Chapter 25: Aggregate Demand, Aggregate Supply and Modern Macroeconomics Chapter25: AggregateDemand,AggregateSupplyandModernMacroeconomics

Questions for Thought and Review 1. The central difference between activist and laissez-faire economists is their differing views about whether the economy is self-regulating. Laissez-faire economists (Classicals) believe the pricing mechanism will bring the economy to an equilibrium (potential output and full employment) while activist economists (Keynesians) do not share that belief. Classicals felt that if the wage was lowered, the Depression would end. They saw unions as preventing the fall in wages, and they saw the government lacking the political will to break up unions. Five factors that shift the AD curve are: changes in foreign income, changes in expectations, changes in exchange rates, changes in the distribution of income, and changes in government aggregate demand policy. Say there is a rise in the price level. That would make the holders of money poorer (the wealth effect). It would also reduce the real money supply, increasing the interest rate (the interest rate effect). Assuming fixed exchange rates, it would also make goods less internationally competitive (the international effect). All three account for the quantity of aggregate demand decreasing decreasing spending as the price level rises. These initial increases are then multiplied by the multiplier effect as the initial spending reverberates through the economy. Two factors that shift the SAS curve are changes in productivity and changes in input prices. If the economy is in short-run equilibrium below potential output, input prices will fall, causing the short-run aggregate supply curve to shift down and the price level to fall. This will set the wealth, interest rate, and international effects in motion, increasing the quantity of aggregate demand and thereby bringing the economy into long-run equilibrium at potential output. This implies that productivity is increasing significantly. If computers are a large portion of the economy, and wages do not rise by the full amount of the productivity increase, the result will be to lower the SAS curve. It can also shift out the potential output curve to the right, increasing equilibrium potential output and lowering the price level. Yes, they would emphasize the inherent value of the program rather than discussing the programs effect on aggregate demand. This is because programs that increase aggregate demand when the economy is close to potential will ultimately lead to inflation and little increase in real output. Countercyclical fiscal policy is difficult to implement because it is difficult to assess the condition of the economy at any one time, it takes a long time to enact new government policies, and politically it is difficult to raise taxes when the economy is doing well (or at any time). Often times politics, not the needs of the economy, guide tax and spending decisions. To design an appropriate fiscal policy, it is important to know the level of potential output because where the economy is relative to potential tells you whether to implement expansionary or contractionary policy. Conducting fiscal policy without having an estimate of potential output would be like driving without being able to see the road.

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Chapter 25: Aggregate Demand, Aggregate Supply and Modern Macroeconomics

11. As can be seen in the following diagram, a large increase in potential output (shifting the LAS curve to the right) would cause downward pressure on the price level from P0 to P1. As the price level shifts down the output level increases from Y0 to Y1. This is the argument some economists used to suggest policymakers didnt need to worry about inflation.
LAS 0 Price Level P 0 SAS P D
1

LAS 1

SAS

AD

Y Y Real Output 12. The simple model abstracts from a number of important issues such as the problem of estimating potential income. Without knowing potential income, we cannot know whether expansionary or contractionary policy is called for. Also, the model does not take into account the difficulties in implementing fiscal policies and the uncertain effectiveness of those policies.
0 1

Chapter 25: Problems and Exercises 1. a. b. c. d. The SAS curve will shift up since wages rise by more than the rise in productivity. The SAS curve will shift down since productivity rises by more than the rise in wages. The SAS curve will shift up since wages rise and productivity declines. The SAS curve will not shift since the wage increase is exactly offset by a productivity increase.

