Unit 3:�Aggregate Demand and Supply and Fiscal Policy

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Debates Over Aggregate Supply

Classical Theory

• A change in AD will not change output even in the short run because prices of resources (wages) are very flexible.
• AS is vertical so AD can’t increase without causing inflation.

Price level

Real domestic output, GDP

AS

Q_f

AD

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Debates Over Aggregate Supply

Classical Theory

• A change in AD will not change output even in the short run because prices of resources (wages) are very flexible.
• AS is vertical so AD can’t increase without causing inflation.

Price level

Real domestic output, GDP

AS

Q_f

AD

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Recessions caused by a fall in AD are temporary.

Price level will fall and economy will fix itself.

No Government Involvement Required

AD₁

Debates Over Aggregate Supply

Keynesian Theory

• A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible.
• Increase in AD during a recession doesn’t cause inflation

Price level

Real domestic output, GDP

AS

Q_f

AD

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Debates Over Aggregate Supply

Keynesian Theory

• A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible.
• Increase in AD during a recession puts no pressure on prices

Price level

Real domestic output, GDP

AS

Q_f

AD

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Q₁

“Sticky Wages” prevents wages to fall.

The government should increase spending to close the gap

AD₁

Debates Over Aggregate Supply

Keynesian Theory

• A decrease in AD will lead to a persistent recession because prices of resources (wages) are NOT flexible.
• Increase in AD during a recession puts no pressure on prices

Price level

Real domestic output, GDP

AS

Q_f

AD₂

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AD₁

Q₁

When there is high unemployment, an increase in AD doesn’t lead to higher prices until you get close to full employment

AD₃

The Ratchet Effect

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Like a ratchet, prices can easily move up but not down!

Does deflation (falling prices) often occur?

Not as often as inflation. Why?

• If prices were to fall, the cost of resources must fall or firms would go out of business.
• The cost of resources (especially labor) rarely fall because:
• Labor Contracts (Unions)
• Wage decrease results in poor worker morale.
• Firms must pay to change prices (ex: re-pricing items in inventory, advertising new prices to consumers, etc.)

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Sticky Wages & Prices

• This is an important concept to not only understand but its effects as well.

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Three Ranges of Aggregate Supply

1. Keynesian Range- Horizontal at low output

2. Intermediate Range- Upward sloping

3. Classical Range- Vertical at Physical Capacity

Price level

Real domestic output, GDP

AS

Q_f

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Keynesian

Range

Intermediate

Range

Classical

Range

What?! I’m still confused.

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Click the Khan Academy image above for an additional video explanation.

Classical Theory

• Views the economy as self-adjusting or self-correcting. It is able to reach Long Run Full Employment and output without government interference.
• Don’t worry, be happy, it will all work in the LONG RUN!

Keynesian Economics

• John Maynard Keynes said, “We’ll all be dead in the LONG RUN!”
• There will be times when we need to expand the economy and government should increase spending.
• Fiscal Policy

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Adam Smith

1723-1790

John Maynard Keynes

1883-1946

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Classical

vs.

Keynesian

F.A. Hayek

1899-1992

Video Rap: �Hayek vs. Keynes

We will watch this in class.

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