Macro Theory:Macro Theory:

Dr. D. Foster – ECO 285 – Spring 2014

The AS/AD Model II -The AS/AD Model II -Keynesian VersionKeynesian Version

Warning .. Warning .. WarningWarning .. Warning .. Warning

• Aggregate Supply and Aggregate Demand are not Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!!like market supply & demand !!!!!

• The “static” analysis only hints at dynamic The “static” analysis only hints at dynamic interpretation.interpretation.

• Ceteris Paribus assumption problematic to the point Ceteris Paribus assumption problematic to the point of being wholly inappropriate.of being wholly inappropriate.

Keynesian model notes:Keynesian model notes:•Descriptive analysis.Descriptive analysis.•Some numerical interpretation.Some numerical interpretation.•Only AS/AD graphical Only AS/AD graphical representation.representation.

AS/AD Model – Short Run & Long RunAS/AD Model – Short Run & Long Run

AD shows demand from 4 AD shows demand from 4 sectors of economy.sectors of economy.

AS in LR shows full AS in LR shows full employment of resources.employment of resources.

AS in SR shows effect of AS in SR shows effect of inflexible wages.inflexible wages.

Keynesian Keynesian argumentargument

AD1

P

Q or R-GDP

ASLR

P1

AS1

Q*

AS/AD Model – Hints at 4 types of changesAS/AD Model – Hints at 4 types of changes

• Inflation with growth due Inflation with growth due to rising AD.to rising AD.

• Depression with deflation Depression with deflation due to falling AD.due to falling AD.

• Growth with deflation due Growth with deflation due to rising AS.to rising AS.

• Depression with inflation Depression with inflation due to falling AS. due to falling AS. (stagflation)(stagflation)

AD1

P

Q or R-GDP

ASLR

P1

AS1

Q*

The Keynesian PerspectiveThe Keynesian Perspective

•The short run is more important to us.•We live our lives through the SR not the LR and the LR may take too long!

•We need a theory of the SR to smooth out the business cycle.

•Equilibrium occurs whenplanned spending planned spending equalsrealized spendingrealized spending.

In fact, Keynes didn’t really have a business cycle theory (“animal

spirits”). He had a theory of how to deal with a business cycle.

The Keynesian ModelThe Keynesian Model

•Where there is no inflation/deflationno inflation/deflation,output = RGDP = Income (Y)

•Consumption is assumed to vary with income:C = CC = Caa + (mpc)*Y + (mpc)*Y

where Ca is “autonomous” consumption w.r.t. Ympc is the “marginal propensity to consume” which shows how much (%) C changes when Y does.by definition, 0<mpc<1

The Keynesian ModelThe Keynesian Model

•All other spending components areassumed autonomous with regard to income:Investment (I), Government (G), Foreign (net X)

•All income can be spent (C) or saved (S), so: S = Sa + (1-mpc)*Y or S = SS = Saa + mps*Y + mps*Ywhere mpc + mps = 1 (we spend & save 100% of our income)

•Except for Investment, all planned spending will be realized/actual.

•When economy is in disequilibrium, IIpp ≠ I ≠ Irr

FYI – we are skipping non-

AS/AD graphical

representation.

Equilibrium in the Keynesian ModelEquilibrium in the Keynesian Model

• In equilibrium, planned spending = realized = Y. Y = [Agg. Expenditures] = C + I + G + net X

•What if planned spending exceeds income? Business inventories are drawn down to compensate. But, the ∆inventories was unplanned∆inventories was unplanned, and so planned I

is greater than realized/actual I. Businesses will then plan to produce more, to make up

for the shortfall in inventories, raising employment, production and income.

This process will continue until Y = AEY = AEpp

• What if planned spending is less than income?What if planned spending is less than income?

The multiplier process in theThe multiplier process in theKeynesian ModelKeynesian Model•Consider the following:

Y = 1000, planned AE = 1100 and mpc = .8[Inventories fall by 100 to make up the difference.] Incomes will rise by 100 as businesses expand. But, consumption will rise by another 80 (=80%*100). So, now, Y=1100 and planned AE = 1180. But, the But, the C will C will Y (by 80), which will further increase C by Y (by 80), which will further increase C by

64. This will 64. This will Y by another 64 and on and on and …Y by another 64 and on and on and … Eventually this process comes to an end when:

Y = old Y + [1/(1-mpc)]*(AEp – old Y) here: Y = 1000 + [1/(1-.8)]*(+100) = 1000 + 5*100 = 1500

Here, the multiplier

was 5[1/(1-mpc)]

Details of the Keynesian ModelDetails of the Keynesian Model

•This only applies when there is no inflation.•So additional resources can be employed

without raising wages/prices.•Provides a Keynesian avenue for economic

growth – the autonomous increase in Investment spending (which results in AEp>Y).

•Investment determined by: future expected profit, real interest return, state of the capital stock.

•Consumption is determined by: wealth and future expected income (permanent income permanent income hypothesishypothesis).

Keynesian theory in AS/AD ModelKeynesian theory in AS/AD Model

AD1

P

Q or R-GDP

ASLRAS1

Q*Q1

AD2

Q2 Q3

AD3

Introduce a flat AS.Introduce a flat AS.

Introduce Introduce disequilibrium at Qdisequilibrium at Q11 with ADwith AD22..

Equilibrium process Equilibrium process moves us to Qmoves us to Q22..

But, we still have a But, we still have a depression.depression.

If we can further If we can further increase spending to increase spending to ADAD33 we can boost we can boost employment and employment and output.output.

Continue until we Continue until we reach Q*.reach Q*.

Macro Theory:Macro Theory:

Dr. D. Foster – ECO 285 – Spring 2014

The AS/AD Model II -The AS/AD Model II -Keynesian VersionKeynesian Version