11 Aggregate Demand and Aggregate Supply
A key part of macroeconomics is the use of models to analyze macro issues and problems. How is the rate of economic growth connected to changes in the unemployment rate? Is there a reason why unemployment and inflation seem to move in opposite directions: lower unemployment and higher inflation from 1997 to 2000, higher unemployment and lower inflation in the early 2000s, lower unemployment and higher inflation in the mid-2000s, and then higher unemployment and lower inflation in 2009? Why did the current account deficit rise so high, but then decline in 2009?
To analyze questions like these, we must move beyond discussing macroeconomic issues one at a time, and begin building economic models that will capture the relationships and interconnections between them. The next three chapters take up this task. This chapter introduces the macroeconomic model of aggregate supply and aggregate demand, how the two interact to reach a macroeconomic equilibrium, and how shifts in aggregate demand or aggregate supply will affect that equilibrium. This chapter also relates the model of aggregate supply and aggregate demand to the three goals of economic policy (growth, unemployment, and inflation), and provides a framework for thinking about many of the connections and tradeoffs between these goals. The chapter on The Keynesian Perspective focuses on the macroeconomy in the short run, where aggregate demand plays a crucial role. The chapter on The Neoclassical Perspective explores the macroeconomy in the long run, where aggregate supply plays a crucial role.
11.1 Macroeconomic Perspectives on Demand and Supply
Macroeconomists over the last two centuries have often divided into two groups: those who argue that supply is the most important determinant of the size of the macroeconomy while demand just tags along, and those who argue that demand is the most important factor in the size of the macroeconomy while supply just tags along.
11.1.1 Say’s Law and the Macroeconomics of Supply
Those economists who emphasize the role of supply in the macroeconomy often refer to the work of a famous French economist of the early nineteenth century named Jean-Baptiste Say (1767–1832). Say’s law is: “Supply creates its own demand.” As a matter of historical accuracy, it seems clear that Say never actually wrote down this law and that it oversimplifies his beliefs, but the law lives on as useful shorthand for summarizing a point of view.
The intuition behind Say’s law is that each time a good or service is produced and sold, it generates income that is earned for someone: a worker, a manager, an owner, or those who are workers, managers, and owners at firms that supply inputs along the chain of production. The forces of supply and demand in individual markets will cause prices to rise and fall. The bottom line remains, however, that every sale represents income to someone, and so, Say’s law argues, a given value of supply must create an equivalent value of demand somewhere else in the economy. Because Jean-Baptiste Say, Adam Smith, and other economists writing around the turn of the nineteenth century who discussed this view were known as “classical” economists, modern economists who generally subscribe to the Say’s law view on the importance of supply for determining the size of the macroeconomy are called neoclassical economists.
If supply always creates exactly enough demand at the macroeconomic level, then (as Say himself recognized) it is hard to understand why periods of recession and high unemployment should ever occur. To be sure, even if total supply always creates an equal amount of total demand, the economy could still experience a situation of some firms earning profits while other firms suffer losses. Nevertheless, a recession is not a situation where all business failures are exactly counterbalanced by an offsetting number of successes. A recession is a situation in which the economy as a whole is shrinking in size, business failures outnumber the remaining success stories, and many firms end up suffering losses and laying off workers.
Say’s law that supply creates its own demand does seem a good approximation for the long run. Over periods of some years or decades, as the productive power of an economy to supply goods and services increases, total demand in the economy grows at roughly the same pace. However, over shorter time horizons of a few months or even years, recessions or even depressions occur in which firms, as a group, seem to face a lack of demand for their products.
11.1.2 Keynes’ Law and the Macroeconomics of Demand
The alternative to Say’s law, with its emphasis on supply, can be named Keynes’ law: “Demand creates its own supply.” As a matter of historical accuracy, just as Jean-Baptiste Say never wrote down anything as simpleminded as Say’s law, John Maynard Keynes never wrote down Keynes’ law, but the law is a useful simplification that conveys a certain point of view.
