1. Chapter 6 - Aggregate Supply and Aggregate Demand

2. 6-1a Keynes’ Challenge
1936 – AS/AD framework begins in a book titled, “The General Theory of Employment, Interest and Money”
Markets effortlessly achieve equilibrium
(Quantity supplied = Quantity demanded)
No surpluses / No shortages
Say’s law: everything that is produced will be bought up as market moves towards equilibrium
Money and Banking – Michael Brandl ©2017 Cengage Learning

3. 6-1a Keynes’ Challenge (continued)
1930s – Market economies of U.S. & Europe experiencing massive surpluses and massive shortages
Unemployment rate approaches 25% - massive surplus in the labor market
Soviet Style Central Planning becomes popular in Europe and U.S.
Keynes view: traditional classical economy does happen – BUT only in the Long Run.
This is seen as radical thinking
Money and Banking – Michael Brandl ©2017 Cengage Learning

4. 6-1b Keynes’ Aggregate Demand
Aggregate Demand = Total Demand
Pigou wealth effect: lower prices increase the purchasing power of public’s savings, resulting in a higher level of spending
AD = C+I+G+ (X-M)
Money and Banking – Michael Brandl ©2017 Cengage Learning

5. 6-2a Changes in Consumption
Factors that can cause the AD curve to shift are
Taxes
Savings
Consumer optimism
Money and Banking – Michael Brandl ©2017 Cengage Learning

6. 6-2b Changes in Investment
Investment spending includes Business Capital Spending as well as New Home Construction
Causes shifting of the AD curve.
Business spending will occur and influence changes in interest rates and/or changes in business expectations about the future.
Interest Rates: the main factor of change in investment spending and thus the AD
Money and Banking – Michael Brandl ©2017 Cengage Learning

7. 6-2c Changes in Government Spending
3rd factor influencing a change in AD:
Government spending on final goods and services
Occur at the Federal, State and local governments
Money and Banking – Michael Brandl ©2017 Cengage Learning

8. 6-2d Changes in Net Exports
4th factor that can shift the AD curve:
Net exports = Exports – Imports
However, some of the spending that goes on in the economy involves buying things that are not produced within the economy.
Thus for GDP to measure correctly how much the economy is actually producing, this amount of spending needs to be removed, which is why spending on imports is subtracted in the calculation of GDP.
Money and Banking – Michael Brandl ©2017 Cengage Learning

9. 6-2f Keynes Spending Multiplier
One person’s spending is someone else’s income
How much of this additional income will actually be spent?
To answer this question, Keynes came up with the marginal propensity to consume (MPC). The MPC is the change in consumption brought about by a change in disposable income:
Money and Banking – Michael Brandl ©2017 Cengage Learning

10. 6-3a Keynes’ Original Aggregate Supply Curve
Full employment level of output
A level of output in the economy where all of the resources would be efficiently used
Money and Banking – Michael Brandl ©2017 Cengage Learning

11. 6-3b Keynesian Three-part Aggregate Supply
Flat horizontal part: recessions and depressions with stable prices
Upward sloping part: some, but not all, input markets experience shortages
Vertical part: all input markets “clear”
Money and Banking – Michael Brandl ©2017 Cengage Learning

12. 6-4a Changing Assumptions
If, in an attempt to explain how the economy works, you allow people to plan and form expectations about the future, you get very different outcomes than the traditional Keynesian approach.
One of the major things that changes is the AS curve.
Money and Banking – Michael Brandl ©2017 Cengage Learning

13. 6-4b A Different Approach to Aggregate Supply
Cost of inputs changes
Cost of doing business changes
Seller expectations changes
# of sellers changes
Taxes changes
Money and Banking – Michael Brandl ©2017 Cengage Learning

14. 6-5a Business Cycles
The actual level of output, or actual GDP, is determined by the intersection of the SRAS (output) and AD (spending).
This actual level of output can and does change as the SRAS and/or AD changes.
Money and Banking – Michael Brandl ©2017 Cengage Learning

15. 6-5b Business Cycles: How fast do gaps close?
An output or recessionary gap occurs when the actual level of GDP is less than the potential level of GDP.
Think about what an output gap means in terms of inputs: There is an underutilization of resources, or some inputs are going unused. If markets work correctly, the market price of these unused resources should decrease as these markets move to equilibrium.
Therefore economy moves back into equilibrium
Money and Banking – Michael Brandl ©2017 Cengage Learning

16. Summary AD
Government multiplier AS
SRAS
Business cycles