Aggregate Demand and Supply

 Short Run vs. Long Run

 Classical vs. Keynesian
 Developed vs. Developing Economies
The US Economy is suffering from low
demand. Higher wages would help
How does a weak demand hurt productivity?
• Buy less sophisticated goods and services
• Reduction in economies of scale (eg)
• Weak investment
What are the structural reasons for
demand decline in US?
• Slowing population growth
• Rising income inequality is shifting purchasing power from the most
likely to spend to those more likely to save
How to boost demand in US?
• Productive investment as fiscal priority
• Growing the purchasing power of low-income consumers with the
highest propensity to consume
• Unlocking private business and residential investment
• Supporting worker training and transition programs to ensure that
periods of transition do not disrupt incomes
Session 7: Case
1. “Durable goods industries (both capital and consumer) fluctuate
much more violently during the course of business cycle than do
nondurable goods industries” Do you agree with this statement?
Explain
2. What is the difference between multiplier and accelerator? Provide
some real life example.
3. Mention the factors that might alter the values of multiplier and
accelerator.
What is the difference between multiplier and
accelerator? Provide some real life example.
• The accelerator theory of investment argues that we can suppose
investment is related to a change in demand. If demand increases, firms
have incentive to invest. In its development, one postulates that there is an
optimal amount of capital related to the output of the firm and that the firm
would react quickly to changes in the output so as to operate efficiently.
• The investment multiplier argues that if we begin from equilibrium
income and then change investment, the system moves to a new
equilibrium income, the change in which is a multiple of the initial change
in investment.
• The accelerator is a theory of what causes investment to increase
and the multiplier is a theory which measures the effect of the
increase in investment on equilibrium income.
Mention the factors that might alter the
values of multiplier and accelerator.
It may be influenced by many factors such as:
• excess capacity
• elasticity of bank credit
• unemployed resource
• marginal propensity to consume
 The Assumptions of Classical Economics
• The Classical Dichotomy
– Separation of variables into two groups:
• Real – quantities, relative prices
• Nominal – measured in terms of money
• Monetary neutrality:
– Changes in the money supply affect nominal but not real
variables

8
 The Reality of Short-Run Fluctuations
• Classical theory
– Describes the world in the long run, but not the short run
• In the short run
– Changes in nominal variables (like the money supply or
P ) can affect real variables (like Y or the u-rate).
– We use a new model…

. 9
Model of Aggregate Demand and Aggregate Supply
The price level P
“Short-Run
The model Aggregate Supply”
determines the SRAS
equilibrium
price level P1
AD
“Aggregate
Demand”
and equilibrium Y
Y1
output (real GDP).
Real GDP, the
quantity of output
10
 The Aggregate-Demand (AD) Curve
The AD curve shows the
P
quantity of all g&s
demanded in the economy P2
at each price level.
Why the AD curve slopes
downward? P1
Y = C + I + G + NX AD
Assume G is fixed by
government policy. Y2 Y1 Y
To understand the slope of AD, must determine how a
change in P affects C, I, and NX.
11
 The Wealth Effect (P and C )
• Suppose the price level, P, declines
– Increase in the real value of money
– Consumers are wealthier
– Increase in consumer spending, C
– Increase in quantity demanded of goods and services

12
 The Interest-Rate Effect (P and I)
• Suppose the price level, P, declines
– Buying goods and services requires fewer dollars: people
buy bonds and other assets
– Decrease in the interest rate
– Increase spending on investment goods, I
– Increase in quantity demanded of goods and services

13
 The Exchange-Rate Effect (P and NX )
• Suppose the U.S. price level, P, declines
– Decrease in the U.S. interest rate
– U.S. dollar depreciates (decline in the real value of the
dollar in foreign-exchange markets)
– Stimulates U.S. net exports, NX
– Increase in quantity demanded of goods and services

14
 Why the AD curve slopes downward

An increase in P P
reduces the quantity of
goods and services P2
demanded because:
1. the wealth effect
(C falls)
P1
2. the interest-rate
effect (I falls) AD
3. the exchange-rate Y
effect (NX falls) Y2 Y1

15
EXAMPLE 1: A shift in the AD curve
What is the effect of a
stock market boom on P
the AD curve?
A stock market boom
makes households feel P1
wealthier, C rises,
the AD curve shifts right.
AD2
Any event that changes AD1
C, I, G, or NX (except Y
a change in P) will shift Y1 Y2
the AD curve.
. 16
 Why the AD Curve Might Shift – 1
• Changes in C
– Stock market boom/crash
– Preferences re: consumption/saving tradeoff
– Tax hikes/cuts
• Changes in I
– Firms buy new computers, equipment, factories
– Expectations, optimism/pessimism
– Interest rates,
– Monetary policy,
– Tax policy or other tax incentives
17
 Why the AD Curve Might Shift – 2
• Changes in G
– Federal spending, e.g., defense
– State & local spending, e.g., roads, schools

• Changes in NX
– Booms/recessions in countries that buy our
exports
– Appreciation/depreciation resulting from
international speculation in foreign exchange
market

. 18
Active Learning 1: The aggregate-demand curve

What happens to the AD curve in each of the following

scenarios?
A. A ten-year-old investment tax credit expires.
B. The U.S. exchange rate falls.
C. A fall in prices increases the real value of consumers’
wealth.
D. State governments replace their sales taxes with new
taxes on interest, dividends, and capital gains.

19
Active Learning 1: Answers
A. A ten-year-old investment tax credit expires.
– I falls, AD curve shifts left.
B. The U.S. exchange rate falls.
– NX rises, AD curve shifts right.
C. A fall in prices increases the real value of
consumers’ wealth.
– Move down along AD curve (wealth-effect).
D. State governments replace their sales taxes with
new taxes on interest, dividends, and capital
gains.
– C rises, AD shifts right.
20
The case: Economic slowdown: will the fiscal
stimulus package put India back on track?
• Mention Fiscal stimulus package and aggregate demand in
India
• What is the fiscal stimulus transmission mechanism?
• Factors that determine the successful transmission of the
fiscal policies
• Limitations of the multiplier model
• Structural supply-side reforms
 The aggregate-supply (AS ) curves
The AS curve shows
P LRAS
the total quantity of
goods and services SRAS
firms produce and sell
at each price level.