2. a. Keynes used models not in a mechanistic way, but in an interpretive way. He was a Marshallian who saw economic models as an engine of analysis, not an end in themselves. b. It fits in nicely with the other things constant assumption since the policy relevance follows only when one has eliminated that assumption and taken into account all the things held at the back of ones mind. c. It definitely was primarily in the art of economics since the above method is the method used in the art of economics. 3. a. The AD curve will be steeper because a change in the price level will be offset by a change in the exchange rate eliminating the international effect on the AD curve. b. The AD curve will become steeper if a fall in the price level doesn't make people feel richer since the fall in the price will not cause them to increase their expenditures. This is an example of the wealth effect not working. c. The AD curve will be steeper if a fall in the price level creates expectations of a further fall in the price level (it may even be backward bending) since the fall in the price level will cause people to shift expenditures further out into the future. d. Assuming poor people consume more than rich people, the AD curve will shift to the right. e. The AD curve will shift to the right by a multiple of 20. f. The AD curve will shift to the left by a multiple of 10. 4. a. An increase in the availability of inputs will shift the LAS curve to the right. b. A civil war will presumably destroy productive capacity or otherwise halt production and cause a shift in the LAS curve to the left. In the short run, it will also increase the prices of inputs and increase inflationary expectations shifting the SAS up. c. To the degree that the rise in oil prices results in an overall rise in the price level, this will shift the SAS curve up. Otherwise, other relative prices will decline to offset the rise in oil prices and the SAS curve will not shift at all.

Chapter 25: Aggregate Demand, Aggregate Supply and Modern Macroeconomics

d. If wages that were fixed become flexible and aggregate demand increases, the SAS curve will shift up as wages rise.

5. a

We would suggest that the rise in oil prices will SAS 1 LAS shift the SAS curve up and the drop in world Price income will shift the AD curve in, causing Level equilibrium income to fall even more below SAS 0 potential (to point B in the accompanying B P 1 graph). A b. We might suggest expansionary fiscal and P 0 monetary policy to shift the AD curve out (from AD 2 AD0 to AD2) and bring equilibrium income to its AD 0 potential. We would caution the government AD 1 about the possible inflationary consequences, but since the economy is significantly below Y0 potential, we would argue that it is a risk worth Y Real Output 1 taking. c. A real business cycle economists would say that the actual level of the economy is the best estimate of its potential income. He would suggest that the policy would be inflationary because it is not affecting the real supply-side issues. If the economy were left on its own, the SAS curve will shift down below SAS0 until output reached its potential .
LAS Price Level

6. a. The slowing of foreign economies will reduce exports, shifting the AD curve to the left by a multiple of the initial decline in exports (from AD0 to AD1 in the graph below). I would recommend that the government increase expenditures by an amount equal to the initial decline in exports. This will shift the AD curve back to its initial position, as shown in the graph.

SAS

AD

Price Level

LAS

AD

Real Output

b. An economy operating above potential is shown by point A in the accompanying graph. To keep the inflation from rising (the SAS curve from shifting up), the government should reduce expenditures enough (shifting the AD curve from AD0 to AD1) to bring the

SAS A P 0 P
1

AD AD YP Y
0 1

Real Output

Chapter 25: Aggregate Demand, Aggregate Supply and Modern Macroeconomics

economy back to long-run equilibrium at potential output, YP, and the price level, P1, as shown below. c.

c. A new technology that increases potential output will shift the LAS curve (from LAS0 to LAS1), creating excess capacity and downward pressure on factor prices. If left alone, the price level will fall and real output will rise. If the government wants to keep the price level constant, it can increase expenditures enough to increase output to the new potential (shifting the AD curve from AD0 to AD1).

Price Level

LAS 0

LAS

SAS 0

0 1

SAS 1

AD 1 AD Y
P 0

Real Output

Chapter 25: Web Questions 1. a. The CPI has been relatively low in the past year or so. This would suggest that the economy is at or below potential output. b. The fact that inflation is low suggests government should 112 do nothing. If it follows expansionary fiscal policy, it risks 110 igniting inflation. 108 2. a-b. The level of output and price level is shown in the 106 104 accompanying graph. 102 c. Since the curve involves shifts in both the SAS curve and 100 AD curves, all we can say is that these are points of 98 equilibrium given certain assumptions. It is neither an AD 96 nor an SAS curve. In order to draw one or the other, 94 simplifying assumptions must be made regarding what is 0 0 0 0 00 0 0 00 0 0 00 0 0 0 0 65 70 75 80 85 90 95 100 105 held constant.
Price level Real output (billions of real dollars)

3.

