Keynesian Income and Expenditure Model 6

Aggregate Demand

• From late 2007 to early 2009, the US and most of the world experienced a severe recession
• Economists agree that the recession resulted from a massive negative demand shock
• A negative demand shock causes a leftward shift of the aggregate demand curve (AD)
• The aggregate demand (AD) curve shows the relationship between inflation and aggregate output demanded by households, firms, the government, and the rest of the world
• The AD curve slopes downward; a lower inflation rate increases the quantity of aggregate demand, other things equal
• GDP (Y) can be expressed as: Y = C + I + G + (X – IM).
  • C, I, and (X – IM) are private sector decisions
  • G is government spending
  • Real GDP represents the quantity of domestically produced final goods and services
• A rise in inflation (π) reduces C, I, and (X – IM), causing the AD curve to slope downward
• A rise in π leads to a fall in Y due to the interest rate effect
• The interest rate effect states that higher prices leave less money for lending, pushing up interest rates
• Higher interest rates reduce both investment (I) and consumption (C)
  • Investment decreases with higher borrowing costs
  • Households save more due to higher interest rates, reducing consumption
• Prices are assumed to be fixed in the income-expenditure model
  • A fixed price level implies a fixed rate of inflation (π)
• A decrease in π will result in decreased interest rates, increased planned investment, and increased planned aggregate expenditure
• Planned aggregate expenditure increasing leads to increased output, leading to a multiplier process, which increases income-expenditure real GDP
• Change in expectations, wealth, the stock of capital, fiscal and monetary policy can shift the AD curve
• Government policies are composed of fiscal and monetary policy
• Changes in above factors start a multiplier process:
  • Initial change in real GDP leads to a change in disposable income (Yd), resulting in additional changes in aggregate spending and leading to further changes in real GDP

Factors that Shift the AD Curve

• If consumers/firms become more optimistic, aggregate spending rises; if pessimistic, it falls
• Increased real value of household assets raises purchasing power, increasing aggregate spending
• Firms plan investment based on their existing capital; the more they have, the less they need to add
• Government purchases of final G&S (G) directly affect the AD curve
• Taxes (T) and transfer payments (TR) influence the AD curve indirectly through their effect on Yd
• Increasing the quantity of money in circulation leads interest rates down

Aggregate Supply

• The 2008 recession brought a decrease in aggregate demand
  • GDP Deflator rose 2.6% in 2007, but only 0.1% in 2009
  • Production of G&S was 6% below its pre-crisis trend by mid-2009
  • Unemployment rate increased from 5% to 10%
• The US economy decreased its aggregate supply between 2007 and 2009
• The aggregate supply (AS) curve shows the relationship between the economy's inflation rate and total aggregate output producers are willing to supply
• There is the short-run aggregate supply curve (SRAS) and long-run aggregate supply curve (LRAS)
• There is a positive relationship between inflation (π) and real GDP in the short run

Short Run Aggregate Supply Curve (SRAS)

• Nominal wages are sticky in the short run
• Nominal wage (W) is the dollar amount of wage paid
• W is often determined by contracts, making firms reluctant to change wages with economic conditions
• Sticky wages refers to W being slow to change, slow to fall even in the face of high unemployment, and slow to increase even in the face of labor shortages
• W is not sticky forever; eventually, contracts expire and negotiations begin
• Fixed nominal costs explain an upward-sloping SRAS curve
• Prices are set differently depending on the markets
  • In perfectly competitive markets, firms are price takers
  • In imperfectly competitive markets, firms have some ability to choose their price
• In perfectly competitive markets, output increases with profit per unit (P ↑ → profit per unit ↑ → output ↑)
• In imperfectly competitive markets, firms will likely increase price and output when demand rises (D ↑ → firm will likely P↑ and output ↑)

SRAS Curve Shifts

• Commodity prices
  • A commodity is a standardized input bought and sold in bulk quantities, an increase in cost will decrease SRAS
• Expectations regarding nominal wage
  • Workers ask for high nominal wage when they expect higher inflation, also decreasing SRAS
• Productivity
  • An output with the same inputs will shift the SRAS curve to the right

Long Run Aggregate Supply Curve (LRAS)

• W is not sticky in the long run
  • Contracts are renegotiated fully and adjusts to π.
  • W and other prices are flexible.
• π does not affect the quantity of aggregate output supplied (real GDP)
• If prices are flexible, profit per unit = price per unit - production cost per unit
• The long-run aggregate supply (LRAS) curve shows the relationship between π and real GDP
  • Under the condition that all prices (including W) are fully flexible -The economy would produce real GDP, or potential output, only if all prices were fully flexible
• The LRAS curve is vertical and it represents significant measure.
• The level of real GDP is almost always either above or below potential because of short-run fluctuations
• Economies normally produce more or less than potential output
  • Early 1990s saw output below potential -Late 1990s saw output above potential
  • Most of the 2000s was below potential output
  • The 2008 recession saw output significantly below potential
• SRAS shifts over time until it crosses the LRAS curve, so the economy can increase real aggregate output to potential output making SRAS relevant
• At production point A1 and relatively low unemployment:
  • y1 > yP, only because πe has not caught up with π (π e < π)
• Once workers adjust their expectation, SRAS decreases:
  • πe ↑ → W ↑ → SRAS ↓
• At point A2 with relatively high unemployment: -y2 < yP , only because πe is higher than π
• Once workers adjust their SRAS increases -πe ↓ → W ↓ → SRAS ↑