AS is:
 upward-sloping in
short run Y
 vertical in long run

22
 The long-run aggregate-supply curve (LRAS)

The natural rate of output

P LRAS
(YN) is the amount of
output the economy
produces when
unemployment is at its
natural rate.
Also called
potential output
or
YN Y
full-employment output.

23
 Why LRAS is vertical
YN determined by the
P LRAS
economy’s stocks of
labor, capital, and natural
resources, and on the
level of technology. P2

An increase in P P1
does not affect any of
these, so it does not
affect YN.
YN Y
(Classical dichotomy)

24
EXAMPLE 2: A shift in the LRAS curve

What is the effect of an

P LRAS1 LRAS2
increase in immigration
on the LRAS curve?
Immigration increases the
economy’s stock of labor,
L, causing YN to rise.
Any event that changes
any of the determinants
of YN will shift LRAS. YN Y’N Y

25
 Why the LRAS Curve Might Shift – 1
• Changes in L or natural rate of
unemployment
– Immigration
– Changes in natural u-rate (government policies:
more generous unemployment insurance; a new
successful job training program)
• Changes in K or H
– Investment in factories, equipment
– Investment in human capital
– Factories destroyed by a hurricane
26
 Why the LRAS Curve Might Shift – 2
• Changes in natural resources
– Discovery of new mineral deposits
– Reduction in supply of imported oil
– Changing weather patterns that affect agricultural
production
• Changes in technological knowledge
– Productivity improvements from
technological progress

27
 Using AD & AS to depict long-run growth & inflation

Over the long run,

tech. progress shifts LRAS2020
P LRAS2010
LRAS to the right LRAS2000
• and growth in the
money supply P2020
shifts AD to the
right. P2010
AD2020
• Result: P2000
ongoing inflation AD2010
and growth in AD2000
output. Y
Y 2000Y 2010 Y2020

28
 Short run aggregate supply (SRAS) curve
The SRAS curve
P
is upward sloping:
SRAS
Over the period
P2
of 1–2 years,
an increase in P
P1

• causes an increase
in the quantity of Y
goods and services Y1 Y2
supplied.

29
 Why the Slope of SRAS Matters
If AS is vertical, LRAS
P
fluctuations in AD
do not cause Phi
SRAS
fluctuations in output or
Phi
employment.

ADhi
If AS slopes up, Plo
then shifts in AD AD1
Plo
do affect output and ADlo
employment. Ylo Y1 Yhi Y

30
 The Sticky-Wage Theory – 1
• Imperfection:
– Nominal wages are sticky in the short run,
they adjust sluggishly.
• Due to labor contracts, social norms
• Firms and workers set the nominal wage in advance
based on PE, the price level they expect to prevail.

31
 The Sticky-Wage Theory – 2
• If P > PE,
– Revenue is higher, but labor cost is not.
– Production is more profitable, so firms increase output and
employment.
Hence, higher P causes higher Y, so the SRAS curve slopes
upward.

. 32
 The Sticky-Price Theory – 1
• Imperfection:
– Many prices are sticky in the short run.
• Due to menu costs, the costs of adjusting prices.
• Examples: cost of printing new menus,
the time required to change price tags
– Firms set sticky prices in advance based
on PE

33
 The Sticky-Price Theory – 2
• Suppose the Reserve Bank increases the money supply
unexpectedly
– In the long run, P will rise
– In the short run:
• Firms without menu costs can raise their prices immediately
• Firms with menu costs wait to raise prices. With relatively low
prices: increase demand for their products: increase output and
employment
Hence, higher P is associated with higher Y.

34
 The Misperceptions Theory
• Imperfection:
– Firms may confuse changes in P with changes in the relative price
of the products they sell.
• If P rises above PE
– A firm sees its price rise before realizing all prices are rising.
• The firm may believe its relative price is rising, and may
increase output and employment.
So, an increase in P can cause an increase in Y, making the SRAS curve
upward-sloping.

35
 What the 3 theories have in common – 1
• In all 3 theories, Y deviates from YN when
P deviates from PE.
Y = YN + a (P – PE)
Expected
Quantity of
price level
output
supplied a > 0, measures
how much Y Actual
Natural rate responds to price level
of output unexpected
(long-run) changes in P

. 36
 What the 3 theories have in common – 2
Y = YN + a (P – PE)
P

SRAS
When P > PE

the expected
PE
price level

When P < PE

Y
YN
Y < YN Y > YN
37
 SRAS and LRAS
• The imperfections in these theories are temporary. Over
time,
– Sticky wages and prices become flexible
– Misperceptions are corrected
• In the LR,
– PE = P
– AS curve is vertical

38
 SRAS and LRAS

Y = YN + a (P – PE)

P LRAS

SRAS
In the long run,
PE = P
PE
and
Y = YN.

Y
YN
39
 Why the SRAS Curve Might Shift
Everything that shifts
LRAS shifts SRAS,
too. P LRAS
SRAS2
Also, PE shifts SRAS:
SRAS1
If PE rises, PE
workers & firms set
higher wages. PE
At each P,
production is less
profitable, Y falls,
Y
SRAS shifts left. YN

40
 The long-run equilibrium

In the long-run
P LRAS
equilibrium:
• PE = P, SRAS

• Y = YN ,
• and PE

unemployment is
at its natural rate. AD
Y
YN

41
 Analyzing Economic Fluctuations
• Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD–AS diagram to see how the shift changes Y and P in
the short run.
4. Use AD–AS diagram to see how economy moves from new SR
equilibrium to new LR equilibrium .

