Frank & Bernanke Ch. 13: Aggregate Demand and Output in the Short Run

(Neo) Classical Theory Markets always clear. When Supply does not equal to Demand, price changes to equate the two. Labor market works the same way, too. In the 19th century, general price levels sometimes went up and sometimes down but there hasn’t been any trend.

The Great Depression Living through the Great Depression, people rightfully questioned the received wisdom of economists. – If markets tended to clear, why did the labor market show up to 25% unemployment? The 1936 publication of The General Theory of Employment, Interest and Money by John Maynard Keynes provided an explanation for markets not to clear in the short run.

The Model by Keynes Prices (including the price of labor - wages) do not change in the short run. Firms respond to demand changes by adjusting their production and keeping the price constant. Demand changes occur all the time and the structure of the economy changes as the demand for say, horse carriages fell and trains and cars rose. This would not affect labor.

The Model by Keynes If the total spending (aggregate demand) fell, then almost all markets would feel the drop in demand. Production in general would fall. Recession (and depression) would be felt. To avoid this aggregate demand shortfall, the government should step in and by the use of monetary and fiscal policies, should stimulate total spending.

Why Are Prices Constant in the Short Run? Menu costs. Fear of uncertainty. Contracts. Information lag.

Constant Price Means Wide Output Fluctuations P Q S Q1 Q2

Circular Flow Explanation Firms Households Consumption Expenditures Wages, profits, rent, interest If the upper flow (C+I+G+NX) is LESS THAN the lower flow (Income = Value of Output), inventories will pile up (I>I p ) and the firms will cut back in production. If the upper flow is MORE THAN the lower flow, inventories will fall below the desired level (I<I p ) and the firms will increase production.

Circular Flow Explanation Firms Households Consumption Expenditures Wages, profits, rent, interest The upper flow is the aggregate demand: C+I+G+NX. The lower flow is Output: Y. When Aggregate Demand is <Y and also Y* there is a positive output gap (Y*-Y>0) and the economy has slowed down. When I Y* and there is an expansionary (negative) output gap.

Aggregate Demand Fluctuations Consumption expenditures fluctuate. – Confidence, fear levels, demography, wealth, taxes, etc. change. Investment expenditures fluctuate. – Optimism/pessimism about the future; interest rate changes. Government expenditures change. – Budget items, wars… Net Exports change. – Demand for our exports or exchange rates change.

Algebraic Short Run Equilibrium Y = C + I + G + NX (Output=Aggregate Demand) C = a +c (Y-T) (Consumption=Autonomous+c*Disposable Income) c = MPC = Change in Consumption/Change in Disposable Income Y = a +cY -cT + I + G + NX Y = (a + I +G + NX - cT) + cY Aggregate Demand Function is comprised of autonomous and induced parts. Y = [1/(1-c)][a+I+G+NX-cT] Equilibrium income is multiplier times autonomous expenditures.

Numerical Short Run Equilibrium a=400; c=0.8; I=300; G=250; NX=10; T=200

Graphical Short Run Equilibrium Y AD Slope=3200/4000=0.8 AD C 240

Recession Iraq’s invasion of Kuwait forced oil prices to shoot up and dampened consumer confidence. The Savings and Loan Debacle forced many banks to bankruptcy and created a credit crunch. Both C and I dropped.

2001 Recession Both NASDAQ and NYSE dropped precipitously. During , the Fed increased interest rates by 50%. Wealth loss => C drop. Stock market drop => I drop. Interest rate rise => I drop.

Multiplier If a and I drops, what will happen to Y? Y = [1/(1-c)][a+I+G+NX-cT] One can plug in the new values and find Y. One can take the “Change in Y” to be equal to [1/(1-c)]*Change in a+I. One can show the effect graphically by shifting AD downward.

Multiplier Suppose a dropped from 400 to 350, and I dropped from 300 to 250. Find the new equilibrium Y. Y = [1/(1-c)][a+I+G+NX-cT] Y = 5 (700) = 3500  Y = 5 (-100) = -500

Graphical Short Run Equilibrium Y AD AD

Role of Fiscal Policy In the Keynesian system, it is obvious that in response to changes in C, I, and NX, government can counter them by changing G or T. If a+I fell by 100, how much G should change to keep Y=4000? If a+I fell by 100, how much T should change to keep Y=4000?

Limitations of Fiscal Policy Lags. Political considerations. Effects on potential output. – Savings changes – Investment changes.

Automatic Stabilizers Without any act by the Congress, fiscal measures kick in to keep Y close to Y*. – Income taxes. – Unemployment insurance. – Welfare payments. – Recession aid transfers.