1. © 2003 McGraw-Hill Ryerson Limited. Aggregate Demand, Aggregate Supply, and Modern Macroeconomics Chapter 9

2. 9 - 2 © 2003 McGraw-Hill Ryerson Limited. Introduction u Markets unleash individual initiative, increase supply, and bring about growth. u But markets create recessions too.

3. 9 - 3 © 2003 McGraw-Hill Ryerson Limited. Introduction u Macro intervention tools – monetary and fiscal policy – are tools governments use on the aggregate demand side of the economy to deal with recessions, inflation, and unemployment.

4. 9 - 4 © 2003 McGraw-Hill Ryerson Limited. Introduction u Since politicians make policy, it is unlikely that they would do nothing in the face of a recession even if all economists agreed it was the right thing to do.

5. 9 - 5 © 2003 McGraw-Hill Ryerson Limited. The Historical Development of Modern Macroeconomics u The Great Depression of the 1930s was a defining event in society's view of markets, and in the thinking about government macro policy.

6. 9 - 6 © 2003 McGraw-Hill Ryerson Limited. The Historical Development of Modern Macroeconomics u During the Depression, output fell by 30 percent and unemployment rose to nearly 20 percent. People wanted to work but could not find jobs at any wage.

7. 9 - 7 © 2003 McGraw-Hill Ryerson Limited. The Historical Development of Modern Macroeconomics u Before the Depression, the prominent ideology was laissez-faire - keep the government out of the economy.

8. 9 - 8 © 2003 McGraw-Hill Ryerson Limited. The Historical Development of Modern Macroeconomics u After the Depression, most people believed government should have a role in regulating the economy.

9. 9 - 9 © 2003 McGraw-Hill Ryerson Limited. From Classical to Keynesian Economics u Pre-Depression economists focused on long-run issues such as growth. u They were called Classical economists.

10. 9 - 10 © 2003 McGraw-Hill Ryerson Limited. From Classical to Keynesian Economics u Depression-era economists began to focus on short-run economic issues, especially the issue of how to dig out of the Depression.

11. 9 - 11 © 2003 McGraw-Hill Ryerson Limited. From Classical to Keynesian Economics u They were called Keynesians after economist John Maynard Keynes, author of The General Theory of Employment, Interest and Money, and the founder of modern macroeconomics.

12. 9 - 12 © 2003 McGraw-Hill Ryerson Limited. Classical Economics u The Classical economists' approach was laissez-faire (leave the market alone). u They felt the market was self-adjusting, and they also concentrated on the long- run and largely ignored the short-run.

13. 9 - 13 © 2003 McGraw-Hill Ryerson Limited. Classical Economics u When the Great Depression hit with high unemployment, their response was to refer to supply and demand in the labour market.

14. 9 - 14 © 2003 McGraw-Hill Ryerson Limited. Classical Economics u Their solution to the high unemployment was to eliminate labour unions and government policies that kept wages too high.

15. 9 - 15 © 2003 McGraw-Hill Ryerson Limited. The Layperson's Explanation for Unemployment u The layperson's explanation for unemployment was different. u They were not pleased with the classical argument but believed instead that the Depression was caused by an oversupply of goods that glutted the market.

16. 9 - 16 © 2003 McGraw-Hill Ryerson Limited. The Layperson's Explanation for Unemployment u Lay people advocated hiring people even if the work was not needed.

17. 9 - 17 © 2003 McGraw-Hill Ryerson Limited. The Layperson's Explanation for Unemployment u Classical economists opposed deficit spending, arguing that the money to create jobs had to come from somewhere.

18. 9 - 18 © 2003 McGraw-Hill Ryerson Limited. The Layperson's Explanation for Unemployment u Government demands for capital would crowd out private demands for money so the net effect would be zero, according to the Classical view. u Their advice was to have faith in the markets.

19. 9 - 19 © 2003 McGraw-Hill Ryerson Limited. The Essence of Keynesian Economics u The essence of Keynesian economics is stabilization through government efforts. u As Keynes put it: “In the long run we are all dead”.

