COORDINATING ECONOMIC ACTIVITY:

1

• COORDINATING ECONOMIC ACTIVITY
• AGGREGATE DEMAND SUPPLY

2
ECONOMIC FLUCTUATIONS

• Movements of GDP away from potential output
• Also referred to as business cycles

3
KEYNESIAN ECONOMICS

• Models based on the idea that demand determines
  output in the short run
• Short run -- The period of time when prices are
  fixed

4
REAL SHOCKS TO THE ECONOMY

• One cause of economic fluctuations
• Developing countries dependent on agriculture,
  which suffer loss to cash crop
• Sharp increases in the price of oil can hurt
  modern economies
• Wars can devastate entire regions of the world
• Natural disasters can cause sharp reductions in
  GDP
• Major shifts in technology leading to the birth
  of new industries have profound effects on the
  economy

5
REAL BUSINESS CYCLE THEORY

• School of economic thought that emphasizes the
  role that shocks to technology can play in
  causing economic fluctuations
• Led by Edward Prescott of the University of
  Minnesota
• Developed models that integrate technology shocks
  into classical models
• Changes in technology will usually change the
  level of full employment or potential output
• It portrays economic fluctuations as movements in
  potential output, not as deviations away from
  potential output

6
INITIAL PATTERN OF DEMAND AND PRICES
Price
S
P0
D
Tennis Racquets
Quantity
Q0
7
INITIAL PATTERNS OF DEMAND AND PRICES
Price
Price
S
S
P0
P1
D
D
Tennis Racquets
Quantity
Quantity
Roller blades
Q0
Q1
8
DEMAND AND PRICES AFTER CHANGES IN TASTES
Price
Price
S
S
P1
PA
DB
D
D
DA
Tennis Racquets
Quantity
Quantity
Roller blades
Q1
QA
Suppose rollerblading starts to replace tennis.
Demand shifts to DA in the market in tennis
racquets and DB in the market for roller blades.
9
DEMAND AND PRICES AFTER CHANGES IN TASTES
Price
Price
S
S
PB
P0
P1
PA
DB
D
D
DA
Tennis Racquets
Quantity
Quantity
Roller blades
Q0
Q1
QA
QB
Suppose rollerblading starts to replace tennis.
Demand shifts to DA in the market in tennis
racquets and DB in the market for roller blades.
Prices of rollerblades will rise to PB, prices
of tennis racquets will fall to PA.
10
PRICES AND ECONOMIC COORDINATION

• The change in tastes from tennis racquets to
  rollerblading has caused the economy to produce
  more roller blades and fewer tennis racquets
• The economy accomplishes this through prices
• When roller blading became more popular than
  tennis, the price of roller blades rose and the
  price of tennis racquets fell
• The producers of roller blades were given a
  signal to step up production
• The producers of tennis racquets were given a
  signal to cut back their production
• Workers will leave tennis racquet industry to be
  employed by roller blade industry

11
FUTURE PRICES

• There is no price for automobiles to be delivered
  five years from now, so automobiles do not
  receive any direct signals that consumers wish to
  purchase automobiles in the future
• Only a few commodities, such as metals and
  certain agricultural commodities, can be traded
  for future delivery in worldwide markets

12
TOO LITTLE INFORMATION

• Prices may not always contain all the information
  that producers need
• What matters to any firm is the real price its
  price relative to all other prices in the economy
• Reality Principle What matters to people is the
  real value or purchasing power of money or
  income, not its face value

13
TOO LITTLE INFORMATION

• Problems can occur if firms are uncertain about
  whether a change in their output price is an
  increase in the real price or only on the nominal
  or dollar price
• If producers believe demand for their product has
  fallen, they will cut back production
• If this happened throughout the economy, it would
  lead to a recession

14
STICKY PRICES

• If prices are sticky or not sufficiently
  flexible, prices will not coordinate activity as
  efficiently
• In modern economies, some prices are flexible,
  while others are not
• Auction Prices -- those determined on nearly a
  daily basis
• Prices for fresh fish, vegetables, and other food
  are very flexible
• Custom Prices -- those that adjust rather slowly
• Prices for industrial commodities, such as steel
  rods or machine tools, are custom prices

