Chapter 26: The Short-Run Keynesian Policy Model: Demand-Side Policies

The Theory of Economicsis a method rather than a doctrine, an apparatus of the mind, a technique of thinking which helps its possessor to draw correct conclusions.J.M. KeynesThe Short-Run Keynesian Policy Model: Demand-Side PoliciesCopyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/IrwinChapter GoalsDiscuss the key insight of the AS/AD model and list both its assumptions and its componentsDescribe the shape of the aggregate demand curve and what factors shift the curveExplain the shape of the short-run and long-run aggregate supply curves and what factors shift the curvesShow the effects of shifts of the aggregate demand and aggregate supply curves on the price level and output in both the short run and long runDiscuss the limitations of the macro policy modelKey Insight of the Keynesian AS/AD ModelShort-run equilibrium output may differ from long-run potential output assuming a fixed price levelEquilibrium output is the level of output toward which the economy gravitates in the short run because of the cumulative cycles of declining or increasing productionPotential output is the highest amount of output an economy can sustainably produce using existing production processes and resourcesMarket forces may not be strong enough to correct deviations from potential outputKey Insight of the Keynesian AS/AD ModelParadox of thriftIn the long run, saving leads to investment and growthIn the short run, saving may lead to a decrease in spending, output, and employmentAggregate demand management, which is government’s attempt to control the aggregate level of spending, may be necessaryKeynesian economists advocated an activist demand management policyThe Components of the AS/AD ModelAggregate Demand Curve (AD)Is a curve that shows how a change in the price level will change aggregate expenditures on all goods and services in an economyShort-Run Aggregate Supply Curve (SAS)Is a curve that specifies how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constantLong-Run Aggregate Supply Curve (LAS)Is a curve that shows the long-run relationship between output and the price levelThe Slope of the AD CurveThe AD curve is downward sloping because of:Interest rate effect, the effect that a lower price level has on investment expenditures through the effect that a change in the price level has on interest ratesInternational effect, as the price level falls (assuming the exchange rate does not change), net exports will riseMoney wealth effect, a fall in the price level will make the holders of money richer, so they buy moreMultiplier effect, the amplification of initial changes in expendituresThe Aggregate Supply CurvesThe SAS curve is upward sloping because of:Auction marketsPrices are determined by demand and supply and supply curves are upward sloping Posted price marketsAlso called quantity-adjusting markets, markets in which firms respond to changes in demand by changing production instead of changing their pricesFirms tend to increase their markup when demand increasesThe Slope of the Short-Run Aggregate Supply (SAS) Curve The Long-Run Aggregate Supply CurveThe long-run aggregate supply (LAS) curve shows the long-run relationship between output and the price levelThe position of the LAS curve depends on potential output which is the amount of goods and services an economy can produce when both capital and labor are fully employedThe LAS curve is vertical because potential output is unaffected by the price levelThe LAS CurvePotential output is assumed to be in the middle of a range bounded by high and low levels of potential outputLASPrice levelReal outputLow-level potential outputHigh-level potential outputSASUnderutilized resourcesOverutilized resourcesABCWhen resources are over-utilized (point C), factor prices may be bid up and the SAS shifts upWhen resources are under-utilized (point A), factor prices may decrease and SAS shifts downShort-Run Equilibrium in the AD/AS ModelShort-run equilibrium is where the SAS and AD curves intersect and point E is short-run equilibriumPrice levelReal outputAD0P0AD1P1Y0Y1SASA shift in the aggregate demand curve to the right changes equilibrium from E to F, increasing output from Y0 to Y1 and increasing price level from P0 to P1EFShort-Run Equilibrium in the AD/AS ModelPrice levelReal outputADP0P2Y0Y2SAS1A shift up in the short-runaggregate supply curve changes equilibrium from E to G, decreasing output from Y0 to Y2 and increasing price level from P0 to P2SAS0EGLong-Run Equilibrium in the AD/AS ModelLong-run equilibrium is where the LAS and AD curves intersect Price levelReal outputAD0P0AD1P1LASA shift in the aggregate demand curve changes equilibrium from E to H, increasing the price level from P0 to P1 but leaving output unchangedEHAggregate Demand PolicyA primary reason for government policy makers’ interest in the AS/AD model is that monetary or fiscal policy shifts the AD curveMonetary policy involves the Federal Reserve Bank changing the money supply and interest ratesFiscal policy is the deliberate change in either government spending or taxes to stimulate or slow down the economyLimitations of the AS/AD ModelThe AS/AD model assumes away many possible feedback effects that can significantly affect the macroeconomy and lead to quite different conclusionsImplementing fiscal policy through changing taxes and government spending is a slow legislative processThere is no guarantee that government will do what economists say is necessaryLimitations of the AS/AD ModelThere are two ways to think about the effectiveness of fiscal policy: in the model and in realityThe effectiveness of fiscal policy depends on the government’s ability to perceive and to react appropriately to a problem Countercyclical fiscal policy is fiscal policy in which the government offsets any change in aggregate expenditures that would create a business cycleFine-tuning is used to describe such fiscal policy designed to keep the economy always at its target or potential level of incomeChapter Summary The key idea of the Keynesian AS/AD model is that in the short run the economy can deviate from potential outputThe AS/AD model consists of the aggregate demand curve, and the short-run aggregate supply curve, and the long-run aggregate supply curveShort-run equilibrium is where the SAS and AD curves intersect; Long-run equilibrium is where the AD and LAS curves intersectAggregate demand management policy attempts to influence the level of output in the economyChapter Summary Fiscal policy works by providing a deliberate countershock to offset unexpected shocks to the economyMacroeconomic policy is difficult to conduct because:Implementing fiscal policy is a slow processWe don’t really know where potential output isThere are interrelationships not included in the modelThe economy can become dynamically unstable