20. 9 - 20 © 2003 McGraw-Hill Ryerson Limited. The Essence of Keynesian Economics u By changing his focus, he created the macroeconomic framework that emphasizes stabilization policy.

21. 9 - 21 © 2003 McGraw-Hill Ryerson Limited. The Essence of Keynesian Economics u Keynes thought that the economy could be stuck in a rut as wages and price level adjusted to sudden changes in expenditures.

22. 9 - 22 © 2003 McGraw-Hill Ryerson Limited. The Essence of Keynesian Economics u The Keynesian linkage was: decrease in investment demand  job layoffs  fall in consumer demand  firms decrease production  more job layoffs  further fall in consumer demand, and so forth

23. 9 - 23 © 2003 McGraw-Hill Ryerson Limited. The Essence of Keynesian Economics u Too little spending caused unemployment. u To break out of the rut, spending had to increase.

24. 9 - 24 © 2003 McGraw-Hill Ryerson Limited. Equilibrium Income Fluctuates u Income is not fixed at the economy's long-run potential income – it fluctuates. u For Keynes there was a difference between equilibrium income and potential income.

25. 9 - 25 © 2003 McGraw-Hill Ryerson Limited. Equilibrium Income Fluctuates u Equilibrium income – the level of income toward which the economy gravitates in the short run because of the cumulative circles of declining or increasing production.

26. 9 - 26 © 2003 McGraw-Hill Ryerson Limited. Equilibrium Income Fluctuates u Potential income – the level of income that the economy technically is capable of producing without generating accelerating inflation.

27. 9 - 27 © 2003 McGraw-Hill Ryerson Limited. Equilibrium Income Fluctuates u Keynes felt that at certain times the economy needed help to reach its potential income. u Market forces would not work fast enough and not be strong enough to get the economy out of a recession

28. 9 - 28 © 2003 McGraw-Hill Ryerson Limited. Equilibrium Income Fluctuates u Because short-run aggregate production decisions and expenditure decisions were interdependent, the downward spiral could start at any time.

29. 9 - 29 © 2003 McGraw-Hill Ryerson Limited. The Paradox of Thrift u The paradox of thrift is important to the Keynesian story. u According to the paradox of thrift, an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession.

30. 9 - 30 © 2003 McGraw-Hill Ryerson Limited. The Paradox of Thrift u Saving can be seen as something good, it leads to investments that leads to growth.

31. 9 - 31 © 2003 McGraw-Hill Ryerson Limited. The Paradox of Thrift u But if savings were not translated into investment as happened during the Great Depression total spending would fall and unemployment would rise.

32. 9 - 32 © 2003 McGraw-Hill Ryerson Limited. The Paradox of Thrift u These concerns led to the development of the aggregate demand/aggregate supply model.

33. 9 - 33 © 2003 McGraw-Hill Ryerson Limited. The Paradox of Thrift u It is this model that most economists use to discuss short-term fluctuations in output and unemployment.

34. 9 - 34 © 2003 McGraw-Hill Ryerson Limited. The AS/AD Model u The AS/AD model consists of three curves: the short run aggregate supply curve (SRAS), the aggregate demand curve (AD), and the long run aggregate supply curve (LRAS).

35. 9 - 35 © 2003 McGraw-Hill Ryerson Limited. The AS/AD Model u The short run aggregate supply curve – the curve describing the supply side of the aggregate economy.

36. 9 - 36 © 2003 McGraw-Hill Ryerson Limited. The AS/AD Model u The aggregate demand curve – the curve describing the demand side of the aggregate economy.

37. 9 - 37 © 2003 McGraw-Hill Ryerson Limited. The AS/AD Model u The long run supply curve – the curve describing the highest sustainable level of output.

38. 9 - 38 © 2003 McGraw-Hill Ryerson Limited. The AS/AD Model u The AS/AD model is fundamentally different from the microeconomic supply/demand model.