42
EXAMPLE 3: The effects of a shift in AD
Use the AD–AS diagram to show the effect of a
stock market crash. P LRAS
1. Affects C, AD curve SRAS1
2. C falls, so AD shifts left
3. SR equilibrium at B. P1 A SRAS2
P and Y lower,
P2 B
unemployment higher
AD1
4. Over time, PE falls, P3 C
AD2
SRAS shifts right,
until LR equilibrium at C. Y2 YN Y
Y and unemployment back at initial levels.
43
Active Learning 2: Working with the model
Draw the AD–AS diagram for the U.S. economy starting in a
long-run equilibrium (point A).
• A boom occurs in Canada. Use your diagram to determine
the SR and LR effects on U.S. GDP, the price level, and
unemployment.

44
Active Learning 2: Answers
Event: Boom in Canada P LRAS
SRAS2
1. Affects NX, AD curve
2. Shifts AD right
P3 C SRAS1
3. SR equilibrium at point
B. P and Y higher, P2 B
unemployment lower A
P1 AD2
4. Over time, PE rises,
SRAS shifts left, until AD1
Y
LR equilibrium at C. YN Y2
Y and unemployment
back at initial levels.
45
EXAMPLE 4: The effects of a shift in SRAS
Use the AD–AS diagram to show the effect of an
increase in oil prices (assume the LRAS is constant)
1. Increases costs, shifts P LRAS
SRAS
2. SRAS shifts left SRAS2
3. SR equilibrium at point B.
P higher, Y lower, SRAS1
B
unemployment higher P2
From A to B, stagflation, P1 A a
period of falling output
and rising prices. AD1
Y
Y2 YN
46
EXAMPLE 4: What happens in the long run?
If policymakers do nothing,
4. Low employment P LRAS
causes wages to fall, SRAS2
SRAS shifts right, until
P3 C SRAS1
LR equilibrium at A. B
Or, policymakers could use P2
fiscal or monetary policy to P1 A
increase AD and AD2
accommodate the AS shift: AD1
• Y back to YN, but
Y2 YN Y
P permanently higher.

47
 John Maynard Keynes, 1883–1946
The General Theory of Employment, Interest, and Money, 1936
• Argued recessions and depressions
can result from inadequate demand;
policymakers should shift AD.
• Famous critique of classical theory:
The long run is a misleading guide to
current affairs. In the long run, we are all dead.
Economists set themselves too easy, too useless a task if in tempestuous
seasons they can only tell us when the storm is long past, the ocean will
be flat.

Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 48
 The Covid Recession of 2020, AD-AS model
• AD curve shifted left
– Shopping centers closed by government decree
– People avoided the still open businesses to
reduce the risk of infection
• AS shifted left
– Businesses temporarily shut down
– Caused a sudden, massive reduction in the
quantity of goods and services supplied at every
price level
• Simultaneous shifts in AD and AS (both declined)
– Sharp reduction in production and employment

Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 49
 THINK-PAIR-SHARE
You are watching the evening news on television. The
news anchor reports that union wage demands are much
higher this year because the workers anticipate an increase
in the rate of inflation. Your roommate says, “Inflation is a
self-fulfilling prophecy. If workers think there are going to be
higher prices, they demand higher wages. This increases the
cost of production and firms raise their prices. Expecting
higher prices simply causes higher prices.”

Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 50
 THINK-PAIR-SHARE

A. Is this true in the short run? Explain.

B. If policymakers do nothing and allow the
economy to adjust to the natural level of
output on its own, does expecting higher
prices cause higher prices in the long run?
Explain.
C. If policymakers accommodate the adverse
supply shock, does the expectation of higher
prices cause higher prices in the long run?
Explain.

Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 51
 AS, AD, and Equilibrium
 The amount of the
increase/decrease in P
and Y after a shift in
either aggregate supply
or aggregate demand
depends on:
1. The slope of the AS curve
2. The slope of the AD
curve
3. The extent of the shift of
AS/AD

Figure 5-3 shows the result of an

adverse AS shock: AS  Y, P

5-52
 Classical Supply Curve
• The classical supply curve is vertical, indicating that the same amount of goods will be supplied,
regardless of price [Figure 5-4 (b)]
– Based upon the assumption that the labor market is in equilibrium with full employment of the
labor force
– The level of output corresponding to full employment of the labor force = potential GDP, Y*

5-53
 Classical Supply Curve
• Y* grows over time as the economy accumulates resources and technology improves  AS curve moves
to the right
• Y* is “exogenous with respect to the price level”
 illustrated as a vertical line, since graphed in terms of the price level

5-54
 Keynesian Supply Curve
• The Keynesian supply curve is horizontal, indicating firms will supply whatever
amount of goods is demanded at the existing price level [Figure 5-4 (a)]
– Since unemployment exists, firms can obtain any amount of labor at the going
wage rate
– Since average cost of production does not change as output changes, firms
willing to supply as much as is demanded at the existing price level

5-55
 Keynesian Supply Curve
• Intellectual genesis of the Keynesian AS curve is found in the Great Depression,
when it seemed firms could increase production without increasing P by putting
idle K and N to work
• Additionally, prices are viewed as “sticky” in the short run  firms reluctant to
change prices and wages when demand shifts
– Instead firms increase/decrease output in response to demand shift  flat AS curve in
the short run

5-56
Frictional Unemployment and the Natural Rate
of Unemployment
• Taken literally, the classical model implies that there is no involuntary
unemployment  everyone who wants to work is employed
– In reality there is some unemployment due to frictions in the labor market (Ex. Someone
is always moving and looking for a new job)
• The unemployment rate associated with the full employment level of output is
the natural rate of unemployment
– Natural rate of unemployment is the rate of unemployment arising from normal labor
market frictions that exist when the labor market is in equilibrium

5-57
 AD Relationship Between
Output and Prices
• Key to the AD relationship between output and prices is the dependency of AD on
real money supply
– Real money supply = value of money provided by the central bank and the banking
system
– Real money supply is written as M , where M is the nominal money supply, and P is the
P
price level
– M M
  r  I  AD AND   r  I  AD
P P
• For a given level of M , high prices result in low M OR high prices mean that the
P
value of the number of available dollars is low and thus a high P = low level of AD

