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Transcript of © The McGraw-Hill Companies, Inc., 1998 Irwin/McGraw-Hill The Modern Macroeconomic Debate Chapter...
![Page 1: © The McGraw-Hill Companies, Inc., 1998 Irwin/McGraw-Hill The Modern Macroeconomic Debate Chapter 10.](https://reader035.fdocuments.us/reader035/viewer/2022062518/56649f155503460f94c2aabc/html5/thumbnails/1.jpg)
© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
The Modern The Modern Macroeconomic DebateMacroeconomic Debate
Chapter 10
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Laugher CurveLaugher Curve
We adults do have something in common with today’s teenagers.
![Page 3: © The McGraw-Hill Companies, Inc., 1998 Irwin/McGraw-Hill The Modern Macroeconomic Debate Chapter 10.](https://reader035.fdocuments.us/reader035/viewer/2022062518/56649f155503460f94c2aabc/html5/thumbnails/3.jpg)
© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
Laugher CurveLaugher Curve
We adults do have something in common with today’s teenagers.
They listen to rock groups and we listen to economists.
![Page 4: © The McGraw-Hill Companies, Inc., 1998 Irwin/McGraw-Hill The Modern Macroeconomic Debate Chapter 10.](https://reader035.fdocuments.us/reader035/viewer/2022062518/56649f155503460f94c2aabc/html5/thumbnails/4.jpg)
© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
Laugher CurveLaugher Curve
We adults do have something in common with today’s teenagers.
They listen to rock groups and we listen to economists.
None of us understands a word they’re saying.
![Page 5: © The McGraw-Hill Companies, Inc., 1998 Irwin/McGraw-Hill The Modern Macroeconomic Debate Chapter 10.](https://reader035.fdocuments.us/reader035/viewer/2022062518/56649f155503460f94c2aabc/html5/thumbnails/5.jpg)
© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
Laugher CurveLaugher Curve
We adults do have something in common with today’s teenagers.
They listen to rock groups and we listen to economists.
None of us understands a word they’re saying.
Jean Stapleton
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Chapter ObjectivesChapter Objectives
Discuss the historical development of modern macroeconomics.
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© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
Chapter ObjectivesChapter Objectives
Discuss the historical development of modern macroeconomics.
Outline the reasoning behind Say’s law.
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© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
Chapter ObjectivesChapter Objectives
Discuss the historical development of modern macroeconomics.
Outline the reasoning behind Say’s law. Explain the shape of the AED curve and
what factors shift the AED curve.
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Chapter ObjectivesChapter Objectives
Explain the shape of the aggregate supply path and what factors shift the aggregate supply path.
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© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
Chapter ObjectivesChapter Objectives
Explain the shape of the aggregate supply path and what factors shift the aggregate supply path.
State which ranges of the macro policy model are relevant for the activist Keynesian and laissez-faire Classical policy model.
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Chapter ObjectivesChapter Objectives
Work with the macro policy model showing the effects of shifts in aggregate equilibrium demand and the aggregate supply path on price level and output.
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© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
Chapter ObjectivesChapter Objectives
Work with the macro policy model showing the effects of shifts in aggregate equilibrium demand and the aggregate supply path on price level and output.
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Chapter ObjectivesChapter Objectives
Discuss two reasons why macro policy is more complicated than the model makes it look.
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The Historical The Historical Development of Development of Modern Modern Macroeconomics Macroeconomics Recent Economic History and the
Debate
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The Historical The Historical Development of Development of Modern Modern Macroeconomics Macroeconomics Recent Economic History and the
Debate In the late 1990s, workers worry
about downsizing—the laying off of workers by large firms.
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The Historical The Historical Development of Development of Modern Modern Macroeconomics Macroeconomics Recent Economic History and the
Debate In the late 1990s, workers worry
about downsizing—the laying off of workers by large firms.
Despite this, few policy actions at the federal level focused on unemployment.
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The Historical The Historical Development of Development of Modern Modern Macroeconomics Macroeconomics Recent Economic History and the
Debate The focus was on the federal deficit
and how to eliminate it, or structural policies that would make the economy more competitive.
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The Historical The Historical Development of Development of Modern Modern Macroeconomics Macroeconomics Recent Economic History and the
Debate The policy debate did not focus on
fiscal policy and focused less than in the past on monetary policy.
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The Historical The Historical Development of Development of Modern Modern Macroeconomics Macroeconomics The macro policy model demonstrates
the effects of macro policy on output and prices.
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The Historical The Historical Development of Development of Modern Modern Macroeconomics Macroeconomics For simplicity, only two sides of the
debate will be presented.
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The Historical The Historical Development of Development of Modern Modern MacroeconomicsMacroeconomics Activist Economists
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The Historical The Historical Development of Development of Modern Modern MacroeconomicsMacroeconomics Activist Economists
Activist economists are those who believe that the government can create and implement policy proposals that can positively effect the economy.
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The Historical The Historical Development of Development of Modern Modern MacroeconomicsMacroeconomics Activist Economists
They are sometimes called Keynesian economists since they follow the “do something” recommendations of John Maynard Keynes.
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The Historical The Historical Development of Development of Modern Modern MacroeconomicsMacroeconomics Laissez-Faire Economists
Laissez-faire economists are those who believe that government policies would probably make things worse, so the best policy is (relatively) little government involvement with the economy.
