in posted-price markets are not totally fixed.
Because raw materials are often sold in auction
markets, a change in AD will change input prices.
Shifts in the SAS Curve

The AS curve shifts when a shift factor
changes – other things are not constant:
–
–
–
–
–
Changes in input prices.
Changes in expectations of inflation.
Productivity.
Excise and sales taxes.
Import prices.
Changes in Input Prices


When input prices are raised, the curve shifts
up.
When input prices are lowered, the curve
shifts down.
Changes in Expectations of
Inflation


Expectations of inflation is a shift factor that
works through nominal wages.
If workers expect 2 percent inflation, they will
push for a wage increase of at least 2
percent.
Changes in Factor Productivity


An increase in productivity reduces the cost
of production and shifts the AS curve down.
A decrease in productivity shifts the curve up.
Changes in Import Prices



Import prices are a component of an
economy’s price level.
The SAS curve shifts up when import prices
rise.
It shifts down when import prices fall.
Changes in Excise and Sales
Taxes


Higher sales taxes shift the SAS curve up.
Lower sales taxes shift the curve down.
Input Prices and Labor
Productivity
Economists use a rule of thumb combining
the wage component of input prices and
labor productivity.
% change in the price level =
% change in wages – % change in productivity

Price level
Shifts in the SAS Curve
SAS1
Input prices increase
SAS0
Real output
The Long-Run Aggregate Supply
Curve

The long-run aggregate supply curve
shows the long-run relationship between
output and the price level.
The Long-Run Aggregate Supply
Curve

The LAS is vertical.

At potential output, a rise in the price level means
that all prices, including input prices rise.
Price level
The Long-Run Aggregate Supply
Curve
Long-run
aggregate supply
(LAS)
Real output
A Range for Potential Output and
the LAS Curve


The position of the long-run aggregate
supply curve is determined by potential
output.
Potential output – the amount of goods and
services an economy can produce when both
labor and capital are fully employed.
A Range for Potential Output and
the LAS Curve

–
–
Potential output is considered to be a range
of values.
Resources are likely to be underutilized at points on
the SAS to the left of the LAS.
Factor prices would likely fall and the SAS curve
would shift down.
A Range for Potential Output and
the LAS Curve

Potential output is considered to be a range
of values.
–
Resources are likely to be overutilized at points
on the SAS to the right of the LAS.
–
Factor prices would likely rise and the SAS curve
would shift up.
A Range for Potential Output and
the LAS Curve
Real output
LAS
A
Underutilized
resources
Low-level
potential
output
C
B
SAS
Overutilized
resources
High-level Real output
potential
output
Shifts in the LAS Curve

The LAS curve will shift whenever there is a
changes in:
–
–
–
–
–
Capital.
Available resources.
Growth-compatible institutions.
Technological development.
Entrepreneurship.
Equilibrium in the Aggregate
Economy

Changes in the SAS, AD, and LAS curves
affect short-run and long-run equilibrium.
Short-Run Equilibrium

Short-run equilibrium is where the AS and
AD curves intersect.
Short-Run Equilibrium

Increases (decreases) in aggregate demand
lead to higher (lower) real output and higher
(lower) price level.

Upward (downward) shift the SAS curve lead to
lower (higher) real output and higher (lower)
price level.
Price level
Short-Run Equilibrium:
Shift in Aggregate Demand
SAS
P1
P0
E
F
AD1
AD0
Y0
Y1
Real output
Price level
Short-Run Equilibrium:
Shift in Aggregate Supply
P1
SAS1
G
SAS0
E
P0
AD
Y1
Y0
Real output
Long-Run Equilibrium


Long-run equilibrium is where the AD and
long-run aggregate supply curves intersect.
In the long run, output is fixed and the price
level is variable.
Long-Run Equilibrium

Aggregate demand determines the price
level.

Increases (decreases) in aggregate demand
lead to higher (lower) prices.
Long-Run Equilibrium:
Shift in Aggregate Demand
Price
level
P1
P0
LAS
H
E
AD1
AD0
Y0
Real output
Integrating the Short-Run and
Long-Run Frameworks

The economy is in both short-run and longrun equilibrium when all three curves
intersect in the same location.
Integrating the Short-Run and
Long-Run Frameworks

The ideal situation is for aggregate demand
to grow at the same rate as aggregate supply
and potential output.

Unemployment and growth are at their target
rates with no inflation.
Long-Run Equilibrium
Price level
LAS
P0
E
SAS
AD
YP
Real output
The Recessionary Gap

A recessionary gap is the amount by which
equilibrium output is below potential output.
The Recessionary Gap


If the economy remains at this level for a long
time, there would be an excess supply of
factors of production.
Costs and wages would tend to fall.
The Recessionary Gap

As factor prices fall, the SAS curve will shift
down to eliminate the recessionary gap.
The Recessionary Gap
Price level
LAS
P0
P1
SAS0
A
B
SAS1
AD
Recessionary gap
Y1
YP
Real output
The Inflationary Gap



The inflationary gap occurs when the
economy is above potential that exists at the
current price level.
Factor prices rise causing the SAS curve to
shift up.
The price level rises, and the inflationary gap
is eliminated.
The Inflationary Gap
Price level
LAS
D
P2
P0
SAS2
C
SAS0
AD
Inflationary gap
YP
(c)
Y2
Real
output
The Economy Beyond Potential


When the economy operates below its
potential, firms can hire additional factors of
production without increasing production
costs.
Once the economy reaches its potential
output, that is no longer possible.
The Economy Beyond Potential

As firms compete for resources, costs rise
beyond productivity increases.