5-58
 AD and the Money Market
• For the moment, ignore the goods market and focus on the money market and the
determination of AD
• The quantity theory of money offers a simple explanation of the link between the
money market and AD
– The total number of dollars spent in a year, is P*Y
– The total number of times the average dollar changes hands in a year is the velocity of
money, V
– The central bank provides M dollars

 The fundamental equation underlying the quantity theory of money is the

quantity equation: (2) M V  P  Y

5-59
 AD and the Money Market
M V  P  Y (2)
• If the velocity of money is assumed constant, equation (2) becomes M  V  P  Y
, and is an equation for the AD curve
• For a given level of M, an increase in Y must be offset by a decrease in P,
and vice versa
– Inverse relationship between Y and P as illustrated by downward sloping AD curve
• An increase in M shifts the AD curve upward for any value of Y

5-60
Changes in the Money Stock and AD: Classical
• An increase in the nominal
money stock shifts the AD
schedule up in proportion to
the increase in nominal
money
– Suppose M 0 corresponds to
AD and the economy is
operating at P0 and Y0
– If money stock increases by
10% to M   1.1M 0 , AD shifts to
AD’  the value of P
corresponding to Y0 must be
P’ = 1.1P0 M  1.1M 0 M 0
 
– Therefore P 1.1P0 P0  real
money balances and Y are
unchanged (neutrality)

5-61
AD Policy & the Keynesian Supply Curve
• Figure 5-9 shows the AD
schedule and the
Keynesian supply schedule
– Initial equilibrium is at
point E (AS = AD)
– Suppose an aggregate
demand policy increases
AD to AD’  G,  T ,  M S 

The new equilibrium point, E’,

corresponds to the same price level,
and a higher level of output
(employment is also likely to
increase)

5-62
AD Policy & the Classical Supply Curve
• In the classical case, AS
schedule is vertical at FE level
of output
– Unlike the Keynesian case, the
price level is not given, but
depends upon the interaction
between AS and AD
• Suppose AD increases to AD’
– Spending increases to E’ BUT
firms can not obtain the N
required to meet the increased
demand
– Firms hire more workers &
wages and costs of production
rise  firms must charge
higher price
– Move up AS and AD curves to
E’’ where AS = AD’

5-63
AD Policy & the Classical Supply Curve
• The increase in price from the
increase in AD reduces the real
money stock,   MP  , and
 
leads to a reduction in
spending
• The economy only moves up
AD until prices have risen
enough, and M/P has fallen
enough, to reduce total
spending to a level consistent
with full employment

 this is true at E’’, where AD = AS

5-64
 Supply Side Economics
• Supply side economics focuses on AS as the driver in the economy
• Supply side policies are those that encourage growth in potential output  shift AS
to right
– Such policy measures include:
• Removing unnecessary regulation
• Maintaining efficient legal system
• Encouraging technological progress
• Politicians use the term supply side economics in reference to the idea that cutting
taxes will increase AS enough that tax collections will actually increase, rather than
fall

5-65
 Supply Side Economics
• Cutting tax rates has an impact on
both AS and AD
– AD shifts to AD’ due to increase
in disposable income
• Shift is relatively large
compared to that of the AS
– AS shifts to AS’ as the incentive to
work increases
• In short run, move to E’: GDP
increases, tax revenues fall
proportionately less than tax cut
(AD effect)
• In the LR, moves to E’’: GDP is
higher, but by a small amount, tax
collections fall as the deficit rises,
and prices rise (AS effect)

5-66
 Supply Side Economics
• Supply side policies are useful, despite previous example
– Only supply side policies can permanently increase output
– Demand side policies are useful for short run results
• Many economists support cutting taxes for the incentive effect, but with a
simultaneous reduction in government spending
– Tax collections fall, but the reduction in government spending minimizes the impact
on the deficit

5-67
 AD and Equilibrium Output
• AD is the total amount of goods demanded in the economy: AD  C  I  G  NX (1)
• Output is at its equilibrium level when the quantity of output produced is equal to
the quantity demanded, or Y  AD  C  I  G  NX (2)
• When AD is not equal to output there is unplanned inventory investment or
disinvestment:IU  Y  AD (3), where IU is unplanned additions to inventory
– If IU > 0, firms cut back on production until output and AD are again in equilibrium

10-68
Main Questions to Answer
• How does the interest-rate effect help
explain the slope of the aggregate-demand
curve?
• How can the central bank use monetary
policy to shift the AD curve?
• In what two ways does fiscal policy affect
aggregate demand?
• What are the arguments for and against
using policy to try to stabilize the economy?

69
 Monetary and Fiscal Policy
• Monetary policy
– The open-market operations conducted by the central
bank
– And the interest rate it pays on reserves
• Fiscal policy
– The levels of government spending and taxation set by the
government

70
 Aggregate Demand
• Recall, the AD curve slopes downward for three reasons:
– The wealth effect
– The interest-rate effect the most important
– The exchange-rate effect of these effects for
• Next: the U.S. economy

– A supply-demand model that helps explain the interest-

rate effect and how monetary policy affects aggregate
demand.

