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Objectives
After working through this topic you should be able to:
· Understand the meaning and derivation of the Extreme Keynesian
aggregate supply curve
· Understand the meaning and derivation of the General Keynesian
aggregate supply curve
· Understand the meaning and derivation of the Classical aggregate
supply curve
· Explain the effects of demand management policy in each case
· Explain the way the three approaches can be synthesised
· Explain the importance of price expectations for the proper definition
of a full employment equilibrium
Key Concepts
Extreme Keynesian AS curve synthesis AS analysis
General Keynesian AS curve price expectations
Classical AS curve full employment equilibrium
demand management
real effects
Introduction
In this topic, we will complete the derivation of the AD/AS model by
considering how the aggregate supply curve is derived. The key point
is that there are three separate (but linked) AS curves to consider,
each one corresponding to one of the three assumptions about
workers’ price expectation discussed in the last topic. Complete
money illusion gives rise to the Extreme Keynesian AS curve,
imperfect foresight underpins the General Keynesian curve, whilst
with perfect foresight the Classical AS curve holds true. The
implications for the effectiveness of demand management are
explored in each of the three cases.
Y1
Y0
N Y0 Y1 Y
W P
NS0
D
A
W1 ASEK
W0
P1
P0
ND1
ND0
N0 N1 N Y
Activity 1
Illustrate and explain the effect on the Extreme Keynesian AS curve
of an increase in (marginal) labour productivity. (Hint: what is the
effect on the demand for labour curve?)
Demand Management
P1
P0
AD1
AD0
Y0 Y1 Output (Y)
On the vertical axis is the price level (P), on the horizontal axis are
units of output (Y). The aggregate supply curve is represented by
ASEK, and the initial aggregate demand curve by AD0. This derives a
price level P0 and output Y0 where the goods, money and labour
markets are all in simultaneous equilibrium.
Suppose the authorities think that output Y0 is too low, and wish to
increase it to Y1 by means of an expansionary fiscal and/or monetary
policy. Such an expansionary policy will shift the aggregate demand
curve to the right to AD1. Consequently the level of output will rise
to Y1, at the cost of a higher price level P1. Actually the higher price
level, which is entirely unanticipated by workers i.e. complete money
illusion, is necessary to allow the real wage rate to fall and the
equilibrium volume of employment to increase.
If a contractionary demand management policy is pursued the
aggregate demand curve will shift to the left causing the level of
output and the price level to fall.
The important thing to remember is that:
· in an extreme Keynesian world demand management policies have
‘real’ effects on the economy in terms of the equilibrium levels
of employment and output.
Y1
Y0
N Y0 Y1 Y
W P
NS1
NS0
D
W1 A
ASGK
W0
P1
P0
ND1
ND0
N0 N1 N Y
Demand Management
This issue is illustrated by reference to Figure 10-4 below. The
general Keynesian aggregate supply curve is represented by ASGK;
the initial aggregate demand curve is shown as AD0.
Price
level ASGK
(P)
P1
P0
AD1
AD0
Y0 Y1 Output (Y)
Activity 2
Use a (single) diagram to compare the effect on real output and the
price level of a contractionary monetary policy in the Extreme and
General Keynesian cases. Explain your answer.
Y0
N Y0 Y
W NS1 P
NS0
D
W1 A ASC
W0
P1
P0
ND1
ND0
N0 N Y
Activity 3
Illustrate and explain the effect on the Classical AS curve of a
reduction in labour supply at every real wage rate.
P0
AD1
AD0
Y0 Output (Y)
AD1
AD0
Y0 Y2 Y1 Output (Y)
Figure 10-7: Expansionary Policy in the Short, Medium & Long Run
There are three aggregate supply curves on this diagram. ASEK is the
Extreme Keynesian curve; ASGK is the General Keynesian curve; and
ASc is the Classical schedule. With an initial aggregate demand curve
AD0 the economy is in equilibrium at point A with price level P 0 and
output Y0.
Suppose that the government expands the level of demand, such that
the aggregate demand curve shifts to AD1. Using the three supply
curves the impact of the higher demand on the price level and output
can be charted over different time periods. In the immediate time
period after the disturbance the initial effect is shown by reference to
the ASEK curve. At first the higher demand pulls up the actual price
level to P1; workers suffer complete money illusion; and as the real
wage falls there is a significant increase in output up to Y1 - point B.
In the medium term, however, workers begin to adjust to the new
circumstances and start to partially anticipate a higher future price
level. The economy moves onto curve ASGK. The workforce push for
higher money wages which firms accommodate because the
conditions of aggregate demand allow prices to rise even higher (i.e.
to P2). Output falls back a little to Y2 - point C, but it is still higher
than Y0.
In the long run the workforce have fully adjusted their price
expectations, and push for increases in wages which firms grant as
they move prices up to a level consistent with P 3. The real wage rate
returns to the level before the increase in aggregate demand, and
output returns to Y0 - point D. The long run effect of an expansion of
aggregate demand is to increase the price level with no impact on the
real level of output and employment.
Activity 4
Using an appropriate diagram, carefully explain the impact in the
short, medium and long term of a contractionary fiscal and
monetary policy. Be sure to make clear what is happening to the
actual and expected real wage rate in each time period.
Pt 1 f Pt E 1
PE
Yet, as noted, earlier the value of t 1 is itself a function of the
actual price level in the present time period (Pt). It follows that there
is an inter-relationship between the actual and expected price levels
which is illustrated below.
Pt E 1 Pt E 2 Pt E 3
The causal relationship between the expected and actual price levels
is a subject taken up by the Rational Expectations School.
Second, the preceding analysis allows a more precise definition of a
full employment equilibrium to be described. Essentially it has a
twofold character. Namely:
1. a position where in the labour market the demand for labour
equals the ‘real world’ supply of labour
2. for every economic agent (especially those in the workforce) the
actual and expected price levels are equal; i.e. price expectations
are correct and there is no money illusion.
The above is a more accurate definition of full employment than that
contained in Economic Principles notes on the ‘Natural Rate of
Unemployment’ because it explicitly deals with price expectations.
In terms of Figure 10-7 this means that only points A and D meet the
criterion of a full employment equilibrium. Points B and C are
actually positions where the economy is operating at an above full
employment level.
Activity 5
Why is the economy not in a stationary equilibrium when the
expected and actual price levels differ?
Further Reading
Dornbusch & Fischer: Chapter 7
Branson: Chapter 8