Frank & Bernanke Ch. 13: Aggregate Demand and Output in the Short Run.

Frank & BernankeFrank & Bernanke

Ch. 13: Aggregate Demand and Output in the Short Run

(Neo) Classical Theory(Neo) Classical TheoryMarkets always clear.When Supply does not equal to Demand,

price changes to equate the two.Labor market works the same way, too.In the 19th century, general price levels

sometimes went up and sometimes down but there hasn’t been any trend.

The Great DepressionThe Great DepressionLiving through the Great Depression,

people rightfully questioned the received wisdom of economists.– If markets tended to clear, why did the labor

market show up to 25% unemployment?The 1936 publication of The General

Theory of Employment, Interest and Money by John Maynard Keynes provided an explanation for markets not to clear in the short run.

The Model by KeynesThe Model by KeynesPrices (including the price of labor - wages) do

not change in the short run.Firms respond to demand changes by adjusting

their production and keeping the price constant.

Demand changes occur all the time and the structure of the economy changes as the demand for say, horse carriages fell and trains and cars rose. This would not affect labor.

The Model by KeynesThe Model by KeynesIf the total spending (aggregate demand) fell,

then almost all markets would feel the drop in demand.

Production in general would fall.Recession (and depression) would be felt.To avoid this aggregate demand shortfall, the

government should step in and by the use of monetary and fiscal policies, should stimulate total spending.

Why Are Prices Constant in Why Are Prices Constant in the Short Run?the Short Run?

Menu costs.Fear of uncertainty.Contracts.Information lag.

Constant Price Means Wide Constant Price Means Wide Output FluctuationsOutput Fluctuations

P

Q

S

Q1 Q2

Circular Flow ExplanationCircular Flow Explanation

Firms Households

Consumption Expenditures

Wages, profits, rent, interest

If the upper flow (C+I+G+NX) is LESS THAN the lower flow (Income = Value of Output), inventories will pile up (I>Ip) and the firms will cut back in production. If the upper flow is MORE THAN the lower flow, inventories will fall below the desired level (I<Ip) andthe firms will increase production.

Circular Flow ExplanationCircular Flow Explanation

Firms Households

Consumption Expenditures

Wages, profits, rent, interest

The upper flow is the aggregate demand: C+I+G+NX. The lower flowis Output: Y. When Aggregate Demand is <Y and also Y* there is a positive output gap (Y*-Y>0) and the economy has slowed down. When I<Ip, C+I+G+NX is greater than Y, or Y>Y* and there isan expansionary (negative) output gap.

Aggregate Demand Aggregate Demand FluctuationsFluctuations

Consumption expenditures fluctuate.– Confidence, fear levels, demography, wealth,

taxes, etc. change.Investment expenditures fluctuate.

– Optimism/pessimism about the future; interest rate changes.

Government expenditures change.– Budget items, wars…

Net Exports change.– Demand for our exports or exchange rates change.

Algebraic Short Run Algebraic Short Run EquilibriumEquilibrium

Y = C + I + G + NX (Output=Aggregate Demand)C = a +c (Y-T)(Consumption=Autonomous+c*Disposable Income)

c = MPC = Change in Consumption/Change in Disposable Income

Y = a +cY -cT + I + G + NX

Y = (a + I +G + NX - cT) + cY Aggregate Demand Function is comprised of autonomous and induced parts.Y = [1/(1-c)][a+I+G+NX-cT]Equilibrium income is multiplier times autonomous expenditures.

Numerical Short Run EquilibriumNumerical Short Run Equilibriuma=400; c=0.8; I=300; G=250; NX=10; T=200

Y AggregateDemand

0 800500 12001000 16001500 20002000 24002500 28003000 32003500 36004000 40004500 44005000 48005500 52006000 5600

Graphical Short Run EquilibriumGraphical Short Run Equilibrium

800

4000 Y

AD

Slope=3200/4000=0.8

AD

C

240

1990-91 Recession1990-91 RecessionIraq’s invasion of Kuwait forced oil prices

to shoot up and dampened consumer confidence.

The Savings and Loan Debacle forced many banks to bankruptcy and created a credit crunch.

Both C and I dropped.

2001 Recession2001 RecessionBoth NASDAQ and NYSE dropped

precipitously.During 1999-2000, the Fed increased

interest rates by 50%.Wealth loss => C drop.Stock market drop => I drop.Interest rate rise => I drop.

MultiplierMultiplierIf a and I drops, what will happen to Y?Y = [1/(1-c)][a+I+G+NX-cT]One can plug in the new values and find Y.One can take the “Change in Y” to be equal

to [1/(1-c)]*Change in a+I.One can show the effect graphically by

shifting AD downward.

MultiplierMultiplierSuppose a dropped from 400 to 350, and I

dropped from 300 to 250. Find the new equilibrium Y.

Y = [1/(1-c)][a+I+G+NX-cT]Y = 5 (700) = 3500Y = 5 (-100) = -500

Graphical Short Run EquilibriumGraphical Short Run Equilibrium

800

4000 Y

ADAD

700

3500

Role of Fiscal PolicyRole of Fiscal PolicyIn the Keynesian system, it is obvious that

in response to changes in C, I, and NX, government can counter them by changing G or T.

If a+I fell by 100, how much G should change to keep Y=4000?

If a+I fell by 100, how much T should change to keep Y=4000?

Limitations of Fiscal PolicyLimitations of Fiscal PolicyLags.Political considerations.Effects on potential output.

– Savings changes– Investment changes.

Automatic StabilizersAutomatic StabilizersWithout any act by the Congress, fiscal

measures kick in to keep Y close to Y*.– Income taxes.– Unemployment insurance.– Welfare payments.– Recession aid transfers.