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33
Aggregate Demand and Aggregate
Supply
PRINCIPLES OF
ECONOMICS
FOURTH EDITION
N. G R E G O R Y M A N K I W
PowerPoint® Slides
by Ron Cronovich
© 2007 Thomson South-Western, all rights reserved
Second Midterm
 This coming Thursday, regular lecture time.
 It will cover chapters 26, 27, 28, and whatever
we discuss today.





Scantron form;
No. 2 pencils;
Ink pens;
Non-programmable calculator;
Picture ID.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
1
Long run v.s. short run
 Long run growth: what determines long-run
output (and the related employment…)?
 Short run fluctuations: what determines short-run
output (and the related employment…)?
• Aggregate demand and aggregate supply.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
2
In this chapter, look for the answers to
these questions:
 What are economic fluctuations? What are their
characteristics?
 How does the model of aggregate demand and
aggregate supply explain economic fluctuations?
 Why does the Aggregate-Demand curve slope
downward? What shifts the AD curve?
 What is the slope of the Aggregate-Supply curve in
the short run? In the long run?
What shifts the AS curve(s)?
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
3
Introduction
 Over the long run, real GDP grows about
3% per year on average.
 In the short run, GDP fluctuates around its trend.
• recessions:
periods of falling real incomes
and rising unemployment
• depressions:
severe recessions (very rare)
 Short-run economic fluctuations are often called
business cycles.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
4
Three Facts About Economic Fluctuations
FACT 1: Economic fluctuations are
irregular and unpredictable.
$ 11,000
U.S. real GDP,
billions of 2000 dollars
10,000
9,000
8,000
7,000
6,000
The shaded
bars are
recessions
5,000
4,000
3,000
2,000
1965
1970
1975
1980
1985
1990
1995
2000
2005
Three Facts About Economic Fluctuations
FACT 2: Most macroeconomic
quantities fluctuate together.
$ 1,800
Investment spending,
billions of 2000 dollars
1,600
1,400
1,200
1,000
800
600
400
200
1965
1970
1975
1980
1985
1990
1995
2000
2005
Three Facts About Economic Fluctuations
FACT 3: As output falls,
unemployment rises.
12
Unemployment rate,
percent of labor force
10
8
6
4
2
0
1965
1970
1975
1980
1985
1990
1995
2000
2005
Explaining the short-run fluctuations
 Warning! This chapter is very theoretical.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
8
Introduction, continued
 Explaining these fluctuations is difficult, and the
theory of economic fluctuations is controversial.
 Most economists use the model of
aggregate demand and aggregate supply
to study fluctuations.
 This model differs from the classical economic
theories economists use to explain the long run.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
9
Classical Economics
 The previous chapters are based on the ideas of
classical economics, especially:
 The Classical Dichotomy, the separation of
variables into two groups:
• real – quantities, relative prices
• nominal – measured in terms of money
 The neutrality of money:
Changes in the money supply affect nominal but
not real variables.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
10
Classical Economics
 Most economists believe classical theory
describes the world in the long run,
but not the short run.
 In the short run, changes in nominal variables
(like the money supply or P ) can affect
real variables (like Y or the u-rate).
 To study the short run, we use a new model.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
11
The Model of Aggregate Demand and
Aggregate Supply
P
The price
level
The model
determines the
eq’m price level
and the eq’m
level of output
(real GDP).
CHAPTER 33
SRAS
P1
“Aggregate
Demand”
“Short-Run
Aggregate
Supply”
AD
Y1
Y
Real GDP, the
quantity of output
AGGREGATE DEMAND AND AGGREGATE SUPPLY
12
The Aggregate-Demand (AD) Curve
P
The AD curve
shows the
quantity of
all g&s
demanded
in the economy
at any given
price level.
P2
P1
AD
Y2
CHAPTER 33
Y1
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
13
Why the AD Curve Slopes Downward
Y=C+I+G
C, I, G are
the components
of agg. Demand for
a closed economy.
Assume G fixed
by govt policy.