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The Historical The Historical Development of Development of Modern Modern MacroeconomicsMacroeconomics Laissez-Faire Economists
They are sometimes called Classical economists.
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The Historical The Historical Development of Development of Modern Modern MacroeconomicsMacroeconomics In spite of policy differences, there is
much more agreement that disagreement in reference to policy and to the macro policy model.
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists Built on Adam
Smith’s Wealth of Nations
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists Built on Adam
Smith’s Wealth of Nations The Classical economists’ approach
was laissez-faire (leave the market alone).
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists Built on Adam
Smith’s Wealth of Nations The Classical economists’ approach
was laissez-faire (leave the market alone).
They felt the market was self-adjusting.
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© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists Built on Adam
Smith’s Wealth of Nations The Classical economists’ approach
was laissez-faire (leave the market alone).
They felt the market was self-adjusting.
They also concentrated on the long-run and largely ignored the short-run.
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists’ Explanation of
the Depression
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists’ Explanation of
the Depression When the Great Depression hit with
25 percent unemployment, their response was to refer to supply and demand in the labor market.
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists’ Explanation of
the Depression The problem, as they saw it, was that
the real wage—the wage level relative to the price level—was too high.
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists’ Explanation of
the Depression Thus, the solution to unemployment
was to eliminate labor unions and government policies that held the wages too high.
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists’ Explanation of
the Depression Lay people didn’t like this argument.
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists’ Explanation of
the Depression Lay people didn’t like this argument. They believed instead that the
Depression was caused by an oversupply of goods that glutted the market.
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The Emergence of The Emergence of Classical EconomicsClassical Economics Classical Economists’ Explanation of the
Depression Lay people didn’t like this argument. They believed instead that the
Depression was caused by an oversupply of goods that glutted the market.
The Classicals argued that an oversupply of goods was impossible.
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Unemployment in the Unemployment in the Classical ModelClassical Model
Re
al w
ag
e
W1
We
0
Number of workers
Unemployment
S
D
Q QD S
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Say’s LawSay’s Law
The belief that an oversupply of goods was impossible was first formulated by J.B. Say.
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Say’s LawSay’s Law
According to Say’s Law, supply creates its own demand.
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Say’s LawSay’s Law
According to Say’s Law, supply creates its own demand. Demand for goods and services as a
whole will always be sufficient to buy what is supplied.
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Say’s LawSay’s Law
According to Say’s Law, supply creates its own demand. Thomas Malthus argued that Say’s
Law was not necessarily true for if people saved, part of their income would be lost to the economy.
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Say’s LawSay’s Law
According to Say’s Law, supply creates its own demand. Another Classical writer, David
Ricardo, rejected Malthus’ argument and stated that any savings would come back into the circular flow by way of investment.
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Say’s LawSay’s Law
According to Say’s Law, supply creates its own demand. Say’s Law did not say unemployment
could not exist, only that it was localized wage-price problem.
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Say’s LawSay’s Law
According to Say’s Law, supply creates its own demand. Classical economists believed that
frictional and structural unemployment could exist, but they did not believe cyclical unemployment could be caused by a shortage of aggregate demand.
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The Equality of Saving The Equality of Saving and Investmentand Investment
Employee compensation, rents, interest, profit (a)
Households
Savings
Financial sector
Consumption (c)
Investment (b)
Firms (production)
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The Quantity Theory of The Quantity Theory of MoneyMoney In its simplest terms, the quantity theory
of money says that the price level varies in response to changes in the quantity of money.
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The Quantity Theory of The Quantity Theory of MoneyMoney The quantity theory of money can be
seen in the equation of exchange:
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The Quantity Theory of The Quantity Theory of MoneyMoney The quantity theory of money can be seen
in the equation of exchange: MV = PQ
M = money supply V = velocity of money (is relatively constant
and determined by institutional forces) P = price level Q = real output (is relatively constant and
determined by real, not monetary forces)
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The Quantity Theory of The Quantity Theory of MoneyMoney The quantity theory of money can be
seen in the equation of exchange: This leaves M and P directly related to
each other with the arrow of causation going from left to right:
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© The McGraw-Hill Companies, Inc., 1998Irwin/McGraw-Hill
The Quantity Theory of The Quantity Theory of MoneyMoney The quantity theory of money can be
seen in the equation of exchange: This leaves M and P directly related to
each other with the arrow of causation going from left to right:
MV PQ
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Classicals’ View of the Classicals’ View of the Great DepressionGreat Depression While the Classicals were waiting for
the long-run to kick in, nations were sinking deeper and deeper into the Depression.
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Classicals’ View of the Classicals’ View of the Great DepressionGreat Depression They reluctantly developed a short-run
analysis of why the Depression was lingering so long.
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Classicals’ View of the Classicals’ View of the Great DepressionGreat Depression They centered on the social and political
forces that prevented market forces from operating.
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Classicals’ View of the Classicals’ View of the Great DepressionGreat Depression They centered on the social and political
forces that prevented market forces from operating. Stop the measures that governments
were passing to hold up wages and prices.
