Macro Theory: Macro Theory: Dr. D. Foster – ECO 285 – Spring 2014 The AS/AD Model II - Keynesian Version

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. Some numerical interpretation. Some numerical interpretation. Only AS/AD graphical representation. Only AS/AD graphical representation.

AS/AD Model – Short Run & Long 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*

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*

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.

The Keynesian Model no inflation/deflationWhere there is no inflation/deflation, output = RGDP = Income (Y) C = C a + (mpc)*YConsumption is assumed to vary with income: C = C a + (mpc)*Y where C a is “autonomous” consumption w.r.t. Y mpc is the “marginal propensity to consume” which shows how much (%) C changes when Y does. by definition, 0<mpc<1

The Keynesian Model All other spending components are assumed autonomous with regard to income: Investment (I), Government (G), Foreign (net X) S = S a + mps*YAll income can be spent (C) or saved (S), so: S = S a + (1-mpc)*Y or S = S a + mps*Y where mpc + mps = 1 (we spend & save 100% of our income) Except for Investment, all planned spending will be realized/actual. I p ≠ I rWhen economy is in disequilibrium, I p ≠ I r FYI – we are skipping non- AS/AD graphical representation.

Equilibrium in the Keynesian Model In equilibrium, planned spending = realized = Y. Y = [Agg. Expenditures] = C + I + G + net X What if planned spending exceeds income?  Business inventories are drawn down to compensate. ∆inventories was unplanned  But, the ∆inventories was unplanned, and so planned I is greater than realized/actual I.  Businesses will then plan to produce more, to make up for the shortfall in inventories, raising employment, production and income. Y = AE p  This process will continue until Y = AE p What if planned spending is less than income?What if planned spending is less than income?

The multiplier process in the Keynesian Model Consider the following: Y = 1000, planned AE = 1100 and mpc =.8 [Inventories fall by 100 to make up the difference.]  Incomes will rise by 100 as businesses expand.  But, consumption will rise by another 80 (=80%*100).  So, now, Y=1100 and planned AE =  But, the  C will  Y (by 80), which will further increase C by 64. This will  Y by another 64 and on and on and …  Eventually this process comes to an end when: Y = old Y + [1/(1-mpc)]*(AE p – old Y) here: Y = [1/(1-.8)]*(+100) = *100 = 1500 Here, the multiplier was 5 [1/(1-mpc)]

Details of the Keynesian Model This only applies when there is no inflation. So additional resources can be employed without raising wages/prices. Provides a Keynesian avenue for economic growth – the autonomous increase in Investment spending (which results in AE p >Y). Investment determined by: future expected profit, real interest return, state of the capital stock. permanent income hypothesisConsumption is determined by: wealth and future expected income (permanent income hypothesis).

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*.

Macro Theory: Macro Theory: Dr. D. Foster – ECO 285 – Spring 2014 The AS/AD Model II - Keynesian Version