Macro Theory: Dr. D. Foster – ECO 285 – Macroeconomics The AS/AD Model Part 1 – The Basics Part 1 – The Basics Part 2 – The Keynesian View Part 2 – The Keynesian View

Warning.. Warning.. Warning Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!!Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!! The “static” analysis only hints at dynamic interpretation.The “static” analysis only hints at dynamic interpretation. Ceteris Paribus assumption problematic to the point of being wholly inappropriate.Ceteris Paribus assumption problematic to the point of being wholly inappropriate. Keynesian model notes: Descriptive analysis. Descriptive analysis. No numerical interpretation. No numerical interpretation. Only AS/AD graphical representation. Only AS/AD graphical representation. Part 1 – The Basics Part 1 – The Basics

The Aggregate Demand Schedule AD 1 P Q or R-GDP B P1P1 Q2Q2 A P2P2 Q1Q1 P = Price Level; CPI or GDP deflator Q = real output; Real GDP AD = Agg. Demand; From 4 sectors – HH, Bus, G, Foreign

Aggregate Demand The price level and real output demanded are inversely related.The price level and real output demanded are inversely related. A fall in the price level will increase quantity demanded.A fall in the price level will increase quantity demanded. Why? -- the Wealth EffectWhy? -- the Wealth Effect All prices and wages change.All prices and wages change. But, the fixed wealth is … well, still fixed!But, the fixed wealth is … well, still fixed! So, with lower prices we feel wealthier. Woo Hoo!So, with lower prices we feel wealthier. Woo Hoo! And, so we want to buy more stuff.And, so we want to buy more stuff.

Aggregate Demand What about:What about:  Interest effect  Foreign trade effect  Exchange rate effect AD can shift to the left or right.AD can shift to the left or right.  Increase AD – shift to the right.  Decrease AD – shift to the left.  Whenever C, I, G, net X increase/decrease.  Why? Due to changes in optimism & pessimism, and due to fiscal & monetary policies. Can’t do “all else equal.” e.g. Lower prices:  Consumption, but one price is wages!!! If they fall, then we’d see a  Consumption!!!

The Aggregate Demand Schedule AD 2 AD 1 P Q or R-GDP AD 3 Increases in C, I, G, net X Decreases in C, I, G, net X

Long Run Equilibrium between Aggregate Demand and Aggregate Supply There is an Aggregate Supply that reflects fully employed resource use. Output level: Q* or RGDP* or potential RGDP AD 1 P Q or R-GDP AS 1 P1P1 Shifts in AD can only change the price level and not real output (nor employment). Classical Model of the Economy

What affects the Aggregate Supply? Labor force participation. Labor productivity. Marginal tax rates on wages. Provision of government benefits that affect household incentives w.r.t. supply labor. State of technology. Capital stock. A change in these factors can  AS (shift right) or  AS (shift left)

Short Run Aggregate Supply – Wage Inflexibility sluggishNominal wages are sluggish upwards:  A rise in prices has delayed effect on wages. inflexibleNominal wages are inflexible downwards:  A fall in prices will result in  employment and  income. money illusionWorkers have money illusion:  Higher nominal wages are viewed as  real wage.  So, more workers available even though real wage has not risen.  e.g. if prices rise 5% and wages rise 3%…

Short Run Aggregate Supply The Short Run will adjust to the Long RunThe Short Run will adjust to the Long Run:  An  AD will  P and  Q, but only in the SR.  Prices rise but wages lag. Firms  employment and  output.  Eventually, workers realize their real wages (W/P) are falling, get comparable wage,  AS.  The temporary profit motive has been eliminated. What about:What about:  Sticky prices  Misperception  Intertemporal substitution Unnecessary complications to explain the SR AS. Inflexible wages is all we need. What happens if there is a  AD?

From SR to LR Aggregate Supply An increase in AD triggers events. Prices rise, wages lag, output rises. Eventually, wages catch up and AS declines. In LR, only prices rise. AD 1 P Q or R-GDP AS LR P1P1 AS 1 AD 2 P2P2 Q2Q2 Q* P3P3 AS 2 AS 3

AS/AD Model – Hints at 4 types of changes Inflation with growth due to rising AD.Inflation with growth due to rising AD. Depression with deflation due to falling AD.Depression with deflation due to falling AD. Growth with deflation due to rising AS.Growth with deflation due to rising AS. Depression with inflation due to falling AS. (stagflation)Depression with inflation due to falling AS. (stagflation) AD 1 P Q or R-GDP AS LR P1P1 AS 1 Q*

Macro Theory: Macro Theory: Dr. D. Foster – ECO 285 – Macroeconomics The AS/AD Model II - Keynesian Version

AS/AD Model – Long Run & Short Run AD shows demand from 4 sectors of economy. AS in LR shows full employment of resources. AS in SR shows effect of inflexible wages. Keynesian argument AD 1 P Q or R-GDP AS LR P1P1 AS 1 Q* Part 2 – The Keynesian View

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. planned spending realized spendingEquilibrium 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 may notBut, planned I may not equal realized I  If AD>AS then I p >I r and inventories fall unexpectedly.  And business will  I which  production and  income/employment.  If AD<AS then I p <I r and inventories build up unexpectedly.  And business will  I which  production and  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.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 AD 1 P Q or R-GDP AS LR AS 1 Q* Q1Q1 AD 2 Q2Q2 Q3Q3 AD 3 Introduce a flat AS. Introduce disequilibrium at Q 1 with AD 2. Equilibrium process moves us to Q 2. But, we still have a depression. If we can further increase spending to AD 3 we can boost employment and output. Continue until we reach Q*.

Fiscal Policies Government spending & taxes.  G  G has a direct effect on AD (just as  C, I, net X) Since G is discretionary, it can be controlled, unlike others. TaxesTaxes 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] balanced budget multiplier = 1 Odd Keynesian balanced budget multiplier = 1, where ∆G = ∆T = ∆Y

Fiscal Policies An  TP will  C and  S, so overall  Y just like a  TTransfer 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 automatic stabilizersSome 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! crowding outIf 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.

2014:Q4 $18.1 t 2014:Q %

2014 $485 b %

2014:Q4 $3.9 t.

CBOCBO; By 2038 %GDP: Fed’l spending 26% Fed’l revenue 19.5% Interest on debt 5% 2014:Q4 $420.5 b.

Macro Theory: Dr. D. Foster – ECO 285 – Macroeconomics The AS/AD Model Part 1 – The Basics Part 1 – The Basics Part 2 – The Keynesian View Part 2 – The Keynesian View