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Chapter 10 homework
• Number 4: Kyoko Yamashita
• Number 7: Harry Keyser
• Number 11: Audrey Stawecki
• Number 12: Scott Anderson
• Number 18: Michael Schwager
• Alternate: Trevor Thomas
Chapter 11
From Short-Run
to Long-Run
Equilibrium: The
Model in Action
Curing an Underperforming or
Overheating Economy
• We can use the long-run model to explain how
the macroeconomy self-adjusts to two major
problems:

An underperforming economy (recessionary gap)

An overheating economy (inflationary gap)
• Hint: it is all about SRAS…
The Underperforming Economy and
Recessionary Gaps
• Symptoms of an underperforming economy:

High equilibrium price level

Real GDP is below the full employment level.
• Recessionary Gap

Unemployment is above the full employment level.
Figure 11.4(a)
The Underperforming Economy: Identification
and Elimination of the Recessionary Gap
Curing the Underperforming Economy
• Excess unemployment puts downward
pressure on the nominal wage rate.

Decreases costs of production.
• Falling costs increase the profit potential
• Producers respond by increasing output.

The short-run aggregate supply curve shifts
to the right.
Figure 11.4(b)
The Underperforming Economy: Identification
and Elimination of the Recessionary Gap
Curing the Underperforming Economy
• What does the adjustment process do?

increases real GDP, reduces the actual
unemployment rate, and causes the price level to
fall.
• Gets us back to LR equilibrium
The Overheating Economy and
Inflationary Gaps
• Symptoms of an overheating economy:

Increasing incomes put upward pressure on the
price level.

Real GDP is above the full employment level.
• Inflationary Gap

Unemployment is below the full employment level.
Figure 11.5(a)
The Overheating Economy: Identification and
Elimination of the Inflationary Gap
Curing the Overheating Economy
• An overheating economy will put
upward pressure on nominal wages and
resource prices.

Increase firm’s costs of production.
• Higher costs reduce profits, causing firms to
reduce output.

The short-run aggregate supply curve shifts to
the left.
Figure 11.5(b)
The Overheating Economy: Identification and
Elimination of the Inflationary Gap
Curing the Overheating Economy
• What does the adjustment process do?

reduces real GDP, increases unemployment and
causes the price level to rise.
• Gets us back to LR equilibrium
Can we do it? (number 15)
• In each case, identify which type of gap is
being described:




The full employment unemployment rate is
greater than the actual unemployment rate
Full employment real GDP is greater than
actual real GDP
The major economic problem is
unemployment
When this gap is removed in the long run, the
price level rises and real GDP falls
Real-World Difficulties
of the Long-Run Model
• Determining the length of the long-run period:

Production decisions by firms are not
made immediately.

Firms and workers may initially overestimate or
underestimate the necessary adjustments.
Real-World Difficulties
of the Long-Run Model (cont’d)
• Estimating the full employment level of output:

The full employment level of output can be a moving
target over time, increasing or decreasing with
changes in resources and technology.

Different perceptions of full employment will
lead to different predictions about the behavior of the
economy.
• Does it seem that our government sits back and
lets things happen?
Figure 11.6 Conflicting Estimates of Full
Employment Real GDP
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.
The Importance of Aggregate Demand
in the Short Run
• The long-run model  aggregate supply runs
the economy and cures for any economic
problems.
• Keynesian short-run model  aggregate
demand causes and cures economic problems.
Figure 12.1(a) Impact of Changing Aggregate
Demand on Short-Run Equilibrium
Figure 12.1(b) Impact of Changing Aggregate
Demand on Short-Run Equilibrium
Changes in Aggregate Demand
• Changes in aggregate demand can result
from

Consumption

Investment

Government Spending

Net Exports

C+I+G+(X-M)
The Role of Consumption
• Consumption

Is the largest component of aggregate
demand in the United States

Represents about 70% of total GDP

Is very stable and difficult to change
The Role of Consumption
• Factors that can affect consumption:





Household wealth and debt
Consumers’ optimism or pessimism about
the future
The level of real interest rates
The overall price level
Households current stock of durable goods
Consumption and Income
• Most important determinant is disposable
income.

Income that remains after all taxes
are paid
• As disposable income increases, households
generally spend more dollars.
• But…they spend a smaller percentage of each
additional dollar of disposable income.
Consumption and Income (cont’d)
• The marginal propensity to consume
(MPC) is the fraction of additional income that
is spent on consumption:
Change in Consumption
C
MPC 

Change in Disposable Income DI

Example: Suppose a family receives a
$600 tax cut, of which it spends $400 on
consumption goods.

The MPC is then $400/$600 = .67
Consumption and Income (cont’d)
• The marginal propensity to save
(MPS) is the fraction of additional
income that is saved:
Change in Saving
S
MPS 

Change in Disposable Income DI


Example: Suppose a family receives a
$600 tax cut, of which it saves $200.
The MPS is then $200/$600 = .33
Consumption and Income (cont’d)
• The value of the MPC plus the value of
the MPS must equal 100%
• Disposable income can only be
consumed or saved.
Can we do it? (number 4)
• Based on the following
information calculate the
MPC

What is the MPS for this
sample household?

If the income increases to
$12,900 and the MPC
remains the same what
will be the amount of
consumption at the new
level of income?
Income
Consumption
$12,000 $12,100
$12,300 $12,350
$12,600 $12,600
Answer anyone??
•
The MPC and MPS for this household
are:
Change in C
250
MPC 

 0.83
Change in Income 300
MPS  1 MPC  1 0.83  0.17
C
MPC 
I
C
0.83 
(12900  12600)
C  249
C  12600  249  12849
The Role of Investment
• Unlike consumption, investment can and
does easily change.
• Depends on:

Business expectations about economic
performance

Interest rates

Tax policies
The Role of Investment
• Can be easily but not reliably changed.

Not a good candidate for policy makers who
want to change aggregate demand.
The Role of Net Exports
• The amount of net exports is determined
by:

The value of the dollar
• If the dollar appreciates, U.S. imports would
increase and U.S. exports would decrease.
• But value is determined in a huge market, policy
makers can’t do much to affect its value.

The economic health of other nations
• Cannot be influenced by U.S. policy makers
The Role of Government
• So…it is hard to use consumption, investment
or net exports to alter aggregate demand.
• So…Keynes concluded that it was up to the
government to use its own spending and taxes
to change aggregate demand.
• The government could:

Be the spender of last resort, or

Cut taxes to encourage consumption.
Summary
• The long-run model predicts that realworld economies will adjust to equilibrium
at the full employment level of real GDP.

The Great Depression demonstrated the
shortcomings of the long-run model.

The Keynesian short-run model emerged as
an explanation of and a cure for
macroeconomic problems.
Chapter 12 homework
• Numbers 5, 10, 13, and 15