Chapter 11 Homework Number 1, 4, 8, and 14

Chapter 12 The Role of Aggregate Demand in the Short Run

Emergence of the Keynesian Short-Run Model Classical economists thought that an economy will self-adjust to any problems.  Economy will always be at or near full employment.  Called the Long Run Economic Model The Great Depression set the stage for a new short-run economic model.

The Great Depression’s Challenge to the Long-Run Model Most severe economic trauma in U.S. history.  From 1929 to 1933, the unemployment rate increased from about 3% to almost 25%.  By 1933, real GDP had fallen by almost 27%.  Marriage and birth rates fell.  Participation in radical political movements increased.  Fear was fostered by not knowing what was happening or how to fix it.

The Great Depression’s Challenge to the Long-Run Model (cont’d) Following the long-run economic model, the belief was that the economy would eventually cure itself.  However, during the1930s it didn’t seem to be working The nation’s short-run suffering required immediate action.

The Keynesian Short-Run Model Emerges John Maynard Keynes was a professor of economics at Cambridge University in England.

The Keynesian Short-Run Model Emerges (cont’d) Keynes’ book, The General Theory of Employment, Interest and Money, was published in  Arguably the most important economics book of the 20th century  It challenged the accepted long- run macroeconomic model.

The Keynesian Challenge to the Long-Run Model The Keynesian model is a short-run model of the behavior of the macroeconomy that:  Emphasizes the role of aggregate demand and government action in the macroeconomy  Questions the validity of the long-run model as an effective guide for macroeconomic policy

The Keynesian Challenge to the Long-Run Model (cont’d) Compared to the Classical long-run model, the Keynesian model:  Is concerned with the short run “In the long run, we’re all dead.”  Focuses on aggregate demand Can be shaped by policy  Suggests that the economy could remain below full employment for prolonged periods Because markets don’t adjust quickly  Promotes government stabilization policy

The Keynesian Model and Economic Policy In 1933, President Roosevelt proposed—and Congress passed—a wide variety of economic legislation designed to stabilize the economy and put people back to work.  Roosevelt was unwilling for the economy to “fix itself”.

Characteristics of the Short-Run Model Major belief is that full employment is the exception rather than the rule.  Advocates an aggressive approach to economic policy that attacks and cures short-run problems quickly and effectively.

Characteristics of the Short-Run Model (cont’d) Three pillars of the model  Each is a contradiction of a characteristic of the long- run model. Challenges:  Say’s Law  The loanable funds market  Flexible prices and wages

Challenge to Say’s Law Say’s Law = “supply creates its own demand.” Keynes taught that demand creates its own supply.  Aggregate demand motivates firms Produce a good only if there is a demand for it.  If something is wrong with the economy, it’s due to a problem with aggregate demand.

Challenge to the Loanable Funds Market Long-run model  interest rate adjusted so that the quantity supplied of funds equals the quantity demanded of funds.  Saving was channeled into investment spending. Short-run model  no mechanism converts saving to investment spending. Factors other than the interest rate can also influence saving and investment:  Disposable income has a major impact on saving.  Expected return on investment affects the decision to invest.

Challenge to Price and Wage Flexibility Long-run model  freely adjusting prices and wages.  Based on an economy comprised of small, competitive firms, workers negotiating their own wages, and minimal government. Short-run model  prices and wages are “sticky downward.”  Based on an economy characterized by: Large firms with some control over the prices they charge Workers represented by strong unions with the power to negotiate wages and other benefits

Price Inflexibility Long-run model  AD decline leads to lower prices as the short-run aggregate supply curve shifts to the right.  Firms are not required to reduce output or employment. Short-run model  little pressure for firms to cut prices.  AD declines  firms cut output and employment.  Unless and until prices adjust, the economy will remain below full employment.

Wage Inflexibility long-run model  decline AD workers accept lower nominal wages to keep their jobs. short-run model  workers resist accepting lower wages.  Wage stickiness doesn’t allow the economy to self- adjust to a decline in aggregate demand. Employers will ultimately have to lay off some workers.