CH. 13: Aggregate Demand, Aggregate Supply and
Inflation
aggregate
demand & aggregate supply
AGGREGATE: a mass of distinct things gathered
into
a total or whole.
THEREFORE, Aggregate Demand (AD) is the sum of all consumers’ demand in all markets & Aggregate Supply (AS) is the sum of all producers’ supply in all markets.
The notion of AD & AS is within a macro context, but, they are based on the laws of demand & supply within a micro context.
The Law of Demand: P up, Qd down -- ceteris
paribus.
1. Society’s income
2. Ps of other goods
3. Tastes & preferences
4. Expectations
The Law of Supply: P up, Qs up -- ceteris
paribus.
1. changes in the price of inputs
2. changes in technology
3. changes in suppliers’ expectations
4. changes in taxes & subsidies
AD: relation between
aggregate
Qd & the economy’s price level -- ceteris paribus.
HELD CONSTANT 1. Real
interest rates
2. Quantity of money
3. Changes in the international value of the $
4. Wealth
5. Gov. Spending & taxes
6. Expectations about the future
7. Y & conditions affecting demand in foreign mkts
AS: relation between aggregate Qs & the price level -- ceteris paribus.
HELD CONSTANT 1.
Availability
& quality of inputs
2. Institutional environment
3.Technology
4. Expectations
5. Wage/price ratio
CH. 14: The Labor Market,
Unemployment, and Inflation
Long Run Classical AS curve
Keynesian Short Run AS cure
The
Integration
of the Long & Short Run AS Curves
Price-flexibility curve
classical (laissez-fair, no government
intervention)
=> neo => new
labor theory of value
keynesian (government ok in times of economic
stress)
=> neo => new
DEBATE grew out of the Great Depression (GD) the classicals didn’t really have an answer for how we got there or how to get out
Classicals => Adam Smith--laissez-faire
self-adjusting long-run equilibrium
FIRST TENET OF THE CLASSICAL SCHOOL: if wages & prices are flexible then relative prices would adjust and excess inventories (unsold goods, a glut) would be cleared. This self adjusting process would return the economy to its long-run equilibrium.
Then the level of supply must be at the
full-employment,
assuming...
1. Firms are price takers
2. Firms always produced at maximum output
The classicals explained U by saying rigidities held the wage rate above E
Reason for Unemployment: wages are too high & they must fall
Classical Solution
for
the Depression: eliminate unions and government
policy that keep wages high
the classicals argued against government intervention into the economy
the popular explanation
of
the people said,
the government should hire the unemployed
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Back in Time.........
J. B. Say (19th century) / made famous by Ricardo & Reagan
"Supply creates its own demand."
SECOND TENET OF THE
CLASSICAL
PARADIGM: AD = AS always
never a glut, according to Say's Law which is part of the
process of self-adjusting long-run equilibrium
Malthus disagreed ~
when
people saved out of income this would create a leakage -- over
supply / under consumption
Ricardo ~ S would be lent to others & used as
investment
i would fluctuate so S = I
therefore AD always = AS => cyclical U impossible
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THIRD TENET OF THE CLASSICAL
SCHOOL:
QUANTITY THEORY OF MONEY
(mid 19th century)
The price level (gp) varies in response to the
quantity
of money
MV
= PQ
where,
M = the money supply
V = velocity
P = the price level
Q = quantity of real output
ASSUMPTIONS:
1. V is constant
2. Q autonomous (independent of
the money supply)
3. Direction of causation, Money
Supply => Price Level
therefore, the price level would change in
response
to the Ms
M & P change proportionally
If M = $100 & V = 20 then
M x V = P x Q = 100 x 20 = $2000
*you could predict nominal GDP ( P x Q)
true by definition (tautology)
Reality 1990, V = 6.67 P x Q / M = 5.5 t / 825 b (ms) = 6.67
If the Ms grows by 10%, so will nominal GDP
classicals assumed real output was autonomous ~ determined by forces outside the quantity theory: productivity & labor force population
CONCLUSION: The Classical Aggregate Supply Curve
Veil of Money Assumption: Real Output (Q)
is independent of the money
supply (M)
Therefore, there is a dichotomy between the real & monetary sectors
Based on intuitive
logic,
e.g., if your income doubled with all prices
then nothing changed in terms of units purchased
direction of causation M=>P
Classical prescription for the Depression,
have faith & in the Long Run the economy will adjust
**************************************************************
CH. 8: Aggregate Expenditure & Equilibrium
Output
Keynes, "In the LR we’re all
dead!"
Keynes agreed that flexible prices could achieve E at full employment, but, only in the long run. Yet, the real reasons for and how to get out of the GD were in the short run.