39. 9 - 39 © 2003 McGraw-Hill Ryerson Limited. The AS/AD Model u In the microeconomic supply/demand model the price of a single good is on the vertical axis and the quantity of a single good on the horizontal axis. u The shapes are based on the concepts of substitution and opportunity cost.

40. 9 - 40 © 2003 McGraw-Hill Ryerson Limited. The AS/AD Model u In the AS/AD model the price of all goods,measured by the GDP deflator, is on the vertical axis and aggregate output is on the horizontal axis.

41. 9 - 41 © 2003 McGraw-Hill Ryerson Limited. The AS/AD Model u The AS/AD model is an historical model that starts at a point in time and says what will happen when changes affect the economy.

42. 9 - 42 © 2003 McGraw-Hill Ryerson Limited. The Aggregate Demand Curve u The aggregate demand (AD) curve shows how a change in the price level changes aggregate expenditures on all goods and services in an economy. u The AD curve is an equilibrium curve.

43. 9 - 43 © 2003 McGraw-Hill Ryerson Limited. The Slope of the AD Curve u The AD is a downward sloping curve. u Aggregate demand is composed of the sum of aggregate expenditures. Expenditures = C + I + G +(X - IM)

44. 9 - 44 © 2003 McGraw-Hill Ryerson Limited. The Slope of the AD Curve u The slope of the curve depends on how these components respond to changes in the price level. u A falling price level is assumed to increase aggregate expenditures, due to the l Wealth effect l Interest rate effect l International effect

45. 9 - 45 © 2003 McGraw-Hill Ryerson Limited. The AD Curve, Fig. 9-1, p 215 Price level Real output Aggregate demand P1P1 Y1Y1 Wealth, interest rate, and international effects Multiplier effect YeYe P0P0 Y0Y0

46. 9 - 46 © 2003 McGraw-Hill Ryerson Limited. The Wealth Effect u The wealth effect tells us that as the price level falls, the value of cash rises so that those who hold money and other financial assets become richer, and buy more.

47. 9 - 47 © 2003 McGraw-Hill Ryerson Limited. The Wealth Effect u While economists accept the logic of the argument, they do not see the wealth effect as strong.

48. 9 - 48 © 2003 McGraw-Hill Ryerson Limited. The Interest Rate Effect u The interest rate effect is the effect a lower price level has on investment expenditures through the effect that a change in the price level has on interest rates.

49. 9 - 49 © 2003 McGraw-Hill Ryerson Limited. The Interest Rate Effect u The linkage is: a decrease in the price level  increase of real cash  interest rates fall  banks have more money to lend  investment expenditures increase  jobs are created  consumer expenditures increase

50. 9 - 50 © 2003 McGraw-Hill Ryerson Limited. The International Effect u The international effect tells us that as the price level falls (assuming the exchange rate does not change), net exports will rise.

51. 9 - 51 © 2003 McGraw-Hill Ryerson Limited. The International Effect u The linkage is: a decrease in the price level in Canada  the fall in price of Canadian goods relative to foreign goods  Canadian goods become more competitive internationally  Canadian exports rise and imports fall.

52. 9 - 52 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Effect u A change in quantity demanded has repercussions on production (supply decisions) and subsequently on income and expenditures (demand decisions). u These repercussions are called multiplier effects.

53. 9 - 53 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Effect u As the price level falls, the initial changes due to the wealth, interest rate, and international effects set in motion a process in the economy that amplifies the initial effects.

54. 9 - 54 © 2003 McGraw-Hill Ryerson Limited. The Multiplier Effect u The multiplier effect is the amplification of initial changes in expenditures. u The multiplier effect makes the aggregate demand curve flatter.

55. 9 - 55 © 2003 McGraw-Hill Ryerson Limited. Shifts in the AD Curve u Except for a change in the price level, anything that changes aggregate expenditures shifts the AD curve.