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Classicals’ View of the Classicals’ View of the Great DepressionGreat Depression They centered on the social and political
forces that prevented market forces from operating. Break up labor unions.
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The Emergence of The Emergence of Keynesian EconomicsKeynesian Economics Politicians and economics students did
not listen to the Classicals’ viewpoints.
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The Emergence of The Emergence of Keynesian EconomicsKeynesian Economics Politicians and economics students did
not listen to the Classicals’ viewpoints. Economists in general had a gut feeling
that there had to be a better way.
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The Emergence of The Emergence of Keynesian EconomicsKeynesian Economics According to Keynes, equilibrium
income is not fixed at the economy’s long-run potential income; it fluctuates.
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The Emergence of The Emergence of Keynesian EconomicsKeynesian Economics The key is that equilibrium income does
not always equal potential income.
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The Emergence of The Emergence of Keynesian EconomicsKeynesian Economics The key is that equilibrium income does
not always equal potential income.
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The Emergence of The Emergence of Keynesian EconomicsKeynesian Economics Equilibrium income is the level of
income toward which the economy gravitates in the short run because of cumulative circles of declining production.
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The Emergence of The Emergence of Keynesian EconomicsKeynesian Economics Potential income is the level of income
which the economy is capable of producing without generating accelerating inflation.
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The Emergence of The Emergence of Keynesian EconomicsKeynesian Economics Keynesian economics explained why
the economy could find itself in a rut with a glut. It offered a way to get the economy
moving again through the use of government spending policies.
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The Emergence of The Emergence of Keynesian EconomicsKeynesian Economics Keynesian economics explained why
the economy could find itself in a rut with a glut. If there was a persistent gap between
equilibrium income and potential income, government had to step to pull the economy out of the rut.
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The Macro Policy ModelThe Macro Policy Model
The Partial Equilibrium Supply/Demand Models
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The Macro Policy ModelThe Macro Policy Model
The Partial Equilibrium Supply/Demand Models Microeconomic models cannot be
used to model the aggregate economy.
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The Macro Policy ModelThe Macro Policy Model
The Partial Equilibrium Supply/Demand Models Macroeconomic models of the
economy depend upon macroeconomic relationships between aggregate output and the price level, not upon relationships between a single good and its relative price.
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The Macro Policy ModelThe Macro Policy Model
The Partial Equilibrium Supply/Demand Models In the aggregate, other things do not
remain constant.
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The Macro Policy ModelThe Macro Policy Model
The Macro Policy Model Consists of Two Curves:
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The Macro Policy ModelThe Macro Policy Model
The Macro Policy Model Consists of Two Curves: The aggregate supply path is the
curve describing the supply side of the aggregate economy.
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The Macro Policy ModelThe Macro Policy Model
The Macro Policy Model Consists of Two Curves: The aggregate equilibrium demand
curve is the curve describing the demand side of aggregate economy.
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The Macro Policy ModelThe Macro Policy Model
The Graphical Framework of the Macro Policy Model
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The Macro Policy ModelThe Macro Policy Model
The Graphical Framework of the Macro Policy Model The price level (the price of a
composite good) is on the vertical axis and the aggregate level of output (GDP) is on the horizontal axis.
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The Macro Policy ModelThe Macro Policy Model
The Graphical Framework of the Macro Policy Model The curve is different from the partial
equilibrium model which has relative price on the vertical axis and the quantity of a single good on the horizontal axis.
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The Macro Policy ModelThe Macro Policy Model
The Graphical Framework of the Macro Policy Model The curve is different from the partial
equilibrium model which has relative price on the vertical axis and the quantity of a single good on the horizontal axis.
The shapes of the macro curves are not based on the principle of substitution.
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The Macro Policy ModelThe Macro Policy Model
The Graphical Framework of the Macro Policy Model The macro policy model is an
historical model.
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The Macro Policy ModelThe Macro Policy Model
The Graphical Framework of the Macro Policy Model The macro policy model is an
historical model. It starts at a point in time, and tells one
what will likely happen when shocks hit the economy.
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components The Aggregate Equilibrium Demand
(AED) Curve
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components The Aggregate Equilibrium Demand
(AED) Curve Shows how a change in the price level
changes aggregate equilibrium demand after all the dynamic interactive effects between production and expenditures are taken into account.
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components Slope of the AED Curve
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components Slope of the AED Curve
The AED is a downward sloping curve.
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components Slope of the AED Curve
The AED is a downward sloping curve. The wealth effect tells us that as the
price level falls, people are richer, so they buy more.
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components Slope of the AED Curve
The AED is a downward sloping curve. The international effect tells us that
as the price level in the U.S. falls, (assuming the exchange rate does not change), the quantity of U.S. goods demanded will increase.
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Determinants of the Slope Determinants of the Slope of the AED Curveof the AED CurveP
rice level
Real output
AED
Wealth and international effects
Repercussions P1
P
Q QQ Qe
0
10 2
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components Repercussions and the Multiplier Effect
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components Repercussions and the Multiplier Effect
A change in quantity demanded has repercussions on production (supply decisions) and subsequently on income and expenditures (demand decisions).
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components Repercussions and the Multiplier Effect
These repercussions are called multiplier effects.
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components Repercussions and the Multiplier Effect
These repercussions are called multiplier effects.