He asked, what if we were in disequilibrium?
if the veil of money assumption is true the
Demand
Curve is vertical too, because a change in the price level has no
affect
on the real economy
The Classical Response:
Veil of Money assumption only in the LR
changes in the price level affected AD in SR
people with a fixed amount of money
would
buy more if prices fell
the wealthy & foreigners ( X up, M down)
In the SR AD curve sloped down & to the right / AS curve still vertical -- unaffected by the price level (suppliers are price takers & produce @ full employment, even w/ excess supply
Keynes shifted the debate to the short
run...
he sought to investigate the short-run adjustment mechanism
as we move toward long-run equilibrium
*************************************************************
Keynes said Say’s Law was wrong -- Demand creates
its own Supply! MALTHUS was right -- gluts could exist.
*************************************************************
the financial sector didn’t work fast enough translating Savings into Investment => S> I, then C is down & AD/AE (excess supply)
firms layoff, Y falls, C & S fall further => Y falls until finally S=I. Now E @ a lower level of Y below full employment.
_______________________________________________________________
Keynes argued that in the GD the economy was in a
glut & there was no way out unless the Gov. stepped in &
provided
the missing AD
_______________________________________________________________
John Maynard Keynes, "The General Theory Of Employment, Interest & Money," 1936
Keynes: price-level adjustment mechanism in the
LR,
only of academic interest
PROBLEMS:
1. Works too slowly
2. Restrictive Institutional Structure
a. Minimum Wage
b. Fair Trade Laws
Look for SR problems
***************************************************************
Keynes looked at how
PRODUCTION
& EXPENDITURE decisions are made
***************************************************************
@ EQUILIBRIUM=> Planned Spending=Planned Output
(PS) = (PO)
what if they are not equal=> DISEQUILIBRIUM
TWO
CASES:
1. PS > PO
Inventories fall
upward Firms
hire
spiral Income
rises
=>The economy expands
2. PS < PO
Inventories rise
downward
Firm’s
layoff
spiral Income
falls
=>The economy contracts
*in both cases we would settle @ a new E
*******************************************************
AGGREGATE PRODUCTION CURVE
AP = Y (real) along the 45 degree line
*******************************************************
THE CONSUMPTION FUNCTION
C = consumption => 2/3 of AD
therefore C is central to the Keynesian Model
C & S (savings) are components of disposable income (Yd)
Yd = C + S
when Yd goes up C goes
up,
but not by as much as the change in Yd => because some of the
increase
in Yd goes to S
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The Consumption Function:
Relationship between C & Yd
algebraically: C =
C0 + b(Y-T) =
C0
+ bYd
Where,
b = mpc
C = consumption expenditures
Yd = Y(personal income) -
T(taxes)
C0 =
autonomous consumption
AUTONOMOUS
CONSUMPTION:
independent of Yd=>
exogenous
consumption if Yd = 0
(borrow
or dissave)
b = mpc = DC / DYd
mps = DS / DYd
mpc + mps = 1
bYd = induced consumption
or
endogenous consumption
Ds in C from Ds
in Yd
PLUG IN NUMBERS: C = 1k + .8Yd
Yd =
C +
S
0 =
1k + (-1k)
1k =
1.8k + (-800)
2k = 2.6k
+ (-600)
3k
= 3.4k + (-400)
4k =
4.2k + (-200)
5k =
5k + (0)
6k =
?
+ ?
7k =
? + ?
8k =
? + ?
9k =
? + ?
10k =
? + ?
Confirm the slope: b = mpc = DC / DYd
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THE AGGREGATE CONSUMPTION
FUNCTION
*********************************************************
GDP = AD = AE = Y = C + I + G + ( X - M )
the simple Keynesian Model, or AE
Curve,
or AE Model
sometimes called the Keynesian Cross
ASSUMPTIONS:
1. Taxes = 0
2. Wages & Prices are fixed (problems in the 70s)
Autonomous Expenditures =>
C0 + I0
+ G0 + ( X0
- M0 )< = AE0
or
DC0
+ DI0 + DG0
+ ( DX0 -
DM0
) = DAE0
(this shifts the AE Curve)
one or all of the components could change this
would DAE0
DISEQUILIBRIUM, when AE>AP
DISEQUILIBRIUM, when AP>AE
Graphical Equilibrium
We can see equilibrium, visually, on a graph and
verify
it algebrically
by plugging in 20K for Y
AE=4K+.8(20K)
= 20K
but without the graph this process would not be as smooth
"OR" Algebraically using the Keynesian
Equation
Y = C + I + G + ( X - M )
Where, by substitution
C = C0 + bY
I = I0
G = G0
( X - M ) = ( X0 + M0
)
Y = C0 + bY + I0 + G0 + ( X0 - M0 )< solve for Y
Y-bY = C0 + I0 + G0 + ( X0 - M0 )
Y(1-b) = C0 + I0 + G0 + ( X0 - M0 ) multiply both sides by (1/1-b), then...