71
 Theory of Liquidity Preference – 1
• The theory of liquidity preference
– Keynes’s theory that the interest rate (r) adjusts to bring
money supply and money demand into balance
• Nominal interest rate and real interest rate
– Assumption: expected rate of inflation is constant

72
 Theory of Liquidity Preference – 2
• The nominal interest rate
– Is the interest rate as usually reported.
• The real interest rate
– Is the interest rate corrected for the effects of inflation.
• When there is no inflation
– The nominal interest rate = the real interest rate

73
 Theory of Liquidity Preference – 3
• Money supply, MS
– Assumed fixed by the Reserve Bank, does not depend
on interest rate
• Tool the Reserve Bank uses to can change the MS:
– Open market operations
– Repo rate and reverse repo rate
– Statutory Liquidity ratio
– Cash Reserve Ratio
– Bank Rate
74
 Theory of Liquidity Preference – 4
• Money demand, MD
– Reflects how much wealth people want to hold in liquid
form
– Assume household wealth includes only two assets:
• Money – liquid but pays no interest
• Bonds – pay interest but not as liquid
– A household’s “money demand” reflects its preference for
liquidity

75
 How r is determined
MS curve is vertical:
Interest Changes in r do not
rate MS affect MS, which is
fixed by the Reserve
r1 Bank.
Eq’m
interest MD curve is
rate MD1 downward sloping:
A fall in r increases
the quantity of money
M, quantity
demanded.
Quantity fixed of Money
by the
Reserve Bank 76
 Theory of Liquidity Preference – 5
• Variables that influence money demand:
– Y, r, and P.
• Suppose real income (Y) rises:
– Households want to buy more goods and services, so they
need more money
– To get this money, they attempt to sell some of their
bonds.
An increase in Y causes an increase in money demand, other
things equal.
77
Active Learning 1: Determinants of money demand

What happens to money demand in the following two

scenarios?

A. Suppose r rises, but Y and P are unchanged.

B. Suppose P rises, but Y and r are unchanged.

78
Active Learning 1: Answers, A
A. Suppose r rises, but Y and P are unchanged.
– r is the opportunity cost of holding money.
– An increase in r reduces the quantity of money demanded:
households attempt to buy bonds to take advantage of the higher
interest rate.
– Hence, an increase in r causes a decrease in the quantity of
money demanded, other things equal.

79
Active Learning 1: Answers, B
B. Suppose P rises, but Y and r are unchanged.
– If Y is unchanged, people will want to buy the same amount of
goods and services.
– Since P is higher, they will need more money to do so.
– Hence, an increase in P causes an increase in money demand,
other things equal.

80
 How the interest-rate effect works
A fall in P reduces money demand, which lowers r.
Interest P
rate MS

r1
P1

r2 P2
MD1 AD
MD2
M Y1 Y2 Y

A fall in r increases I and the quantity of g&s demanded, Y.

81
 Monetary Policy and the AD
• Shifting the aggregate-demand curve using monetary
policy
– If the Reserve Bank decreases the money supply by
selling government bonds in open-market operations
– Interest rate increases to balance money supply and
money demand
– Households and firms respond to the higher interest rate:
reduce spending and investment

82
EXAMPLE 1: Effects of reducing MS
The Reserve Bank can raise r by reducing the
money supply.
Interest P
rate MS2 MS1

r2
P1
r1
AD1
MD AD2
M Y2 Y1 Y

An increase in r reduces the quantity of g&s demanded.

83
 The Role of Interest-Rate Targets
• Because
– The MS is hard to measure with sufficient
precision and MD fluctuates over time
– Leads to fluctuations in interest rates, AD, output
• Reserve Bank policy: set a target for federal
funds rate
– Accommodates the day-to-day shifts in MD by
adjusting the MS accordingly
Monetary policy can be described either in
terms of the money supply or in terms of the
interest rate. 84
Active Learning 2: Monetary policy
For each of the events below,
• Determine the short-run effects on output
• Determine how the Reserve Bank should
adjust the money supply and interest rates to
stabilize output
A. Government tries to balance the budget by
cutting government spending.
B. A stock market boom increases household
wealth.
C. War breaks out in the Middle East, causing oil
prices to soar.
85
Active Learning 2: Answers, A
A. Government tries to balance the budget by
cutting government spending.
– This event would reduce aggregate demand
and output.
– To stabilize output, the Government should
increase MS and reduce r to increase
aggregate demand.

86
Active Learning 2: Answers, B
B. A stock market boom increases household
wealth.
– This event would increase aggregate
demand, raising output above its natural
rate.
– To stabilize output, the Reserve Bank should
reduce MS and increase r to reduce
aggregate demand.

87
Active Learning 2: Answers, C
C. War breaks out in the Middle East,
causing oil prices to soar.
– This event would reduce aggregate supply,
causing output to fall.
– To stabilize output, the Reserve Bank should
increase MS and reduce r to increase
aggregate demand.

88
 The Zero Lower Bound – 1
• Liquidity trap
– If interest rates have already fallen to around zero
– Monetary policy may no longer be effective, since nominal
interest rates cannot be reduced further
– Aggregate demand, production, and employment may be
"trapped" at low levels

89
 The Zero Lower Bound – 2
• A central bank continues to have tools to expand the
economy:
– Forward guidance: raise inflation expectations by committing to
keep interest rates low
– Quantitative easing: buy a larger variety of financial instruments
(mortgages, corporate debt, and longer-term government bonds)
– Both tools were used by the Reserve Bank during coronavirus
recession)

90
 How Fiscal Policy Influences AD
• Fiscal policy:
– Setting the level of government purchases (G) and
taxation (T) by government policymakers
– An increase in G and/or decrease in T,
shifts AD right
– A decrease in G and/or increase in T,
shifts AD left

91
EXAMPLE 2: The multiplier effect
Assume the government buys $2 billion of
military trucks from Oshkosh Corporation.
• What is the effect of this purchase on the
aggregate demand?
• Because G increases by $2 billion, the AD curve
shifts to the right by $2 billion
• Oshkosh’s revenue increases by $2 billion
– Distributed to Oshkosh’s workers (as wages) and
owners (as profits or stock dividends).
– These people are also consumers and will spend a
portion of the extra income: C increases so AD
increases
92
EXAMPLE 2: The multiplier effect diagram
A $2b increase in G P
initially shifts AD
AD2 AD3
to the right by $2b. AD1

The increase in Y P1
causes C to rise, $2 billion
which shifts AD
further to the right.
Y1 Y2 Y3 Y