15
STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS
Price
S
P0
E
D
Tennis Racquets
Quantity
Q0
16
STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS
Price
S
F
P0
E
D
DA
Tennis Racquets
Quantity
Q0
17
STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS
Price
S
F
P0
E
D
DA
Tennis Racquets
Quantity
Q0
18
STICKY PRICES IN THE MARKET FOR TENNIS RACQUETS
Price
S
F
P0
E
D
DA
Tennis Racquets
Quantity
Q0
When demand falls to DA, prices are sticky and
remain at P0. The result is unsold production
measured by the distance between E and F.
19
WAGES

• Wages, the price of labor, adjust extremely
  slowly
• Workers often have long-term contracts that do
  not allow wages to change at all during a given
  year
• Even unskilled, low-wage workers are often
  protected from decreases in their wages by
  minimum wage laws
• For most firms, wages are the single most
  important cost of doing business
• If wages are sticky, their overall costs will be
  sticky
• Stickiness of wages reinforces stickiness of
  prices

20
SHORT-RUN PRICES ARE STICKY

• Firms let demand determine level of output in the
  short run
• Automaker may have higher demand if autos are
  popular or lower demand if autos are unpopular
• Steelmaker who provides steel to automaker may
  provide more or less steel without adjusting
  price
• The same principle applies to workers
• During good times a company will employ many
  workers and may even require some to work
  overtime with no wage change
• The short run in macroeconomics is the period
  when prices are fixed

21
LONG-RUN PRICES

• In the long run, price adjust fully to changes in
  demand
• Over short periods of time, the presence of
  formal and informal contracts mean that demand
  will be reflected primarily in changes in output,
  not prices

22
AGGREGATE DEMAND

• The aggregate demand curve plots the total demand
  for GDP as a function of price level
• The aggregate demand curve is downward sloping
• As the price level falls, the total demand for
  goods and services increases

23
AGGREGATE DEMAND
Price Level
P
AD aggregate demand
Real GDP, Y
The aggregate demand curve plots the total demand
for real GDP as a function of the price level.
The aggregate demand curve slopes downward,
indicating that aggregate demand increases as the
price level falls.
24
REALITY PRINCIPLE

• What matters to people is the real value or
  purchasing power of money or income, not its face
  value.

25
WEALTH EFFECT

• Increase in spending that occurs because the real
  value of money increases when the price level
  falls
• One of the key reasons that aggregate demand
  slopes downward

26
TWO OTHER REASONS WHY DEMAND CURVE SLOPES DOWNWARD

• Interest rate effect
• With a given supply of money in the economy, a
  lower price level will lead to lower interest
  rates
• As interest rates fall, demand for investment
  goods in the economy increase.
• Effects from international trade
• In an open economy, a lower price level will
  mean that domestic goods become cheaper relative
  to foreign goods and demand for domestic goods
  will increase

27
SHIFTS OF AGGREGATE DEMAND

• At any price level, an increase in aggregate
  demand means that total demand for real GDP has
  increased, and the curve shifts to the right
• Factors that decrease the aggregate demand will
  shift the aggregate demand curve to the left
• At any price level, a decrease in aggregate
  demand means that total demand for real GDP has
  decreased

28
KEY FACTORS THAT SHIFT THE AGGREGATE DEMAND CURVE

• Changes in the supply of money
• Changes in taxes
• Changes in government spending
• other factors

29
CHANGES IN THE SUPPLY OF MONEY

• An increase in the supply of money in the economy
  will increase aggregate demand and shift the
  demand curve right
• At any price level, a higher supply of money will
  mean more consumer wealth and an increased demand
  for goods and services
• A decrease in the supply of money will decrease
  aggregate demand and shift the aggregate demand
  curve to the left

30
CHANGES IN TAXES

• A decrease in taxes will increase aggregate
  demand and shift the aggregate demand curve to
  the right
• Lower taxes will increase income available to
  households and increase their spending on goods
  and services
• Increases in taxes will decrease the aggregate
  demand and shift the aggregate demand curve left