They multiply the initial effect of the price level change on the quantity of aggregate demand as the economy adjusts to equilibrium.
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Determinants of the Determinants of the Slope of the AED CurveSlope of the AED Curve
Pri
ce l
evel
Real Ouput
P0
P1
Q0 Q1
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The Aggregate The Aggregate Equilibrium Demand Equilibrium Demand Curve ComponentsCurve Components Shifts in the AED Curve
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Shifts in the AED CurveShifts in the AED Curve
Anything that affects aggregate expenditures, except the price level, shifts the AED curve.
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Shifts in the AED CurveShifts in the AED Curve
Foreign Income
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Shifts in the AED CurveShifts in the AED Curve
Foreign Income When U.S. trading partners go into a
recession, the demand for U.S. goods (exports) will fall, causing the U.S. AED curve to shift to the left.
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Shifts in the AED CurveShifts in the AED Curve
Foreign Income A rise in foreign income leads to an
increase in U.S. exports and a rightward shift of the U.S. AED curve.
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Shifts in the AED CurveShifts in the AED Curve
Expectations About Future Income
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Shifts in the AED CurveShifts in the AED Curve
Expectations About Future Income If businesses expect demand to be
high in the future, they will want to increase their capacity to produce.
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Shifts in the AED CurveShifts in the AED Curve
Expectations About Future Income Their demand for investment, a
component of aggregate equilibrium demand will increase as well.
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Shifts in the AED CurveShifts in the AED Curve
Expectations About Future Income Their demand for investment, a
component of aggregate equilibrium demand will increase as well.
The AED curve will shift to the right.
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Shifts in the AED CurveShifts in the AED Curve
Expectations About Future Income When consumers expect the economy
to do well in the future, they will spend more now.
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Shifts in the AED CurveShifts in the AED Curve
Expectations About Future Income When consumers expect the economy
to do well in the future, they will spend more now.
The AED curve shifts to the right.
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Shifts in the AED CurveShifts in the AED Curve
Expectations of Future Prices
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Shifts in the AED CurveShifts in the AED Curve
Expectations of Future Prices 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.
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Shifts in the AED CurveShifts in the AED Curve
Expectations of Future Prices 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.
The AED curve will shift to the right.
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Shifts in the AED CurveShifts in the AED Curve
Expectations of Future Prices 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.
The is most acutely felt in a hyperinflation.
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Shifts in the AED CurveShifts in the AED Curve
Expectations of Future Prices The is most acutely felt in a
hyperinflation.
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Shifts in the AED CurveShifts in the AED Curve
Expectations of Future Prices It is difficult to specify the exact
reason why expectations will cause a shift in the AED curve because of the interrelatedness of various types of expectations.
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Shifts in the AED CurveShifts in the AED Curve
Exchange Rates
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Shifts in the AED CurveShifts in the AED Curve
Exchange Rates When a currency loses value relative
to other currencies, the foreign demand for its goods increases and its demand for foreign goods decreases as individuals do their spending at home.
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Shifts in the AED CurveShifts in the AED Curve
Exchange Rates When a currency loses value relative
to other currencies, the foreign demand for its goods increases and its demand for foreign goods decreases.
The AED curve will shift to the right.
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Shifts in the AED CurveShifts in the AED Curve
Exchange Rates When a currency loses value relative
to other currencies, the foreign demand for its goods increases and its demand for foreign goods decreases.
When a currency gains value, the AED curve shifts to the left.
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Shifts in the AED CurveShifts in the AED Curve
Distribution of Income
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Shifts in the AED CurveShifts in the AED Curve
Distribution of Income People spend a greater percentage of
their wage income as compared to their profit income.
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Shifts in the AED CurveShifts in the AED Curve
Distribution of Income As real wages increase, while total
income remains constant, it is likely that the AED curve will shift to the right.
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Shifts in the AED CurveShifts in the AED Curve
Government Aggregate Demand Policies
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Shifts in the AED CurveShifts in the AED Curve
Government Aggregate Demand Policies Activist macro policy makers think
they can control the AED curve to some extent.
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Shifts in the AED CurveShifts in the AED Curve
Government Aggregate Demand Policies If the federal government spends lots
of money without raising taxes, it shifts the AED curve to the right.
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Shifts in the AED CurveShifts in the AED Curve
Government Aggregate Demand Policies When the Fed expand money supply,
it can often lower interest rates and thereby shift the AED curve to the right.
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Shifts in the AED CurveShifts in the AED Curve
Government Aggregate Demand Policies This deliberate shifting of the AED
curve to influence the level of income in the economy is what most policy makers mean by the term macro policy.
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Shifts in the AED CurveShifts in the AED Curve
Government Aggregate Demand Policies Expansionary macro policy shifts the
AED curve to the right.
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Shifts in the AED CurveShifts in the AED Curve
Government Aggregate Demand Policies Expansionary macro policy shifts the
AED curve to the right. Contractionary macro policy shifts it
to the left.
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Shifts in the AED CurveShifts in the AED Curve
Multiplier Effects of Shift Factors
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Shifts in the AED CurveShifts in the AED Curve
Multiplier Effects of Shift Factors An AED curve cannot be treated like a
demand curve.