When Keynes wrote his great work The General Theory of Employment, Interest, and Money during the Great Depression of the 1930s, he pointed out that during the Depression, the capacity of the economy to supply goods and services had not changed much. U.S. unemployment rates soared higher than 20% from 1933 to 1935, but the number of possible workers had not increased or decreased much. Factories were closed and shuttered, but machinery and equipment had not disappeared. Technologies that had been invented in the 1920s were not un-invented and forgotten in the 1930s. Thus, Keynes argued that the Great Depression—and many ordinary recessions as well—were not caused by a drop in the ability of the economy to supply goods as measured by labor, physical capital, or technology. He argued the economy often produced less than its full potential, not because it was technically impossible to produce more with the existing workers and machines, but because a lack of demand in the economy as a whole led to inadequate incentives for firms to produce. In such cases, he argued, the level of GDP in the economy was not primarily determined by the potential of what the economy could supply, but rather by the amount of total demand.
Keynes’ law seems to apply fairly well in the short run of a few months to a few years, when many firms experience either a drop in demand for their output during a recession or so much demand that they have trouble producing enough during an economic boom. However, demand cannot tell the whole macroeconomic story, either. After all, if demand was all that mattered at the macroeconomic level, then the government could make the economy as large as it wanted just by pumping up total demand through a large increase in the government spending component or by legislating large tax cuts to push up the consumption component. Economies do, however, face genuine limits to how much they can produce, limits determined by the quantity of labor, physical capital, technology, and the institutional and market structures that bring these factors of production together. These constraints on what an economy can supply at the macroeconomic level do not disappear just because of an increase in demand.
11.1.3 Combining Supply and Demand in Macroeconomics
Two insights emerge from this overview of Say’s law with its emphasis on macroeconomic supply and Keynes’ law with its emphasis on macroeconomic demand. The first conclusion, which is not exactly a hot news flash, is that an economic approach focused only on the supply side or only on the demand side can be only a partial success. Both supply and demand need to be taken into account. The second conclusion is that since Keynes’ law applies more accurately in the short run and Say’s law applies more accurately in the long run, the tradeoffs and connections between the three goals of macroeconomics may be different in the short run and the long run.
- Neoclassical economists emphasize Say’s law, which holds that supply creates its own demand.
- Keynesian economists emphasize Keynes’ law, which holds that demand creates its own supply.
- Many mainstream economists take a Keynesian perspective, emphasizing the importance of aggregate demand, for the short run, and a neoclassical perspective, emphasizing the importance of aggregate supply, for the long run.
Describe the mechanism by which supply creates its own demand.
Describe the mechanism by which demand creates its own supply.
What is Say’s law?
Do neoclassical economists believe in Keynes’ law or Say’s law?
11.2 Building a Model of Aggregate Demand and Aggregate Supply
To build a useful macroeconomic model, we need a model that shows what determines total supply or total demand for the economy, and how total demand and total supply interact at the macroeconomic level. This model is called the aggregate demand/aggregate supply model. This module will explain aggregate supply, aggregate demand, and the equilibrium between them. The following modules will discuss the causes of shifts in aggregate supply and aggregate demand.
11.2.1 The Aggregate Supply Curve and Potential GDP
Firms make decisions about what quantity to supply based on the profits they expect to earn. Profits, in turn, are also determined by the price of the outputs the firm sells and by the price of the inputs, like labor or raw materials, the firm needs to buy. Aggregate supply (AS) refers to the total quantity of output (i.e. real GDP) firms will produce and sell. The aggregate supply (AS) curve shows the total quantity of output (i.e. real GDP) that firms will produce and sell at each price level.
Figure 11.1 shows an aggregate supply curve. In the following paragraphs, we will walk through the elements of the diagram one at a time: the horizontal and vertical axes, the aggregate supply curve itself, and the meaning of the potential GDP vertical line.