Multiplier effect: the additional shifts in AD that

result when expansionary fiscal policy increases
income and thereby increases consumer spending.
93
 Marginal Propensity to Consume
• How big is the multiplier effect?
– Depends on how much consumers respond to increases
in income.
• Marginal propensity to consume, MPC=ΔC/ΔY
– Fraction of extra income that households consume rather
than save
• Example
– If MPC = 0.8 and income rises $100,
C rises $80.
94
 A formula for the spending multiplier
Notation: ΔG is the change in G,
ΔY and ΔC are the ultimate changes in Y and C
Y = C + I + G + NX identity
ΔY = ΔC + ΔG I and NX do not change
ΔY = MPC ΔY + ΔG because ΔC = MPC ΔY
solved for ΔY
1
ΔY = ΔG
1 – MPC

The multiplier

95
EXAMPLE 3: Calculating the spending multiplier
• Calculate the spending multiplier when MPC is
0.5, 0.75, and 0.9.
• What is the relationship between the MPC and
the simple multiplier?
• If MPC = 0.5, multiplier = 1 / (1-MPC) = 2
• If MPC = 0.75, multiplier = 4
• If MPC = 0.9, multiplier = 10
• The bigger the MPC, the bigger the multiplier.
• A bigger MPC means changes in Y cause bigger
changes in C, which in turn cause bigger changes
in Y.
96
 Other Applications of the Multiplier Effect
• The multiplier effect:
– Each $1 increase in G can generate more than a $1
increase in aggregate demand.
– Also true for the other components of GDP (C, I, G, NX)

97
EXAMPLE 4: How big of a change in AD?
Suppose a recession overseas reduces the
demand for U.S. net exports by $8 billion.
• What is the initial change in AD?
• If MPC = 0.8, what is the change in output?

• Initially, AD falls by $8 billion

• The spending multiplier = 1 / (1-MPC) = 5
• The decrease in Y is = multiplier * change
in NX = 5 * $8 billion = $40 billion

98
 The Crowding-Out Effect
• The crowding-out effect
– Offset in aggregate demand
– Results when expansionary fiscal policy raises the
interest rate
– Thereby reduces investment spending
– Which reduces the net increase in aggregate demand.
– So, the size of the AD shift may be smaller than the initial
fiscal expansion.

99
EXAMPLE 5: The crowding-out effect
Assume the government
A $2b increase buys
in G initially $2 billion
shifts of military
AD right by $2b.
trucks from Oshkosh Corporation.
Interest
P
rate MS
AD AD2
r2 AD1 3

P1
r1
MD2 $2 billion

MD1
M Y1 Y3 Y2 Y

But higher Y increases MD and r, which reduces AD.

100
 Changes in Taxes
• A tax cut
– Increases households’ take-home pay
– Households respond by spending a portion of this extra
income, shifting AD to the right
– The size of the shift is affected by the multiplier and crowding-
out effects
• Another factor: households' perception
– Permanent tax cut – large impact on AD
– Temporary tax cut – small impact on AD

101
Active Learning 3: Fiscal policy effects
The economy is in recession. Policymakers think that shifting
the AD curve rightward by $200 billion would end the
recession.
A. If MPC = 0.8 and there is no crowding out,
how much should government increase G
to end the recession?
B. If there is crowding out, will government need to increase
G more or less than this amount?

102
Active Learning 3: Answers, A
Shifting the AD curve rightward by $200b
would end the recession.
A. If MPC = 0.8 and there is no crowding out,
how much should Congress increase G
to end the recession?
– Multiplier = 1 / (1-MPC) = 1/(1 – .8) = 5
– Increase G by $40b
to shift aggregate demand by:
∆Y = multiplier * ∆G = 5 x $40b = $200b.

103
Active Learning 3: Answers, B
Shifting the AD curve rightward by $200b
would end the recession.
B. If there is crowding out, will government need to increase
G more or less than this amount?
– Crowding out reduces the impact of G on AD.
– To offset this, government should increase G by a larger
amount.

104
 Fiscal Policy and Aggregate Supply – 1
Fiscal policy can affect aggregate supply
People respond to incentives
• A cut in the tax rate
– Gives workers incentive to work more, so it might
increase the quantity of goods and services supplied and
shift AS to the right.
– People who believe this effect is large are called “Supply-
siders”

Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 105
 Fiscal Policy and Aggregate Supply – 2
• G might affect aggregate supply.
– Example: government increases spending on roads.
• Better roads may increase business productivity, which
increases the quantity of goods and services supplied, shifts
AS to the right
• This effect is probably more relevant in the long run: it takes
time to build the new roads and put them into use

Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 106
 The Case for Active Stabilization Policy – 1
• Keynes: “Animal spirits” cause waves of pessimism and optimism
among households and firms, leading to shifts in aggregate demand
and fluctuations in output and employment.
• Also, other factors cause fluctuations,
– Booms and recessions abroad
– Stock market booms and crashes
• If policymakers do nothing
– These fluctuations are destabilizing to businesses,
workers, consumers.

107
 The Case for Active Stabilization Policy – 2
• Proponents of active stabilization policy
– Government should use policy to reduce these
fluctuations:
• When GDP falls below its natural rate, use expansionary
monetary or fiscal policy to prevent or reduce a recession.
• When GDP rises above its natural rate, use contractionary
policy to prevent or reduce an inflationary boom

108
 Keynesians in the White House
• 1961, John F Kennedy
– Pushed for a tax cut to stimulate aggregate demand
– Several of his economic advisors were followers of
Keynes
• 2009, President Barak Obama
– Economy in recession
– Policy: stimulus bill - the American Recovery and
Reinvestment Act (ARRA),
• Substantial increase in government spending

Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 109
Name few incidents of government spending in
India used for stabilizing the economy.
 Case Against Active Stabilization Policy – 1
• Monetary policy affects economy with a long lag:
– Firms make investment plans in advance,
so I takes time to respond to changes in r
– Most economists believe it takes at least
6 months for monetary policy to affect output and employment
• Fiscal policy also works with a long lag:
– Changes in G and T require acts of the parliament.
– Legislative process can take months or years

111
 Case Against Active Stabilization Policy – 2
• Due to these long lags
– Critics of active policy argue that such policies may
destabilize the economy rather than help it:
• By the time the policies affect aggregate demand, the
economy’s condition may have changed.
• Contend that policymakers should focus on long-run goals
like economic growth and low inflation.