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Shifts in the AED CurveShifts in the AED Curve
Multiplier Effects of Shift Factors When a shift factor of the AED curve
causes it to move, it moves by more than the initial shift factor because of the multiplier effect.
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Effects of a Shift Factor Effects of a Shift Factor on AEDon AED
Pri
ce le
vel
Real output
P0
AED0
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Effects of a Shift Factor Effects of a Shift Factor on AEDon AED
Pri
ce le
vel
Real output
P0
AED1100AED0
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Effects of a Shift Factor Effects of a Shift Factor on AEDon AED
Pri
ce le
vel
Real output
Initial effect ofshift factor
P0
AED1100AED0
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Effects of a Shift Factor Effects of a Shift Factor on AEDon AED
Pri
ce le
vel
Real output
Initial effect ofshift factor
P0
AED1200100
AED0
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Effects of a Shift Factor Effects of a Shift Factor on AEDon AED
Pri
ce le
vel
Real output
Initial effect ofshift factor
Multipliereffect P0
AED1200100
AED0
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Effects of a Shift Factor Effects of a Shift Factor on AEDon AED
Pri
ce le
vel
Real output
Initial effect ofshift factor
Multipliereffect P0
AED1200100
total output =300
AED0
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The Aggregate Supply The Aggregate Supply PathPath The aggregate supply (AS) path is a
curve that tells us how changes in aggregate equilibrium demand will be split between real output changes and price level changes.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets The curve describing the supply-side
dimension in the macro policy model is called a supply path rather than a supply curve because it incorporates the institutional realities of seller-set prices.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets Institutional realities are emphasized
because they affect the way the aggregate economy adjusts to aggregate demand shocks.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets Markets with seller-set prices are
sometimes called quantity-adjusted markets.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets Markets with seller-set prices are
sometimes called quantity-adjusted markets.
Firms modify their supply in order to bring about equilibrium instead of changing prices.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets About 90-95 percent of retail markets
in the U.S. are quantity-adjusted markets
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets In seller-set markets, central pricing
decisions are long-run, not short-run.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets In seller-set markets, central pricing
decisions are long-run, not short-run. Cutting the long-term prices is the
exception, not the rule.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets In seller-set markets, firms pick a
price and quantity strategy.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets In seller-set markets, firms pick a
price and quantity strategy. In the short-run when they are not selling
as much as expected, they prefer to reduce production rather than cut their price sufficiently to sell all they are producing.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets To say that the U.S. economy is not
perfectly competitive is not to say that it is not highly competitive.
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The Aggregate Supply The Aggregate Supply PathPath The AS Path Pricing Strategies and
Quantity Adjusting Markets Firms are hesitant to cut price when
demand falls because direct competitors will match their price cut.
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The Aggregate Supply The Aggregate Supply PathPath Slope of the AS Path
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The Aggregate Supply The Aggregate Supply PathPath Slope of the AS Path
The slope of the AS path depends on how close the economy is to its potential income.
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The Aggregate Supply The Aggregate Supply PathPath Slope of the AS Path
Three ranges are distinguished.
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The Aggregate Supply The Aggregate Supply PathPath A Fixed Price-Level Range: A Flat AS
Path
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The Aggregate Supply The Aggregate Supply PathPath A Fixed Price-Level Range: A Flat AS
Path Here the price level seems to have a
floor.
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The Aggregate Supply The Aggregate Supply PathPath A Fixed Price-Level Range: A Flat AS
Path Downward shifts in aggregate
equilibrium demand do not result in falls in the price level.
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The Aggregate Supply The Aggregate Supply PathPath A Fixed Price-Level Range: A Flat AS
Path Rightward shifts in the AED curve do
not cause significant rises in the price level.
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The Aggregate Supply The Aggregate Supply PathPath A Partially-Flexible Price-Level Range:
An Upward-Sloping AS Path
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The Aggregate Supply The Aggregate Supply PathPath A Partially-Flexible Price-Level Range:
An Upward-Sloping AS Path As the economy begins approaching
its potential income, the price level rises as aggregate equilibrium demand increases.
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The Aggregate Supply The Aggregate Supply PathPath A Partially-Flexible Price-Level Range:
An Upward-Sloping AS Path This demand tends to split into an
increase in the price level and an increase in aggregate real output.
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The Aggregate Supply The Aggregate Supply PathPath A Partially-Flexible Price-Level Range:
An Upward-Sloping AS Path Within this range, the rise in the price
level does not start an accelerating inflation.
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The Aggregate Supply The Aggregate Supply PathPath An Unsustainable Flexible Price-Level
Range: A Vertical AS Path
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The Aggregate Supply The Aggregate Supply PathPath An Unsustainable Flexible Price-Level
Range: A Vertical AS Path Once the economy reaches its
potential income, an excess in aggregate equilibrium demand results in unsustainable price-level changes.
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The Aggregate Supply The Aggregate Supply PathPath An Unsustainable Flexible Price-Level
Range: A Vertical AS Path Once this range is entered, a change
in the psychology of the economy occurs.
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The Aggregate Supply The Aggregate Supply PathPath An Unsustainable Flexible Price-Level
Range: A Vertical AS Path The economy changes from a stable
price-level psychology to an inflationary psychology.