To understand
the slope of AD,
must determine
how a change in P
affects C, I, and NX.
CHAPTER 33
P
P2
P1
AD
Y2
Y1
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
14
The Wealth Effect (P and C )
 Suppose P rises.
 The dollars people hold buy fewer g&s,
so real wealth is lower.
 People feel poorer, so they spend less.
 Thus, an increase in P causes a fall in C
…which means a smaller quantity of g&s
demanded.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
15
The Interest-Rate Effect (P and I )
 Suppose P rises.
 Buying g&s requires more dollars.
 To get these dollars, people sell some of their
bonds or other assets, which drives up interest
rates.
…which increases the cost of borrowing to fund
investment projects.
 Thus, an increase in P causes a increase in I
…which means a smaller quantity of g&s
demanded.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
16
The Slope of the AD Curve: Summary
An increase in P
reduces the quantity
of g&s demanded
because:
P
P2
• the wealth effect
(C falls)
• the interest-rate
P1
AD
effect (I falls)
Y2
CHAPTER 33
Y1
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
17
Why the AD Curve Might Shift
Any event that changes
C, I, G – except a change
in P – will shift the AD
curve.
Example:
A stock market boom
makes households feel
wealthier, consume
more,
and the AD curve shifts
right.
CHAPTER 33
P
P1
AD2
AD1
Y1
Y2
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
18
AD Shifts arising from things affecting C:
 The world becomes more uncertain, people
decide to save more:
C falls, AD shifts left
 The stock market crashes, the consumer
confidence drops:
C falls, AD shifts left
 tax cut:
C falls, AD shifts right
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
19
AD Shifts Arising from things affecting I
 Firms decide to upgrade their computers:
I rises, AD shifts right
 Firms become pessimistic about future demand:
I falls, AD shifts left
 Central bank uses monetary policy to reduce
interest rates:
I rises, AD shifts right
 Investment Tax Credit or other tax incentive:I
rises, AD shifts right
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
20
AD Shifts Arising from Changes in G
 Congress increases spending on homeland
security:
G rises, AD shifts right
 State govts cut spending on road construction:
G falls, AD shifts left
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
21
ACTIVE LEARNING
Exercise
1:
Try this without looking at your notes.
What happens to the AD curve in each of the
following scenarios?
A. A ten-year-old investment tax credit expires.
B. A fall in prices increases the real value of
consumers’ wealth.
C. State governments eliminates sales taxes.
22
ACTIVE LEARNING
Answers
1:
A. A ten-year-old investment tax credit
expires.
I falls, AD curve shifts left.
B. A fall in prices increases the real value of
consumers’ wealth.
Move down along AD curve (wealtheffect).
C. State governments eliminates sales
taxes. C rises, AD shifts right.
23
Second-midterm
 -Pen & No. 2 Pencil
 -Scantron F-288 Par-L (same as last time)
 -non-programmable calculator -UCI ID
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
24
The Aggregate-Supply (AS) Curves
The AS curve shows
the total quantity of
g&s firms produce
and sell at any given
price level.
P
LRAS
SRAS
In the short run,
AS is
upward-sloping.
In the long run,
AS is vertical.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
25
The Long-Run Aggregate-Supply Curve (LRAS)
The natural rate of
output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
YN is also called
potential output
or
full-employment
output.
CHAPTER 33
P
LRAS
YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
26
Why LRAS Is Vertical
YN depends on the
economy’s stocks of
labor, capital, and
natural resources,
and on the level of
technology.
An increase in P
does not affect
any of these,
so it does not
affect YN.
(Classical dichotomy)
CHAPTER 33
P
LRAS
P2
P1
YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
27
Why the LRAS Curve Might Shift
Any event that
changes any of the
determinants of YN
will shift LRAS.
P
LRAS1 LRAS2
Example:
Immigration
increases L,
causing YN to rise.
