Chapter 25: Aggregate Demand, Aggregate Supply and Modern ...€¦ · Web viewb.Austrians would favor an institutional system that had far less government involvement and left the

CHAPTER 8: THE SHORT-RUN KEYNESIAN POLICY MODEL: DEMAND-SIDE POLICIES

Questions and Exercises

1. According to Keynesians, the economy could deviate from its potential because if aggregate demand falls for some unexplained reason, firms would respond by decreasing output and laying off workers, which lowers people’s income. Lower income leads consumers to cut expenditures further, which once again causes firms to decrease production. So the fall in aggregate demand creates a cycle that feeds on itself and can develop into a vicious downward spiral in which output is less than potential. Note that a similar virtuous upward spiral in hiring, income, and expenditure can explain an output level above an economy's potential.

2. As prices fall during deflation, profits decline, making entrepreneurs hesitant to start businesses, thus slowing the growth of the economy. Asset values (prices of assets such as houses, stocks, and bonds) also decline, thus reducing the value of collateral to support consumer and producer loans and therefore spending. Both of these effects will lead to lower output.

3. The paradox of thrift is the notion that an increase in saving can lead to a decrease in expenditures, which can lead to decreasing supply, decreasing output, causing a recession, and lowering total saving. Government has a role in offsetting the cycle of declining expenditures and production.

If the paradox of thrift holds, increasing savings will lower aggregate income and set in motion a cycle of declining expenditures and production. This will reduce income far enough so that once again saving and investment will be in equilibrium, but then the economy will be in an almost permanent recession, with ongoing unemployment. Keynesians believe that in this case the economy will need government's help to prop up aggregate expenditures.

4. One expects the AD curve to be vertical because when the price level rises, all prices rise together. That is, since wages have risen as much as prices for consumer goods, no relative prices have changed and therefore people’s decisions to consume should not have changed either.

5. a. A rise in the price level reduces the value of cash people hold. They withdraw more from their banks to regain that value, which reduces the amount banks have to lend. Thus, interest rate rises, which reduces investment expenditures. All of these factors lower aggregate quantity demanded.

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b. Assuming fixed exchange rates, a rise in the price level would make goods less internationally competitive. This would lead to a decrease in net exports, lowering aggregate quantity demanded.

c. When there is a rise in the price level, the holders of money become poorer so they will buy less, lowering aggregate quantity demanded.

6. Five factors that shift the AD curve are: (1) changes in foreign income, (2) changes in expectations, (3) changes in exchange rates, (4) changes in the distribution of income, and (5) changes in fiscal and monetary policies. (Note that the multiplier amplifies the effects of these initial shift factors. It is not the initial cause of a shift, so is not included in the list.)

7. When the price level falls real GDP increases because of the interest rate, international, and money wealth effects. However, a falling price level could reduce aggregate demand (shift the demand curve to the left) by more than the lower price level increases the quantity of aggregate demand. This is because a lower price level brings with it expectations of falling aggregate demand and lower asset prices.

8. a. The AD curve will be steeper because a change in the price level will be offset by a change in the exchange rate eliminating the international effect on the AD curve. Note that the exchange rate, the money wealth effect, and international effect all help explain why the aggregate demand curve is not vertical, so any reduction in these three effects would make the aggregate demand curve steeper or closer to a vertical line.

b. The AD curve will become steeper if a fall in the price level doesn't make people feel richer since the fall in the price will not cause them to increase their expenditures. This is an example of the money wealth effect not holding true.

c. The AD curve will be steeper if a fall in the price level creates expectations of a further fall in the price level (it may even be backward bending) since the fall in the price level will cause people to reduce their present expenditures in the hope of getting more for their money in the future.

d. Assuming that poor people spend a higher percentage of their income than rich people (as suggested by the data), the AD curve will shift to the right.

e. The AD curve will shift to the right by a multiple of 20 (the multiplier effect).

f. The AD curve will shift to the left by a multiple of 10 (the multiplier effect).