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The Aggregate Supply The Aggregate Supply PathPath An Unsustainable Flexible Price-Level
Range: A Vertical AS Path The economy changes from a stable
price-level psychology to an inflationary psychology.
Natural resources and labor are in short supply.
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The Aggregate Supply The Aggregate Supply PathPath An Unsustainable Flexible Price-Level
Range: A Vertical AS Path The economy changes from a stable
price-level psychology to an inflationary psychology.
Shortages begin occurring, driving prices higher.
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The Aggregate Supply The Aggregate Supply PathPath An Unsustainable Flexible Price-Level
Range: A Vertical AS Path The economy changes from a stable
price-level psychology to an inflationary psychology.
This point of no return delineated by the economy’s potential income provides the supply-side limit of the economy.
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The Aggregate Supply The Aggregate Supply PathPath
0
Pri
ce le
vel
Real output
AS path
Potential output
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The Aggregate Supply The Aggregate Supply PathPath An Unsustainable Flexible Price-Level
Range: A Vertical AS Path The economy changes from a stable
price-level psychology to an inflationary psychology.
Further expansion will accelerate inflation.
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The Aggregate Supply The Aggregate Supply PathPath Range A
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The Aggregate Supply The Aggregate Supply PathPath Range A
The historically determined price level places a floor on the price level.
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The Aggregate Supply The Aggregate Supply PathPath Range A
The historically determined price level places a floor on the price level.
Any adjustment takes place in real output changes not in price-level changes.
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The Aggregate Supply The Aggregate Supply PathPath Range A
Governments feel that they have to respond to range A problems by doing the following:
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The Aggregate Supply The Aggregate Supply PathPath Range A
Governments feel that they have to respond to range A problems by doing the following:
Introduce policies to get the economy out of this range.
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The Aggregate Supply The Aggregate Supply PathPath Range A
Governments feel that they have to respond to range A problems by doing the following:
Introduce policies to get the economy out of this range.
Prohibit firms from lowering prices.
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The Aggregate Supply The Aggregate Supply PathPath Range A
Why the asymmetry—the price level tends not to fall but tends to rise—between upward and downward price movements?
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The Aggregate Supply The Aggregate Supply PathPath Range A
Why the asymmetry—the price level tends not to fall but tends to rise—between upward and downward price movements?
Sellers do not want to lower nominal prices and “ruin the market.”
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The Aggregate Supply The Aggregate Supply PathPath Range A
Why the asymmetry—the price level tends not to fall but tends to rise—between upward and downward price movements?
Government policy undertakes to prevent price declines and sellers build this into their nominal prices.
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The Aggregate Supply The Aggregate Supply PathPath Range B
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The Aggregate Supply The Aggregate Supply PathPath Range B
The economy begins to experience supply bottlenecks.
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The Aggregate Supply The Aggregate Supply PathPath Range B
The economy begins to experience supply bottlenecks.
Raw material prices rise and labor shortages begin to appear.
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The Aggregate Supply The Aggregate Supply PathPath Range B
As firms’ cost rise, they raise prices to cover increased costs.
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The Aggregate Supply The Aggregate Supply PathPath Range B
As the economy moves closer to potential income, bottlenecks become more pervasive and the psychology of the market begins to change.
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The Aggregate Supply The Aggregate Supply PathPath Range B
Since pricers expect the price level to rise, they build this expectation into their prices until Range C is finally reached.
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The Aggregate Supply The Aggregate Supply PathPath Range C
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The Aggregate Supply The Aggregate Supply PathPath Range C
Range C begins at the economy’s potential income.
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The Aggregate Supply The Aggregate Supply PathPath Range C
Since pricers expect inflation, increasing their prices becomes a self-fulfilling prophecy.
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The Aggregate Supply The Aggregate Supply PathPath Activist Keynesians see the economy in
the fixed price range of the AS path (Range A).
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The Aggregate Supply The Aggregate Supply PathPath Laissez-faire Classicals see the
economy in the perfectly-flexible range of the AS path (Range B).
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The Aggregate Supply The Aggregate Supply PathPath
Pri
ce le
vel
Keynesian range
Range A
Intermediate range
Range B
Classical range
Range C
Real output
Potential output
AS path
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The Aggregate Supply The Aggregate Supply PathPath Where is potential income?
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The Aggregate Supply The Aggregate Supply PathPath Where is potential income?
There is much debate over this question.
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The Aggregate Supply The Aggregate Supply PathPath Where is potential income?
If the price level has remained constant but a small price level rise begins an accelerating inflation, the economy’s true potential output is at the beginning of Range B.
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The Aggregate Supply The Aggregate Supply PathPath Where is potential income?
If the price-level rise does not start an accelerating inflation, the economy can move into Range B, depending on what type of rise in the price level policy makers are willing to accept.
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The Aggregate Supply The Aggregate Supply PathPath Where is potential income?
Thus, the economy’s target level of output somewhere within Range B.
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The Aggregate Supply The Aggregate Supply PathPath Where is potential income?
Thus, the economy’s target level of output somewhere within Range B.
This target level of potential output is that which policy makers feel is achievable in the long run without generating accelerating inflation.