YN
CHAPTER 33
Y’
N
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
28
LRAS Shifts Arising from Changes in L
 The Baby Boom generation retires:
L falls, LRAS shifts left
 New govt policies reduce the natural rate of
unemployment:
the % of the labor force normally employed
rises, LRAS shifts right
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
29
LRAS Shifts Arising from Changes in
Physical or Human Capital
 Investment in factories or equipment:
K rises, LRAS shifts right
 More people get college degrees:
Human capital rises, LRAS shifts right
 Earthquakes or hurricanes destroy factories:
K falls, LRAS shifts left
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
30
LRAS Shifts Arising from Changes in
Natural Resources
 A change in weather patterns makes farming
more difficult:
LRAS shifts left
 Discovery of new mineral deposits:
LRAS shifts right
 Reduction in supply of imported oil or other
resources:
LRAS shifts right
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
31
LRAS Shifts Arising from Changes in
Technology
 Technological advances allow more output to be
produced from a given bundle of inputs:
LRAS shifts right.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
32
In short:
 Anything that affects growth shifts LRAS!
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
33
Using AD & AS to Depict LR Growth and
Inflation
Over the long run,
tech. progress shifts
LRAS to the right
and growth in the
aggregate demand
shifts AD to the
right.
Result:
ongoing inflation
and growth in
output.
CHAPTER 33
P
LRAS2000
LRAS1990
LRAS1980
P2000
P1990
AD2000
P1980
AD1990
AD1980
Y1980
Y1990
Y2000
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
34
Short Run Aggregate Supply (SRAS)
P
The SRAS curve
is upward sloping:
Over the period
of 1-2 years,
an increase in P
causes an
increase in the
quantity of g & s
supplied.
SRAS
P2
P1
Y1
CHAPTER 33
Y2
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
35
Why the Slope of SRAS Matters
If AS is vertical,
fluctuations in AD
do not cause
fluctuations in output
or employment.
If AS slopes up,
then shifts in AD
do affect output
and employment.
CHAPTER 33
LRAS
P
Phi
SRAS
Phi
ADhi
Plo
AD1
Plo
ADlo
Ylo
Y1
Yhi
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
36
Three Theories of SRAS
In each,
• some type of market imperfection
• result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
37
Three Theories of SRAS
P
SRAS
When P > PE
the expected
price level
PE
When P < PE
Y
YN
Y < YN
CHAPTER 33
Y > YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
38
The Sticky-Wage Theory
 Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.
• Due to labor contracts, social norms.
 Firms and workers set the nominal wage in
advance based on PE, the price level they
expect to prevail.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
39
The Sticky-Wage Theory
 The labor contract sets nominal wages
according to expected prices.
 If P > PE,
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.
 Hence, higher P causes higher Y,
so the SRAS curve slopes upward.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
40
The Sticky-Wage Theory
The sticky wage theory implies Y deviates from YN
when P deviates from PE.
Y = YN + a (P – PE)
Output
Natural rate
of output
(long-run)
CHAPTER 33
Expected
price level
a > 0,
measures
how much Y
responds to
unexpected
changes in P
Actual
price level
AGGREGATE DEMAND AND AGGREGATE SUPPLY
41
SRAS and LRAS
 The imperfections in these theories are
temporary. Over time,
• sticky wages and prices become flexible
• misperceptions are corrected
 In the LR,
• PE = P
• AS curve is vertical
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
42
SRAS
and LRAS
Y = YN + a(P – PE)
P
LRAS
In the long run,
PE = P
and
Y = YN.
SRAS
PE
YN
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
43
Why the SRAS Curve Might Shift
Everything that shifts
LRAS shifts SRAS, too.
P
Also, PE shifts SRAS:
If PE rises,
workers & firms set
higher wages.
At each P,
production is less
profitable, Y falls,
SRAS shifts left.
CHAPTER 33
LRAS
SRAS
SRAS
PE
PE
YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
44
The Long-Run Equilibrium
In the long-run
equilibrium,
P
LRAS
SRAS
PE = P,
Y = YN ,
and unemployment
is at its natural rate.
PE
AD
YN
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
45
Economic Fluctuations
 Caused by events that shift the AD and/or
AS curves.
 Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift
changes Y and P in the short run.
4. Use AD-AS diagram to see how economy
moves from new SR eq’m to new LR eq’m.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
46
The Effects of a Shift in AD
Event: stock market crash
P
1. affects C, AD curve
LRAS
2. C falls, so AD shifts left
3. SR eq’m at B.
P and Y lower,
unemp higher
4. Over time, PE falls,
SRAS shifts right,
until LR eq’m at C.
Y and unemp back
at initial levels.
CHAPTER 33
SRAS1
A
P1
P2
SRAS2
B
P3
AD1
C
AD2
Y2
YN
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y
47
Two Big AD Shifts:
1. The Great Depression
U.S. Real GDP,
billions of 2000 dollars
From 1929-1933,
CHAPTER 33
700
650
600
550
AGGREGATE DEMAND AND AGGREGATE SUPPLY
1934
unemp rose
from 3% to 25%
750
1933
P fell 22%
800
1932
Y fell 27%
850
1931
•
•
•
stock prices fell 90%,
reducing C and I
900
1930
•
money supply fell
28% due to problems
in banking system
1929
•
48
Two Big AD Shifts:
2. The World War II Boom
2,000
Y rose 90%
1,400
P rose 20%
1,200
unemp fell
from 17% to 1%
1,000
1,800
1,600
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
1944
1943
1942
800
1939
•
•
•
govt outlays rose
from $9.1 billion
to $91.3 billion
1941
•
U.S. Real GDP,
billions of 2000 dollars
1940
From 1939-1944,
49
ACTIVE LEARNING
Answers
2:
Event: a tax cut
P
1. affects C, AD curve
LRAS
SRAS2
2. shifts AD right
3. SR eq’m at point B.
P and Y higher,
unemp lower
P3
4. Over time, PE rises,
SRAS shifts left,
until LR eq’m at C.
Y and unemp back
at initial levels.
P1
C
SRAS1
B
P2
A
AD2
AD1
YN
Y2
Y
51
John Maynard Keynes, 1883-1946
•
The General Theory of Employment,
Interest, and Money, 1936
•
Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
•
Famous critique of classical theory:
The long run is a misleading guide
to current affairs. In the long run,
we are all dead. Economists set themselves
too easy, too useless a task if in tempestuous seasons
they can only tell us when the storm is long past,
the ocean will be flat.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
55
CONCLUSION
 This chapter has introduced the model of
aggregate demand and aggregate supply,
which helps explain economic fluctuations.
 Keep in mind: these fluctuations are deviations
from the long-run trends explained by the
models we learned in previous chapters.
 In the next chapter, we will learn how
policymakers can affect aggregate demand
with fiscal and monetary policy.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
56
CHAPTER SUMMARY
 Short-run fluctuations in GDP and other
macroeconomic quantities are irregular and
unpredictable. Recessions are periods of falling
real GDP and rising unemployment.
 Economists analyze fluctuations using the model
of aggregate demand and aggregate supply.
 The aggregate demand curve slopes downward
because a change in the price level has a wealth
effect on consumption, an interest-rate effect on
investment, and an exchange-rate effect on net
exports.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
57
CHAPTER SUMMARY
 Anything that changes C, I, G, or NX
– except a change in the price level –
will shift the aggregate demand curve.
 The long-run aggregate supply curve is vertical,
because changes in the price level do not affect
output in the long run.
 In the long run, output is determined by labor,
capital, natural resources, and technology;
changes in any of these will shift the
long-run aggregate supply curve.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
58
CHAPTER SUMMARY
 In the short run, output deviates from its natural
rate when the price level is different than
expected, leading to an upward-sloping short-run
aggregate supply curve. The three theories
proposed to explain this upward slope are the
sticky wage theory, the sticky price theory, and the
misperceptions theory.
 The short-run aggregate-supply curve shifts in
response to changes in the expected price level
and to anything that shifts the long-run aggregate
supply curve.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
59
CHAPTER SUMMARY
 Economic fluctuations are caused by shifts in
aggregate demand and aggregate supply.
