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Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley Chapter 7: Aggregate.

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Presentation on theme: "Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley Chapter 7: Aggregate."— Presentation transcript:

1 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Robert J. Gordon, Macroeconomics, 10 th edition, 2006, Addison-Wesley Chapter 7: Aggregate Demand, Aggregate Supply and the Self Correcting Economy

2 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Combining aggregate demand with aggregate supply  So far we assumed that the price level is fixed. It means that changes in Y are calculated as ∆Y = ∆AD/P; where P is fixed  Now we will drop this assumption. If P increases we have inflation, if P decreases we have deflation. When AD changes we can’t tell whether this is due to changes in Y, P or both. For this reason we need to introduce the AD AS curves  AD curve  Shows different combinations of price level and real output at which money and commodity markets are both in equilibrium.

3 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Short run AS  Shows the amount of output that business firms are willing to produce at different price levels., holding constant the nominal wage rate.  Long run AS  Shows the amount of output that business firms are willing to produce when nominal wage rate has fully adjusted to any change in P.

4 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Flexible prices and the AD curve.  Effects of changing prices on the LM curve.  LM shifts position whenever there is a change in real money supply, either due a change in nominal money supply, while P in fixed, or by a change in the price level, while nominal money supply remains fixed.  The upper part of figure 7-1 shows three values of P given fixed MS 0.  If P were lower (p 1 ), real money supply will be higher. To maintain equilibrium in the money market r should fall to r1 and Y to grow to Y 1. The reverse is true at higher price level.  The lower part presents the relationship between Y and the assumed price level. Y along AD is always at a point where IS and LM cross, i.e., along AD both the commodity and money markets are in equilibrium

5 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-1 Effect on Real Income of Different Values of the Price Level

6 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Note that AD curve is a curved line instead of a straight line, which means that a given percentage decline in P boasts MS by a greater percentage, the lower the price level, hence raising Y by more at a low price level than at a high price level.  At MS=1000, if P declines from 2 to 1.5  Real MS will increase from 500 to 667 (i.e., 33%)  While reducing P from 1.5 to 1 will raise real MS from 667 to 1000 (i.e. an increase by 50%)  Reducing P from 1 to.5, will raise real MS from 1000 to 2000 (i.e. an increase by 100%).

7 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Shifting the AD curve with monetary and fiscal policy  Effects of a change in the nominal MS.  Look at figure 7-2. if MS doubles, LM shits rightward since P is the same the economy shifts right from E0 to H’. The new equilibrium

8 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-2 The Effect on the AD Curve of a Doubling of the Nominal Money Supply

9 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Effects of a Change in Autonomous Spending  Now we assume that IS changes due to e.g., a decline in business spending.  When IS shifts to the left, the position of the economy will shift to F if P is constant.

10 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-3 The Effect on the AD Curve of a Decline in Planned Autonomous Spending

11 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Alternative shapes of the short run aggregates supply curve  How will the increase in AD be divided between higher Y. The answer will depend on AS, i.e., whether it is horizontal, vertical or positively sloped.  Look at Figure 7-4.

12 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-4 Effect of a Rightward Shift in the AD Curve with Three Alternative Short-Run Aggregate Supply Curves

13 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The short run AS (SAS) when nominal wage rate is constant  The Labor demand curve  Nominal wage rate W is the actually paid wage.  Real wage rate is (W/P). As W/p is high, firms will employ less as W/p>marginal product, and vice versa.  Firms hire workers up to the point where real wage rate equal marginal product.  The short run supply curve  Look at figure 7-5. SAS slopes upward because higher P (point C) reduces real wage and induces firms to hire more, and thus produce more output, and vice versa alt lower prices (point A).

14 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-5 The Labor Demand Curve and the Short-Run Aggregate Supply Curve

15 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  How the wage rate is set  If wage rate increases, the SAS curve will shift up and its intersection point with AD will shift as well. Thus the determinants of the actual wage rate paid have a crucial effect on the nature of the economy’s response to a change in AD.  The equilibrium wage rate  In figure 7.6. higher wage rate shifts the SAS curve because at a given price, workers are more costly and so firms hire fewer workers and produce less output. Point B and B’ are identical because we assume that the percentage difference between W1 and W0 is the save as between p1 and p0. thus point B’ lies directly above point B in the right frame.

16 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-6 The Short-Run Aggregate Supply Curve for Two Different Values of the Wage Rate, and W 1 W 0

17 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Determinants of the equilibrium real wage rate  Equilibrium real wage rate is determined by the intersection of labor demand and supply curves. Figure 7-7. if firms are to raise employment to N1 real wage rate must be reduced (at point C).  Employers need to find some factor that will make workers willing to provide more work than shown by their labor supply curve. Otherwise we would never observe changes in employment over the business cycle.  Labor contracts and wage bargaining  Contracts explain fixity of nominal wages in the short run.  If the economy operates above levels that are consistent with labor market equilibrium, firms and workers know that the real wage is reduced below equilibrium. Next change there will be an upward pressure on nominal wage rate to restore the equilibrium wage rate.