112
 Automatic Stabilizers
• Automatic stabilizers:
– Changes in fiscal policy that stimulate
aggregate demand when economy goes into recession
– Occur without policymakers having to take any deliberate
action

113
 Automatic Stabilizers: Examples
• The tax system
– In recession, taxes fall automatically,
which stimulates aggregate demand
• Some government spending
– In recession, more people apply for public assistance
(welfare, unemployment insurance)
• Government spending on these programs automatically rises,
which stimulates aggregate demand

114
 THINK-PAIR-SHARE
The news reports that the Fed raised interest rates by a quarter
of a percent today to head off future inflation. The report then moves
to interviews with prominent politicians. The response of a member of
Congress to the Fed’s move is negative. She says, “The Consumer
Price Index has not increased, yet the Fed is restricting growth in the
economy, supposedly to fight inflation. My constituents will want to
know why they are going to have to pay more when they get a loan,
and I don’t have a good answer. I think this is an outrage and I think
Congress should have hearings on the Fed’s policymaking powers.”

Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 115
 THINK-PAIR-SHARE

A. What interest rate did the Fed raise?

B. State the Fed’s policy in terms of the
money supply.
C. Why might the Fed raise interest rates
before the CPI starts to rise?
D. Many economists believe that the Fed
needs to be independent of politics. Use
the congresswoman’s statement to explain
why so many economists argue for Fed
independence
Mankiw, Principles of Macroeconomics, 10th Edition. © 2024 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 116
 Introduction
• Why output fluctuates around its potential level?
– In business cycle booms and recessions, output rises and falls relative to the trend of
potential output
• Model in this chapter assumes a mutual interaction between output and spending: spending
determines output and income, but output and income also determine spending
• The Keynesian model develops the theory of AD
– Assume that prices do not change at all and that firms are willing to sell any amount of
output at the given level of prices  AS curve is flat
– Key finding: increases in autonomous spending generate additional increases in AD

10-117
 AD and Equilibrium Output
• AD is the total amount of goods demanded in the economy: AD  C  I  G  NX (1)
• Output is at its equilibrium level when the quantity of output produced is equal to
the quantity demanded, or Y  AD  C  I  G  NX (2)
• When AD is not equal to output there is unplanned inventory investment or
disinvestment: IU  Y  AD (3), where IU is unplanned additions to inventory
– If IU > 0, firms cut back on production until output and AD are again in equilibrium

10-118
 The Consumption Function
• Consumption is the largest component of AD
– Consumption increases with income  the relationship between consumption and
income is described by the consumption function
– If C is consumption and Y is income, the consumption function is C  C  cY (4), where
C 0 0  c 1
and
– The intercept of equation (4) is the level of consumption when income is zero  this is
greater than zero since there is a subsistence level of consumption
– The slope of equation (4) is known as the marginal propensity to consume (MPC)  the
increase in consumption per unit increase in income

10-119
The Consumption Function

10-120
 Consumption and Savings
• Income is either spent or saved  a theory that explains consumption is
equivalently explaining the behavior of saving S Y C
– More formally, (5)  a budget constraint
• Combining (4) and (5) yields the savings function:
S  Y  C  Y  C  cY  C  (1  c )Y (6)
– Saving is an increasing function of the level of income because the marginal propensity
to save (MPS), s = 1-c, is positive
• Savings increases as income rises
• Ex. If MPS is 0.1, for every extra dollar of income, savings increases by $0.10 OR consumers save
10% of an extra dollar of income

10-121
 Consumption, AD, and
Autonomous Spending
• Now we incorporate the other components of AD: G, I, taxes, and foreign trade
(assume autonomous)
– Consumption now depends on disposable income, YD  Y  TA  TR
(7) and C  C  cYD  C  c(Y  TR  TA) (8)
• AD then becomes AD  C  I  G  NX
 C  c(Y  TA  TR)  I  G  NX
 C  c(TA  TR )  I  G  NX  cY (9)
 A  cY
where A is independent of the level of income, or autonomous

10-122
Consumption, AD, and
Autonomous Spending

10-123
Equilibrium Income and Output
• Equilibrium occurs where
Y=AD, which is illustrated
by the 45° line  point E
• The arrows show how the
economy reaches
equilibrium
– At any level of output
below Y0, firms’
inventories decline, and
they increase production
– At any level of output
above Y0, firms’
inventories increase, and
they decrease production

10-124
 The Formula for Equilibrium Output
• Can solve for the equilibrium level of output, Y0, algebraically:
– The equilibrium condition is Y = AD (10)
– Substituting (9) into (10) yieldsY  A  cY (11)
– Solve for Y to find the equilibrium level of output:

Y  cY  A (12)
Y (1  c )  A
1
Y0  A
(1  c )

The equilibrium level of output is higher the larger the

MPC and the higher the level of autonomous spending.

