Chapter 25

Chapter 25: The Short-Run - The Keynesian Perspective

1. Motivation

  • The AS/AD model helps explain real GDP growth, inflation, and unemployment.

  • Short-run economic fluctuations explained with Keynesian assumptions (Chapter 25).

  • Long-run economic trends explained with Neo-Classical assumptions (Chapter 26).

2. Outline of Key Sections

  1. Motivation

  2. Determinants of C (Consumption), I (Investment), G (Government Expenditure), and NX (Net Exports)

    • Section 25.1

  3. Keynesian Assumptions

    • Section 25.2

  4. The Short-Run Phillips Curve

    • Section 25.3

  5. Government AD Manipulation

3. Overview of Economic Theories

  • Neoclassical vs. Keynesian Economics

    • Short-term focus vs. long-term focus.

    • Prices & wages: flexible (Neo-Classical) vs. sticky (Keynesian).

    • Output: Aggregate supply primarily vs. Aggregate demand determined.

    • Phillips Curve:

      • Neo-Classical: Vertical.

      • Keynesian: Downward-sloping.

    • Aggregate demand effectiveness in controlling inflation is limited in the long-run but useful in the short-run to reduce unemployment.

4. Keynesian Assumptions Summary

  1. Sticky Wages and Prices: Nominal wages do not change frequently leading to fixed short-term price levels.

  2. Demand-Driven Output: Economic downturns relate to low demand rather than supply fluctuations.

5. Determinants of C, I, G, and NX

A. Determinants of Consumption (C)

  1. Disposable Income: Yd = (Y - T); higher disposable income increases consumption.

  2. Expected Future Income: Higher expectations increase current consumption.

  3. Wealth: Increases in wealth lead to increased consumption.

  4. Interest Rates: Higher rates decrease consumption due to higher costs of borrowing.

  5. Preference Shifts: Changes in societal preferences for consuming or saving.

B. Determinants of Investment (I)

  1. Business Confidence: Optimism leads to more investment in capital goods.

  2. Interest Rates: Lower rates encourage borrowing and investment in capital.

C. Determinants of Government Expenditures (G)

  • Viewed as exogenous; can be altered by political choices.

  • Automatic stabilizers (e.g., unemployment insurance) adjust government spending based on economic conditions.

D. Determinants of Net Exports (NX)

  1. Foreign Demand: Increases in foreign income raise demand for exports.

  2. Relative Prices: Changes in prices affect the competitiveness of Canadian goods abroad.

6. Aggregate Demand Changes

A. Reasons for Increase in AD

  • Decrease in taxes, increase in income, fall in interest rates, rise in wealth, and higher future expected income.

B. Reasons for Decrease in AD

  • Increase in taxes, fall in income, rise in interest rates, desire to save more, and decrease in wealth.

7. Short-Run Phillips Curve

  • Assumes a fixed price level leading to an upward-sloping AS curve.

  • Lower unemployment can lead to higher inflation creating a trade-off (the Phillips Curve).

  • Empirical evidence showed a negative relationship between unemployment and inflation in the 1950s, but post-1971, this relationship varied significantly.

8. Government Manipulation of Aggregate Demand

  • Government can influence AD to stimulate output and employment by increasing G or lowering T.

  • Significant historical events (e.g., 2008-09 recession) prompted fiscal stimulus policies to increase AD and combat unemployment.

9. Challenges of Government Intervention

  1. Recognition Lag: Delay in recognizing a recession.

  2. Measurement Uncertainty: Difficulty in determining actual levels of potential GDP.

  3. Implementation Lag: Slow execution of fiscal policies post-approval.

  4. Debt Concerns: The need to manage growing government debt, which can lead to increasing deficits.