9. Two factors that shift the SAS curve are changes in productivity and changes in input prices.

10. a. The SAS curve will shift up, with inflation equal to 1 percent since wages rise by more than the rise in productivity.

b. The SAS curve will shift down, with inflation equal to -2 percent (deflation) since productivity rises by more than the rise in wages.

c. The SAS curve will shift up, with inflation equal to 2 percent since wages rise and productivity declines.

d. The SAS curve will not shift since the wage increase is exactly offset by a productivity increase.

11. The LAS curve is vertical because potential output depends on the capacity for production, not the price level. In the long run, output is independent of the price level.

12. a. An increase in the availability of inputs will shift the LAS curve to the right. The SAS curve will not shift initially.

b. A civil war will presumably destroy productive capacity or otherwise halt production and cause a shift in the LAS curve to the left. In the short run, it will also increase the prices of inputs and increase inflationary expectations, shifting the SAS curve up.

c. If wages that were fixed become flexible and aggregate demand increases, the SAS curve will shift up as wages rise. The LAS curve does not shift.

13. If the economy is in short-run equilibrium below potential output, underutilization of inputs will cause input prices to fall, causing the short-run aggregate supply curve to shift down and the price level to fall. This will set the money wealth, interest rate, and international effects in motion, increasing the quantity of aggregate demand and thereby bringing the economy into long-run equilibrium at potential output.

14. a. This implies that productivity is increasing significantly. If computers are a large portion of the economy, and wages do not rise by the full amount of the productivity increase, the result will be to lower the price level and increase output.


b. In terms of the AS/AD model, this shifts the SAS curve down. It can also shift out the potential output (LAS) curve to the right, increasing equilibrium potential output and lowering the price level.

15. a It is likely that the rise in oil prices will shift the SAS curve up and the drop in world income will shift the AD curve in, causing equilibrium income to fall even more below potential (from point A to point B in the accompanying graph).

b. We might suggest expansionary fiscal and monetary policy to shift the AD curve out (from AD0 to AD2) and bring equilibrium output to its potential at point C. We would caution the government about the possible inflationary consequences, but since the economy is significantly below potential, we would argue that it is a risk worth taking.

16. a. The slowing of foreign economies will reduce exports, shifting the AD curve to the left by a multiple of the initial decline in exports (from AD0 to AD1 in the accompanying graph). You should recommend that the government increase expenditures by an amount equal to the initial decline in exports. This will shift the AD curve back to its initial position, as shown in graph (a).

b. An economy operating above potential output is shown by point A in graph (b). To keep the inflation from rising (the SAS curve from shifting up), the government should reduce expenditures enough (shifting the AD curve from AD0

to AD1) to bring the economy back to long-run equilibrium at potential output, YP, and the price level, P1, as shown.

c. A new technology that increases potential output will shift the LAS curve to the right (from LAS0 to LAS1), as shown in graph (c), creating excess capacity and downward pressure on factor prices. If left alone, the price level will fall and real output will rise. If the government wants to keep the price level constant, or if it wants to take advantage of a faster increase in aggregate demand, it can increase expenditures enough to increase output to the new potential (shifting the AD curve from AD0 to AD1).


17. When the price level falls, people may expect aggregate demand to decline because falling asset prices reduce people’s wealth. In addition, falling asset prices might lead to banks calling in loans, which will reduce investment. Both of these shift the aggregate demand curve to the left, offsetting the effect of a falling price level on the quantity of aggregate demand. As the SAS curve begins to shift from SAS0 to SAS1, the price level falls and the economy begins to move toward point B. But the aggregate demand curve then shifts to the left from AD0 to AD1 as a result of the price level decline. The economy then moves toward point C. Without government intervention this cycle of falling prices and falling aggregate demand can continue indefinitely.

18. To design an appropriate fiscal policy, it is important to know the level of potential output because where the economy is relative to that potential tells you whether to implement expansionary or contractionary policy. Conducting fiscal policy without having an estimate of potential output would be like driving without being able to see the road.