The horizontal axis of the diagram shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis shows the price level. Remember that the price level is different from the inflation rate. Visualize the price level as an index number, like the GDP deflator, while the inflation rate is the percentage change between price levels over time.
As the price level (the average price of all goods and services produced in the economy) rises, the aggregate quantity of goods and services supplied rises as well. Why? The price level shown on the vertical axis represents prices for final goods or outputs bought in the economy—like the GDP deflator—not the price level for intermediate goods and services that are inputs to production. Thus, the AS curve describes how suppliers will react to a higher price level for final outputs of goods and services, while holding the prices of inputs like labor and energy constant. If firms across the economy face a situation where the price level of what they produce and sell is rising, but their costs of production are not rising, then the lure of higher profits will induce them to expand production.
The slope of an AS curve changes from nearly flat at its far left to nearly vertical at its far right. At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP, which is defined as the quantity that an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions. At these relatively low levels of output, levels of unemployment are high, and many factories are running only part-time, or have closed their doors. In this situation, a relatively small increase in the prices of the outputs that businesses sell—while making the assumption of no rise in input prices—can encourage a considerable surge in the quantity of aggregate supply because so many workers and factories are ready to swing into production.
Video - Aggregate Supply
As the quantity produced increases, however, certain firms and industries will start running into limits: perhaps nearly all of the expert workers in a certain industry will have jobs or factories in certain geographic areas or industries will be running at full speed. In the intermediate area of the AS curve, a higher price level for outputs continues to encourage a greater quantity of output—but as the increasingly steep upward slope of the aggregate supply curve shows, the increase in quantity in response to a given rise in the price level will not be quite as large. (Read the following Clear It Up feature to learn why the AS curve crosses potential GDP.)
WHY DOES AS-CURVE CROSS POTENTIAL GDP?
The aggregate supply curve is typically drawn to cross the potential GDP line. This shape may seem puzzling: How can an economy produce at an output level which is higher than its “potential” or “full employment” GDP? The economic intuition here is that if prices for outputs were high enough, producers would make fanatical efforts to produce: all workers would be on double-overtime, all machines would run 24 hours a day, seven days a week. Such hyper-intense production would go beyond using potential labor and physical capital resources fully, to using them in a way that is not sustainable in the long term. Thus, it is indeed possible for production to sprint above potential GDP, but only in the short run.
At the far right, the aggregate supply curve becomes nearly vertical. At this quantity, higher prices for outputs cannot encourage additional output, because even if firms want to expand output, the inputs of labor and machinery in the economy are fully employed. In this example, the vertical line in the exhibit shows that potential GDP occurs at a total output of 9,500. When an economy is operating at its potential GDP, machines and factories are running at capacity, and the unemployment rate is relatively low—at the natural rate of unemployment. For this reason, potential GDP is sometimes also called full-employment GDP.
11.2.2 The Aggregate Demand Curve
Aggregate demand (AD) refers to the amount of total spending on domestic goods and services in an economy. (Strictly speaking, AD is what economists call total planned expenditure. This distinction will be further explained in the appendix The Expenditure-Output Model . For now, just think of aggregate demand as total spending.) It includes all four components of demand: consumption, investment, government spending, and net exports (exports minus imports). This demand is determined by a number of factors, but one of them is the price level—recall though, that the price level is an index number such as the GDP deflator that measures the average price of the things we buy. The aggregate demand (AD) curve shows the total spending on domestic goods and services at each price level.
Figure 11.2 presents an aggregate demand (AD) curve. Just like the aggregate supply curve, the horizontal axis shows real GDP and the vertical axis shows the price level. The AD curve slopes down, which means that increases in the price level of outputs lead to a lower quantity of total spending. The reasons behind this shape are related to how changes in the price level affect the different components of aggregate demand. The following components make up aggregate demand: consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M): C + I + G + X – M.
