Macro Theory:

Dr. D. Foster – ECO 285 – Macroeconomics

The AS/AD Model Part 1 – The Basics Part 2 – The Keynesian View

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.• No numerical interpretation.• Only AS/AD graphical

representation.

Part 1 – The Basics

The Aggregate Demand Schedule

AD1

P

Q or R-GDP

BP1

Q2

AP2

Q1

P = Price Level;CPI or GDP deflator

Q = real output;Real GDP

AD = Agg. Demand;From 4 sectors – HH, Bus, G, Foreign

Aggregate Demand

• The price level and real output demanded are inversely related.

• A fall in the price level will increase quantity demanded.

• Why? -- the Wealth Effect

• All prices and wages change.• But, the fixed wealth is … well, still fixed!• So, with lower prices we feel wealthier. Woo Hoo!• And, so we want to buy more stuff.

Aggregate Demand

• What about:

Interest effect Foreign trade effect Exchange rate effect

• AD can shift to the left or right. Increase AD – shift to the right. Decrease AD – shift to the left. Whenever C, I, G, net X increase/decrease. Why? Due to changes in optimism & pessimism, and

due to fiscal & monetary policies.

Can’t do “all else equal.”e.g. Lower prices: Consumption, but one price is wages!!! If they fall, then we’d see a Consumption!!!

The Aggregate Demand Schedule

AD2

AD1

P

Q or R-GDP

AD3

Increases inC, I, G, net

X

Decreases in

C, I, G, net X

Long Run Equilibrium betweenAggregate Demand and Aggregate Supply

•There is an Aggregate Supply that reflects fully employed resource use.

•Output level:Q* or RGDP* or potential RGDP

AD1

P

Q or R-GDP

AS1

P1

•Shifts in AD can only change the price level and not real output (nor employment).

Classical Model of the Economy

What affects the Aggregate Supply?

• Labor force participation.

• Labor productivity.

• Marginal tax rates on wages.

• Provision of government benefits that affect household incentives w.r.t. supply labor.

• State of technology.

• Capital stock.A change in these

factors can AS (shift right)

or AS (shift left)

Short Run Aggregate Supply – Wage Inflexibility

• Nominal wages are sluggish upwards:A rise in prices has delayed effect on wages.

• Nominal wages are inflexible downwards:A fall in prices will result in employment and

income.

• Workers have money illusion:Higher nominal wages are viewed as real wage.So, more workers available even though real wage

has not risen. e.g. if prices rise 5% and wages rise 3%…

Short Run Aggregate Supply

• The Short Run will adjust to the Long Run: An AD will P and Q, but only in the SR.

Prices rise but wages lag. Firms employment and output.

Eventually, workers realize their real wages (W/P) are falling, get comparable wage, AS. The temporary profit motive has been eliminated.

• What about:

Sticky prices Misperception Intertemporal substitution

Unnecessary complicationsto explain the SR AS.

Inflexible wages is all we need.

What happens if there is a AD?

From SR to LR Aggregate SupplyAn increase

in AD triggers events.

Prices rise,wages lag,

output rises.

Eventually,wages catch up

and AS declines.

In LR, onlyprices rise.AD

1

P

Q or R-GDP

ASLR

P1

AS1

AD2

P2

Q2Q*

P3

AS2

AS3

AS/AD Model – Hints at 4 types of changes

• 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)

AD1

P

Q or R-GDP

ASLR

P1

AS1

Q*

Macro Theory:

Dr. D. Foster – ECO 285 – Macroeconomics

The AS/AD Model II -Keynesian Version

AS/AD Model – Long Run & Short Run

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

AD1

P

Q or R-GDP

ASLR

P1

AS1

Q*

Part 2 – The Keynesian View

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 whenplanned spending equalsrealized 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.

Equilibrium in the Keynesian Model

• When planned spending = realized spending

• Assumes planned C, G, net X = realized C, G, net X

• But, planned I may not equal realized I

If AD>AS then Ip>Ir and inventories fall

unexpectedly.

And business will I which production and income/employment.

If AD<AS then Ip<Ir and inventories build up

unexpectedly.

And business will I which production and income/employment.

Recall from our discussion of GDP = the change in business inventories, although very small in absolute terms, is a closely

watched variable because it tells us what will happen to business investment …

Details of the Keynesian Model

• Changes in spending have a multiplier effect

on income.

C=$100 will Y=$100; some of this is spent, so C=$80 which Y=$80; some of this is spent, so C=$64 which Y=$64 …

True for in C, I, G, net X

• This only applies when there is no inflation.

All income changes are “real.”

• In a recession, additional resources can be employed without raising wages/prices.

Keynesian theory in AS/AD Model

AD1

P

Q or R-GDP

ASLR

AS1

Q*Q1

AD2

Q2 Q3

AD3

Introduce a flat AS.

Introduce disequilibrium at Q1 with AD2.

Equilibrium process moves us to Q2.

But, we still have a depression.

If we can further increase spending to AD3 we can boost employment and output.

Continue until we reach Q*.

Fiscal Policies

• Government spending & taxes.

• G has a direct effect on AD (just as C, I, net X)

• Since G is discretionary, it can be controlled, unlike others.

• Taxes have a more complicated effect.To keep things simple, assume “lump sum taxes.”T will affect both consumption and saving.

e.g., if taxes are raised by $400 then maybe consumption will fall by $320, and saving will fall by $80 to compensate.

Since changes in income are driven by multiplier effects on spending, the effects are not offsetting!!!! [T = lesser C Y]

Odd Keynesian balanced budget multiplier = 1, where ∆G = ∆T = ∆Y

Fiscal Policies

• Transfer payments can be included here.Recall that they are not included as G in GDP.But, we can consider these as “negative taxes.”That is, total government spending = G + TP,

while total government revenue = T + TP. So an TP can be thought of as an equivalent T

An TP will C and S, so overall Y just like a T

• Some fiscal policies may be “automatic stabilizers.”

With unemployment, transfer payments rise automatically.

e.g., Unemployment insurance, food stamps, welfare.

This would tend to boost AD without explicit Congressional

approval.Also, taxes serve this purpose. As the economy

slides into recession, incomes fall and so do tax

payments.

Taxes, Spending, Debt & Deficits

• A change in taxes should affect AD & ASIs the effect on AS larger?

• The Laffer Curve and tax collection.Of course the purpose isn’tto maximize tax revenues!

• If G is financed by borrowing, how will we react?Ricardian equivalence - do we plan on a future tax

burden?The “crowding out” issue.

• Should budget be set to balance at full employment?

Keynes – No! Balance over the business cycle.Buchanan – Politicians will never do that!“Structural deficit” – what remains at full

employment.

2014:Q4

$18.1 t

2014:Q4

102.5%

2014$485 b

20142.78%

2014:Q4

$3.9 t.

CBO; By 2038 %GDP:

Fed’l spending 26%

Fed’l revenue 19.5%

Interest on debt 5%

2014:Q4

$420.5 b.

Macro Theory:

Dr. D. Foster – ECO 285 – Macroeconomics

The AS/AD Model Part 1 – The Basics Part 2 – The Keynesian View