Onward from Lord

Keyness
Cross
To summarize:
Keynes taught that:
a)
b)
c)

d)

Macro equilibrium full employment equilibrium

Business cycles originate in fluctuations in AE
These cycles can be corrected with or in AE,
especially with direct or in G
Thanks to the multiplier, these or didnt have
to be very big (relative to desired Y)

Therefore, when the Great Recession hit:

Bushs $152B Economic Stimulus Act of 2008

Obamas $787B Am. Recovery & Reinvestment Act of '09
1

Result: All fixed, right?

OK, maybe not but why

not?
Keynesian rationales:

Sticky wages

This time is different

Workers dont adjust wage expectations

downward, so excess supplies of labor persist
Financial crises produce deeper recessions,
longer, slower recoveries by their very nature
Though the evidence is thin

We just havent stimulated AE enough

3

Or maybe the model needs

refinement?
Is it possible demand management policies
(AE) arent as effective as advertised,
perhaps because the multiplier isnt as large?

G crowds out some private spending?

And why do we ignore the supply side?

And what about the price level?

Keynesian cross we have either slack or

inflation never both at same time
Yet in the 70s, we did and coined the term
stagflation to describe the combination
4

Why Jimmy Carter was a 1term Prez

Goal in H&O13 is to build a

more sophisticated, realistic
Macro
modelof
Better integration

decisions about
production/supply
with demand
Incorporation of price
level to enable better
predictions about
inflation
6

Step 1: Understanding Aggregate Demand

The Aggregate Demand (AD) curve shows the relp

between the price level* and the total amount of
(domestically produced) final goods & services that
purchasers are willing to buy;
Just like in an individual market, the AD curve is
negatively sloped (i.e., slopes downward to the right),
so higher P lower quantity demanded
Warning: the reasons for this negative slope are very
different from those that apply in individual markets.
*Remember that P is the aggregate price level now, representing an index of
all prices on final goods and services exchanged.

The
Aggregat
e
Demand
(AD)
Curve

Price
Level

A reduction in the price

P1

level will increase the

quantity of goods &
services demanded.

P2

AD
Y1

Y2

Goods & Services

(real GDP)

Other things constant, a lower price level will (1) increase the wealth
of people holding the fixed quantity of money, (2) lead to lower
interest rates, and (3) make domestically produced goods cheaper
relative to foreign goods.
8

The three reasons the AD curve

has a negative slope

#1: Wealth (or Real

Balance) Effect: A lower
price level increases the
purchasing power of the
fixed quantity of money in
circulation.

E.g., When P falls, your savings

and cash balances can buy
more; you feel (and are)
wealthier, and some of this
increased wealth fuels
increased consumption of
goods and services.
Or, if P rises, lower real wealth
reduced consumption.

The negatively-sloped AD curve

(cont.)
#2: Interest-Rate Effect: A

lower price level will reduce

the demand for money for
day-to-day transactions,
increase the supply of
loanable funds (as people
shift some of their money
balances into interest-bearing
financial assets), and lower
the real interest rate...
which stimulates borrowing
for additional purchases (esp.
durables like houses and
cars).
And vice versa for a higher P.
10

The negatively-sloped AD curve

(cont.)

#3: International-Trade
Effect: A lower domestic
price level domesticallyproduced goods are less
expensive relative to
foreign goods.

Therefore, well buy more

domestic goods and fewer
importsand foreigners will
buy more from us, too.
And vice versa: higher P
we buy more imports,
foreigners buy fewer of our
exports.
11

Moving along vs. shifting

AD
So if P changes, you move along AD

But there are 3 sets of factors that can

shift the whole AD curve left or right:
Changes in government policies

1)

Changes in the expectations of households

and firms

2)

Consumer confidence; investor psychology

Changes in foreign variables

3)

Fiscal or monetary policy

Exchange rates

Practice with Prob 13.1, Table 13.1

12

Table 13.1

Variables That Shift the Aggregate

Demand Curve

An increase in

shifts the aggregate

demand curve

because

Table 13.1

Variables That Shift the Aggregate

Demand Curve

An increase in

shifts the aggregate

demand curve

because

Table 13.1

Variables That Shift the Aggregate

Demand Curve

An increase in

shifts the aggregate

demand curve

because

The table shows the shift in the aggregate demand curve that results from an
increase in each of the variables.
A decrease in these variables would cause the aggregate demand curve to shift
in the opposite direction.

On to: The Aggregate Supply (AS) curve

In generalizing about supplier

behavior, we have to distinguish
between the short and long
runs.

Short run (SRAS):

A period during which some prices,
particularly those in resource markets,
are set by prior contracts and
agreements. Therefore, in the SR,
households and businesses are unable
to adjust these prices when unexpected
changes occur, including unexpected
changes in the price level.
Long run (LRAS):
A period of sufficient duration that
people have the opportunity to modify
their behavior in response to price
changes (e.g., following contracts
expiration).