 When aggregate demand falls, output and the
price level fall in the short run. Over time, a
change in expectations causes wages, prices, and
perceptions to adjust, and the short-run aggregate
supply curve shifts rightward. In the long run, the
economy returns to the natural rates of output and
unemployment, but with a lower price level.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
60
CHAPTER SUMMARY
 A fall in aggregate supply results in stagflation –
falling output and rising prices.
Wages, prices, and perceptions adjust over time,
and the economy recovers.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
61
Fiscal Policy and Aggregate Demand
 Fiscal policy: the setting of the level of govt
spending and taxation by govt policymakers
 Expansionary fiscal policy
• an increase in G and/or decrease in T
• shifts AD right
 Contractionary fiscal policy
• a decrease in G and/or increase in T
• shifts AD left
 Fiscal policy has two effects on AD.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
62
The Multiplier Effect
 If the govt buys $20b of planes from Boeing,
Boeing’s revenue increases by $20b.
 This is distributed to Boeing’s workers (as wages)
and owners (as profits or stock dividends).
 These people are also consumers, and will spend
a portion of the extra income.
 This extra consumption causes further increases
in aggregate demand.
Multiplier effect: the additional shifts in AD
that result when fiscal policy increases income
and thereby increases consumer spending
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
63
The Multiplier Effect
A $20b increase in G
initially shifts AD
to the right by $20b.
The increase in Y
causes C to rise,
which shifts AD
further to the right.
P
AD1
P1
$20 billion
Y1
CHAPTER 33
AD3
AD2
Y2
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Y3
Y
64
Marginal Propensity to Consume
 How big is the multiplier effect?
It depends on how much consumers respond to
increases in income.
 Marginal propensity to consume (MPC):
the fraction of extra income that households
consume rather than save
 E.g., if MPC = 0.8 and income rises $100,
C rises $80.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
65
A Formula for the Multiplier
Notation: G is the change in G,
Y and C are the ultimate changes in Y and C
Y = C + I + G + NX
identity
Y = C + G
I and NX do not change
Y = MPC Y + G
because C = MPC Y
1
Y =
G
1 – MPC
solved for Y
The multiplier
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
66
A Formula for the Multiplier
The size of the multiplier depends on MPC.
e.g.,
if MPC = 0.5
if MPC = 0.75
if MPC = 0.9
1
Y =
G
1 – MPC
The multiplier
CHAPTER 33
multiplier = 2
multiplier = 4
multiplier = 10
A bigger MPC means
changes in Y cause
bigger changes in C,
which in turn cause
more changes in Y.
AGGREGATE DEMAND AND AGGREGATE SUPPLY
67
Other Applications of the Multiplier Effect
 The multiplier effect:
each $1 increase in G can generate
more than a $1 increase in agg demand.
 Also true for the other components of GDP.
Example: Suppose a recession overseas
reduces demand for U.S. net exports by $10b.
Initially, agg demand falls by $10b.
The fall in Y causes C to fall, which further
reduces agg demand and income.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
68
Changes in Taxes
 A tax cut increases households’ take-home pay.
 Households respond by spending a portion of this
extra income, shifting AD to the right.
 The size of the shift is affected by the multiplier
and crowding-out effects.
 Another factor: whether households perceive the
tax cut to be temporary or permanent.
• A permanent tax cut causes a bigger increase
in C – and a bigger shift in the AD curve –
than a temporary tax cut.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
69
ACTIVE LEARNING
Exercise
3:
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
B. If there is crowding out, will Congress need to
increase G more or less than this amount?
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
70
ACTIVE LEARNING
Answers
3:
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = .8 and there is no crowding out,
how much should Congress increase G
to end the recession?
Multiplier = 1/(1 – .8) = 5
Increase G by $40b
to shift agg demand by 5 x $40b = $200b.
CHAPTER 33
AGGREGATE DEMAND AND AGGREGATE SUPPLY
71
ACTIVE LEARNING
Answers
3:
The economy is in recession.
Shifting the AD curve rightward by $200b
would end the recession.
