EIA1003

MACROECONOMICS I

Lecture 8
The Keynesian System (IV):

Aggregate Supply And Demand

Reference: Froyen (Chapter 8)

Aggregate Supply Schedule in the
Fixed-Price Keynesian Model

Aggregate Price level

YS

Output (Real Income) Y

2
Figure 8.1
The Keynesian AD Schedule

3
Contd.

4
Construction of the Aggregate Demand Schedule
LM(M0/P2)
r
LM(M0/P1)

LM(M0/P0)

r2 C
Interest rate

(a) Effect of price changes on the LM schedule

r1 B

r0 A

IS0

Y2 Y1 Y0 Y
P
output
Aggregate price level

(b) Keynesian Aggregate Demand Schedule

P2 C

P1 B

P0 A

Yd(M0)

Y1 Y0 Y
Y2
output 5
Figure 8.2
Contd.

6
Effects on AD of An Increase in the Money Supply
LM(M0/P0)
r

LM(M1/P0)

r0 A
Interest rate

B
r1 (a) IS and LM schedules

IS0

Y0 Y1 Y
P
output

(Y1-Y0)
Aggregate price level

A B (b) Aggregate Demand

P0

Y1d(M1)
Y (M0)
0
d

Y1 Y
Y0
output 7
Figure 8.3
Effects on AD of an Increase in Government Spending
r
LM(M0/P0)

B
r1
Interest rate

r0 A

r2 C IS1 (a) IS and LM schedules

IS0
IS2
Y 2 Y 0 Y1 Y
P
output
Aggregate price level

C A B (b) Aggregate Demand

P0

Y1d(G1)
Y (G0)
0
d

Y2d(G2)
Y 2 Y 0 Y1 Y
output 8
Figure 8.4
THE KEYNESIAN AD SCHEDULE COMBINED
WITH THE CLASSICAL THEORY OF AS

9
Role of Aggregate Supply in Determining the
Output Response to a Policy Shock

P
Y0s
Y1s
Aggregate price level

Y2s

Y1d
Y0d

Y
Y0 Y1 Y2

output

10
Figure 8.5
Contd.

11
A CONTRACTUAL VIEW OF THE
LABOR MARKET

12
Contd.

13
Contd.

14
15
Employment with a Fixed Money Wage

W
- Ns is a dashed line.
NS
- At W , the Ns schedule is to the right of
N0.
W - Demand, not supply, is the factor
constraining N. Ns plays no role.
MPN.P0 -The position of Nd depends on price.
- The number of workers firms hire (as a
consequence of the amount of output they
N0 N will supply) depend on P.

Figure 8.6
16
 Contd.
 Figure 8.7 derives the Keynesian AS Schedule when W is fixed.
 Panel (a):

 Show the levels of employment N0, N1, N2 for three successively higher

price levels, P0, P1, P2 , with the W fixed;

 An increase in P will increase money value of MPN corresponding to any

level of N and increase
 Nd for a given W (see panel b).
 Panel (b):

 As N increases, Y rises from Y0 to Y1 to Y2 .

17
W (a) Labor Demand Y (b) Production Function

F (K , N )
Y2
Y1
W
Y0
MPN.P2
MPN.P1
MPN.P0

N0 N1 N2 N N0 N1 N2 N
Employment Employment

P
YS

P2 (c) Aggregate Supply

Function
P1
P0

Y 0 Y 1 Y2 Y f Y
18
Figure 8.7: The Keynesian Aggregate Supply Schedule When the Money Wage is Fixed
Contd.

19
Contd.

20
Figure 8.8: Effects on An Increase in Money Supply When Price Level Is Flexible

LM(M0/P0)
r LM(M1/P1)
LM(M1/P0)

r0 A
Interest rate

r1 C
r’1 B (a) IS and LM schedules

IS0

Y0 Y1 Y’1 Y
P
output
Ys
Aggregate price level

P1 C
B (b) Aggregate Demand-
P0 A Aggregate Supply
Schedules

Yd(M1)
Y (M0)
d

Y0 Y1 Y’1 Y
output 21
Contd.