Short-run Aggregate Supply (SRAS)

SRAS has a positive slope (i.e., firms

increase Q supplied as P rises). Reasons:

Resource P stickiness: In SR, an unanticipated

increase in the aggregate price level while many
input prices remain fixed will mean that itll be
profitable to produce extra output

From micro: if P but MC doesnt (because long-term

contracts fix wages, resource prices), then P > MC, and
profit-maximizing firms will want to expand Q

Info problems: Belief (mistaken?) that P hike is

personal rather than general can induce Q
increases.

I.e., They like me... they really like me logic

investments in greater capacity and output to capture
greater market share

The
Shortrun
Aggrega
te
Supply
(SRAS)
curve

Price
Level

SRAS(P
P105

An increase in the
price level will increase
the quantity supplied
in the short run.

P100
P95

Y1

100

Y2

Y3

Goods & Services

(real GDP)

In SR, firms expand output as P increases because higher

prices improve profit margins, since many components of costs
will be temporarily fixed as the result of prior contracts, wage
stickiness, menu costs.
18

Long-run Aggregate Supply (LRAS)

LRAS indicates the relp between the price

level and quantity of output after decision
makers have had enough time to adjust their
prior commitments/contracts.
This eliminates the reasons for the SRASs
positive slope, so...
LRAS is vertical, at Potential GDP or Full
Employment Output.

Key: LRAS is determined by an economy's

production possibilities. In LR, a higher P doesnt
loosen the constraints imposed by the economy's
resource base, level of technology, and the efficiency
of its institutional arrangements.

The
Longrun
Aggrega
te
Supply
(LRAS)
curve

Price
Level

LRAS

Change in price level

does not affect quantity
supplied in the long run.

Potential GDP

(full employment
F
rate of output)

Goods & Services

(real GDP)

An economys full employment rate of output (YF), the maximum

output rate that is sustainable, is determined by the supply of
resources, level of technology, and the structure of institutions,
factors that are insensitive to changes in P. Hence the vertical LRAS
curve.
20

Moving along vs. shifting

AS
Again if P changes, you move along AS but 5 factors

can shift AS
1)
2)
3)

4)

5)

Increases in the Labor Force* and/or the Capital Stock SRAS shifts rightward
Technological change productivity increases SRAS shifts rightward
Expected Changes in the Future Price Level

If workers and firms expect the price level to increase by a certain percentage, the
SRAS curve will shift by an equivalent amount, holding constant all other
variables that affect the SRAS curve.
Adjustments of Workers and Firms to Errors in Past Expectations about the Price
Level

If workers and firms across the economy are adjusting to the price level being
higher than expected, the SRAS curve will shift to the left.

If they are adjusting to the price level being lower than expected, the SRAS curve
will shift to the right.
Unexpected Changes in the Price of an Important Natural Resource (shocks)

*Anybody read the CBO report on post-ACA labor force participation?

21

Table 13.2 Variables That Shift the Short-Run Aggregate

Supply Curve
An increase
in

shifts the short-run

aggregate
supply curve
because

Table 13.2 Variables That Shift the Short-Run Aggregate

Supply Curve
An increase
in

shifts the short-run

aggregate
supply curve
because

The table shows the shift in the SRAS curve that results from an increase in
each of the variables.
A decrease in these variables would cause the SRAS curve to shift in the
opposite direction.

On to: Equilibrium in the SR and LR

Just like in micro, short-run equilibrium in

this final goods and services market occurs at
the price level P where quantity demanded
equals quantity supplied.

This occurs (graphically) at the output rate where the

AD and SRAS curves intersect.
At this market-clearing price level P, the amount
that buyers want to purchase is just equal to the
quantity that sellers are willing to supply during the
current period.

Theres no excess supply (buildup of unsold inventory);

Theres no excess demand (inventory below normal).

Short-run equilibrium: AD = SRAS

Price
Level

SRAS(P

100

Intersection of
AD and SRAS
determines output.

AD
Y

Goods & Services

(real GDP)

At P and Y, AD = SRAS
At prices < P, general excess demand P .
Conversely, at prices > P, excess supply P .
25

Long-run equilibrium

requires that transactors are OK with the contracts that

influence current production costs and product prices.

Thatll be true if theyve correctly anticipated the current price

level at the time they arrived at the agreements.
If this isnt the case, buyers and sellers will want to modify the
agreements when the long-term contracts expire.

When long-run equilibrium is

present

Actual GDP = Potential GDP (no more, no less)

The economy is operating at full employment.

I.e., the economy is producing at its maximum

sustainable output consistent with its resource base,
current technology, and institutional structure.
I.e., The measured or actual rate of unemployment
equals the Natural Rate of Unemployment.

Graphically, were at the output rate Y = Yf,

where the AD, SRAS, and LRAS curves
intersect.

Long-run equilibrium in the goods

and services market
Price
Level

LRAS

SRAS100

Note, at this point, the

quantity demanded just
equals quantity supplied.