- The wealth effect holds that as the price level increases, the buying power of savings that people have stored up in bank accounts and other assets will diminish, eaten away to some extent by inflation. Because a rise in the price level reduces people’s wealth, consumption spending will fall as the price level rises.
- The interest rate effect is that as prices for outputs rise, the same purchases will take more money or credit to accomplish. This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and cars—thus reducing consumption and investment spending.
- The foreign price effect points out that if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world. U.S. exports will be relatively more expensive, and the quantity of exports sold will fall. U.S. imports from abroad will be relatively cheaper, so the quantity of imports will rise. Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures.
Truth be told, among economists all three of these effects are controversial, in part because they do not seem to be very large. For this reason, the aggregate demand curve in Figure slopes downward fairly steeply; the steep slope indicates that a higher price level for final outputs reduces aggregate demand for all three of these reasons, but that the change in the quantity of aggregate demand as a result of changes in price level is not very large.
Read the following Work It Out feature to learn how to interpret the AD/AS model. In this example, aggregate supply, aggregate demand, and the price level are given for the imaginary country of Xurbia.
INTERPRETING THE AD/AS MODEL
The following table shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia. What information does Table tell you about the state of the Xurbia’s economy? Where is the equilibrium price level and output level (this is the SR macroequilibrium)? Is Xurbia risking inflationary pressures or facing high unemployment? How can you tell?
| Price Level | Aggregate Demand | Aggregate Supply |
|---|---|---|
| 110 | $700 | $600 |
| 120 | $690 | $640 |
| 130 | $680 | $680 |
| 140 | $670 | $720 |
| 150 | $660 | $740 |
| 160 | $650 | $760 |
| 170 | $640 | $770 |
To begin to use the AD/AS model, it is important to plot the AS and AD curves from the data provided. What is the equilibrium?
Step 1: Draw your x- and y-axis. Label the x-axis Real GDP and the y-axis Price Level.
Step 2: Plot AD on your graph.
Step 3: Plot AS on your graph.
Step 4: Look at Figure 11.3 which provides a visual to aid in your analysis.
Step 5: Determine where AD and AS intersect. This is the equilibrium with price level at 130 and real GDP at $680.
Step 6: Look at the graph to determine where equilibrium is located. We can see that this equilibrium is fairly far from where the AS curve becomes near-vertical (or at least quite steep) which seems to start at about $750 of real output. This implies that the economy is not close to potential GDP. Thus, unemployment will be high. In the relatively flat part of the AS curve, where the equilibrium occurs, changes in the price level will not be a major concern, since such changes are likely to be small.
Step 7: Determine what the steep portion of the AS curve indicates. Where the AS curve is steep, the economy is at or close to potential GDP.
Step 8: Draw conclusions from the given information:
- If equilibrium occurs in the flat range of AS, then economy is not close to potential GDP and will be experiencing unemployment, but stable price level.
- If equilibrium occurs in the steep range of AS, then the economy is close or at potential GDP and will be experiencing rising price levels or inflationary pressures, but will have a low unemployment rate.
11.2.3 Equilibrium in the Aggregate Demand/Aggregate Supply Model
The intersection of the aggregate supply and aggregate demand curves shows the equilibrium level of real GDP and the equilibrium price level in the economy. At a relatively low price level for output, firms have little incentive to produce, although consumers would be willing to purchase a high quantity. As the price level for outputs rises, aggregate supply rises and aggregate demand falls until the equilibrium point is reached.
Figure Figure 11.4 combines the AS curve from Figure 11.1 and the AD curve from Figure 11.2 and places them both on a single diagram. In this example, the equilibrium point occurs at point E, at a price level of 90 and an output level of 8,800.
Confusion sometimes arises between the aggregate supply and aggregate demand model and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital. Read the following Clear It Up feature to gain an understanding of whether AS and AD are macro or micro.
ARE Aggregate Supply (AS) AND Aggregate Demand (AD) MACRO OR MICRO?