31
CHANGES IN GOVERNMENT SPENDING

• An increase in government spending will increase
  aggregate demand and shift the aggregate demand
  curve right
• Since the government is a source of demand for
  goods and services, higher government spending
  naturally leads to an increase in total demand
  for goods and services
• Decreases in government spending will decrease
  aggregate demand and shift the curve to the left

32
OTHER FACTORS

• Any change in demand from households, firms, or
  the foreign sector will also change aggregate
  demand
• When shifts in aggregate demand are discussed,
  any changes that arise from movements in the
  price level are not to be included

33
FACTORS THAT SHIFT DEMAND

• Factors That Increase Factors That Decrease
  Aggregate Demand Aggregate Demand
• Decrease in Taxes Increase in Taxes
• Increase in Decrease in Government
  Spending Government Spending
• Increase in Money Decrease in Money
  Supply Supply

34
SHIFTING AGGREGATE DEMAND
Price Level
P
Original aggregate demand
Output, Y
35
SHIFTING AGGREGATE DEMAND
Price Level
P
Increased aggregate demand
Original aggregate demand
Output, Y
36
SHIFTING AGGREGATE DEMAND
Price Level
P
Increased aggregate demand
Original aggregate demand
Output, Y
Decreases in taxes, increases in government
spending, or an increase in the supply of money
all shift the aggregate demand curve to the
right.
37
SHIFTING AGGREGATE DEMAND
Price Level
P
Increased aggregate demand
Original aggregate demand
Decreased aggregate demand
Output, Y
Decreases in taxes, increases in government
spending, or an increase in the supply of money
all shift the aggregate demand curve to the
right.
38
SHIFTING AGGREGATE DEMAND
Price Level
P
Increased aggregate demand
Original aggregate demand
Decreased aggregate demand
Output, Y
Decreases in taxes, increases in government
spending, or an increase in the supply of money
all shift the aggregate demand curve to the
right. Higher taxes, lower government spending,
or a lower supply of money shift the curve to
the left.
39
AGGREGATE SUPPLY

• Depicts the relationship between the level of
  prices and real GDP
• Two different aggregate supply curves, which
  correspond to the long run and the short run
• -- classical aggregate supply curve
• -- Keynesian aggregate supply curve

40
CLASSICAL AGGREGATE SUPPLY CURVE

• Aggregate supply curve for the long run when the
  economy is at full employment
• Full-employment output depends solely on the
  supply of capital and labor and the state of
  technology
• full-employment output does not depend on the
  price level
• Classical aggregate supply curve is plotted as a
  vertical line (unaffected by prices)

41
CLASSICAL AGGREGATE SUPPLY
AS
p
Price
y
y
Output,
In the long run, the level of output y is
independent of the price level.
42
AGGREGATE DEMAND AND CLASSICAL AGGREGATE SUPPLY
p
Classical
AS
Price
Original AD
y
y
Output,
Output and prices are determined at the
intersection of AD and AS.
43
COMBINING AGGREGATE DEMAND AND AGGREGATE SUPPLY

• The price level and level of output are
  determined by the intersection of aggregate
  supply and aggregate demand
• At that point, total amount demanded will just
  equal the total amount supplied
• The position of the aggregate demand curve will
  depend on the level of taxes, government
  spending, and the supply of money
• The full-employment output determines the
  classical aggregate supply curve

44
AGGREGATE DEMAND AND CLASSICAL AGGREGATE SUPPLY
p
Classical
AS
Price
Increased AD
Original AD
y
y
Output,
Output and prices are determined at the
intersection of AD and AS. An increase in
aggregate demand to a higher price level.
45
COMBINING AGGREGATE DEMAND AND AGGREGATE SUPPLY

• An increase in demand will shift the aggregate
  demand curve right
• With a classical aggregate supply curve, the
  increase in aggregate demand will raise the
  prices but leave the level of output unchanged

46
THE KEYNESIAN AGGREGATE SUPPLY CURVE

• The Keynesian aggregate supply curve is
  horizontal in the short run
• Firms are assumed to supply all output that is
  demanded at the current price
• Formal and informal contracts commit producers to
  supply all that is demanded at the going price
• The entire Keynesian supply curve can shift up or
  down as prices adjust to their long-run levels

