Keynesian Short-Run Model Study Guide

Chapter 8: Keynesian Short-Run Model

Demand-Side Policies

Introduction to the AD/AS Model

• The AD/AS (Aggregate Demand/Aggregate Supply) model consists of three curves:

  • Aggregate Demand (AD)

  • Short-Run Aggregate Supply (SAS)

  • Long-Run Aggregate Supply (LRAS)

• These curves are graphed with the price level on the Y-axis and GDP (Y) on the X-axis.

Goods Market

• Definition: The market for goods and services in the entire economy.

• Influencing Factors: This market depends on purchases made by various actors in the economy:

  • Consumers

  • Firms

  • Government

  • The Rest of the World

Aggregate Demand (AD)

• Aggregate Demand: Total demand for goods and services in an economy by all parties.

• Formula: $AD = C + I + G + (X - M)$

  • Where:

  • $C$ = Consumption

  • $I$ = Investment

  • $G$ = Government Spending

  • $X$ = Exports

  • $M$ = Imports

Components of GDP

1. Consumption (C)

   • Represents goods and services purchased by consumers.

   • Largest component of GDP.

2. Investment (I)

   • Refers to the purchase of new capital goods by firms.

   • Includes residential investment (e.g., new homes).

   • Focus: Future production or housing needs.

3. Government Spending (G)

   • Total expenditures by government on goods and services.

   • Includes spending at local, state, and federal levels.

   • Excludes transfers (e.g., Social Security, Medicare) because these do not count as purchases.

4. Exports (X)

   • Purchases of US goods by foreigners.

5. Imports (M)

   • Purchases of foreign goods and services by US residents, firms, and government.

   • Net Exports: Defined as $NX = (X - M)$

     • Trade Balance:

     • If X > M, the economy experiences a trade surplus.

     • If X < M, the economy experiences a trade deficit.

Characteristics of the Aggregate Demand Curve

• The AD Curve is graphed with the price level (Y-axis) and aggregate output (Y or GDP - X-axis).

• The AD curve depicts how changes in the price level influence aggregate expenditures across the economy.

Slope of the AD Curve

• The AD curve is downward sloping due to:

  • Wealth Effect: Changes in the price level affect consumers' real wealth, thereby influencing their consumption.

  • Interest Rate Effect: Variations in the price level affect interest rates, impacting consumption and investment behavior.

  • International Effect: Shifts in domestic price levels influence exports and imports, affecting net exports.

Factors Influencing Consumption

• Normal Goods: For most goods, consumption rises when income increases.

• Disposable Income (Yd): Income after taxes and transfers. Defined as: $Yd = (Y - T)$

  • Consumption varies with disposable income.

• Impact of Falling Prices:

  • Decreased prices allow consumers to purchase more goods without an increase in income, resulting in enhanced wealth perception leading to increased consumption.

  • Money Wealth Effect: A decrease in overall price levels makes money holdings feel more valuable, prompting increased purchasing behavior.

Investment Dynamics

• Investment: Spending aimed at increasing production capacity.

• Investment often requires borrowing, influenced by interest rates (
  defined as the price of money).

• Real Interest Rate (r): Represents interest rates across various levels, demonstrating a correlation between interest rates and investment levels.

• Interest Rate Effect of Price Level:

  • Falling price levels increase consumers' leftover money, enhancing savings, leading to lower interest rates, ultimately promoting investment and aggregate demand (AD).

Government Spending and Net Exports

• Government Spending (G) is an amount spent annually, not influenced by income or interest rates.

• Net Exports (NX): Depend on product prices and currency valuations.

• A reduction in price levels, assuming stable exchange rates, will raise demand for US exports, benefiting net exports.

Shifts in Aggregate Demand Curve

• Shifts in the AD curve arise from:

  1. Fluctuations in foreign incomes: If a trading partner enters a recession, a decline in demand for US goods follows.

  2. Changes in exchange rates.

  3. Distribution of income: Consumer behaviour versus corporate profit allocation.

  4. Expectations affecting consumer confidence and pricing above typical.

  5. Fiscal and monetary policies adjustments.

Aggregate Supply: Short-Run Dynamics

• The Short-Run Aggregate Supply (SAS) is typically upward sloping; businesses increase output as price levels enhance potential profits.

• Shifts in the SAS Curve are driven by production costs changes, encompassing:

  1. Input prices (e.g., wage changes or supply shocks).

  2. Productivity variations.

  3. Costs of imported intermediate goods integral to the production process.

Wages and Prices Relationship

• Wages and prices are linked through the following:
  %Change in price level = %Change in wages - %Change in productivity.

• Implications: Rising wages without productivity increases lead to heightened prices as firms transmit costs onto consumers.

Long-Run Aggregate Supply Curve (LRAS)

• The LRAS curve establishes the long-term interplay between output and price level.

• Positioning is contingent upon Potential Output: Maximum production level achievable when capital and labor utilization is optimal.

• The LRAS curve is vertical, indicating price level changes have no effect on potential output.

Characteristics of LRAS Curve

• The LRAS curve correlates to potential output (Yp), where:

  • Businesses operate at capacity.

  • Full employment indicates unemployment at the natural rate.

• Natural Rate of Unemployment: The lowest sustainable unemployment rate based on current demographics and economic structure.

Shifts in the LRAS Curve

• Factors influencing long-term potential output include:

  1. Capital accumulation (financial, physical, human).

  2. Resource availability (e.g., new natural resource discoveries).

  3. Technological advancements boosting productivity.

  4. Entrepreneurial developments through innovation and research.

Relationship Between GDP and Unemployment

• The correlation between GDP changes and unemployment rates can be illustrated graphically:

  • An increase in GDP (Y) results in a decrease in unemployment.

  • Conversely, a decline in GDP corresponds with rising unemployment levels.