22
Figure 8.9: Effects on an increase in Government Spending When Price Level Is Flexible

r
LM(M0/P1)

C LM(M0/P0)
r1
r’1
A B
Interest rate

r0

(a) IS and LM schedules

IS(G1)
IS(G0)

Y0 Y1 Y’1 Y
P
output
Ys
Aggregate price level

P1 C
A B (b) Aggregate Demand-
P0 Aggregate Supply Schedules

Yd(G1)
Y (G0)
d

Y0 Y1 Y’1 Y
output 23
LABOR SUPPLY AND
VARIABILITY IN THE MONEY WAGE

24
Contd.

25
26
W (a) Labor Demand and Supply Y (b) Production Function

NS(Pe) F (K , N )
W2 Y2
W1 Y1
W0
Y0
MPN.P2
MPN.P1
MPN.P0

N0 N1 N2 N N0 N1 N2 N
Employment Employment

P
YS

P2 (c) Aggregate Supply

Function
P1
P0

Y 0 Y 1 Y2 Y (output)
27
Figure 8.10: The Keynesian Aggregate Supply Schedule When the Money Wage Variable
Contd.

28
29
 (a) Labor Demand and Supply
W
Based on Figure 8.6
NS (W variable)

(c) Alternative Aggregate Supply Functions

W1 NS(W = W )
W = W0
P
YS (W variable)

MPN.P1
MPN.P0
YS(W = W )
N0 N'1 N1 N P1

P0
Y F (K , N )
Y1
Y'1
Y'1 Y1 Y
Y0 Y0

(b) Production Function

N0 N'1 N1 N
30
Figure 8.11: The Keynesian Aggregate Supply Schedules for the Fixed and Variable Money Wage Cases
Contd.
W = W0

31
Contd.

32
Contd.

33
THE EFFECTS OF SHIFTS IN THE
AS SCHEDULE

34
 Percentage Growth Rates in Real GNP and the
GNP Price Deflator, 1973-1981
Year Growth in Real GNP Increase in GDP Deflator
1973 5.8 5.8
1974 -0.6 8.8
1975 -1.2 9.3
1976 5.4 5.2
1977 5.5 5.8
1978 5.0 7.4
1979 2.8 8.6
1980 -0.3 9.2
1981 2.5 9.6

This pattern of price and output changes is inconsistent with the

Keynesian model unless shifts in AS schedule are taken into account 35
Contd.

36
Figure 8.12: Price and Output Variations with Shifts in Aggregate Demand and Supply

P
r Ys2
Ys1
Y
s

Ys0

P2 P2

P1
P1
P0
P0
Y
d
2
Y d
1 Yd
Y d
0

Y0 Y1 Y2 Y Y2 Y1 Y0 Y

Price and Output Changes with Shifts in Price and Output Changes with Shifts in
Aggregate Demand Aggregate Supply

37
Contd.

38
Contd.

39
Contd.

40
Contd.

41
W (a) Labor Demand and Supply
NS (P1e)

NS (P0e)
(c) Aggregate Supply
W1 Function
W0
P YS (P1e)
MPN.P0 YS (P0e)

N1 N0 P0
N

Y (b) Production Function

Y0 F (K , N )
Y1 Y1 Y0 Y

N1 N0 N

42
Figure 8.13: The Shifts in Aggregate Supply Schedule with An Increase in the Expected Price Level
Contd.

43
Figure 8.14: Effect of An Autonomous Increase in the World Price of Energy Inputs

P
Ys2(Pe1)
Ys1 (Pe0)

Ys0 (Pe0)

P2

P1

P0

Yd

Y2 Y1 Y0 Y

44
KEYNES VERSUS THE CLASSICS

45
 Figure 8.15: Classical and Keynesian Aggregate Demand and Supply Schedules

P
P
Ys
Ys

P0
P0
Yd(M0)
Yd(M0,G0,T0,I0….)

Y0 Y Y0 Y

Classical Case Keynesian Case

46
Contd.

I0

47
48
Contd.

49
Contd.

50
51