47
KEYNESIAN AGGREGATE SUPPLY
p
Price
Keynesian AS
p0
y
Output,
48
AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLY
p
Price
E0
Keynesian AS
p0
Original AD
y 0
y
Output,
49
AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLY
p
Price
E0
E1
Keynesian AS
p0
Increased AD
Original AD
y 0
y
Output,
y 1
With a Keynesian aggregate supply curve, shifts
in aggregate demand lead to changes in output
but no changes in prices.
50
AGGREGATE DEMAND AND KEYNESIAN AGGREGATE SUPPLY
CURVES

• The intersection of AD and AS curves determines
  the price level and the level of output at point
  E
• Since aggregate demand is horizontal, aggregate
  demand totally determines the level of output
• As aggregate demand increases, the new
  equilibrium will be at the same price p0, but
  output will increase from y0 to y1
• The Keynesian aggregate supply curve need not
  correspond to full-employment output
• Changes in demand will lead to economic
  fluctuations with sticky prices and a Keynesian
  aggregate supply curve

51
SUPPLY SHOCKS

• External disturbances that shift the aggregate
  supply curve
• Most important illustrations of supply shocks for
  the world economy have been sharp increases in
  the price of oil that occurred in 1973 and 1979
• When oil prices increased sharply, firms would no
  longer sell all the goods and services that were
  demanded at the current price
• To maintain their profit levels, firms raised
  their prices

52
A SUPPLY SHOCK
p
Price
AS (before the shock)
p0
AD
y
Output,
y0
53
A SUPPLY SHOCK
p
Price
AS (after the shock)
AS (before the shock)
p0
AD
y
Output,
y0
An adverse supply shock, such as an increase in
the price of oil, will shift up the AS curve.
54
A SUPPLY SHOCK
p
Price
AS (after the shock)
p1
AS (before the shock)
p0
AD
y
Output,
y1
y0
An adverse supply shock, such as an increase in
the price of oil, will shift up the AS curve.
The result will be higher prices and a lower
level of output.
55
LINKS BETWEEN SHORT RUN AND LONG RUN

• Provided by adjustments of wages and prices
• -- sticky and do not move immediately in the
  short run
• -- Over time adjust and the economy reaches
  its long-run equilibrium
• Wage and price adjustments provide the links
  between Keynesian and classical economics

56
WAGES AND PRICES IN AN ECONOMY PRODUCING AT A
LEVEL ABOVE FULL EMPLOYMENT

• The Wage Price Spiral
• Firms find it increasingly difficult to hire and
  retain workers
• Workers find it easy to obtain a job and easy to
  change jobs
• To attract workers and to prevent others from
  quitting, firms raise their wages to try to
  outbid their competitors
• The actions of firms start a process in which
  wages increase throughout the economy

57
PRICES IN AN ECONOMY PRODUCING AT A LEVEL ABOVE
FULL EMPLOYMENT

• The Wage Price Spiral
• For most firms, wages are the largest single cost
  of production
• As their labor costs increase, firms have no
  choice but to increase prices as well
• As prices rise, workers know they need higher
  dollar or nominal wages to maintain their real
  wage
• The Reality Principle
• What matters to people is the real value or
  purchasing power of money or income, not its face
  value

58
UNEMPLOYMENT, OUTPUT, AND WAGES AND PRICE CHANGES

• When unemployment is
• below the natural rate above the natural rate
• output is
• above potential below potential
• wages and prices
• rise fall
• When output exceeds potential output, wages and
  prices throughout the economy will rise above the
  previous inflation rate
• If output is less than potential output, wages
  and prices will fall to previous inflation rates

59
AGGREGATE DEMAND

• The aggregate demand curve is plotted with the
  price on the vertical axis and real output on the
  horizontal axis
• It shows the total level of demand for goods and
  services for any level of output

60
AGGREGATE SUPPLY

• The classical aggregate supply curve (long run)
  is a vertical line at the full-employment level
  of output
• The Keynesian aggregate supply curve (short run)
  is a horizontal line at the current level of
  prices
• The Keynesian aggregate supply curve is
  horizontal because changes in demand lead to very
  small changes in prices over short periods of time

