Introduction:

Thinking Like an Economist 1

CHAPTER 2
CHAPTER 26

The Short-Run Keynesian Policy Model:

Demand-Side Policies
The Theory of Economics…is a method
rather than a doctrine, an apparatus of
the mind, a technique of thinking which
helps its possessor to draw correct
conclusions.
―J.M. Keynes

McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Goals
 Discuss the key insight of the AS/AD model and list both its
assumptions and its components
 Describe the shape of the aggregate demand curve and what
factors shift the curve
 Explain the shape of the short-run and long-run aggregate supply
curves and what factors shift the curves
 Show the effects of shifts of the aggregate demand and aggregate
supply curves on the price level and output in both the short run
and long run
 Discuss the limitations of the macro policy model

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Key Insight of the Keynesian AS/AD Model

 Short-run equilibrium output may differ from long-run
potential output assuming a fixed price level
• Equilibrium output is the level of output toward
which the economy gravitates in the short run
because of the cumulative cycles of declining or
increasing production
• Potential output is the highest amount of output an
economy can sustainably produce using existing
production processes and resources
 Market forces (the invisible hand) may not be strong enough
to correct deviations from potential output

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Key Insight of the Keynesian AS/AD Model

 Paradox of thrift
• In the long run, saving leads to investment and growth
• In the short run, saving may lead to a decrease in
spending, output, and employment
Class Discussion: What do both statements mean?
 Aggregate demand management, which is government’s
attempt to control the aggregate level of spending, may be
necessary
 Keynesian economists advocated an activist demand
management policy

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The Components of the AS/AD Model

Aggregate Demand Curve (AD)
• Is a curve that shows how a change in the price level
will change aggregate expenditures on all goods and
services in an economy
Short-Run Aggregate Supply Curve (SAS)
• Is a curve that specifies how a shift in the aggregate
demand curve affects the price level and real output in
the short run, other things constant
Long-Run Aggregate Supply Curve (LAS)
• Is a curve that shows the long-run relationship between
output and the price level

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The Slope of the AD Curve
The AD curve is downward sloping because of:
 Interest rate effect, the effect that a lower price level has on
investment expenditures through the effect that a change in the
price level has on interest rates.
Increasing/lowering AD due to higher/lower interest rate
 International effect, as the price level falls (assuming the
exchange rate does not change), net exports will rise.
Increasing/decreasing AD from foreign markets due to
increase/decrease the price level in domestic
 Money wealth effect, a fall in the price level will make the holders
of money richer, so they buy more. It is obvious.
 Multiplier effect, the amplification of initial changes in
expenditures. Class Discussion: Multiplier effect is ‘Efek
Berganda’, what does it mean?
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The Slope of the AD Curve

Price level The AD curve is downward
sloping because of the
interest rate, international,
and money wealth effects
P0
and the multiplier effect

P1

AD
Real
Y0 Y1 Y2
output

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Dynamic Price Level Adjustment Feedback Effects

 Dynamic effects (or ‘uncertain effects’) exist that can
overwhelm the standard AD shift factors
 Especially important when aggregate demand is declining
• Expectations of falling aggregate demand
• Lower asset prices (declining nominal wealth)
• Financial panics
 These forces (or ‘Anomaly’) counteract the standard shift
factors. What is ‘anomaly’ in the economy?
 If strong enough, dynamic forces can cause aggregate
demand to fall (shift to the left) when the price level falls
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Shifts in the AD Curve

 A shift in the AD curve means that at every price level, total
expenditures have changed. Five important shift factors are:

Class Discussion:

• Foreign income, what if foreign income (net export) increases?