56. 9 - 56 © 2003 McGraw-Hill Ryerson Limited. Shifts in the AD Curve u The main shift factors of aggregate demand are l foreign income, l expectations about future output or prices, l exchange rate fluctuations, l the distribution of income, and l monetary and fiscal policies.

57. 9 - 57 © 2003 McGraw-Hill Ryerson Limited. Foreign Income u When Canada’s trading partners go into a recession, the demand for Canadian goods (exports) will fall, causing the Canadian AD curve to shift to the left. u A rise in foreign income leads to an increase in Canadian exports and a rightward shift of the Canadian AD curve.

58. 9 - 58 © 2003 McGraw-Hill Ryerson Limited. Exchange Rates u When a currency loses value relative to other currencies, export goods produced in that country become less expensive and imports into that country become more expensive.

59. 9 - 59 © 2003 McGraw-Hill Ryerson Limited. Exchange Rates u Foreign demand for its goods increases and its demand for foreign goods decreases as individuals do their spending at home. u The AD curve will shift to the right. u When a currency gains value, the AD curve shifts to the left.

60. 9 - 60 © 2003 McGraw-Hill Ryerson Limited. Expectations About Future Output u If businesses expect demand to be high in the future, they will want to increase their capacity to produce. u Their demand for investment, a component of aggregate equilibrium demand will increase as well. u The AD curve will shift to the right.

61. 9 - 61 © 2003 McGraw-Hill Ryerson Limited. Expectations About Future Output u When consumers expect the economy to do well in the future, they will spend more now. u The AD curve shifts to the right.

62. 9 - 62 © 2003 McGraw-Hill Ryerson Limited. Expectations of Future Prices u If one expects the prices of goods to rise in the future while the current price remains constant, it pays to buy goods now before the prices rise. u The AD curve will shift to the right. u This is most acutely felt in a hyperinflation.

63. 9 - 63 © 2003 McGraw-Hill Ryerson Limited. Expectations of Future Prices u It is difficult to specify the exact reason why expectations will cause a shift in the AD curve because of the interrelatedness of various types of expectations.

64. 9 - 64 © 2003 McGraw-Hill Ryerson Limited. Distribution of Income u People tend to spend a greater percentage of their wage income as compared to their profit income.

65. 9 - 65 © 2003 McGraw-Hill Ryerson Limited. Distribution of Income u As real wages increase, while total income remains constant, it is likely that the AD curve will shift to the right. u As real wages decrease, it is likely that the AD curve will shift to the left.

66. 9 - 66 © 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy u Activist macro policy makers think they can control the AD curve to some extent. u Macro policy is the deliberate shifting of the AD curve to influence the level of income in the economy.

67. 9 - 67 © 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy u If the federal government spends lots of money or lowers taxes, it shifts the AD curve to the right.

68. 9 - 68 © 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy u When the Bank of Canada expands the money supply, it can often lower interest rates and thereby shift the AD curve to the right.

69. 9 - 69 © 2003 McGraw-Hill Ryerson Limited. Monetary and Fiscal Policy u Expansionary macro policy shifts the AD curve to the right. u Contractionary macro policy shifts it to the left.

70. 9 - 70 © 2003 McGraw-Hill Ryerson Limited. Multiplier Effects of Shift Factors u An AD curve cannot be treated like a micro demand curve. u When a shift factor of the AD curve causes it to move, it moves by more than the initial shift factor because of the multiplier effect.

71. 9 - 71 © 2003 McGraw-Hill Ryerson Limited. Effect of a Shift Factor on the AD Curve, Fig. 9-2, p 219 Price level Real output AD 0 P0P0 Initial effect 100 Change in total expenditures 300 AD 1 Multiplier effect 200

72. 9 - 72 © 2003 McGraw-Hill Ryerson Limited. The Aggregate Supply Curve u The Short run aggregate supply (SAS) curve shows how firms adjust the quantity of real output they will supply when the price level changes, holding all input prices fixed.