61
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
AD
Output, y
62
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
Keynesian AS
AD
Output, y
63
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
A
Keynesian AS
p0
AD
Output, y
y0
The aggregate demand curve, AD, intersects the
Keynesian aggregate supply curve at point A.
64
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
Classical AS
A
Keynesian AS
p0
AD
Output, y
y0
The aggregate demand curve, AD, intersects the
Keynesian aggregate supply curve at point A.
65
AGGREGATE DEMAND AND AGGREGATE SUPPLY
Price , p
Classical AS
D
pF
A
Keynesian AS
p0
AD
Output, y
y0
yF
The aggregate demand curve, AD, intersects the
Keynesian aggregate supply curve at point A and
the classical aggregate supply curve at point D.
66
RELATING KEYNESIAN TO CLASSICAL POSITIONS

• At the intersection of aggregate demand and
  Keynesian aggregate supply curves, the current
  level of output Y0, exceeds the full-employment
  level of output, YF
• Unemployment rate is below the natural rate
• Firms find it difficult to hire and retain
  workers, and wage-price spiral begins
• As level of prices increase, Keynesian aggregate
  supply curve shifts up over time
• The shift in the Keynesian aggregate supply curve
  will bring the economy to long-run equilibrium
• -- the intersection of classical AS and AD

67
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
A
AS0
p0
AD
Output, y
y0
As prices rise in the economy, the Keynesian
aggregate supply curve shifts up.
68
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
B
p1
AS1
A
AS0
p0
AD
Output, y
y0
As prices rise in the economy, the Keynesian
aggregate supply curve shifts up. The economy
moves from point A to point B.
69
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
C
p2
AS2
B
p1
AS1
A
AS0
p0
AD
Output, y
y0
As prices rise in the economy, the Keynesian
aggregate supply curve shifts up. The economy
moves from point A to point B. The process will
continue.
70
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
D
p3
AS3
C
p2
AS2
B
p1
AS1
A
AS0
p0
AD
Output, y
y0
As prices rise in the economy, the Keynesian
aggregate supply curve shifts up. The economy
moves from point A to point B. The process will
continue until the economy reaches point D.
71
SHIFTS IN KEYNESIAN AGGREGATE SUPPLY
Price , p
D
p3
AS3
C
p2
AS2
B
p1
AS1
A
AS0
p0
AD
Output, y
y0
yF
As prices rise in the economy, the Keynesian
aggregate supply curve shifts up. The economy
moves from point A to point B. The process will
continue until the economy reaches point D. The
price-wage spiral stops when the economy reaches
full employment. Unemployment is at the natural
rate.
72
RETURNING TO FULL EMPLOYMENT
Price , p
A
AS0
p0
AD
Output, y
If the initial level of output is less than full
employment,
73
RETURNING TO FULL EMPLOYMENT
Price , p
A
AS0
p0
AS1
p1
AD
Output, y
If the initial level of output is less than full
employment, wages and prices will fall.
74
RETURNING TO FULL EMPLOYMENT
Price , p
A
AS0
p0
B
AS1
p1
AD
Output, y
If the initial level of output is less than full
employment, wages and prices will fall.
75
RETURNING TO FULL EMPLOYMENT
Price , p
A
AS0
p0
B
AS1
p1
D
AS2
p2
AD
Output, y
If the initial level of output is less than full
employment, wages and prices will fall.
76
RETURNING TO FULL EMPLOYMENT
Price , p
A
AS0
p0
B
AS1
p1
D
AS2
p2
AD
Output, y
yF
If the initial level of output is less than full
employment, wages and prices will fall. As the
aggregate supply curve shifts down, the economy
will return to full employment at D.
77
RETURNING TO FULL EMPLOYMENT
Price , p
A
AS0
p0
B
AS1
p1
D
AS2
p2
AD
Output, y
yF
If the initial level of output is less than full
employment, wages and prices will fall. As the
aggregate supply curve shifts down, the economy
will return to full employment at D.
78
THE ECONOMY WILL EVENTUALLY RETURN TO FULL
EMPLOYMENT