The Consumer Confidence index fell in February 2005 after rising the previous month. This suggests that the AD curve might shift in to the left. If the trend continues equilibrium output will likely be lower than otherwise and inflation pressures will be weakened. The situation is shown in the accompanying graph. Assuming the economy begins at

LAS 0 Price level SAS 0

P0 P1

A B AD0 AD1
Y1 Y0

Real output

Chapter 25: Aggregate Demand, Aggregate Supply and Modern Macroeconomics

potential output (point A), a weak consumer confidence may reduce expenditures, shifting the AD curve in to the left. In the short run, the economy will move to point B, at a lower price level, P 1, and lower real output, Y1. If expenditures dont rise at some point, the short-run aggregate supply curve will eventually shift down and the economy will return to its potential output but at a lower price level. (Not shown.)

Chapter26: TheMultiplierModel
Questions for Thought and Review 1. If planned expenditures are below actual production, income will decline. Heres how: when planned expenditures are below actual production, firms will see that their inventories are building up faster than theyd like. In response, they cut production. As production falls, so does income. Consumption falls by a fraction of the decline in income leading to a further decline in planned expenditures. This process continues until planned expenditure equals actual production. At levels of output above equilibrium inventories are building up because planned expenditures are below actual production. People are not buying all that is produced. The aggregate expenditures curve shifts down by the decline in autonomous expenditures. The AE curve becomes steeper when the marginal propensity to expend increases. Equilibrium income rises. If savings were immediately translated into investment, the size of the multiplier would be infinite since leakages from the economy would be zero. However, autonomous expenditures would no longer exist. In short, under these conditions the multiplier model would break down. Shocks to aggregate expenditures are any sudden changes in factors that affect C, I, G, X, or M. This includes consumer sentiment, business optimism, foreign income, and government policy. It is possible that people could change their marginal propensities to consume and save, and this could also have an effect on the economy. In mid-2005, the government budget was in deficit and the state of fiscal policy was expansionary (lower taxes and higher expenditures). Although taxes were lowered because of the administrations ideological beliefs in lower taxes and for political reasons, and expenditures were raised to increase national security and to fight a war in Iraq, the policy made some economic sense because inflation was not believed to be a threat, although some upward pressure on prices was building due to higher energy costs. Signs currently point to the economy beginning to expand faster, so this policy may not be economically viable for too much longer. (This answer may change as the economy progresses.) If the mpe is 0.5, the multiplier is 2. Every $1 increase in autonomous expenditures will raise income by $2. To close a recessionary gap of $200 the government needs to generate $100 of additional autonomous spending. It can accomplish this by increasing government expenditures by $100, or by cutting taxes by somewhat more than that (about $200). Cutting taxes by $100 has a smaller effect on GDP than increasing expenditures by the same amount because people dont spend the entire amount of the tax cutthey save some of it, too. The multiplier begins with the increased individual spending resulting from the tax cut, or the mpc times the tax cut.

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The effects of this invention on the economy would be manifold and in many ways unpredictable because such major shocks have social, institutional, and political effects, as well as economic effects. The obvious effect is that the demand for the pill would likely be tremendous (after people were sure it was safe), and so production of the pill would gear up to meet the demand. Market structure and pricing decisions will play a big role in determining the new effect of the change. Alternative forms of transportation would suffer decreases in demand (cars, mass transit, airplanes, etc.), and levels of production of those goods and services would adjust, as would employment in those industries and related industries. Measured GDP might actually fall. The circular flow diagram of the economy that would more accurately describe the multiplier model would include leakages of savings to investment that cause the diagram to pulsate as the economy continually overshoots equilibrium in response to shocks to the economy. A mechanistic model states the equilibrium independent of where the economy has been or where people want it to be. A mechanistic model is used as a direct guide for policy prescriptions. An interpretive model is used as a guide that highlights dynamic interdependencies and suggests the possible response of aggregate output to various policy initiatives. If there is a delay, it will mean that the initial multiplier effects can be small or nonexistent, and then, suddenly, they become large and fast. Uncertain, changing, expectations can add to the ambiguity of the models result.

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Chapter 26: Problems and Exercises

Real expenditures

1.

If the mpe is .8, then the value of the multiplier is (1/.2) or 5. If autonomous expenditures are $4,200, the equilibrium level of income in the economy is 5 x 4200 = $21,000. This is demonstrated in the accompanying graph.