73. 9 - 73 © 2003 McGraw-Hill Ryerson Limited. The Slope of the SAS Curve u The SAS curve is an upward sloping line because: l Firms adjust both price and quantity in response to changes in aggregate demand. l Differences between expected and actual price causes firms to i) adjust output believing there was a relative price change; ii) adjust quantity when it is costly to change price; and iii) change employment and production when real wages is not as expected.

74. 9 - 74 © 2003 McGraw-Hill Ryerson Limited. Shifts in the SAS Curve u Firms change their quantity and pricing decisions when aggregate demand changes as well as in response to changes in their cost of production.

75. 9 - 75 © 2003 McGraw-Hill Ryerson Limited. Shifts in the SAS Curve u Costs of production include wage rates, interest rates, energy prices, and change in prices of other factors of production. u SAS will shift in response to the change in productivity, as well as change in costs of production.

76. 9 - 76 © 2003 McGraw-Hill Ryerson Limited. Shifts in the SAS Curve u The net effect on prices : % change in the price level = % change in wages – % change in productivity

77. 9 - 77 © 2003 McGraw-Hill Ryerson Limited. Shifts in the SAS Curve u An increase in factor prices increases the costs of production and shifts the SAS curve leftward. u A decline shifts it to the right.

78. 9 - 78 © 2003 McGraw-Hill Ryerson Limited. Shifts in the SAS Curve u An increase in productivity reduces the cost of production and shifts the SAS curve to the right. u A decrease shifts it to the left.

79. 9 - 79 © 2003 McGraw-Hill Ryerson Limited. The Short Run Aggregate Supply, Fig. 9-3a and b, p 220 P0P0 P1P1 SAS 0 SAS 1 Wage rates rise Real output Price level

80. 9 - 80 © 2003 McGraw-Hill Ryerson Limited. The Long Run Aggregate Supply Curve u The final curve that makes up the AD/AS model is the long run supply curve. u The long run supply curve shows the amount of goods and services an economy can produce when both labour and capital are fully employed.

81. 9 - 81 © 2003 McGraw-Hill Ryerson Limited. The Long Run Aggregate Supply Curve u LRAS is vertical since at potential output, a rise in the price level means that all prices, including input prices rise. u Available resources do not rise, thus, neither does the potential output.

82. 9 - 82 © 2003 McGraw-Hill Ryerson Limited. The Long Run Aggregate Supply Curve, Fig. 9-4, p 222 Potential output Price level Real output LRAS

83. 9 - 83 © 2003 McGraw-Hill Ryerson Limited. Equilibrium in the Aggregate Economy u Changes in the aggregate supply, aggregate demand, and potential output curves affect short-run and long-run equilibrium.

84. 9 - 84 © 2003 McGraw-Hill Ryerson Limited. Short-Run Equilibrium u Short-run equilibrium is where the SAS and AD curves intersect. u Shifts in either AD or SAS will affect price levels and output. l If AD increases (decreases), so do output and prices. l If SAS increases (decreases), output will also increase (decrease), while price levels move in the opposite direction.

85. 9 - 85 © 2003 McGraw-Hill Ryerson Limited. Short-Run Equilibrium: Shift in Aggregate Demand, Fig. 9-5a, p 222 Y0Y0 AD 1 Real output Price level E AD 0 SAS P0P0 Y1Y1 F P1P1

86. 9 - 86 © 2003 McGraw-Hill Ryerson Limited. Short-Run Equilibrium: Shift in Short-run Aggregate Supply, Fig. 9-5b, p 222 E Real output Price level SAS 1 Y0Y0 SAS 0 P0P0 AD 0 G Y2Y2 P2P2

87. 9 - 87 © 2003 McGraw-Hill Ryerson Limited. Long-Run Equilibrium u Long-run equilibrium is determined by the intersection of the AD curve and LRAS curve. u In the long run, output is fixed and the price level is variable.

88. 9 - 88 © 2003 McGraw-Hill Ryerson Limited. Long-Run Equilibrium u Aggregate demand determines the price level. u Increases (decreases) in aggregate demand lead to higher (lower) prices.

