Student Notes 10:

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Rose-Hulman Institute of Technology Department of
Humanities Social Sciences / K. Christ SL 151,
Principles of Economics
Student Notes 10 Macroeconomic Policy, Part 1
-- The AS/AD Model
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U.S. Annual Percent Change in Real GDP
Great Depression and World War II
Sources 1900 1930, Angus Maddison, Dynamic
Forces in Capitalist Development (1991), Appendix
A 1930 to present, Bureau of Economic Analysis.
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Macroeconomic Policy Classical Theory vs.
Keynesianism

• The Classical View
• Inherent stability
• No need for government intervention

• The Keynesian View
• Inherent instability
• A role for government intervention

Every individual intends only his own security
and by directing that industry in such a manner
as its produce may be of the greatest value, he
intends only his own gain, and he is in this, as
in many other cases, led by an invisible hand to
promote an end which was no part of his
intention. Adam Smith The Wealth of Nations
(1776) A general over-supply, or excess of all
commodities above the demand, so far as demand
consists in means of payment, is thus shown to be
an impossibility there is no over-production
production is not excessive, but merely ill
assorted. John Stuart Mill Principles of
Economics (1848)
It may well be that the classical theory
represents the way in which we should like our
Economy to behave. But to assume that it actually
does so is to assume our difficulties away. John
Maynard Keynes The General Theory (1937) Adam
Smith was so thrilled by the recognition of an
order in the economic system that he proclaimed
the mystical principle of the invisible hand
This unguarded conclusion has done almost as much
harm as good in the past century and a half
Paul Samuelson Principles of Economics (1948)
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Key macroeconomic concerns / variables
Key macroeconomic concerns / policy options

• Spending and financing decisions of the federal
  government
• Implemented by Congress in conjunction with the
  President
• Subject to noticeable lags in implementation
• Money supply, credit and interest rate decisions
  by the central bank
• Implemented by the Federal Reserve, subject to
  oversight by Congress
• Rapid implementation

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Interpretation of aggregate fluctuations using
the AS/AD model
PRICE LEVEL (Average Prices)
AGGREGATE REAL OUTPUT
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Interpretation of aggregate fluctuations using
the AS/AD model
A modified AS/AD model
PRICE LEVEL (Average Prices)
AGGREGATE REAL OUTPUT
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Interpretation of aggregate fluctuations using
the AS/AD model
PRICE LEVEL (Average Prices)
AGGREGATE REAL OUTPUT
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Interpretation of aggregate fluctuations using
the AS/AD model
PRICE LEVEL (Average Prices)
AGGREGATE REAL OUTPUT
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Interpretation of aggregate fluctuations using
the AS/AD model
PRICE LEVEL (Average Prices)
AGGREGATE REAL OUTPUT
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Interpretation of aggregate fluctuations using
the AS/AD model
PRICE LEVEL (Average Prices)
AGGREGATE REAL OUTPUT
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Empirical regularity 1 Okuns law output and
unemployment An empirical relationship between
GDP Growth and Unemployment Rate
DReal GDP 3.18 - 1.90 DUnemployment Rate
1960 - 1998
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Empirical regularity 2 The Phillips curve
inflation and unemployment
Based on annual data.
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Empirical regularity 2 The Phillips curve
inflation and unemployment
Based on annual data.