These aggregate supply and aggregate demand model and the microeconomic analysis of demand and supply in particular markets for goods, services, labor, and capital have a superficial resemblance, but they also have many underlying differences.
For example, the vertical and horizontal axes have distinctly different meanings in macroeconomic and microeconomic diagrams. The vertical axis of a microeconomic demand and supply diagram expresses a price (or wage or rate of return) for an individual good or service. This price is implicitly relative: it is intended to be compared with the prices of other products (for example, the price of pizza relative to the price of fried chicken). In contrast, the vertical axis of an aggregate supply and aggregate demand diagram expresses the level of a price index like the Consumer Price Index or the GDP deflator—combining a wide array of prices from across the economy. The price level is absolute: it is not intended to be compared to any other prices since it is essentially the average price of all products in an economy. The horizontal axis of a microeconomic supply and demand curve measures the quantity of a particular good or service. In contrast, the horizontal axis of the aggregate demand and aggregate supply diagram measures GDP, which is the sum of all the final goods and services produced in the economy, not the quantity in a specific market.
In addition, the economic reasons for the shapes of the curves in the macroeconomic model are different from the reasons behind the shapes of the curves in microeconomic models. Demand curves for individual goods or services slope down primarily because of the existence of substitute goods, not the wealth effects, interest rate, and foreign price effects associated with aggregate demand curves. The slopes of individual supply and demand curves can have a variety of different slopes, depending on the extent to which quantity demanded and quantity supplied react to price in that specific market, but the slopes of the AS and AD curves are much the same in every diagram (although as we shall see in later chapters, short-run and long-run perspectives will emphasize different parts of the AS curve).
In short, just because the AD/AS diagram has two lines that cross, do not assume that it is the same as every other diagram where two lines cross. The intuitions and meanings of the macro and micro diagrams are only distant cousins from different branches of the economics family tree.
11.2.4 Defining SRAS and LRAS
In the Clear It Up feature titled “Why does AS cross potential GDP?” we differentiated between short run changes in aggregate supply which are shown by the AS curve and long run changes in aggregate supply which are defined by the vertical line at potential GDP.
Video - Short-Run Aggregate Supply
In the short run, if demand is too low (or too high), it is possible for producers to supply less GDP (or more GDP) than potential.
In the long run, however, producers are limited to producing at potential GDP. For this reason, what we have been calling the AS curve, will from this point on may also be referred to as the short run aggregate supply (SRAS) curve. The vertical line at potential GDP may also be referred to as the long run aggregate supply (LRAS) curve.
The upward-sloping short run aggregate supply (SRAS) curve shows the positive relationship between the price level and the level of real GDP in the short run.
Aggregate supply slopes up because when the price level for outputs increases, while the price level of inputs remains fixed, the opportunity for additional profits encourages more production. The aggregate supply curve is near-horizontal on the left and near-vertical on the right.
In the long run, aggregate supply is shown by a vertical line at the level of potential output, which is the maximum level of output the economy can produce with its existing levels of workers, physical capital, technology, and economic institutions.
The downward-sloping aggregate demand (AD) curve shows the relationship between the price level for outputs and the quantity of total spending in the economy. It slopes down because of:
- the wealth effect, which means that a higher price level leads to lower real wealth, which reduces the level of consumption;
- the interest rate effect, which holds that a higher price level will mean a greater demand for money, which will tend to drive up interest rates and reduce investment spending; and
- the foreign price effect, which holds that a rise in the price level will make domestic goods relatively more expensive, discouraging exports and encouraging imports.
The short run aggregate supply curve was constructed assuming that as the price of outputs increases, the price of inputs stays the same. How would an increase in the prices of important inputs, like energy, affect aggregate supply?
In the AD/AS model, what prevents the economy from achieving equilibrium at potential output?
What is on the horizontal axis of the AD/AS diagram? What is on the vertical axis?
