Introduction Thinking Like an Economist CHAPTER 9 The

Introduction: Thinking Like an Economist CHAPTER 9 The Short-Run Keynesian Policy Model: Demand-Side Policies Theory of Economics…is a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions. ―J. M. Keynes Mc. Graw-Hill/Irwin Copyright © 2013 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Key Insight of the Keynesian AS/AD Model Ø Short-run equilibrium output may differ from long-run potential output assuming a fixed price level • Equilibrium output is the level of output toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing production • Potential output is the highest amount of output an economy can sustainably produce using existing production processes and resources Ø Market forces may not be strong enough to correct deviations from potential output 9 -2

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Key Insight of the Keynesian AS/AD Model Ø Paradox of thrift • In the long run, saving leads to investment and growth • In the short run, saving may lead to a decrease in spending, output, and employment Ø Aggregate demand management, which is government’s attempt to control the aggregate level of spending, may be necessary Ø Keynesian economists advocated an activist demand management policy 9 -3

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 US Savings Rates 9 -4

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 The Components of the AS/AD Model Aggregate Demand Curve (AD) • Is a curve that shows how a change in the price level will change aggregate expenditures on all goods and services in an economy Short-Run Aggregate Supply Curve (SAS) • Is a curve that specifies how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constant Long-Run Aggregate Supply Curve (LAS) • Is a curve that shows the long-run relationship between output and the price level 9 -5

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 The Slope of the AD Curve The AD curve is downward sloping because of: Ø Interest rate effect, the effect that a lower price level has on investment expenditures through the effect that a change in the price level has on interest rates Ø International effect, as the price level falls (assuming the exchange rate does not change), net exports will rise Ø Money wealth effect, a fall in the price level will make the holders of money richer, so they buy more Ø Multiplier effect, the amplification of initial changes in expenditures 9 -6

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 The Slope of the AD Curve Price level The AD curve is downward sloping because of the interest rate, international, and money wealth effects P 0 and the multiplier effect P 1 AD Y 0 Y 1 Y 2 Real output 9 -7

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Dynamic Price Level Adjustment Feedback Effects Ø Dynamic effects exist that can counteract the standard AD shift factors; If strong enough, can cause AD to fall (shift to the left) when the price level falls Ø Especially important when aggregate demand is declining • Expectations of falling aggregate demand • Lower asset prices (declining nominal wealth) • Financial panics 9 -8

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Shifts in the AD Curve Ø A shift in the AD curve means that at every price level, total expenditures have changed. Five important shift factors are: • Foreign income • Exchange rates • Distribution of income • Expectations • Monetary and fiscal policy Ø Deliberate shifting of the AD curve is what most policy makers mean by macro policy, or AD management 9 -9

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Shifts in the AD Curve The AD curve shifts out by more than the initial change in expenditures Price level • Exports increase by 100 Initial Multiplier effect • The multiplier magnifies this shift (assuming multiplier = 3) P 0 Total effect 100 200 AD 0 300 AD 1 AD curve shifts to the right by a multiple of 100, in this case by 300 Real output 9 -10

19 The Short-Run Keynesian Policy Model: Demand-Side Policies The Aggregate Supply Curves The Slope of the Short-Run Aggregate Supply (SAS) Curve The SAS curve is upward sloping because of: Ø Auction markets • Prices are determined by demand supply curves are upward sloping (higher P, higher Q) Ø Posted price markets • Also called quantity-adjusting markets, markets in which firms respond to changes in demand by changing production instead of changing their prices • Firms tend to increase their markup when demand increases 9 -11

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Shifts in the SAS Curve Price level SAS 1 SAS 0 SAS 2 Ø Shifts in the SAS are caused by changes in: • Input prices • Productivity • Import prices • Excise and sales taxes Ø When production costs increase, the SAS curve shifts up Ø In general: Real output %Δ in price level = %Δ in wages – %Δ in productivity 9 -12

19 The Short-Run Keynesian Policy Model: Demand-Side Policies The Long-Run Aggregate Supply Curve Ø The long-run aggregate supply (LAS) curve shows the long -run relationship between output and the price level Ø The position of the LAS curve depends on potential output which is the amount of goods and services an economy can produce when both capital and labor are fully employed Ø The LAS curve is vertical because potential output is unaffected by the price level 9 -13

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 The LAS Curve Price level LAS Potential output is assumed to be in the middle of a range bounded by high and low levels of potential output C SAS B A Overutilized resources Underutilized resources Low-level potential output High-level potential output Real output • When resources are overutilized (point C), factor prices may be bid up and the SAS shifts up • When resources are underutilized (point A), factor prices may decrease and SAS shifts down 9 -14