10-125
 The Formula for Equilibrium Output
• Equation (12) shows the level of output as a function of the MPC and A
– Frequently we are interested in knowing how a change in some component of
autonomous spending would change output
– Relate changes in output to changes in autonomous spending through Y  1 A (13)
(1  c )
• Ex. If the MPC = 0.9, then 1/(1-c) = 10  an increase in government spending by $1 billion
results in an increase in output by $10 billion
• Recipients of increased government spending increase their own spending, the recipients of that
spending increase their spending and so on

10-126
 Saving and Investment
• In equilibrium, planned
investment equals saving in
an economy with no
government or trade
– Vertical distance between
the AD and consumption
schedules equal to planned
investment spending, I
– The vertical distance
between the consumption
schedule and the 45° line
measures saving at each
level of income
 at Y0 the two vertical distances
are equal and S = I

10-127
 Saving and Investment
• The equality between planned investment and saving can be seen directly
from national income accounting
– Income is either spent or saved: Y  C  S
– Without G or trade, Y  C  I
– Putting the two together: C  S  C  I
SI

10-128
 Saving and Investment
• With government and foreign trade in the model:
– Income is either spent, saved, or paid in taxes: Y  C  S  TA  TR
– Complete aggregate demand is AD  C  I  G  NX
– Putting the two together:

C  I  G  NX  C  S  TA  TR
(14)
I  S  (TA  TR  G )  NX

10-129
 The Multiplier
• By how much does a $1 increase in autonomous spending raise the equilibrium level of
income?  The answer is not $1
– Out of an additional dollar in income, $c is consumed
– Output increases to meet increased expenditure; change in output = (1+c)
– Expansion in output and income results in further increases

10-130
 The Multiplier
• If we write out the successive rounds of increased spending, starting with the initial
increase in autonomous demand, we have:
AD  A  cA  c 2 A  c 3A  ... (15)
 A (1  c  c 2  c 3  ...)
– This is a geometric series, where c < 1, that simplifies to:
1 (16)
AD  A  Y0
(1  c )
• Multiplier = amount by which equilibrium output changes when autonomous aggregate
demand increases by 1 unit
– The general definition of the multiplier is
Y
 
1 (17)
A (1  c )

10-131
 The Multiplier
• Effect of an increase in
autonomous spending on
the equilibrium level of
output:
– The initial equilibrium is at
point E, with income at Y0
– If autonomous spending
increases, the AD curve
shifts up by A , and
income increases to Y’
– The new equilibrium is at
E’ with income at

Y0  Y0  Y0

10-132
 The Government Sector
• The government affects the level of equilibrium output in two ways:
1. Government expenditures (component of AD)
2. Taxes and transfers
• Fiscal policy is the policy of the government with regards to G, TR, and TA
– Assume G and TR are constant, and that there is a proportional income tax (t)
– The consumption function becomes: C  C  c(Y  TR  tY ) (19)

 C  cTR  c(1  t )Y

10-133
 The Government Sector
• Combining (19) with AD: AD  C  I  G  NX
 C  cTR  c(1  t )Y  I  G  NX
 A  c(1  t )Y (20)

• Using the equilibrium condition, Y=AD, and equation (19), the equilibrium level of
output is: Y  A  c(1  t )Y
Y  c(1  t )Y  A
Y 1  c(1  t )  A
(21)
A
Y0 
1  c(1  t )
• The presence of the government sector flattens the AD curve and reduces the
multiplier to 1
(1  c(1  t ))

10-134
 Income Taxes as an Automatic Stabilizer
• Automatic stabilizer is any mechanism in the economy that automatically (without
case-by-case government intervention) reduces the amount by which output
changes in response to a change in autonomous demand
– One explanation of the business cycle is that it is caused by shifts in autonomous
demand, especially investment
– Swings in investment demand have a smaller effect on output when automatic
stabilizers are in place (ex. Proportional income tax)
• Unemployment benefits are another example of an automatic stabilizer  enables unemployed
to continue consuming even though they do not have a job

10-135
Effects of a Change in Fiscal Policy
• Suppose government
expenditures increase
– Results in a change in
autonomous spending and
shifts the AD schedule
upward by the amount of
that change
– At the initial level of output,
Y0, the demand for goods >
output, and firms increase
production until reach new
equilibrium (E’)
• How much does income
expand? The change in
1
Y0 
equilibrium G  G is:
income G
1  c(1  t )
(22)

10-136
Effects of a Change in Fiscal Policy
1
Y0   G   G G
1  c(1  t )
(22)

• A $1 increase in G will lead

to an increase in income in
excess of a dollar
– If c = 0.80 and t = 0.25, the
multiplier is 2.5

® A $1 increase in G results in
an increase in equilibrium
income of $2.50
® G, Y shown in Figure 10-
3

10-137
 Effects of a Change in Fiscal Policy
• Suppose government increases TR instead
– Autonomous spending would increase by only cTR, so output would increase by G
cTR
– The multiplier for transfer payments is smaller than that for G by a factor of c
• Part of any increase in TR is saved (since considered income)
• If the government increases marginal tax rates, two things happen:
– The direct effect is that AD is reduced since disposable income decreases, and thus
consumption falls
– The multiplier is smaller, and the shock will have a smaller effect on AD

10-138
 The Budget
• The budget surplus is the excess of the government’s revenues, TA, over its initial
expenditures consisting of purchases of goods and services and TR: (24)
BS  TA  G  TR
– A negative budget surplus is a budget deficit

10-139
 The Budget
• If TA = tY, the budget surplus is defined as: BS  tY  G  TR (24a)
• Figure 10-6 plots the BS as a function of the level of income for given G, TR,
and t
– At low levels of income, the budget is in deficit since spends more than it
receives in income
– At high levels of income, the budget is in surplus since the government receives
more in income than it spends

10-140
 The Budget
• Figure 10-6 shows that the budget deficit depends on the government’s policy choices (G, t,
and TR) and also anything else that shifts the level of income
– Ex. Suppose that there is an increase in I demand that increases the level of output
 budget deficit will fall as tax revenues increase

10-141
 Effects of Government Purchases
and Tax Changes on the BS

• How do changes in fiscal policy affect the budget? OR Must an increase in

G reduce the BS?
– An increase in G reduces the surplus, but also increases income, and thus tax
revenues

® Possibility that increased tax collections > increase in G

10-142
 Effects of Government Purchases
and Tax Changes on the BS
• The change in income due to increased G is equal to Y0  G G
, a fraction of which is collected in taxes
– Tax revenues increases by t G G
– The change in BS is
BS  TA  G
 tG G  G
(25)
(1  c )(1  t )
 G
1  c(1  t )

10-143