B. If there is crowding out, will Congress need to
increase G more or less than this amount?
Crowding out reduces the impact of G on AD.
To offset this, Congress should increase G by
a larger amount.
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Using Policy to Stabilize the Economy
 Since the Employment Act of 1946, economic
stabilization has been a goal of U.S. policy.
 Economists debate how active a role the govt
should take to stabilize the economy.
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The Case for Active Stabilization Policy
 Keynes: “animal spirits” cause waves of
pessimism and optimism among households
and firms, leading to shifts in aggregate demand
and fluctuations in output and employment.
 Also, other factors cause fluctuations, e.g.,
• booms and recessions abroad
• stock market booms and crashes
 If policymakers do nothing, these fluctuations
are destabilizing to businesses, workers,
consumers.
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The Case for Active Stabilization Policy
 Proponents of active stabilization policy
believe the govt should use policy
to reduce these fluctuations:
• when GDP falls below its natural rate,
should use expansionary monetary or fiscal
policy to prevent or reduce a recession
• when GDP rises above its natural rate,
should use contractionary policy to prevent or
reduce an inflationary boom
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Keynesians in the White House
1961:
John F Kennedy pushed for a
tax cut to stimulate agg demand.
Several of his economic advisors
were followers of Keynes.
2001:
George W Bush pushed for a
tax cut that helped the economy
recover from a recession that
had just begun.
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The Case Against Active Stabilization Policy
 Monetary policy affects economy with a long lag:
• firms make investment plans in advance,
so I takes time to respond to changes in r
• most economists believe it takes at least
6 months for mon policy to affect output and
employment
 Fiscal policy also works with a long lag:
• Changes in G and T require Acts of Congress.
• The legislative process can take months or
years.
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The Case Against Active Stabilization Policy
 Due to these long lags,
critics of active policy argue that such policies
may destabilize the economy rather than help it:
By the time the policies affect agg demand,
the economy’s condition may have changed.
 These critics contend that policymakers should
focus on long-run goals, like economic growth
and low inflation.
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CONCLUSION
 Policymakers need to consider all the effects of
their actions. For example,
• When Congress cuts taxes, it needs to
consider the short-run effects on agg demand
and employment, and the long-run effects
on saving and growth.
• When the Fed reduces the rate of money
growth, it must take into account not only the
long-run effects on inflation, but the short-run
effects on output and employment.
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Final
 Thursday, June 12th, 1:30 to 3:30pm.
 Final will cover chapters 23, 24, 25, 28, and 33.
 You are suppose to hand in your extra
assignment to one of the TAs before or on this
Friday (June 5th).
 You can also give it to me. I will be in my office
from 3:00 to 5:00 this Friday.
 I will curve the class before taking into account
the extra-credit assignment.
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CHAPTER SUMMARY
 In the theory of liquidity preference,
the interest rate adjusts to balance
the demand for money with the supply of money.
 The interest-rate effect helps explain why the
aggregate-demand curve slopes downward:
An increase in the price level raises money
demand, which raises the interest rate, which
reduces investment, which reduces the aggregate
quantity of goods & services demanded.
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CHAPTER SUMMARY
 An increase in the money supply causes the
interest rate to fall, which stimulates investment
and shifts the aggregate demand curve rightward.
 Expansionary fiscal policy – a spending increase
or tax cut – shifts aggregate demand to the right.
Contractionary fiscal policy shifts aggregate
demand to the left.
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CHAPTER SUMMARY
 When the government alters spending or taxes,
the resulting shift in aggregate demand can be
larger or smaller than the fiscal change:
The multiplier effect tends to amplify the effects of
fiscal policy on aggregate demand.
The crowding-out effect tends to dampen the
effects of fiscal policy on aggregate demand.
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CHAPTER SUMMARY
 Economists disagree about how actively
policymakers should try to stabilize the economy.
Some argue that the government should use
fiscal and monetary policy to combat destabilizing
fluctuations in output and employment.
Others argue that policy will end up destabilizing
the economy, because policies work with long
lags.
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