89. 9 - 89 © 2003 McGraw-Hill Ryerson Limited. Long-Run Equilibrium, Fig. 9-6, p 225 LRAS Real output Price level P0P0 Y0Y0 E H P1P1 AD 1 AD 0

90. 9 - 90 © 2003 McGraw-Hill Ryerson Limited. Integrating the Short-Run and Long-Run Frameworks u When SAS and AD curves intersect at the potential output, the economy is in both the long run and the short run equilibrium.

91. 9 - 91 © 2003 McGraw-Hill Ryerson Limited. Integrating the Short-Run and Long-Run Frameworks u The ideal situation is for aggregate demand to grow at the same rate as aggregate supply and potential output. u Unemployment and growth will be at their target rates with no inflation.

92. 9 - 92 © 2003 McGraw-Hill Ryerson Limited. Short-Run and Long-Run Equilibrium, Fig. 9-7a, p 225 P0P0 Y AD LRAS E Real output Price level SAS

93. 9 - 93 © 2003 McGraw-Hill Ryerson Limited. The Recessionary Gap u When the economy is in short-run equilibrium but not in long-run equilibrium, and the output is below potential, there is a recessionary gap.

94. 9 - 94 © 2003 McGraw-Hill Ryerson Limited. The Recessionary Gap u A recessionary gap is the amount by which equilibrium output is below potential output.

95. 9 - 95 © 2003 McGraw-Hill Ryerson Limited. The Recessionary Gap u If the economy remains at this level of output for a long time, costs and wages would tend to fall because there would be an excess supply of factors of production.

96. 9 - 96 © 2003 McGraw-Hill Ryerson Limited. The Recessionary Gap u Factor prices will fall causing the SAS curve to shift down to eliminate the recessionary gap.

97. 9 - 97 © 2003 McGraw-Hill Ryerson Limited. The Recessionary Gap, Fig. 9-7b, p 225 A Recessionary gap Y0Y0 Real output Price level LRAS B Y1Y1 SAS 1 SAS 0 P0P0 P1P1 AD

98. 9 - 98 © 2003 McGraw-Hill Ryerson Limited. The Inflationary Gap u The inflationary gap occurs when the economy is above potential output that exists at the current price level. u If the economy is in a situation where short-run equilibrium is at a higher price level than the economy's potential output curve, we have inflation.

99. 9 - 99 © 2003 McGraw-Hill Ryerson Limited. The Inflationary Gap u Factor prices will rise causing the SAS curve to shift up to eliminate the inflationary gap.

100. 9 - 100 © 2003 McGraw-Hill Ryerson Limited. (c) The Inflationary Gap, Fig. 9-7c, p 225 Y0Y0 Real output Price level LRAS C Y2Y2 D Inflationary gap AD SAS 0 SAS 2 P2P2 P0P0

101. 9 - 101 © 2003 McGraw-Hill Ryerson Limited. The Economy Beyond Potential u How can the economy operate beyond potential? u It is possible to overutilize resources beyond their potential for a brief time.

102. 9 - 102 © 2003 McGraw-Hill Ryerson Limited. The Economy Beyond Potential u When a firm is below potential, firms can hire additional factors of production to increase production without increasing production costs.

103. 9 - 103 © 2003 McGraw-Hill Ryerson Limited. The Economy Beyond Potential u Once the economy reaches its potential output that is no longer possible. u If at that point, the firm wishes to increase production, it must lure resources away from other firms.

104. 9 - 104 © 2003 McGraw-Hill Ryerson Limited. The Economy Beyond Potential u As firms compete for resources, costs rise beyond productivity increases. u The SAS curve shifts up and the price level rises.

105. 9 - 105 © 2003 McGraw-Hill Ryerson Limited. The Economy Beyond Potential u At this point the economy will slow down by itself or the government will step in with a policy to contract output and eliminate the inflationary gap.