19. The simple model abstracts from a number of important issues such as the problem of estimating potential income. Without knowing potential income, we cannot know whether expansionary or contractionary policy is called for. Also, dynamic price level adjustment feedback effects are ignored. Finally, the model does not take into account the difficulties in implementing fiscal policies and the uncertain effectiveness of those policies.


20. Countercyclical fiscal policy is difficult to implement because it is difficult to assess the condition of the economy at any one time. Furthermore, it takes a long time to enact new government policies and it is politically difficult to raise taxes when the economy is doing well (or at any time). Often times, politics, not the needs of the economy, guide tax and spending decisions.

Questions from Alternative Perspectives

1. Austriana. It could be consistent with the AS/AD model if one sees the SAS and AD curves

driven by expectations, and agrees that the expectation of government involvement shifted both back to the left.

b. Austrians would favor an institutional system that had far less government involvement and left the market to self-correct, whereas the ideas put forward in this book advocate for government intervention when necessary.

2. Institutionalista. When oil production declines, the production possibility curve shifts in, the LAS

curve shifts in to the left and the result is an increase in the price level. An increase in AD will offset the resulting unemployment but cause even more inflation. Declining physical output will make investment in alternative resources more costly (greater opportunity cost in terms of consumption goods).

b. What will happen depends on why oil production declines. If the decline is due to lower demand, then the price will fall and oil producers will be hurt. If the decline is due to a decline in supply, then the price of oil will rise and consumers will be hurt. In either case society may be better off if the decline causes less global warming.

3. Post KeynesianWhile Minsky predicted many of the current problems, he did not predict the timing of those problems, which allows people to argue that his theory is not generally applicable, but is simply a theory that is right only some of the time. The existing theory is also tied to income of individuals, and to adopt a different theory would likely lead to changes that would undermine the existing income and institutional power structure. Thus the economics profession, which is supported by the current institutional power structure, continues to teach the current theory in order to protect its income.


4. Radicala. The graph shown at the right shows the situation where aggregate demand has

been reduced. The excess capacity is shown by the gap between the quantity of aggregate demand and the potential output at the price level. If the price level is flexible, there is no problem. A decline in one of the components of aggregate would shift the AD curve to the left, creating excess capacity.

b. What should be done is a judgment question and judgments differ. Classicals tend to believe that the economy should be left to itself, allowing the price level to fall. Radical economists believe that the easiest and best policy is for the government to increase aggregate demand to restore full employment.

c. It suggests that the model (positive economics) embodies in it certain biases toward specific policies. For example, the AS/AD model suggests that if the wage and price level were flexible, the problem of unemployment would not exist.

d. While some measure of value judgment is inherent in positive economics, it attempts to be less value laden than normative economics, which is explicitly value laden. So, ideally, positive economics is less value laden. However, to the degree that values are hidden in the assumptions of positive models, the application of those models may be more value laden since the values are not laid out as they are in normative economics.

Issues to Ponder

1. a. Keynes used models not in a mechanistic way, but in an interpretive way. He was a Marshallian who saw economic models as an engine of analysis, not an end in and of themselves.

b. It fits in nicely with the “other things constant” assumption since the policy relevance of theory follows only when one has eliminated that assumption and taken into account all the things held at the back of one’s mind.

c. Keynes’ interest definitely was primarily in the art of economics since the above method is the method used in the art of economics. Keynes was interested in


using well thought out theories and models to develop policies that would help society fulfill its goals.

2. Yes, the closer the economy is to a high potential output, the more policy makers would emphasize the inherent value of the program rather than discussing the program’s effect on aggregate demand. This is because programs that increase aggregate demand when the economy is close to potential output will ultimately lead to inflation and little increase in real output.


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Chapter 25: Aggregate Demand, Aggregate Supply and Modern ...€¦ · Web viewb.Austrians would favor an institutional system that had far less government involvement and left the