Aggregate Demand, Aggregate Supply, and the Self-Correcting Economy

1
Aggregate Demand, Aggregate Supply, and the
Self-Correcting Economy

• Chapter 7

2
Flexible Prices and the AD Curve

• What is meant by the Keynes effect of a change
  in the aggregate price level? How does this
  shift the LM curve for a given IS curve?
• What happens to real income due to the Keynes
  effect?
• What is meant by the Pigou effect of a change
  in the price level on real wealth? How does this
  shift the IS curve for a given LM curve?
• What happens to the level of income when the
  price level changes when (a) only the Keynes
  effect influences real income versus (b) when
  both the Keynes effect and the Pigou effect
  influence real income?
• What happens to the slope of the AD curve when
  the Pigou effect is added to the Keynes effect?

3
Shifts versus Movement Along the AD Curve

• Why does a change in the price level result in a
  movement along the AD curve even though it shifts
  the LM (and possibly the IS) curve(s)?
• How does a change in the money supply, fiscal
  policy, or any other autonomous spending affect
  the AD curve?
• How does a flatter IS curve (higher multiplier or
  more interest sensitive investment demand) affect
  the slope of the AD curve?
• What is the slope of the AD curve if the economy
  experiences a liquidity trap?
• Why does the effect of a change in AD on price
  versus output depend on the slope of the AS curve?

4
Deriving the Short-run Aggregate Supply Curve
When the Nominal Wage is Rigid

• What is meant by an aggregate production function
  that relates aggregate output as a function of
  labor, capital, and technology?
• Why is technology a broad term that relates to
  the development of ideas, organization,
  managerial innovation, etc.?
• How is the demand for labor derived from the
  production function under the assumption that
  firms maximize profits? Why is the marginal
  physical product of labor at each real wage rate?

5
SAS continued

• How is the real wage related to the nominal wage
  and the price level?
• What determines the supply of labor in the
  economy? How does it relate to the real wage in
  the economy?
• Why in the long-run will the labor market clear
  toward equilibrium at full employment?
• But, why in the short-run is it possible for a
  higher price level to lower the real wage and
  increase employment and output?

6
The LAS and SAS Curves

• Why does a higher price level shift up the
  short-run aggregate supply curve, SAS, as the
  nominal wage rate adjusts to the higher price
  level? (See figure 7-6)
• Although the SAS is upward sloping, why is the
  long-run aggregate supply curve, LAS, vertical?
• Why is the real wage unchanged along the LAS
  curve?
• What determines employment and real wages at the
  natural rate of employment and output?

7
Fiscal and Monetary Expansion in the Short Run
and Long Run

• How does the initial effect of fiscal policy on
  expansion in AD that increases the price level
  have on the real wage, employment, and output for
  a given (sticky) nominal wage?
• Why does fiscal policy have no cyclical effect on
  output in the long-run?
• Can the same conclusions also be reached
  regarding the short-run versus long-run effects
  of monetary policy?

8
Neoclassical Macroeconomics and the Role of
Keynes

• Why according to the neoclassical model would
  output occur along the LAS curve at all times?
• Why according to the neoclassical school is
  fiscal policy primarily a tool that affects the
  allocation of resources?
• Why does the money supply determine the price
  level in the long-run but not the rate of output
  and employment?
• Why, according to the neoclassical school, is a
  change in real output from full employment
  equilibrium only due to a supply shock or an
  unexpected change in demand?

9
The Keyness Revolution The Failure of
Self-Correction (Three areas of dispute)

• In the goods market, why doesnt a reduction in
  planned investment automatically result in less
  saving and more consumption as the interest rate
  falls? (Says Law)
• In the money market, why isnt the velocity of
  money constant as predicted by the Classical
  school? (The Quantity Theory of Money)
• In the labor market, why doesnt the level of
  employment always occur at the natural rate in
  the short-run?
• Why did Keynes say that in the long-run we are
  all dead.

10
The Effect of Lower Prices During Recession

• How can the Pigou effect be offset by the
  destabilizing effect on expectations when prices
  are falling? (Effect of deflation on postponing
  the purchase of goods.)
• What is the redistribution effect of lower prices
  on aggregate demand?
• How has deflation deepened Japans dilemma and
  recently led to concern that it could impact the
  U.S. economy?

11
The Great Depression

• Why was aggregate demand so low during the Great
  Depression?
• Is there any evidence that monetary policy was
  ineffective during the Great Depression due to a
  liquidity trap?
• Did the economys SAS curve shift downward to
  provide self-correction or did it remain
  stationary during the Great Depression?
• Were nominal wages rigid and did real wages
  fluctuate counter cyclically as predicted by the
  Keynesian model?