106. 9 - 106 © 2003 McGraw-Hill Ryerson Limited. Some Additional Policy Examples u If politicians suddenly increase government expenditures when the economy is well below potential output, output rises while the price level remains unchanged.

107. 9 - 107 © 2003 McGraw-Hill Ryerson Limited. Some Additional Policy Examples u If consumer optimism leads to an increase in expenditures when the economy is at the target rate of unemployment, the price level rises while output remains unchanged.

108. 9 - 108 © 2003 McGraw-Hill Ryerson Limited. Shifting AD and SAS Curves, Fig 9-8a, p 228 Y0Y0 Y1Y1 Real output Price level A LRAS B AD 0 AD 1 SAS 90

109. 9 - 109 © 2003 McGraw-Hill Ryerson Limited. Shifting AD and SAS Curves, Fig 9-8b, p 228 Y0Y0 LRAS Real output Price level Y1Y1 C D E AD 0 AD 1 SAS 0 SAS 1

110. 9 - 110 © 2003 McGraw-Hill Ryerson Limited. Macro Policy Is More Complicated Than It Looks u The problem in the AS/AD model is that we have no way of knowing the level of potential output. u As a result, it is difficult to predict whether the SAS curve will be shifting up or not when aggregate demand increases.

111. 9 - 111 © 2003 McGraw-Hill Ryerson Limited. Three Policy Ranges u An economy has three policy ranges where the effect of an expansion of AD on the price level will be different: l The Keynesian range. l The Classical range. l The intermediate range.

112. 9 - 112 © 2003 McGraw-Hill Ryerson Limited. Three Policy Ranges u The Keynesian range – when the economy is far from potential income, and there is little fear that an increase in aggregate demand will cause the SAS curve to shift up and cause inflationary pressure. u The SAS is horizontal in this range, because all firms are quantity-adjusters.

113. 9 - 113 © 2003 McGraw-Hill Ryerson Limited. Three Policy Ranges u In the Keynesian range an increase in aggregate demand will increase income and have no effect on the price level. u The price/output path of the economy is horizontal so that prices are fixed.

114. 9 - 114 © 2003 McGraw-Hill Ryerson Limited. Three Policy Ranges u The Keynesian range corresponds to the recessionary gap and it is because of this that Keynesian economics is sometimes called depression or recession economics.

115. 9 - 115 © 2003 McGraw-Hill Ryerson Limited. Three Policy Ranges u The Classical range –the economy is above the level of potential output so that any increase in aggregate demand will increase factor prices. u The SAS curve is pushed up by the full amount of the aggregate demand increase.

116. 9 - 116 © 2003 McGraw-Hill Ryerson Limited. Three Policy Ranges u In the Classical range, an increase in aggregate demand will push up the price level and not affect real output. u The price/output path is vertical so that prices are flexible.

117. 9 - 117 © 2003 McGraw-Hill Ryerson Limited. Three Policy Ranges u The Classical range corresponds to the inflationary gap.

118. 9 - 118 © 2003 McGraw-Hill Ryerson Limited. Three Policy Ranges u The intermediate range – when the economy is between the two ranges, the AS curve will shift up some and real output will increase some. u The ratio between the two increases is determined by how close the economy is to its potential income.

119. 9 - 119 © 2003 McGraw-Hill Ryerson Limited. Three Policy Ranges u In the intermediate range, the price/output path of the economy is upward sloping. u The economy is usually in this range.

120. 9 - 120 © 2003 McGraw-Hill Ryerson Limited. Three Ranges of the Economy, Fig. 9-9, p 229 High potential Keynesian range Price level fixed Low potential Price/output path Real output Price level Price level partially flexible Intermediate range Classical range Price level very flexible

121. 9 - 121 © 2003 McGraw-Hill Ryerson Limited. The Problem of Estimating Potential Output u A key to policy is determining which range we are in which requires us to determine the level of potential output. u Estimating potential output is difficult.