AP

AE

$4,200 $21,000 Real income

Real expenditures

2. a. If the mpe is .66, the value of the multiplier is 3. A decrease in autonomous expenditures of $20 will likely result in a decrease in income of $60. b. This is demonstrated in the accompanying graph. 3. a. Given the mpe is 0.8 and autonomous investment has risen by 20, income will increase by 100 (the multiplier is 1/.2 or 5, and 5 X 20 is 100). b. The multiplier is now only 2 (1/.5), and so the change in investment causes income to change by 40.

AP AE0 AE1

D 20 Real income

D 60

c. The decrease in exports and increase in investment cancel each other out so that autonomous expenditures in the aggregate are unchanged. d. See the graphs below. The graph on the left corresponds to (a) and the accompanying graph corresponds to (b). The graph to (c) would show the AE curve not moving at all.
AP
E1

AE1 AE0
Real expenditures

AP AE1
E1

Real expenditures

20

AE0

E0

20 E0 40

100

Real income

Real income

4. a. b. c.

d.

Given that the mpe is .6, I0 = 1,000; G0 = 8,000; C0 = 10,000; and (X0 - M0) = 1,000, then: Y = 10,000 + .6Y + 1,000 + 8,000 + 1,000. Y - .6Y = 20,000; 0.4Y = 20,000; Y = 50,000. Thus, the level of income in the country is $50,000. If net exports increase by $2,000, income will increase by $5,000 (the multiplier is 2.5, or 1/.4). According to Okuns law, a one-percentage-point change in unemployment will cause a 2 percent change in income in the opposite direction. Thus, if income has increased by $5,000, which is a 10 percent increase, then unemployment should drop by 5 percentage points. If the mpe falls from 0.6 to 0.5, the multiplier decreases from 2.5 to 2. The answer to part a would now be $40,000; the answer to part b would be $4,000; and the answer to part c is that unemployment should fall by 5 percentage points.
Real expenditures AP AE0 AE2 AE1

5. a. A likely culprit was a decline in investment spending, partly due to increased bank regulation and Federal Resolution Trust Corporation scrutiny of loans in the wake of the failed S&Ls and liquidity problems of commercial banks in the late 1980s and early 1990s. This was commonly known as the credit crunch, where lower interest rates failed to increase investment spending in the early 1990s. This is shown as a shift down of the AE curve from AE0 to AE1 and a decline in real income. b. An improvement would be graphically represented by a shift up of the AE curve shown in the graph as the shift from AE1 to AE2 and a rise in real income. The improvement occurred most likely as a result of expectations of an improving economy and further reductions in interest rates increasing consumption and investment expenditures. Government expenditures did not change much in this period and probably did not contribute to the economic improvement. c. President Bush would have had to increase government expenditures or reduce taxes significantly to stop the slowdown, but given the political atmosphere regarding the high deficit and debt, it is unlikely he could have done so. d. President Clinton faced the same political imperatives to decrease the size of the deficit, so he implemented some policies designed to affect potential output (the supply side). He lowered some taxes, calling them supply-enhancing tax cuts, changed the composition

