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Macro Theory:
The AS/AD Model II Keynesian Version
Dr. D. Foster – ECO 285 – Spring 2014
Warning .. Warning .. Warning
• Aggregate Supply and Aggregate Demand are not
like market supply & demand !!!!!
• The “static” analysis only hints at dynamic
interpretation.
• Ceteris Paribus assumption problematic to the point
of being wholly inappropriate.
Keynesian model notes:
• Descriptive analysis.
• Some numerical interpretation.
• Only AS/AD graphical representation.
AS/AD Model – Short Run & Long Run
P
ASLR
AS1
AD shows demand from 4
sectors of economy.
AS in LR shows full
employment of resources.
AS in SR shows effect of
inflexible wages.
Keynesian argument
P1
AD1
Q*
Q or R-GDP
AS/AD Model – Hints at 4 types of changes
P
ASLR
AS1
• Inflation with growth due
to rising AD.
• Depression with deflation
due to falling AD.
• Growth with deflation due
to rising AS.
• Depression with inflation
due to falling AS.
(stagflation)
P1
AD1
Q*
Q or R-GDP
The Keynesian Perspective
• The short run is more important to us.
• We live our lives through the SR not the LR
and the LR may take too long!
• We need a theory of the SR to smooth out the
business cycle.
• Equilibrium occurs when
planned spending equals
realized spending.
In fact, Keynes didn’t really
have a business cycle
theory (“animal spirits”).
He had a theory of how to
deal with a business cycle.
The Keynesian Model
• Where there is no inflation/deflation,
output = RGDP = Income (Y)
• Consumption is assumed to vary with income:
C = Ca + (mpc)*Y
where Ca is “autonomous” consumption w.r.t. Y
mpc is the “marginal propensity to consume”
which shows how much (%) C changes when Y
does.
by definition, 0<mpc<1
The Keynesian Model
• All other spending components are
assumed autonomous with regard to income:
Investment (I), Government (G), Foreign (net X)
• All income can be spent (C) or saved (S), so:
S = Sa + (1-mpc)*Y or S = Sa + mps*Y
where mpc + mps = 1
(we spend & save 100% of our income)
• Except for Investment, all planned spending will be
realized/actual.
• When economy is in disequilibrium,
Ip
≠
Ir
FYI – we are
skipping nonAS/AD graphical
representation.
Equilibrium in the Keynesian Model
• In equilibrium, planned spending = realized = Y.
Y = [Agg. Expenditures] = C + I + G + net X
• What if planned spending exceeds income?
 Business inventories are drawn down to compensate.
 But, the ∆inventories was unplanned, and so planned I is
greater than realized/actual I.
 Businesses will then plan to produce more, to make up for
the shortfall in inventories, raising employment, production
and income.
 This process will continue until Y = AE
p
• What if planned spending is less than income?
The multiplier process in the
Keynesian Model
• Consider the following:
Y = 1000, planned AE = 1100 and mpc = .8
[Inventories fall by 100 to make up the difference.]
 Incomes will rise by 100 as businesses expand.
 But, consumption will rise by another 80 (=80%*100).
 So, now, Y=1100 and planned AE = 1180.
 But, the C will Y (by 80), which will further increase C by
64. This will Y by another 64 and on and on and …
 Eventually this process comes to an end when:
p
Y = old Y + [1/(1-mpc)]*(AE – old Y)
here: Y = 1000 + [1/(1-.8)]*(+100)
= 1000 + 5*100 = 1500
Here, the
multiplier
was 5
[1/(1-mpc)]
Details of the Keynesian Model
• This only applies when there is no inflation.
• So additional resources can be employed without
raising wages/prices.
• Provides a Keynesian avenue for economic growth
– the autonomous increase in Investment
p
spending (which results in AE >Y).
• Investment determined by: future expected
profit, real interest return, state of the capital
stock.
• Consumption is determined by: wealth and future
expected income (permanent income hypothesis).
Keynesian theory in AS/AD Model
Introduce a flat AS.
P
ASLR
Introduce
disequilibrium at Q1
with AD2.
AS1
Equilibrium process
moves us to Q2.
AD2
But, we still have a
depression.
AD3
If we can further
increase spending to
AD3 we can boost
employment and
output.
AD1
Q1 Q 2 Q 3
Q*
Q or R-GDP
Continue until we
reach Q*.
Macro Theory:
The AS/AD Model II Keynesian Version
Dr. D. Foster – ECO 285 – Spring 2014