P100

AD100
YF

(full employment
rate of output)

Goods & Services

(real GDP)

The subscripts on SRAS and AD indicate that buyers and sellers

alike anticipated the price level P100 (where 100 indicates prices = those
during earlier base year, i.e., are stable).
28

Disequilibrium and temporary equilibrium in

this goods and services market

If our expectations (about P, etc.) do not

match current reality, we wont be in LR
equilibrium
But we may be in a temporary or SR
equilibrium where Y > Yf (boom), or Y < Yf
(bust)
I.e., AD or SRAS can shift, moving us away
from Yf (either above or below it) in the short run
Then the question is, how do we get back to Y
f
and LR equilibrium?

Next step: Using our AD/AS

model to forecast
macroeconomic
cycles

Goal: Gather info you

can use to predict
effects of events on
output, prices,
employment, interest
rates, profits, wages,
stock values, etc.

30

Check on current conditions,

possible AD
1.
2.
3.

Wealth: Dow Jones Industrial Average

Optimism (pessimism): Consumer Confidence Index
Expected inflation: (i - TIPs yield)?
FRB: Selected Interest Rates

4.
5.

Incomes abroad: Int'l Data

$ exchange rate: American Dollar vs. Euro

31

Practice questions (on you!)

How will the following events affect AD in

these United States?

A terrorist attack
An increase in expected inflation
A decrease in Federal income tax rates
A depression in China
Fed chairman Janet Yellen decides to nip
inflation in the bud by tightening monetary policy

32

Practice questions (again, on you!):

Indicate whether the following would affect

SRAS and/or LRAS, and how:
(a) An increase in real wage rates.
(b) A severe freeze that destroys half of the
orange crop in Florida.

(c) An increase in the expected rate of inflation.

Note: can this also affect AD?
(d) Congress bans use of all fossil fuels
(e) Abundant rainfall during the growing season of
agricultural states.

Economic growth and our expectations

So: increases in the productive capacity of an

economy, like those resulting from capital
formation or improvements in technology, will
shift the economy's LRAS curve to the right.
But when such growth is steady and
predictable, we anticipate it, so

SRAS and maybe AD go along for the ride (i.e.,

we expect steady or declining P, and negotiate
contracts accordingly)
See transparencies, p. 439: shows movie rather
than snapshot, increases in GDP that dont
disrupt SR or LR macroeconomic equilibrium.

On to: Unanticipated shocks to AD

Suppose Fed surprises markets with a

substantial increase in the money supply
growth rate, which kicks interest rates down
In SR output rises above Yf as prices in the
goods and services market deviate from the
price level that people expected.
In the LR, though, there are forces present
that will produce supply shifts that get the
economy back to potential GDP

Note the oddity: AD shift ultimately leads to

SRAS shift, as well describe

E.g.: Unanticipated increase in AD (in words)

AD leads to

1.

2.

3.

4.

Initially, the strong demand and higher price level

in the goods & services market will temporarily
improve profit margins.
Output will increase, the rate of unemployment will
drop below the natural rate, and output will
temporarily exceed the economy's long-run
potential.
With time, however, contracts will be modified and
resource prices will rise and return to their
competitive relation with product prices.
Once this happens (SRAS falls), output will
recede to the economy's long-run potential.

AD
(in
pictures)
:
The
short
run

Price
Level

LRAS

SRAS1
Short-run effects of
an unanticipated
increase in AD

P105
P100

AD2

AD1
YF Y2

Goods & Services

(real GDP)

In response to an unanticipated increase in AD for goods &

services (shift from AD1 to AD2), prices rise to P105 and output will
increase to Y2, temporarily exceeding full-employment capacity.
37

AD :
The
longer
run

Price
Level

SRAS2
LRAS
SRAS1

P110

Long-run effects of
an unanticipated
increase in AD

P105
P105

AD2

AD1
YF Y2

Goods & Services

(real GDP)

With time, resource prices, including labor, rise due to strong demand. Higher
costs reduce SRAS to SRAS2.
In LR, a new equilibrium at a higher price level P110 and output consistent with
long-run potential will occur. So in AD only temporarily expands Y.
38

More practice questions:

How will these shocks affect AD and/or AS:

Firms and/or households become pessimistic

about the economys future prospects
Crop failure due to weather
The Fed puts on the brakes with respect to
money growth, and interest rates spike

For each, plot SR equilibrium, then describe

what must happen over time to get back to
LR equi
39

Side discussion(s):
Labor supply and shifts in
LRAS
Dan ONeills Econversations Ch. 3

What did Spain do about illegal immigration since

1996? What were effects (before and after)?
What is effect of immigration on LRAS? AD? (I.e.,
what does a pizza party have to do with this?)
Is US any different?

40

Labor supply and shifts in

LRAS
(cont.)
What about CBO report on ACA?

Why will labor supply decline?

What are marginal tax rates?

Example on Moodle regarding
minimum wage

LRAS consequences?
Other LR consequences?

41

Coming attractions

If were away from

LR equi, what can
policy-makers do to
alleviate suffering?

Monetary policy
(H&O Chs. 14-15)
Fiscal policy (Chs.
16-17)

42