Real income

of government spending calling the changes supply-enhancing changes, and raised other taxes (discounting their effects on the economy). 6. Given that income is $50,000, the mpe is .75: a. To reduce unemployment by 2 percentage points (again, by Okuns rule of thumb) requires a 4 percent increase in income, which in this case is $2,000. The multiplier is 4.0, calculated as [1/(1 - mpe)]. To generate a $2,000 increase in income, increase government spending by $500 or decrease taxes by about $650. b. If the mpe is .67, the multiplier is about 3, which means that to generate a $2,000 increase in income, government spending would have to increase by $666.66. c. If the mpe is .5, then the multiplier is 2.0, which means that to generate a $2,000 increase in income, government spending would have to increase by $1,000. 7. a. If the mpe is .5, the multiplier is 2, because there is a recessionary gap of $800, government spending would have to increase by $400 to bring the economy back to longrun equilibrium. b. If the mpe is .8, the multiplier is 5, because there is an inflationary gap of $1500, government spending would have to decrease by $300 to bring the economy back to long-run equilibrium. c. If the mpe is .2, the multiplier is 1.25. Because there is an inflationary gap of $1,200, the government will want to reduce expenditures by $960. d. If the mpe is .7, the multiplier is 3.33. Because there is an recessionary gap of $1,500, the government will want to reduce expenditures by $450. 8. a. If the mpe is .5, the multiplier is 2. To eliminate the inflationary gap, the government should undertake a contractionary fiscal policy. Since the economy is $36,000 above potential, we would advise decreasing government spending by $18,000. b. Using Okuns rule of thumb, since income falls by 6 percent, we would expect unemployment to rise by 3 percentage points to 8 percent. c. The multiplier now becomes 5, so we would advise decreasing spending by $7,200. We would not change our answer to b. Chapter 26: Web Questions 1. a. Consumer confidence slipped in March 2005, after having already declined in February 2005. It is now at 102.4 (1985=100) down from 104.4 in February. b. Falling consumer confidence means that consumption expenditures, and hence aggregate demand will fall. The multiplier model says that the decline in national output will be greater than the fall in aggregate demand. c. CEO confidence has fallen in the past three quarters (2004Q2 2004Q4). It stood at 61 in the fourth quarter of 2004.. (A reading of more than 50 reflects more positive than negative responses). d. They match somewhat. Both are falling. We would therefore expect the economy to be weaker than in 2004. It is unclear what will happen to inventories. If business confidence rises before consumer confidence, inventories will rise. On the other hand, consumption expenditures havent been following consumer confidence well. If consumer spending remains strong while business cut back production, inventories will fall. 2. a. Inventories were up 0.9 percent in January 2005 from the previous month. Inventories are 8 percent above levels a year ago. b. Rising inventories either mean that consumer expenditures, and therefore aggregate demand, are falling, or that production is rising faster than aggregate demand is rising (or

a combination of the two). Either way, production is outpacing expenditures. Unless expenditures pick up, eventually producers will want to cut production. In terms of the multiplier model, it is possible that the economy is going to slow or experience a recession. Chapter 26: Appendix A 1. We would suggest a decrease in taxes. To determine precisely how much we would need to determine what the multiplier is. Assuming all other marginal propensities are zero, the multiplier is 5. The tax cut would initially affect the economy by only .8 times the tax cut, so to increase output by 400, we would decrease taxes by 100 (.8 X 100 X 5 = 400). We would recommend increasing expenditures by 80. This makes the multiplier 3.57. This means that we would increase expenditures by about 112, or cut taxes by about 140. This makes the multiplier 2.08. This means that we would increase expenditures by about 192 or cut taxes by about 213. Making taxes and imports endogenous reduces the size of the multiplier because they increase the leakages from the expenditure flow. Because of taxes and imports, increases in income will lead to lower increases in expenditures than otherwise. This would make the multiplier = 1/(1 - c + ct + m - mt). It would be a slightly higher multiplier. (The difference between the two assumptions is whether we are assuming government imports.)

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Chapter 26: Appendix B 1. a. As shown in the left-hand graph below, an increase in autonomous expenditures shifts the AE curve up and causes a movement along the AP curve to the right and results in a higher equilibrium income level twice the shift in the AE curve. b. As shown in the right-hand graph below an increase in autonomous expenditures shifts the AD curve to the right by twice the increase in autonomous expenditures. Since the price level is fixed, real output increases by twice the rise in autonomous expenditures.
Real expenditures AP AE1 AE0

Price level

SAS curve AD1 AD0

Real income

Real output

c. Since prices are somewhat flexible, the rise in expenditures is split between an upward shift of the AE curve and a rise in prices that causes a downward shift of the AE curve that is smaller than the initial upward shift. The rise in income is less than twice the initial shock. This is shown in the graph an the right . In the AS/AD model, a flexible price means that the shift in the AD curve is split between increases in the price level and increases in real output. Real output rises by less than the multiplier times the increase in autonomous expenditures.

Real expenditures

AP AE1 AE2 AE0 P1 P0

Y0 Y1 Price level

Real output

SAS P1 P0 AD0 Y0 Y2 Y1 AD1 Real output

2. a. The AD curve will become steeper. b. An increase in the size of the multiplier makes the AD curve flatter because the effect of changes in the price level on aggregate demand will be augmented even more by the multiplier. c. An increase of $20 in autonomous expenditures has no effect on the slope of the AD curve; it only affects its position. d. A decline in the price level disrupting the financial market will make the AD curve steeper because it decreases the price-level interest rate effect.