Transcript Figure 7-12 The Price Level - College of Business Administration

Robert J. Gordon,
Macroeconomics, 10th edition,
2006, Addison-Wesley
Chapter 7:
Aggregate Demand, Aggregate Supply and
the Self Correcting Economy
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Combining aggregate demand with aggregate supply
 So far we assumed that the price level is fixed. It means that
changes in Y are calculated as
∆Y = ∆AD/P;
where P is fixed
 Now we will drop this assumption. If P increases we have
inflation, if P decreases we have deflation. When AD changes we
can’t tell whether this is due to changes in Y, P or both. For this
reason we need to introduce the AD AS curves
 AD curve
 Shows different combinations of price level and real output at
which money and commodity markets are both in equilibrium.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Short run AS
 Shows the amount of output that business firms are willing to
produce at different price levels., holding constant the nominal
wage rate.
 Long run AS
 Shows the amount of output that business firms are willing to
produce when nominal wage rate has fully adjusted to any
change in P.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Flexible prices and the AD curve.
 Effects of changing prices on the LM curve.
 LM shifts position whenever there is a change in real money
supply, either due a change in nominal money supply, while P in
fixed, or by a change in the price level, while nominal money
supply remains fixed.
 The upper part of figure 7-1 shows three values of P given fixed
MS0.
 If P were lower (p1), real money supply will be higher. To
maintain equilibrium in the money market r should fall to r1
and Y to grow to Y1. The reverse is true at higher price level.
 The lower part presents the relationship between Y and the
assumed price level. Y along AD is always at a point where IS
and LM cross, i.e., along AD both the commodity and money
markets are in equilibrium
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-1 Effect on Real Income of Different Values of the Price Level
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Note that AD curve is a curved line instead of a straight line,
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
which means that a given percentage decline in P boasts MS by a
greater percentage, the lower the price level, hence raising Y by
more at a low price level than at a high price level.
At MS=1000, if P declines from 2 to 1.5
Real MS will increase from 500 to 667 (i.e., 33%)
While reducing P from 1.5 to 1 will raise real MS from 667 to
1000 (i.e. an increase by 50%)
Reducing P from 1 to .5, will raise real MS from 1000 to 2000
(i.e. an increase by 100%).
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Shifting the AD curve with monetary and fiscal policy
 Effects of a change in the nominal MS.
 Look at figure 7-2. if MS doubles, LM shits rightward since P is
the same the economy shifts right from E0 to H’. The new
equilibrium
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-2 The Effect on the AD Curve of a Doubling of the Nominal Money
Supply
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Effects of a Change in Autonomous Spending
 Now we assume that IS changes due to e.g., a decline in business
spending.
 When IS shifts to the left, the position of the economy will shift
to F if P is constant.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-3 The Effect on the AD Curve of a Decline in Planned Autonomous
Spending
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Alternative shapes of the short run aggregates supply curve
 How will the increase in AD be divided between higher Y. The
answer will depend on AS, i.e., whether it is horizontal, vertical
or positively sloped.
 Look at Figure 7-4.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-4 Effect of a Rightward Shift in the AD Curve with Three Alternative
Short-Run Aggregate Supply Curves
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The short run AS (SAS) when nominal wage rate is constant
 The Labor demand curve
 Nominal wage rate W is the actually paid wage.
 Real wage rate is (W/P). As W/p is high, firms will employ less as
W/p>marginal product, and vice versa.
 Firms hire workers up to the point where real wage rate equal
marginal product.
 The short run supply curve
 Look at figure 7-5. SAS slopes upward because higher P (point
C) reduces real wage and induces firms to hire more, and thus
produce more output, and vice versa alt lower prices (point A).
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-5 The Labor Demand Curve and the Short-Run Aggregate Supply
Curve
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 How the wage rate is set
 If wage rate increases, the SAS curve will shift up and its
intersection point with AD will shift as well. Thus the
determinants of the actual wage rate paid have a crucial effect
on the nature of the economy’s response to a change in AD.
 The equilibrium wage rate
 In figure 7.6. higher wage rate shifts the SAS curve because at a
given price, workers are more costly and so firms hire fewer
workers and produce less output. Point B and B’ are identical
because we assume that the percentage difference between W1
and W0 is the save as between p1 and p0. thus point B’ lies
directly above point B in the right frame.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-6 The Short-Run Aggregate Supply Curve for Two Different Values of
the Wage Rate, and W1 W0
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Determinants of the equilibrium real wage rate
 Equilibrium real wage rate is determined by the intersection of labor demand
and supply curves. Figure 7-7. if firms are to raise employment to N1 real
wage rate must be reduced (at point C).
 Employers need to find some factor that will make workers willing to provide
more work than shown by their labor supply curve. Otherwise we would
never observe changes in employment over the business cycle.
 Labor contracts and wage bargaining
 Contracts explain fixity of nominal wages in the short run.
 If the economy operates above levels that are consistent with labor market
equilibrium, firms and workers know that the real wage is reduced below
equilibrium. Next change there will be an upward pressure on nominal wage
rate to restore the equilibrium wage rate.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-7 Determination of the Equilibrium Real Wage Rate
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Fiscal and monetary expansion in the short and long run
 Initial short run effect of a fiscal expansion
 Look at figure 7-8. Initial fiscal stimulus shifts AD to AD1, the
economy shifts to point C.
 The rising nominal wage and the arrival at long run equilibrium
 Businesses are satisfied at point C but workers are not, as wage
rate is the same. Workers would insist to increase nominal wage
rate to W1/P1, but this is less than the equilibrium real wage
rate. As they raise real wage rate, the economy slides to E3.