• If output exceeds full employment, prices will
  rise and output will fall back to full employment
• If output is less than full employment, prices
  will fall as the economy returns to full
  employment

79
MOVING FROM THE SHORT TO THE LONG RUN

• Economists disagree about the time it takes
  range between 2 and 6 years
• Alternatives bring long-run (full employment)
  about
• -- Do nothing and allow adjustment process,
  with falling wages and prices to return the
  economy to full employment
• -- Use expansionary policies (open market
  purchases, increases in government spending or
  tax cuts) to shift the aggregate demand curve
  right
• -- Use contractionary policies to reduce
  demand / level of GDP until it reaches potential
  output

80
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
A
p0
AD0
Output, y
yF
81
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
A
p0
D
AD0
Output, y
yF
82
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
A
p0
D
AD0
Output, y
yF
Rather than letting the economy naturally return
to full employment at D,
83
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
A
p0
D
AD1
AD0
Output, y
yF
Rather than letting the economy naturally return
to full employment at D, we can increase
aggregate demand from AD0 to AD1
84
USING ECONOMIC POLICY TO FIGHT A RECESSION
Price , p
E
A
p0
D
AD1
AD0
Output, y
yF
Rather than letting the economy naturally return
to full employment at D, we can increase
aggregate demand from AD0 to AD1 to bring the
economy to full employment at E.
85
ACTIVE ECONOMIC POLICIES AND ECONOMIC STABILITY

• Active economic policies are more likely to
  destabilize the economy if the adjustment process
  operates quickly
• Economists who believe the economy adjusts
  rapidly to full employment generally oppose using
  monetary or fiscal policy to try to stabilize the
  economy
• Economists who believe the adjustment process
  operates slowly are more sympathetic to using
  monetary or fiscal policy to stabilize the
  economy
• It is possible for the speed of adjustment to
  vary over time, making decisions about policy
  more difficult

86
THE ADJUSTMENT PROCESS

• Interest rates are determined by the demand and
  supply of money
• Interest rates determine the level of investment
  spending in the economy
• Investment spending, along with consumption,
  government spending and net exports determines
  the level of GDP

87
MODEL OF DEMAND WITH MONEY
Interest Rates
Ms
r0
A
88
MODEL OF DEMAND WITH MONEY
Interest Rates
Interest Rates
Ms
r0
r0
Md (P0 )
Money
Investment
I0
A
B
89
MODEL OF DEMAND WITH MONEY
Interest Rates
Interest Rates
Total Demand
Ms
450
r0
r0
C I0 G NX
Md (P0 )
Money
Investment
I0
y0
Output
A
B
C
90
MODEL OF DEMAND WITH MONEY
Interest Rates
Interest Rates
Total Demand
Ms
450
r0
C I0 G NX
Md (P0 )
Money
Investment
I0
y0
yF
Output
A
B
C
At the current price level, P0, the economy is
producing y0, which is below full employment, yF
91
APPLYING THE REALITY PRINCIPLE

• Reality Principle What matters to people is the
  real value or purchasing power of money or
  income, not its face value.
• The amount of money that people want to hold will
  depend on the price level
• If prices are cut in half, you need to hold only
  half as much money to purchase the same goods and
  services
• Decreases in the price level will cause the
  money demand curve to shift left