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Shifts in the LAS Curve Price level LAS 0 LAS 1 LAS 2 Increases in the LAS are caused by increases in: Ø Capital Ø Resources Ø Growth-compatible institutions Ø Technology Ø Entrepreneurship Real output 9 -15

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Short-Run Equilibrium in the AD/AS Model Price level Short-run equilibrium is where the SAS and AD curves intersect and point E is short-run equilibrium F P 1 P 0 SAS E AD 1 AD 0 Y 1 A shift in the aggregate demand curve to the right changes equilibrium from E to F, increasing output from Y 0 to Y 1 and increasing price level from P 0 to P 1 Real output 9 -16

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Short-Run Equilibrium in the AD/AS Model Price level SAS 1 P 2 P 0 SAS 0 G E A shift up in the short-run aggregate supply curve changes equilibrium from E to G, decreasing output from Y 0 to Y 2 and increasing price level from P 0 to P 2 AD Y 2 Y 0 Real output 9 -17

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Long-Run Equilibrium in the AD/AS Model Price level Long-run equilibrium is where the LAS and AD curves intersect LAS P 1 H P 0 E AD 1 AD 0 YP A shift in the aggregate demand curve changes equilibrium from E to H, increasing the price level from P 0 to P 1 but leaving output unchanged Real output 9 -18

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Application: A Recessionary Gap in the AD/AS Model Price level LAS SAS 1 A SAS 0 P 1 E P 0 Gap Y 1 YP AD 0 • A recessionary gap is the amount by which equilibrium output is below potential output • At point A, some resources are unemployed and the recessionary gap is YP – Y 1 Eventually wages and prices decrease and SAS shifts down to return the economy to a long and short-run equilibrium at E Real output 9 -19

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Application: An Inflationary Gap in the AD/AS Model Price level • An inflationary gap is the amount by which equilibrium output is above potential output LAS SAS 0 P 0 E B SAS 2 P 2 Gap YP Y 2 AD 0 • At point B, resources are being used beyond their potential and the inflationary gap is Y 2 – YP Eventually wages and prices increase and SAS shifts to return the economy to a long and short-run equilibrium at E Real output 9 -20

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Utilizing the AS/AD Model: Aggregate Demand Policy Ø A primary reason for government policy makers’ interest in the AS/AD model is that monetary or fiscal policy shifts the AD curve • Monetary policy involves the Federal Reserve Bank changing the money supply and interest rates • Fiscal policy is the deliberate change in either government spending or taxes to stimulate or slow down the economy 9 -21

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Utilizing the AS/AD Model: Aggregate Demand Policy Ø Countercyclical fiscal policy is fiscal policy in which the government offsets any change in aggregate expenditures that would create a business cycle Ø Fine-tuning is used to describe such fiscal policy designed to keep the economy always at its target or potential level of income 9 -22

19 The Short-Run Keynesian Policy Model: Demand-Side Policies Application: Expansionary Fiscal Policy in the AD/AS Model Price level • If the economy is at point A, there is a recessionary gap equal to YP – Y 0 LAS P 1 • The appropriate fiscal policy is to increase government spending and/or decrease taxes E P 0 A Gap Y 0 AD 0 YP AD 1 AD shifts to the right and output returns to potential output YP and prices increase to P 1 Real output 9 -23

19 The Short-Run Keynesian Policy Model: Demand-Side Policies Application: Contractionary Fiscal Policy in the AD/AS Model Price level LAS • If the economy is point B, there is an inflationary gap Y 2 – YP B P 2 P 1 • The appropriate fiscal policy is to decrease government spending and/or increase taxes E Gap YP Y 2 AD 0 AD 2 AD shifts to the left, output returns to potential output YP and inflation is prevented Real output 9 -24

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Limitations of the AS/AD Model Ø Feedback effects mentioned earlier Ø Potential output is difficult to estimate precisely Ø The economy can become dynamically unstable—a shock can generate changes that are not self-correcting Ø Implementing fiscal policy through changing taxes and government spending can be a slow legislative process • There is no guarantee that government will do what economists say is necessary • Automatic stabilizers can avoid this (automatic tax and spending policies that are programmed to occur without additional government action) 9 -25

The Short-Run Keynesian Policy Model: Demand-Side Policies 19 Chapter Summary Ø The key idea of the Keynesian AS/AD model is that in the short run the economy can deviate from potential output Ø The AS/AD model consists of the aggregate demand curve, and the short-run aggregate supply curve, and the long-run aggregate supply curve Ø Short-run equilibrium is where the SAS and AD curves intersect; Long-run equilibrium is where the AD and LAS curves intersect Ø Aggregate demand management policy attempts to influence the level of output in the economy 9 -26