11.3 Shifts in Aggregate Supply
The original equilibrium in the AD/AS diagram will shift to a new equilibrium if the AS or AD curve shifts. When the aggregate supply curve shifts to the right, then at every price level, a greater quantity of real GDP is produced. When the SRAS curve shifts to the left, then at every price level, a lower quantity of real GDP is produced. This module discusses two of the most important factors that can lead to shifts in the AS curve: productivity growth and input prices.
11.3.1 How Productivity Growth Shifts the AS Curve
In the long run, the most important factor shifting the AS curve is productivity growth. Productivity means how much output can be produced with a given quantity of labor. One measure of this is output per worker or GDP per capita. Over time, productivity grows so that the same quantity of labor can produce more output. Historically, the real growth in GDP per capita in an advanced economy like the United States has averaged about 2% to 3% per year, but productivity growth has been faster during certain extended periods like the 1960s and the late 1990s through the early 2000s, or slower during periods like the 1970s.
A higher level of productivity shifts the AS curve to the right, because with improved productivity, firms can produce a greater quantity of output at every price level. Figure 11.5 (a) shows an outward shift in productivity over two time periods. The AS curve shifts out from SRAS0 to SRAS1 to SRAS2, reflecting the rise in potential GDP in this economy, and the equilibrium shifts from E0 to E1 to E2.
A shift in the SRAS curve to the right will result in a greater real GDP and downward pressure on the price level, if aggregate demand remains unchanged. However, if this shift in SRAS results from gains in productivity growth, which are typically measured in terms of a few percentage points per year, the effect will be relatively small over a few months or even a couple of years.
11.3.2 How Changes in Input Prices Shift the AS Curve
Higher prices for inputs that are widely used across the entire economy can have a macroeconomic impact on aggregate supply. Examples of such widely used inputs include wages and energy products. Increases in the price of such inputs will cause the SRAS curve to shift to the left, which means that at each given price level for outputs, a higher price for inputs will discourage production because it will reduce the possibilities for earning profits. Figure 11.5 (b) shows the aggregate supply curve shifting to the left, from SRAS0 to SRAS1, causing the equilibrium to move from E0 to E1.
The movement from the original equilibrium of E0 to the new equilibrium of E1 will bring a nasty set of effects: reduced GDP or recession, higher unemployment because the economy is now further away from potential GDP, and an inflationary higher price level as well. For example, the U.S. economy experienced recessions in 1974–1975, 1980–1982, 1990–91, 2001, and 2007–2009 that were each preceded or accompanied by a rise in the key input of oil prices. In the 1970s, this pattern of a shift to the left in SRAS leading to a stagnant economy with high unemployment and inflation was nicknamed stagflation.
Conversely, a decline in the price of a key input like oil will shift the SRAS curve to the right, providing an incentive for more to be produced at every given price level for outputs. From 1985 to 1986, for example, the average price of crude oil fell by almost half, from $24 a barrel to $12 a barrel. Similarly, from 1997 to 1998, the price of a barrel of crude oil dropped from $17 per barrel to $11 per barrel. In both cases, the plummeting price of oil led to a situation like that presented earlier in Figure 11.5 (a), where the outward shift of SRAS to the right allowed the economy to expand, unemployment to fall, and inflation to decline.
Along with energy prices, two other key inputs that may shift the SRAS curve are the cost of labor, or wages, and the cost of imported goods that are used as inputs for other products. In these cases as well, the lesson is that lower prices for inputs cause SRAS to shift to the right, while higher prices cause it to shift back to the left.
11.3.3 Other Supply Shocks
The aggregate supply curve can also shift due to shocks to input goods or labor. For example, an unexpected early freeze could destroy a large number of agricultural crops, a shock that would shift the AS curve to the left since there would be fewer agricultural products available at any given price.
Similarly, shocks to the labor market can affect aggregate supply. An extreme example might be an overseas war that required a large number of workers to cease their ordinary production in order to go fight for their country. In this case, aggregate supply would shift to the left because there would be fewer workers available to produce goods at any given price.
