Transcript Macro Theory

Macro Theory:
The AS/AD Model
Part 1 – The Basics
Part 2 – The Keynesian View
Dr. D. Foster – ECO 285 – Macroeconomics
Part 2 – The Keynesian View
P
AS/AD Model –
Long Run & Short Run
ASLR
AS1
AD shows demand from 4
sectors of economy.
AS in LR shows full
employment of resources.
AS in SR shows effect of
inflexible wages.
P1
Keynesian argument
AD1
Q*
Q or R-GDP
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 when
planned spending equals
realized 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 Ip>Ir then AD>AS and inventories fall unexpectedly.

And business will I which AD and raises income/employment.
If Ip<Ir then AD<AS and inventories build up unexpectedly.

And business will I which AD and lowers 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
Introduce a flat AS.
P
ASLR
Introduce
disequilibrium at Q1
with AD2.
AS1
Equilibrium process
moves us to Q2.
AD2
But, we still have a
depression.
AD3
If we can further
increase spending to
AD3 we can boost
employment and
output.
AD1
Q1 Q 2 Q 3
Q*
Q or R-GDP
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 & AS
Is the effect on AS larger?
• The Laffer Curve and tax collection.
Of course the purpose isn’t
to 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.
2015:Q4
104.2%
1966-2015
Total @ 2015:Q4 $18.9 t
2015
-2.46%
1930-2015
Federal gov’t. deficit 2015 = $438 b
2015:Q4
$4.06 t.
1980-2015
CBO; By 2038 %GDP:
Fed’l spending 26%
Fed’l revenue 19.5%
Interest on debt 5%
1970-2015
2015:Q4
$440.1 b.
Macro Theory:
The AS/AD Model
Part 1 – The Basics
Part 2 – The Keynesian View
Dr. D. Foster – ECO 285 – Macroeconomics