18 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-7 Determination of the Equilibrium Real Wage Rate

19 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Fiscal and monetary expansion in the short and long run  Initial short run effect of a fiscal expansion  Look at figure 7-8. Initial fiscal stimulus shifts AD to AD1, the economy shifts to point C.  The rising nominal wage and the arrival at long run equilibrium  Businesses are satisfied at point C but workers are not, as wage rate is the same. Workers would insist to increase nominal wage rate to W1/P1, but this is less than the equilibrium real wage rate. As they raise real wage rate, the economy slides to E3.  The long run aggregate supply curve  LAS, the level of output YN is the labor market in equilibrium at the original real wage rate

20 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-8 Effects on the Price Level and Real Income of an Increase in Planned Autonomous Spending from to AD 1 AD 0

21 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Short run and long run equilibrium  Short run equilibrium occurs at the point where the AD crosses he SAS curve.  Long run equilibrium is a situation in which labor input is the amount voluntarily supplied and demanded at the equilibrium wage rate.  Interpretation of the business cycle.  Note that in the short run prices are flexible while the wage rate is fixed. Price flexibility and wage fixity implies a countercyclical movement of the real wage rate, i.e., movements of real wage rate are in the opposite direction of real GDP. (in reality movements are not in that manner)

22 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  An alternative view is that both prices and wages are fixed in the short run, and the SAS is relatively flat. When real GDP rises above equilibrium both prices and wage rise, and inflationary pressures continue until the economy returns to a point along the LAS (E3).

23 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Classical macroeconomics: the quantity theory of money and the self correcting economy.  Classical economists believed that the economy possessed a powerful self correcting forces that guaranteed full employment and prevented Y from falling below Y N for a long time.  these forces are flexible wages and prices that would adjust rapidly to absorb the impact of shifts in aggregate demand.  The quantity equation and the quantity theory of money. M S V ≡ PY V ≡ PY/M S  Changes in M S cause proportional changes in P. Note that V is assumed to be stable in the short run, and business cycles are attributed to changes in M S.

24 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Self correction in aggregate demand-supply model  Look at figure 7-9. the classical economists assumed that the economy would not operate away from the LAS. No business cycle in Y would occur.  Classical view of unemployment and output fluctuations  Classical economists did not believe that Y could remain for more than short time below Y N. How did they explain unemployment. Unemployed were described as irresponsible, or having an insufficient desire to work. Any unemployment will reduce real wage rate until equilibrium is obtained in the labor market.

25 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-9 Effect of a Decline in Planned Spending When the Price Level Is Perfectly Flexible

26 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  The Keynesian revolution: the Failure of self correction.  The Great Depression of 1929 Y had declined by one third by 1932 and unemployment rose to more than 20%. It was time for a new diagnosis. This is presented by Keynes in 1936 and J. Hicks presented the IS-LM model a year later.  Monetary impotence and the failure of self correction in extreme cases  For Keynes the problem could be divided into two categories, one concerning demand due to the possibility of monetary impotence and the other concerning supply due to rigid wages.

27 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Unresponsive expenditure: the vertical IS curve  If IS is vertical any change in MS will shift LM up or down a vertical IS curve, leaving Y unaffected. Look at figure 7-10. If IS is vertical changes in P will have no effect on Y’.  The liquidity trap: A horizontal LM curve  If the LM is horizontal see figure 7-10. if the IS intersects the LM in the horizontal section, an increase in MS/P does not shift the LM and Y stuck to Y’ where AD remains vertical.  Monetary impotence and a failure of self correction arise when there is a vertical IS or horizontal LM  The price level can fall to P” and Y remains at Y’. The economy would move from F to F’ or F” without any right word motion.

28 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-10 The Lack of Effect of a Drop in the Price Level When There Is a Failure of Self-Correction

29 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Fiscal policy and the real balances effect  The crucial problem that makes AD curve lie to the left of Y N is due to low business and consumer confidence. Keynes believed that fiscal policy can shift the IS curve and thus an anti- depression tool to use.  C. Pigou pointed out that the vertical AD’ may not be a dilemma at all. Since demand for commodities may depend on the level MS/P, this would make IS shift rightward whenever P falls, this guarantees a negative slope for AD. The Pigou (real balances) effect occurs whenever an increase in MS/P directly influences the demand for commodities without requiring interest rates to fall and AD can not be vertical in the presence of real balances effect. Why? A fixed nominal money buys more when price level falls. When P is perfectly elastic and real balances is in effect, no monetary or fiscal policy will be necessary.

30 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Two stimulative effects of price deflation. 1- the Keynesian effect. An increase in C or I due to a decline in r either because of higher MS or lower P, both will increase MS/P. 2- the Pigou effect. the direct stimulus to C when a price deflation causes an increase in MS/P.  Destabilizing effects of falling prices  Unfortunately the stimulative effects are not always favorable. There are two major unfavorable effects of deflation; 1. The expectation effect. People tend to postpone their purchases as the prices continue to decline. This may be strong enough to offset the stimulus of the Pigou effect.

31 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University 2. The redistribution effect. As unexpected deflation causes a redistribution of income from debtors to creditors, which reduces AD.  Nominal wage rigidity  Keynes’ second line of attack was simply that deflation would not occur in the necessary amount because of rigid nominal wages. Look at figure 7-11. Keynes pointed out that the economy would remain stuck at point A even with the normally sloped AD curve AD1.

32 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-11 Effect of a Decline in Planned Spending When the Nominal Rate Is Fixed at W 0

33 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Table 7-1 Money, Output, Unemployment, Prices, and Wages in the Great Depression, 1929–41

34 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University International Perspective Why Was the Great Depression Worse in the United States than in Europe?

35 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University Figure 7-12 The Price Level (P) and the Ratio of Actual to Natural Real GDP (Y /Y N ) During the Great Depression, 1929–41

36 Macroeconomic Theory Prof. M. El-Sakka CBA. Kuwait University  Failure to attain equilibrium in the labor market.  Keynes’ assumption of nominal wage rigidity fails to explain how and why wage remains rigid. Its only virtue is that it provides an explanation of the persistent unemployment at A without requiring any special shape of AD curve.


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