Transcript Short-Run Aggregate Supply

Chapter 8
Aggregate Demand,
Aggregate Supply,
and the Great
Depression
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• 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
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 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.
• AD curve
• Shows different combinations of price level and real output at
which money and commodity markets are both in equilibrium.
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• 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 is
fixed, or by a change in the price level, while nominal money
supply remains fixed.
• The upper part of the figure shows three values of P given fixed
MS0.
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• 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
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Figure 8-1 Effect on Real Income
of Different Values of the Price Level
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• Note that AD curve is a curved line instead of a straight line,
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%).
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• Shifting the AD curve with monetary and fiscal policy
• Effects of a change in the nominal MS.
• Look at the figure. if MS doubles, LM shits rightward since P is
the same the economy shifts right from E0 to H’. The new
equilibrium
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Figure 8-2 The Effect on the AD Curve of a
Doubling of the Nominal Money Supply
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• 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.
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Figure 8-3 The Effect on the AD Curve of a
Decline in Planned Autonomous Spending
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• 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.
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Aggregate Supply
• The Short-Run Aggregate Supply (SAS) curve shows the
amount of output that business firms are willing to produce at
different price levels, holding constant the nominal wage rate
– The SAS curve is upward sloping since an increase in the price level will
increase profits for firms assuming wages and other input costs are fixed.
This results in firms increasing output at higher prices
• The Long-Run Aggregate Supply (LAS) curve shows the
amount that business firms are willing to produce when the
nominal wage rate has fully adjusted to any changes in the price
level
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Controversies Surrounding AS
• The three possible shapes of the AS curve has created decades of
controversy.
• The horizontal AS curve assumes prices are fixed, but is
unrealistic because it cannot explain inflation.
• The vertical AS curve assumes prices are perfectly flexible and
is useful to analyze inflation, but cannot explain unemployment.
• The positively sloped short run AS curve assumes that wages
are fixed, so it cannot be applied to the long run, but it helps to
explain short-run fluctuations in output.
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Figure 8-4 Effect of a Rightward Shift in the
AD Curve with Three Alternative Short-Run
Aggregate Supply Curves
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•
•
•
•
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).
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Figure 7-5 The Labor Demand Curve and the Short-Run
Aggregate Supply Curve
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• 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.
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Figure 7-6 The Short-Run Aggregate Supply Curve for
Two Different Values of the Wage Rate, and W1 W0
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• 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.
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Figure 7-7 Determination of the Equilibrium Real Wage
Rate
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• 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
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Figure 7-8 Effects on the Price Level and Real Income of
an Increase in Planned Autonomous Spending from to
AD1 AD0
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• 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.
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• 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)
• 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).
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• 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.
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• 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.
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Figure 7-9 Effect of a Decline in Planned Spending When
the Price Level Is Perfectly Flexible
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• 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.
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• 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.
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Figure 7-10 The Lack of Effect of a Drop in the Price
Level When There Is a Failure of Self-Correction
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• 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 anti-depression 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.
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• 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.
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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.
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Figure 7-11 Effect of a Decline in Planned Spending
When the Nominal Rate Is Fixed at W0
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Figure 8-10 The Output Ratio in
1929-41 and After 2007
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Table 8-1 Money, Output, Unemployment,
Prices, and Wages in the Great Depression,
1929–41
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International Perspective
Why Was the Great Depression Worse in the
United States than in Europe?
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Figure 8-11 The Price Level (P) and the Ratio
of Actual to Natural Real GDP (Y /YN) During the
Great Depression, 1929–41
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