• Exchange rates, what if exchange rates are weaken?
• Distribution of income, what if income distributes not equal?
• Expectations, what does it mean?
• Monetary and fiscal policy

 Deliberate shifting of the AD curve is what most policy makers mean

by macro policy

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Shifts in the AD Curve

Price level
The AD curve shifts out by
more than the initial change
in expenditures
Initial Multiplier
effect effect • Exports increase by 100
P0 • The multiplier magnifies
this shift
Total effect

AD curve shifts to the right

100 200
by a multiple of 100, in
AD1 this case by 300
AD0
Real
300 output

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The Aggregate Supply Curves

The Slope of the Short-Run Aggregate Supply (SAS) Curve
The SAS curve is upward sloping because of:
 Auction markets
• Prices are determined by demand and supply and supply curves
are upward sloping

 Posted price markets

• Also called quantity-adjusting markets, markets in which firms
respond to changes in demand by changing production instead
of changing their prices
• Firms tend to increase their markup when demand increases.
Class Discussion: Can somebody elaborate these
two statements?
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Shifts in the SAS Curve

 Shifts in the SAS are caused by changes in:
Price level
Class Discussion:
SAS1 • Input prices, what if input prices
increase/decrease?
• Productivity, what if productivity level
SAS0
increases/decreases?
• Import prices, what if import prices
SAS2 increase/decrease?
• Excise and sales taxes

 When production costs increase, the SAS

curve shifts up

 In general:

Real output %Δ in price level =

%Δ in wages – %Δ in productivity

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The Long-Run Aggregate Supply Curve

 The long-run aggregate supply (LAS) curve shows the
long-run relationship between output and the price level
 The position of the LAS curve depends on potential
output which is the amount of goods and services an
economy can produce when both capital and labor are
fully employed
 The LAS curve is vertical because potential output is
unaffected by the price level

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The LAS Curve

Price level
LAS Potential output is assumed to be in
the middle of a range bounded by high
and low levels of potential output

• When resources are over-

C SAS
utilized (point C), factor prices
B
A may be bid up and the SAS
Overutilized shifts up
resources
Underutilized • When resources are under-
resources utilized (point A), factor
Real prices may decrease and
Low-level High-level
output SAS shifts down
potential potential
output output

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When did Indonesia reach its potential output?

15 Indonesia’s potential
output (LAS) How about during
1985-1996 around 8% 2005-2015?
10
Are we in potential?

-5

-10

-15

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Shifts in the LAS Curve

Price level
LAS0 LAS1 LAS2 Increases in the LAS are
caused by increases in:
 Capital
 Resources
 Growth-compatible
institutions
 Technology
 Entrepreneurship

Real output

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Short-Run Equilibrium in the AD/AS Model

Price level
Short-run equilibrium is where the
SAS and AD curves intersect and
point E is short-run equilibrium

A shift in the aggregate

SAS
F demand curve to the right
P1 changes equilibrium from E
P0 E to F, increasing output from
Y0 to Y1 and increasing
AD1 price level from P0 to P1

AD0
Real output
Y0 Y1

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Short-Run Equilibrium in the AD/AS Model

Price level

SAS1 A shift up in the short-run

aggregate supply curve
SAS0 changes equilibrium from E
G
P2 to G, decreasing output from
E
Y0 to Y2 and increasing price
P0 level from P0 to P2

AD
Real output
Y2 Y0

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Long-Run Equilibrium in the AD/AS Model

Price level
LAS Long-run equilibrium is where the
LAS and AD curves intersect

A shift in the aggregate

demand curve changes
H
P1 equilibrium from E to H,
increasing the price level
from P0 to P1 but leaving
E output unchanged
P0
AD1
AD0
Real output
YP

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Application:
A Recessionary Gap in the AD/AS Model
Price level • A recessionary gap is the
LAS amount by which equilibrium
SAS1 output is below potential output
• At point A, some resources
A
SAS0 are ‘unemployed’ and the
P1
recessionary gap is YP – Y1
E
P0
Eventually ‘wages and prices
decrease’ and SAS shifts
down to return the economy
Gap to a long and short-run
AD0 equilibrium at E
Y1 YP Real output

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Application:
An Inflationary Gap in the AD/AS Model
Price level • An inflationary gap is the
LAS amount by which equilibrium
output is above potential output