The aggregate demand/aggregate supply (AD/AS) diagram shows how AD and AS interact.
The intersection of the AD and AS curves shows the equilibrium output and price level in the economy. Movements of either AS or AD will result in a different equilibrium output and price level.
The aggregate supply curve will shift out to the right as productivity increases. It will shift back to the left as the price of key inputs rises, and will shift out to the right if the price of key inputs falls.
If the AS curve shifts back to the left, the combination of lower output, higher unemployment, and higher inflation, called stagflation, occurs.
If AS shifts out to the right, a combination of lower inflation, higher output, and lower unemployment is possible.
Suppose the U.S. Congress passes significant immigration reform that makes it easier for foreigners to come to the United States to work. Use the AD/AS model to explain how this would affect the equilibrium level of GDP and the price level.
Suppose concerns about the size of the federal budget deficit lead the U.S. Congress to cut all funding for research and development for ten years. Assuming this has an impact on technology growth, what does the AD/AS model predict would be the likely effect on equilibrium GDP and the price level?
Name some factors that could cause the SRAS curve to shift, and say whether they would shift SRAS to the right or to the left.
Will the shift of SRAS to the right tend to make the equilibrium quantity and price level higher or lower? What about a shift of SRAS to the left?
11.4 Shifts in Aggregate Demand
As mentioned previously, the components of aggregate demand are consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M). (Read the following Clear It Up feature for explanation of why imports are subtracted from exports and what this means for aggregate demand.)
A shift of the AD curve to the right means that at least one of these components increased so that a greater amount of total spending would occur at every price level.
A shift of the AD curve to the left means that at least one of these components decreased so that a lesser amount of total spending would occur at every price level. The Keynesian Perspective will discuss the components of aggregate demand and the factors that affect them. Here, the discussion will sketch two broad categories that could cause AD curves to shift: changes in the behavior of consumers or firms and changes in government tax or spending policy.
DO IMPORTS DIMINISH AGGREGATE DEMAND?
We have seen that the formula for aggregate demand is AD = C + I + G + X - M, where M is the total value of imported goods. Why is there a minus sign in front of imports? Does this mean that more imports will result in a lower level of aggregate demand?
When an American buys a foreign product, for example, it gets counted along with all the other consumption. So the income generated does not go to American producers, but rather to producers in another country; it would be wrong to count this as part of domestic demand. Therefore, imports added in consumption are subtracted back out in the M term of the equation.
Because of the way in which the demand equation is written, it is easy to make the mistake of thinking that imports are bad for the economy. Just keep in mind that every negative number in the M term has a corresponding positive number in the C or I or G term, and they always cancel out.
11.4.1 How Changes by Consumers and Firms Can Affect AD
When consumers feel more confident about the future of the economy, they tend to consume more. If business confidence is high, then firms tend to spend more on investment, believing that the future payoff from that investment will be substantial. Conversely, if consumer or business confidence drops, then consumption and investment spending decline.
The University of Michigan publishes a survey of consumer confidence and constructs an index of consumer confidence each month. The survey results are then reported at http://www.sca.isr.umich.edu, which break down the change in consumer confidence among different income levels. According to that index, consumer confidence averaged around 90 prior to the Great Recession, and then it fell to below 60 in late 2008, which was the lowest it had been since 1980. Since then, confidence has climbed from a 2011 low of 55.8 back to a level in the low 80s, which is considered close to being considered a healthy state.
One measure of business confidence is published by the OECD: the "business tendency surveys". Business opinion survey data are collected for 21 countries on future selling prices and employment, among other elements of the business climate. After sharply declining during the Great Recession, the measure has risen above zero again and is back to long-term averages (the indicator dips below zero when business outlook is weaker than usual). Of course, either of these survey measures is not very precise. They can however, suggest when confidence is rising or falling, as well as when it is relatively high or low compared to the past.