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The Aggregate Supply The Aggregate Supply PathPath The Macro Policy Model in an Economy
With Ongoing Inflation
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The Aggregate Supply The Aggregate Supply PathPath The Macro Policy Model in an Economy
With Ongoing Inflation The macro policy model allows for the
incorporation of inflationary expectations as well as for deflationary expectations.
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The Aggregate Supply The Aggregate Supply PathPath The Macro Policy Model in an Economy
With Ongoing Inflation The macro policy model allows for the
incorporation of inflationary expectations as well as for deflationary expectations.
Disinflation is a fall in the rate at which the price level is rising.
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The Aggregate Supply The Aggregate Supply PathPath The Macro Policy Model in an Economy
With Ongoing Inflation The macro policy model allows for the
incorporation of inflationary expectations as well as for deflationary expectations.
Deflation is a fall in the price level.
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The Aggregate Supply The Aggregate Supply PathPath The Macro Policy Model in an Economy
With Ongoing Inflation By measuring inflation relative to
expected inflation on the vertical axis, a movement down the AS path represents disinflation rather than deflation.
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The Aggregate Supply The Aggregate Supply PathPath Up and Down Shifts of the AS Path
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The Aggregate Supply The Aggregate Supply PathPath Up and Down Shifts of the AS Path
If the price level shifts for some reason other than a shift in aggregate equilibrium demand, the AS path will shift up and down.
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The Aggregate Supply The Aggregate Supply PathPath Up and Down Shifts of the AS Path
The horizontal portion of the AS path can shift up or down due to nominal price level shocks.
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The Aggregate Supply The Aggregate Supply PathPath Up and Down Shifts of the AS Path
Examples includes the Mexican peso devaluation in late 1994, and the sudden increase in nominal oil prices in the 1970s.
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The Aggregate Supply The Aggregate Supply PathPath Right and Left Shifts of the AS Path
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The Aggregate Supply The Aggregate Supply PathPath Right and Left Shifts of the AS Path
An increase in productive capacity will shift the AS path to the right; a decrease will shift it to the left.
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The Aggregate Supply The Aggregate Supply PathPath Right and Left Shifts of the AS Path
Productive capacity is determined by technology, available resources (including labor and capital), institutions, and regulations.
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The Aggregate Supply The Aggregate Supply PathPath Right and Left Shifts of the AS Path
Although it is subject to debate, and increase in the first two would move the AS curve to the right; and increase in the latter two would move it to the left.
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The Aggregate Supply The Aggregate Supply PathPath Right and Left Shifts of the AS Path
Expectations of any of the above can also shift the AS curve to the right or left.
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Shifts of the AS PathShifts of the AS PathP
rice
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AS path
Real output
(a) Up and down shifts
Pri
ce le
vel
Real output
(b) Right and left shifts
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Shifts of the AS PathShifts of the AS PathP
rice
leve
l
AS path
Real output
(a) Up and down shifts
Pri
ce le
vel
Real output
(b) Right and left shifts
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Shifts of the AS PathShifts of the AS PathP
rice
leve
l
An upward shift
AS path
Real output
(a) Up and down shifts
Pri
ce le
vel
Real output
(b) Right and left shifts
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Shifts of the AS PathShifts of the AS PathP
rice
leve
l
An upward shift
AS path
AS path
Real output
(a) Up and down shifts
Pri
ce le
vel
Real output
(b) Right and left shifts
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Shifts of the AS PathShifts of the AS PathP
rice
leve
l
An upward shift
AS path
AS path
Real output
(a) Up and down shifts
Pri
ce le
vel
Real output
(b) Right and left shifts
An outward shift
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Equilibrium in the Equilibrium in the Macro Policy ModelMacro Policy Model Equilibrium is achieved when the AED
curve intersects the AS path.
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Equilibrium in the Equilibrium in the Macro Policy ModelMacro Policy Model Equilibrium is achieved when the AED
curve intersects the AS path. If either of the two curves shift, the
equilibrium will change.
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Equilibrium in the Equilibrium in the Macro Policy ModelMacro Policy Model An initial shift factor will move the AED
curve more than the magnitude of the shift factor because of the multiplier effect.
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The Basic Macro Policy The Basic Macro Policy ModelModel
Pri
ce le
vel
AED
Real output
(a) Equilibrium in the macro policy model
Equilibrium
AS path
Potential output
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The Basic Macro Policy The Basic Macro Policy ModelModel
Pric
e le
vel
P2
Pe
AED1AED0
AED2
Q1 Qe Q2Q
Real output
(b) Shifts in the AED curve
AS path
3
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The Basic Macro Policy The Basic Macro Policy ModelModel
Pri
ce le
vel
P1
Pe
AED
Q1 Qe
Real output
(c) Shifts in the AS path
AS path 2
AS path 1
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Alternative Shifts
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Alternative Shifts
In Range A, the economy is below its potential income.
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Alternative Shifts
In Range A, the economy is below its potential income.
A policy of increasing aggregate equilibrium will expand output and create jobs without inflation.
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Alternative Shifts
In Range B, an increase in aggregate equilibrium demand will cause both the price level and real output to rise.
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Alternative Shifts
The problem in Range B is that by achieving a higher output (a desired goal) you have to move away from another desired goal—price-level stability.
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Alternative Shifts
In Range C, the equilibrium of the economy is at its potential income.