92
RETURNING TO FULL EMPLOYMENT
Interest Rates
Interest Rates
Total Demand
Ms
450
r0
r0
C I0 G NX
Md (P0 )
Money
Investment
I0
y0
yF
Output
A
B
C
When output is below full employment, the price
level falls
93
RETURNING TO FULL EMPLOYMENT
Interest Rates
Interest Rates
Total Demand
Ms
450
r0
r0
C I0 G NX
Md (P0 )
Money
Investment
I0
y0
yF
Output
A
B
C
When output is below full employment, the price
level falls. This reduces the demand for money
and interest rates.
94
RETURNING TO FULL EMPLOYMENT
Interest Rates
Interest Rates
Total Demand
Ms
450
r0
r0
C I0 G NX
r1
Md (P0 )
r1
Md (P1)
Money
Investment
I0
y0
yF
Output
A
B
C
When output is below full employment, the price
level falls. This reduces the demand for money
and interest rates.
95
RETURNING TO FULL EMPLOYMENT
Interest Rates
Interest Rates
Total Demand
Ms
450
r0
r0
C I0 G NX
r1
Md (P0 )
r1
Md (P1)
I0
I1
Money
Investment
y0
yF
Output
A
B
C
When output is below full employment, the price
level falls. This reduces the demand for money
and interest rates. Lower interest rates
increase investment
96
RETURNING TO FULL EMPLOYMENT
Interest Rates
Interest Rates
Total Demand
Ms
450
r0
r0
C I0 G NX
r1
Md (P0 )
r1
Md (P1)
I0
I1
Money
Investment
y0
yF
Output
A
B
C
When output is below full employment, the price
level falls. This reduces the demand for money
and interest rates. Lower interest rates
increase investment and stimulate spending.
97
RETURNING TO FULL EMPLOYMENT
Interest Rates
Interest Rates
Total Demand
Ms
450
C I 1 G NX
r0
r0
C I0 G NX
r1
Md (P0 )
r1
Md (P1)
I0
I1
Money
Investment
y0
yF
Output
A
B
C
When output is below full employment, the price
level falls. This reduces the demand for money
and interest rates. Lower interest rates
increase investment and stimulate spending. The
economy returns to full employment.
98
IF OUTPUT IS BELOW FULL EMPLOYMENT

• Unemployment exceeds the natural rate, and there
  will be excess unemployment
• Wages and prices will start to fall
• Falling prices will decrease the demand for
  holding money
• Interest rates will fall
• Investment spending will increase with falling
  interest rates
• As investment increases, the total demand line
  shifts up and raises the level of output until
  full-employment output is reached
• This process works in reverse if output exceeds
  potential

99
NEUTRALITY OF MONEY
Interest Rates
Interest Rates
Total Demand
Ms0
450
C I F G NX
rF
rF
Md
I
IF
I0
Money
yF
Output
Investment
C
A
B
Starting at full employment,
100
NEUTRALITY OF MONEY
Interest Rates
Interest Rates
Total Demand
Ms0
Ms1
450
C I 0 G NX
C I F G NX
rF
rF
r0
r0
Md
I
IF
I0
Money
yF
y0
Output
Investment
C
A
B
Starting at full employment, an increase in the
supply of money will initially reduce interest
rates from rF to r0, raise investment spending
from I F to I 0 and increase output above full
employment from yF to y0.
101
NEUTRALITY OF MONEY
Interest Rates
Interest Rates
Total Demand
Ms0
Ms1
450
C I 0 G NX
C I F G NX
rF
rF
r0
r0
Md
I
IF
I0
Money
yF
y0
Output
Investment
C
A
B
Starting at full employment, an increase in the
supply of money will initially reduce interest
rates from rF to r0, raise investment spending
from IF to I0 and increase output above full
employment from yF to y0. As wages and prices
increase, the demand for money increases
102
NEUTRALITY OF MONEY
Interest Rates
Interest Rates
Total Demand
Ms0
Ms1
450
C I 0 G NX
C I F G NX
rF
rF
r0
r0
Md
I
IF
I0
Money
yF
y0
Output
Investment
C
A
B
Starting at full employment, an increase in the
supply of money will initially reduce interest
rates from rF to r0, raise investment spending
from IF to I0 and increase output above full
employment from yF to y0. As wages and prices
increase, the demand for money increases,
restoring interest rates, investment and output
to full employment.
103
LONG-RUN EFFECTS OF AN INCREASE IN THE MONEY
SUPPLY

• If the economy is at full employment and the
  Bank increases the money supply
• In the Short Run
• Interest rates will decline
• The level of investment spending will increase
• The increased demand for output will raise the
  output above full employment
• In the Long Run
• Wages and prices will start to increase
• The demand for money will increase
• Interest Rates will increase
• Investment will start to fall and output will fall

104
LONG-RUN NEUTRALITY OF MONEY

• In the long run, increases in the supply of
  money have no effect on real variables, only on
  prices.