• At point B, resources are being

SAS0 used beyond their potential and
E the inflationary gap is Y2 – YP
P0 SAS2
B
Eventually wages and prices
P2
increase and SAS shifts to
Gap
return the economy to a long
AD0 and short-run equilibrium at E

YP Y2 Real output
Class Discussion: What is the effect if resources are used above their
potential/inflationary gap occurs? 26-21
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Inflationary gap: learn from China

Commodity boom 2003-2011
China was due to China’s inflationary
30 gap (overheat in its economy)

20

10

0
61 63 6 5 67 69 71 73 7 5 7 7 79 8 1 83 85 8 7 89 91 9 3 95 97 9 9 01 03 0 5 07 09 11 13 15 17 19
19 19 19 19 19 19 19 19 1 9 19 19 1 9 19 19 1 9 19 19 1 9 19 19 2 0 20 2 0 20 20 2 0 20 20 2 0 20

-10

-20

-30

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Aggregate Demand Policy

 A primary reason for government policy makers’ interest

in the AS/AD model is that monetary or fiscal policy
shifts the AD curve
• Monetary policy involves the Federal Reserve
Bank changing the money supply and interest
rates
• Fiscal policy is the deliberate change in either
government spending or taxes to stimulate or
slow down the economy

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Application:
Expansionary Fiscal Policy in the AD/AS
Price level
Model
• If the economy is at point A,
LAS
there is a recessionary gap
equal to YP – Y0
• The appropriate fiscal policy
P1 E is to increase government
spending and/or decrease
P0 A taxes
AD shifts to the right and
output returns to potential
output YP and prices
Gap
AD1 increase to P1
AD0
Y0 YP Real output
Class Discussion: What is the implication of these policy options?
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Application:
Contractionary Fiscal Policy in the AD/AS
Price level Model
LAS • If the economy is point B, there
is an inflationary gap Y2 – YP

• The appropriate fiscal policy

B is to decrease government
P2 spending and/or increase taxes
P1
E AD shifts to the left, output
returns to potential output YP
AD0 and inflation is prevented
Gap
AD2
YP Y2 Real output
Class Discussion: What is the implication of these policy options?
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Limitations of the AS/AD Model

 The AS/AD model assumes away many possible feedback

effects that can significantly affect the macroeconomy and
lead to quite different conclusions
 Implementing fiscal policy through changing taxes and
government spending is a slow legislative process
• There is no guarantee that government will do what
economists say is necessary

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Limitations of the AS/AD Model

 Potential output (the level of output that the economy is

capable of producing without generating inflation) is difficult
to estimate
• We do have ways to get a rough idea of where it is
 There are many other possible interrelationships in the
economy that the model does not take into account
 The aggregate economy can become dynamically unstable,
so a shock can set in motion changes that will not
automatically be self-correcting

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Limitations of the AS/AD Model

 There are two ways to think about the effectiveness of

fiscal policy: in the model and in reality
 The effectiveness of fiscal policy depends on the
government’s ability to perceive and to react appropriately
to a problem
 Countercyclical fiscal policy is fiscal policy in which the
government offsets any change in aggregate expenditures
that would create a business cycle
 Fine-tuning is used to describe such fiscal policy designed
to keep the economy always at its target or potential level
of income

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Chapter Summary
 The key idea of the Keynesian AS/AD model is that in the
short run the economy can deviate from potential output
 The AS/AD model consists of the aggregate demand
curve, and the short-run aggregate supply curve, and the
long-run aggregate supply curve
 Short-run equilibrium is where the SAS and AD curves
intersect; Long-run equilibrium is where the AD and LAS
curves intersect
 Aggregate demand management policy attempts to
influence the level of output in the economy

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Chapter Summary
 Fiscal policy works by providing a deliberate countershock
to offset unexpected shocks to the economy
 Macroeconomic policy is difficult to conduct because:
• Implementing fiscal policy is a slow process
• We don’t really know where potential output is
• There are interrelationships not included in the model
• The economy can become dynamically unstable

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