Y = ( 1 / 1-b ) [ C0
+ I0 + G0
+ ( X0 - M0
)]
multiplier
autonomous expenditure
SET 1/1-b = α as above C0 + I0 + G0 + ( X0 - M0 )< = AE0
The Keynesian Equation
becomes:
Y = α
AE0
since
the Keynesian Equation finds equilibrium, it may written as...
AE = α AE0
given any two of the
above variables lets you solve for the unknown
Let's say you just want to find the DAE0,
or, the DY...then
DY = α
DAE0
or
DAE = α
DAE0
α magnifies a DY
resulting from a DAE0,
because Y is respent
if the change is positive the AE Curve shifts up
if the change is negative the AE Curve shifts down
What causes shifts in the AE Curve?
C
1. Natural Disasters
2. Expectations
I
1. Changes in i ( liquidity preference )
2. Expectations
3. Technology
G 1. Changes in Government Spending
( X - M )
1.
Currency Values
2. Productivity
3. Income
Downturn => when Yd
goes down
C goes down, but not by as much as the change in Y.
Paradox of Thrift: S up, Y down => S down
shift in AS curve is movement along AP curve & when AS shifts it causes AD to shift
The shifts get progressively smaller until
there
is a new Equilibrium
Effective Demand
Interpretative vs. Mechanistic Keynesian Model
CH. 9, The Government &Fiscal Policy
Initially Keyesian Economics suggested
1. Government Spending (deficits)
LATER...
2. Tax Policy
3. Monetary Policy
***************************************************
FISCAL POLICY (this
chapter)
1.
Discretionary
government spending policy
2.
Discretionary
tax policy
*we’ll talk about discretionary monetary policy later
Keynes noticed that I dried up during the GD, leaving the economy @ an E @ less than potential output
1. Recessionary Gap
graphically}
2. Inflationary
Gap
Keynes thought the government could step in &
create
a
COUNTERSHOCK
to close these gaps, this would affect autonomous
expenditures,
shifting AE
IN TERMS OF FISCAL POLICY:
Recessionary Gap=> expansionary fiscal policy
G up and/or T down
Inflationary Gap=> contractionary fiscal policy
G down and/or T up
*sometimes called Aggregate Demand Policy, *show
t-58
According to the Keynesian equation--a small change would be amplified by the multiplier
D Y=(1/1-b)[D Co+D Io+D Go+D (Xo-Mo)]
*y changed by a multiple of a change in autonomous expenditure
***************************************************
In the previous chapter we assumed taxes were zero
in this chapter we drop that assumption
Taxes affect consumption by changes in Yd
C = Co + bYd = Co + b(Y-T)
Taxes shift the AE curve up & down
Transfer payments:payments to individuals that are not a payment for goods or services
Transfer payments can also shift the AE curve up
&
down
With taxes the Keynesian equation becomes:
DY = (1/1-b) [D Co + D Io + D Go - bD To + D (Xo - Mo)]
BUT, a change in G is different than a change
in T
by -bD T *T is reduced by the
fraction
b, G is not
THEREFORE: to have an equivalent change in Y you must change T more than G
D Y = (1/1-b) D G
D Y = (1/1-b) -bD T = -mpc/1-mpc D T
EXAMPLE: inflationary gap of a $1000 & the mpc = .8
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THE MULTIPLIER & REALITY = 2 or 2.5
leakages=> savings, taxes & imports
1 / [ 1 - ( b + bt + mpm )] = 1 / mpe
where=> mpm = marginal propensity to import
Mpe = marginal propensity to expend
PROBLEMS WITH COUNTER CYCLICAL POLICY
or is it possible to fine tune the economy=> ?
1. Lags in data collection
2. Lags in implementation
ALTERNATIVES TO FISCAL POLICY
1. rosy scenario
2. Government guarantees
3. Interest rates
4. Trade Policy
a. Export-led growth
b. Exchange rates
5. Autonomous Consumption Policy
a. Availability of credit
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In reality T is dependent on Y
T = To + tY
this influences fiscal policy results
CROWDING OUT
AUTOMATIC
STABILIZERS
1. Welfare payments
2. U insurance
3. Progressive income tax
*show t-62