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Alternative Shifts
In Range C, the equilibrium of the economy is at its potential income.
The AS path is vertical.
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Alternative Shifts
In Range C, the equilibrium of the economy is at its potential income.
In this range, any increase in aggregate equilibrium demand will not bring about any increase in real output or additional jobs.
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Alternative Shifts
In Range C, the equilibrium of the economy is at its potential income.
It will simply cause the price level to rise.
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Adjustment in the Adjustment in the Three Ranges of the AS Three Ranges of the AS
PathPath
Pric
e lev
el
P0
Q0
AED0 AED1
Q1
(a) Range A adjustment
Real output
AS path
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Adjustment in the Adjustment in the Three Ranges of the AS Three Ranges of the AS
PathPathP
ric
e l
ev
el
P 1
P 0
AED0
AED1
Q 1Q '1Q 0
Real output
(b) Range B adjustment
AS path
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Adjustment in the Adjustment in the Three Ranges of the AS Three Ranges of the AS
PathPath
Pric
e le
vel
P1
Q1
AED1
AED0
Q0
Real output
P0
(c) Range C adjustment
Potential income
Short-run AS path
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Some Additional Examples
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Some Additional Examples
Shifts in aggregate equilibrium demand and the aggregate supply path can affect the price level and real output.
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Macro Policy in the Macro Policy in the Macro Policy ModelMacro Policy Model Some Additional Examples
How it does so depends upon the shift as well as where the economy is before the shift.
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The Macro Policy Model The Macro Policy Model in Actionin Action
Pric
e le
vel
Initial shock
90
30
AED0
P0
Q0 Q1
Real output
(a) The macro policy model in the fixed price-level range
AED1
AS path
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The Macro Policy Model The Macro Policy Model in Actionin Action
Pric
e le
vel P1
Pe
AS path
AED1
AED0
Qe
Real output
(b) The macro policy model at potential output
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Economists have no way of precisely
knowing for sure what range the economy is in, or precisely where the correct target level of potential output is.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks One way to determine potential income
is to take the economy’s previous income level and add the normal growth factor of 3 percent (the trend growth rate).
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks One way to determine potential income
is to take the economy’s previous income level and add the normal growth factor of 3 percent (the trend growth rate). This method is problematic if shift
factors are changing quickly or dramatically.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks In some cases, the economy may be
undergoing significant structural readjustment.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks In some cases, the economy may be
undergoing significant structural readjustment. The economy is trying to change from
what it has been doing to something new, not repeat what it did in the past.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The United States in the mid-1990s
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The United States in the mid-1990s The economy was expanding slowly with
structural unemployment rampant.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The United States in the mid-1990s It was thought that 6 percent
unemployment was the threshold for inflation to begin, and when the unemployment rate hit 5 percent with no inflation, economists lost face.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
Canada in the mid-1990s
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
Canada in the mid-1990s Unemployment was 9 percent—high by
normal standards—while inflation was 2 percent.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
Canada in the mid-1990s Most economists saw the AS path close to
vertical, so that any expansion in the economy would be inflationary.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
Japan in the late 1990s
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
Japan in the late 1990s Unemployment was 3 percent, while
inflation was well below 1 percent.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
Japan in the late 1990s While it would seem the Japanese
economy was in Range C, most economists believed their economy had room for expansion since it was in Range B.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The EU in the mid-1990s
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The EU in the mid-1990s Unemployment was above 10 percent so
it would seem that the economy was in Range A.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The EU in the mid-1990s There was major economic restructuring
going on with social welfare programs significantly reducing peoples’ willingness to work.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The EU in the mid-1990s Economic theory could not explain what
range the EU was actually in.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The formerly socialist countries
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The formerly socialist countries Structural change in these nations is
especially critical.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The formerly socialist countries Output has fallen by 40 to 50 percent.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Some Examples
The formerly socialist countries As they struggle to create new
institutional structures, past data are meaningless.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Debates About Potential Income
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Debates About Potential Income
Since the problems of estimating the target level of potential income remain, some economists argue that the best estimate of potential income is the actual income in the economy.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Debates About Potential Income
Their Classical supply-side explanation is called a real business cycle theory, which sees all changes in the economy as real shifts—shifts in potential income—that reflect real causes such as technological changes or shifting tastes.
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Macro Policy is More Macro Policy is More Complicated Than It Complicated Than It LooksLooks Debates About Potential Income
For a real business cycle theorist, the economy is always in Range B.
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Conclusion and a Look Conclusion and a Look AheadAhead Classicals Believe:
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Conclusion and a Look Conclusion and a Look AheadAhead Classicals Believe:
In laissez-faire policies
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Conclusion and a Look Conclusion and a Look AheadAhead Classicals Believe:
In laissez-faire policies The AS path is vertical.
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Conclusion and a Look Conclusion and a Look AheadAhead Keynesians Believe:
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Conclusion and a Look Conclusion and a Look AheadAhead Keynesians Believe:
In activist policies
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Conclusion and a Look Conclusion and a Look AheadAhead Keynesians Believe:
In activist policies The AS path is flat
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Conclusion and a Look Conclusion and a Look AheadAhead Most economists are a combination of
the two.
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The Modern The Modern Macroeconomic DebateMacroeconomic Debate
End of Chapter 10