The short-run AS curve shifts up and the price
level rises.
The Economy Beyond Potential

The economy will slow down by itself or the
government will step in with a policy to
contract output and eliminate the inflationary
gap.
Aggregate Demand Policy

Fiscal policy – the deliberate change in
either government spending or taxes to
stimulate or slow down the economy.
Aggregate Demand Policy

Expansionary fiscal policy is appropriate if
aggregate income is too low.

The deficit should be increased by decreasing
taxes or increasing government spending.
The AD curve shifts to the right.

Aggregate Demand Policy

Contractionary fiscal policy is appropriate if
aggregate income is too high.

The deficit should be decreased by increasing
taxes or decreasing government spending.
The AD curve shifts to the left.

Expansionary Fiscal Policy
Price level
LAS
P1
P0
AS
AD1
A
Y0
YP
AD0
Real output
Contractionary Fiscal Policy
Price level
LAS
B
P2
AS
AD0
AD2
YP
Y2 Real output
Some Additional Policy Examples



Unemployment is 12 percent and there is no
inflation.
What policy would you recommend?
Use expansionary fiscal policy to shift the AD
curve out to its potential income.
Expansionary Fiscal Policy
Price
level
P1
P0
LAS
B
SAS
AD1
A
AD0
Y0
YP
Real output
Some Additional Policy Examples



Unemployment is at its target rate and it is
likely that consumer expenditures will rise.
What policy would you recommend?
Use contractionary fiscal policy to shift the
AD curve inward to counteract the expected
increase in AD.
Contractionary Fiscal Policy
Price
level
LAS
B
P1
SAS
AD0
AD2
YP
Y1
Real output
Some Additional Policy Examples



What would have happened if the
government didn’t institute a contractionary
fiscal policy?
There would be an inflationary gap which
would increase factor prices.
The SAS curve would shift up until it
intersects the AD curve at YP.
Economy Above Potential
Price
level
LAS
SAS1
E
P1
D
SAS0
P0
C
AD1
AD0
YP
Y1
Real output
Fiscal Policy in World War II



The deficit increased greatly during World
War II.
Real GDP grew by even more than the
increase in the deficit.
Wartime wage and price controls prevented
the SAS curve from shifting up.
Fiscal Policy in World War II

–
–
Although World War II expanded the
economy, that doesn’t mean wars are good
for the economy.
The production of military goods increased, but the
production of consumer goods decreased.
Many people were killed or permanently disabled.
War Finance: Expansionary Fiscal
Policy
Year
1937
1938
1939
1940
1941
1942
1943
1944
1945
1946
GDP
Deficit
(billions of
1958 dollars)
(billions of
Dollars)
$ 90
84
90
99
124
157
191
210
211
208
$ -2.8
-1.0
-2.9
-2.7
-4.8
-19.4
-53.8
-46.1
-45.0
-18.2
McGraw-Hill/Irwin
Unemployment
rate
14.3%
19.0
17.2
14.6
9.9
4.7
1.9
1.2
1.9
3.9
LAS
SAS
AD1
AD0
$90
$208
Real output (in billions of dollars)
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
U.S. Economic Expansion


The economy boomed during the late 1990s
and early 2000s.
The budget went from a large deficit to a
large surplus.
U.S. Economic Expansion
Significant increases in consumer and
investment spending offset the contractionary
effect of the surplus.
The surplus was more due to a booming
economy than due to contractionary policy.


U.S. Economic Expansion
During 2000-2001, political pressures
increased government spending and cut
taxes which led to a shrinking surplus.
The tax cut came just at the right time because
the economy moved into a recession in mid2001.


Macro Policy Is More Complicated
Than It Looks

Using the AS/AD model to analyze the
economy is more complicated than it looks.
–
–
–
Implementing fiscal policy.
Estimating potential output.
Effectiveness of fiscal policy.
The Problem of Implementing
Fiscal Policy

There is no guarantee that government will
do what the economy needs to be done.
–
–
Implementing government spending and tax
changes is a slow legislative process.
Government spending and tax decisions are
made for political rather than for economic
reasons.
The Problem of Estimating
Potential Output

Increasing AD when the economy is
operating at its potential will accelerate
inflation by shifting up the SAS curve.
The Problem of Estimating
Potential Output
One way of estimating potential output is to
estimate the target rate of unemployment.
Target rate of unemployment – the rate below
which inflation began to accelerate in the past.


The Problem of Estimating
Potential Output
Unfortunately, the target rate of
unemployment fluctuates and is difficult to
predict.
For example, there is structural but no cyclical
unemployment at potential output – it is difficult
to differentiate between the two.


The Problem of Estimating
Potential Output
Another way to determine potential output is
to add the normal growth factor (3%) the
economy’s previous level.
Estimating the economy’s potential from past
growth rates is complicated by potentially
dramatic changes in regulations, technology,
and expectations.


The Questionable Effectiveness of
Fiscal Policy

The effectiveness of fiscal policy depends on
the government’s ability to perceive a
problem and react appropriately to it.
The Questionable Effectiveness of
Fiscal Policy

Countercyclical fiscal policy – fiscal policy
in which the government offsets any change
in aggregate expenditures that would create
a business cycle.
The Questionable Effectiveness of
Fiscal Policy


Most economists agree that the government
is unable to fine tune the economy.
Fine tuning – fiscal policy designed to keep the
economy always at its target or potential level of
income.
Aggregate Demand, Aggregate
Supply, and Modern
Macroeconomics
End of Chapter 25