122. 9 - 122 © 2003 McGraw-Hill Ryerson Limited. The Problem of Estimating Potential Output u One way of estimating potential output is to estimate the rate of unemployment below which inflation has begun to accelerate in the past. u This is called the target rate of unemployment.

123. 9 - 123 © 2003 McGraw-Hill Ryerson Limited. The Problem of Estimating Potential Output u One can then calculate output at the target rate of unemployment, adjust for productivity growth, and estimate potential output.

124. 9 - 124 © 2003 McGraw-Hill Ryerson Limited. The Problem of Estimating Potential Output u Unfortunately, the target rate of unemployment fluctuates and is difficult to predict. u For example, we don't know if we are dealing with structural or cyclical unemployment.

125. 9 - 125 © 2003 McGraw-Hill Ryerson Limited. The Problem of Estimating Potential Output u Another way gives us a very rough estimate of potential output. u The secular trend rate of growth is added to the economy's previous income level.

126. 9 - 126 © 2003 McGraw-Hill Ryerson Limited. The Problem of Estimating Potential Output u Estimating potential income from past growth rates can by questionable if such shift factors as regulations, technology, expectations, etc. are changing quickly or dramatically.

127. 9 - 127 © 2003 McGraw-Hill Ryerson Limited. Some Real-World Examples u Canada in the mid-1990s: l Unemployment was 9 percent—high by normal standards—while inflation was 2 percent.

128. 9 - 128 © 2003 McGraw-Hill Ryerson Limited. Some Real-World Examples u Canada in the mid-1990s: l Economist felt that the output was in the intermediate range (close to, or at, its potential). l If the economy expanded, the result would be inflation, not strong growth.

129. 9 - 129 © 2003 McGraw-Hill Ryerson Limited. Some Real-World Examples u Japan in the late 1990s: l Unemployment was at 4.6 percent and inflation was at 1 percent. l The majority of economists believed that the economy had room for expansion and was far below potential compared to other industrial countries.

130. 9 - 130 © 2003 McGraw-Hill Ryerson Limited. Some Real-World Examples u The European Union in the mid-1990s: l Unemployment was above 10 percent leading economists to think the EU was in the Keynesian range. l The EU was undergoing a restructuring of its economy.

131. 9 - 131 © 2003 McGraw-Hill Ryerson Limited. Some Real-World Examples u The European Union in the mid-1990s: l Social programs significantly reduced people's incentive to work. l Economic theory could not explain what range the EU was actually in.

132. 9 - 132 © 2003 McGraw-Hill Ryerson Limited. Some Real-World Examples u The United States in the mid-1990s: l The economy was expanding slowly albeit accompanied with major structural changes. l As firms expanded, they often laid off workers simultaneously. l These structurally unemployed workers needed retraining which needed time.

133. 9 - 133 © 2003 McGraw-Hill Ryerson Limited. Some Real-World Examples u The United States in the mid-1990s: l Economists maintained that unemployment below 6.5 percent would generate inflation. l The unemployment rate fell to 5 percent – no inflation l Then to almost 4 percent – still no inflation.

134. 9 - 134 © 2003 McGraw-Hill Ryerson Limited. Some Real-World Examples l Output has fallen by 40 to 50 percent. l As they struggle to create new institutional structures, past data are meaningless. u Structural change in these countries is especially critical.

135. 9 - 135 © 2003 McGraw-Hill Ryerson Limited. Debates About Potential Output u Knowing potential output is crucial in knowing what policy to advocate. u According to real business cycle economists, the best estimate of potential output is the actual income in the economy.

136. 9 - 136 © 2003 McGraw-Hill Ryerson Limited. Debates About Potential Output u Their Classical supply-side explanation is called real business cycle theory. l All changes in the economy result from real shifts—shifts in potential output—that reflect real causes such as technological changes or shifting tastes.

137. © 2003 McGraw-Hill Ryerson Limited. End of Chapter 9 Aggregate Demand, Aggregate Supply, and Modern Macroeconomics