 The long run aggregate supply curve
 LAS, the level of output YN is the labor market in equilibrium at
the original real wage rate
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-8 Effects on the Price Level and Real Income of an Increase in Planned
Autonomous Spending from to AD1 AD0
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Short run and long run equilibrium
 Short run equilibrium occurs at the point where the AD crosses
he SAS curve.
 Long run equilibrium is a situation in which labor input is the
amount voluntarily supplied and demanded at the equilibrium
wage rate.
 Interpretation of the business cycle.
 Note that in the short run prices are flexible while the wage rate
is fixed. Price flexibility and wage fixity implies a countercyclical
movement of the real wage rate, i.e., movements of real wage
rate are in the opposite direction of real GDP. (in reality
movements are not in that manner)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 An alternative view is that both prices and wages are fixed in the
short run, and the SAS is relatively flat. When real GDP rises
above equilibrium both prices and wage rise, and inflationary
pressures continue until the economy returns to a point along the
LAS (E3).
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Classical macroeconomics: the quantity theory of money and the
self correcting economy.
 Classical economists believed that the economy possessed a
powerful self correcting forces that guaranteed full employment
and prevented Y from falling below YN for a long time.
 these forces are flexible wages and prices that would adjust
rapidly to absorb the impact of shifts in aggregate demand.
 The quantity equation and the quantity theory of money.
MSV ≡ PY
V ≡ PY/MS
 Changes in MS cause proportional changes in P. Note that V is
assumed to be stable in the short run, and business cycles are
attributed to changes in MS.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Self correction in aggregate demand-supply model
 Look at figure 7-9. the classical economists assumed that the
economy would not operate away from the LAS. No business
cycle in Y would occur.
 Classical view of unemployment and output fluctuations
 Classical economists did not believe that Y could remain for
more than short time below YN. How did they explain
unemployment. Unemployed were described as irresponsible, or
having an insufficient desire to work. Any unemployment will
reduce real wage rate until equilibrium is obtained in the labor
market.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-9 Effect of a Decline in Planned Spending When the Price Level Is
Perfectly Flexible
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The Keynesian revolution: the Failure of self correction.
 The Great Depression of 1929 Y had declined by one third by
1932 and unemployment rose to more than 20%. It was time for
a new diagnosis. This is presented by Keynes in 1936 and J.
Hicks presented the IS-LM model a year later.
 Monetary impotence and the failure of self correction in extreme
cases
 For Keynes the problem could be divided into two categories,
one concerning demand due to the possibility of monetary
impotence and the other concerning supply due to rigid wages.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Unresponsive expenditure: the vertical IS curve
 If IS is vertical any change in MS will shift LM up or down a
vertical IS curve, leaving Y unaffected. Look at figure 7-10. If IS
is vertical changes in P will have no effect on Y’.
 The liquidity trap: A horizontal LM curve
 If the LM is horizontal see figure 7-10. if the IS intersects the LM
in the horizontal section, an increase in MS/P does not shift the
LM and Y stuck to Y’ where AD remains vertical.
 Monetary impotence and a failure of self correction arise when
there is a vertical IS or horizontal LM
 The price level can fall to P” and Y remains at Y’. The economy
would move from F to F’ or F” without any right word motion.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-10 The Lack of Effect of a Drop in the Price Level When There Is a
Failure of Self-Correction
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Fiscal policy and the real balances effect
 The crucial problem that makes AD curve lie to the left of YN is
due to low business and consumer confidence. Keynes believed
that fiscal policy can shift the IS curve and thus an antidepression tool to use.
 C. Pigou pointed out that the vertical AD’ may not be a dilemma
at all. Since demand for commodities may depend on the level
MS/P, this would make IS shift rightward whenever P falls, this
guarantees a negative slope for AD. The Pigou (real balances)
effect occurs whenever an increase in MS/P directly influences
the demand for commodities without requiring interest rates to
fall and AD can not be vertical in the presence of real balances
effect. Why? A fixed nominal money buys more when price level
falls. When P is perfectly elastic and real balances is in effect, no
monetary or fiscal policy will be necessary.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Two stimulative effects of price deflation.
1- the Keynesian effect. An increase in C or I due to a decline in r
either because of higher MS or lower P, both will increase
MS/P.
2- the Pigou effect. the direct stimulus to C when a price deflation
causes an increase in MS/P.
 Destabilizing effects of falling prices
 Unfortunately the stimulative effects are not always favorable.
There are two major unfavorable effects of deflation;
1. The expectation effect. People tend to postpone their purchases
as the prices continue to decline. This may be strong enough to
offset the stimulus of the Pigou effect.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
2.
The redistribution effect. As unexpected deflation causes a
redistribution of income from debtors to creditors, which
reduces AD.
 Nominal wage rigidity
 Keynes’ second line of attack was simply that deflation would
not occur in the necessary amount because of rigid nominal
wages. Look at figure 7-11. Keynes pointed out that the
economy would remain stuck at point A even with the normally
sloped AD curve AD1.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-11 Effect of a Decline in Planned Spending When the Nominal Rate Is
Fixed at W0
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Table 7-1 Money, Output, Unemployment, Prices, and Wages in the Great
Depression, 1929–41
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
International Perspective Why Was the Great Depression Worse in the United
States than in Europe?
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 7-12 The Price Level (P) and the Ratio of Actual to Natural Real GDP (Y
/YN) During the Great Depression, 1929–41
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Failure to attain equilibrium in the labor market.
 Keynes’ assumption of nominal wage rigidity fails to explain how
and why wage remains rigid. Its only virtue is that it provides an
explanation of the persistent unemployment at A without
requiring any special shape of AD curve.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University