Keynseian Income and Expenditure Model 7

The Keynesian Income and Expenditure Model

• The AD-AS model is a tool used to analyze economic fluctuations
• Monetary and fiscal policy can stabilize the economy

Short-Run Macroeconomic Equilibrium

• The AD-AS model utilizes aggregate supply and demand curves to analyze economic fluctuations
• The economy is in short-run macroeconomic equilibrium when aggregate output supplied equals aggregate output demanded (ESR)
• Short-run equilibrium inflation rate is denoted as πE
• Short-run equilibrium aggregate output is denoted as YE

Demand Shock

• An event that shifts the AD curve
• A shift of the AD curve can be either a negative or a positive demand shock

Supply Shock

• An event that shifts the SRAS curve
• A shift of the SRAS curve can be either a negative or positive supply shock

Long-Run Macroeconomic Equilibrium

• The economy is in long-run macroeconomic equilibrium when the short-run macroeconomic equilibrium is on the LRAS curve

Recessionary and Inflationary Gaps

• Recessionary gap: aggregate output is below potential output
• Inflationary gap: aggregate output is above potential output
• Output gap: the percentage difference between actual and potential aggregate output
• Output gap is calculated as follows:
  • Output gap = (Actual aggregate output − Potential output) / Potential output × 100

Demand Shock Example 1

• Initial negative demand shock
• This reduces π and aggregate output, leading to higher unemployment in the short run (a recessionary gap)
• Until an eventual fall in 𝑾 in the long run increases 𝑆𝑅𝐴𝑆, and moves the economy back to potential output
• Long-run macroeconomic equilibrium is restored at 𝐸3

Demand shock example 2

• Initial positive demand shock
• Increases 𝝅 and aggregate output, leading to lower unemployment in the short run (an inflationary gap)
• Until an eventual increase in 𝑾 in the long run decreases 𝑆𝑅𝐴𝑆 and moves the economy back to potential output.
• Long-run macroeconomic equilibrium is restored at 𝐸3

Practice Question 1

• In short-run equilibrium, if real GDP is less than potential output, then nominal wages fall in the long run and the SRAS curve shifts right, restoring the economy to potential output

Practice Question 2

• If short-run equilibrium real GDP is greater than potential output:
  • Nominal wages will have to adjust upward as the economy moves from the short run to the long run
  • The level of unemployment is very low
  • Jobs are plentiful
  • To reach long-run equilibrium, the SRAS curve will shift to the left, resulting in a higher aggregate price level

Macroeconomic Policy

• The economy is self-correcting in the long run, typically taking a decade or more
• Economists advise governments not to wait for the economy to self-correct and to use monetary and fiscal policy to return the economy to potential output
• Stabilization policy: the use of government policy to reduce the severity of recessions and restrain excessively strong expansions

Policy for Demand Shocks

• Negative demand shock: instead of waiting for SRAS to increase in the long run, policymakers can react quickly to the fall in AD
  • The government could make the economy stay at the original equilibrium by shifting AD to the right
• Positive demand shock: instead of waiting for SRAS to increase in the long run, policymakers can react quickly to the increase in AD
  • The government could make the economy stay at the original equilibrium by shifting AD to the left
• Macroeconomic policy is desirable because:
  • The temporary fall in aggregate output is associated with high unemployment
  • It Prevents deflation
• Policy makers should always act to offset declines in aggregate demand, but not necessarily because:
  • Some policy measures may have long-term costs in terms of lower long-run growth (budget deficits, for example).
  • Policy makers are not perfectly informed, and the effects of their policies are not perfectly predictable, which creates the danger that stabilization policy will do more harm than good

Policy for Supply Shocks

• Example: A negative supply shock leads to π↑ and unemployment ↑ and poses a policy dilemma:
  • Stabilization of unemployment requires an increase in aggregate demand, which leads to inflation
  • Stabilization of prices requires a decrease in aggregate demand, which leads to higher unemployment