Because a rise in confidence is associated with higher consumption and investment demand, it will lead to an outward shift in the AD curve, and a move of the equilibrium, from E0 to E1, to a higher quantity of output and a higher price level, as shown in Figure 11.6 (a).
Consumer and business confidence often reflect macroeconomic realities; for example, confidence is usually high when the economy is growing briskly and low during a recession. However, economic confidence can sometimes rise or fall for reasons that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure. U.S. presidents, for example, must be careful in their public pronouncements about the economy. If they offer economic pessimism, they risk provoking a decline in confidence that reduces consumption and investment and shifts AD to the left, and in a self-fulfilling prophecy, contributes to causing the recession that the president warned against in the first place. A shift of AD to the left, and the corresponding movement of the equilibrium, from E0 to E1, to a lower quantity of output and a lower price level, is shown in Figure 11.6 (b).
11.4.2 How Government Macroeconomic Policy Choices Can Shift AD
Government spending is one component of AD. Thus, higher government spending will cause AD to shift to the right, as in Figure (a), while lower government spending will cause AD to shift to the left, as in Figure (b). For example, in the United States, government spending declined by 3.2% of GDP during the 1990s, from 21% of GDP in 1991, and to 17.8% of GDP in 1998. However, from 2005 to 2009, the peak of the Great Recession, government spending increased from 19% of GDP to 21.4% of GDP. If changes of a few percentage points of GDP seem small to you, remember that since GDP was about $14.4 trillion in 2009, a seemingly small change of 2% of GDP is equal to close to $300 billion.
Tax policy can affect consumption and investment spending, too. Tax cuts for individuals will tend to increase consumption demand, while tax increases will tend to diminish it. Tax policy can also pump up investment demand by offering lower tax rates for corporations or tax reductions that benefit specific kinds of investment. Shifting C or I will shift the AD curve as a whole.
During a recession, when unemployment is high and many businesses are suffering low profits or even losses, the U.S. Congress often passes tax cuts. During the recession of 2001, for example, a tax cut was enacted into law. At such times, the political rhetoric often focuses on how people going through hard times need relief from taxes. The aggregate supply and aggregate demand framework, however, offers a complementary rationale, as illustrated in Figure. The original equilibrium during a recession is at point E0, relatively far from the full employment level of output. The tax cut, by increasing consumption, shifts the AD curve to the right. At the new equilibrium (E1), real GDP rises and unemployment falls and, because in this diagram the economy has not yet reached its potential or full employment level of GDP, any rise in the price level remains muted. Read the following Clear It Up feature to consider the question of whether economists favor tax cuts or oppose them.
DO ECONOMISTS FAVOR TAX CUTS OR OPPOSE THEM?
One of the most fundamental divisions in American politics over the last few decades has been between those who believe that the government should cut taxes substantially and those who disagree. Ronald Reagan rode into the presidency in 1980 partly because of his promise, soon carried out, to enact a substantial tax cut. George Bush lost his bid for reelection against Bill Clinton in 1992 partly because he had broken his 1988 promise: “Read my lips! No new taxes!” In the 2000 presidential election, both George W. Bush and Al Gore advocated substantial tax cuts and Bush succeeded in pushing a package of tax cuts through Congress early in 2001. Disputes over tax cuts often ignite at the state and local level as well.
What side are economists on? Do they support broad tax cuts or oppose them? The answer, unsatisfying to zealots on both sides, is that it depends. One issue is whether the tax cuts are accompanied by equally large government spending cuts. Economists differ, as does any broad cross-section of the public, on how large government spending should be and what programs might be cut back. A second issue, more relevant to the discussion in this chapter, concerns how close the economy is to the full employment level of output. In a recession, when the intersection of the AD and AS curves is far below the full employment level, tax cuts can make sense as a way of shifting AD to the right. However, when the economy is already doing extremely well, tax cuts may shift AD so far to the right as to generate inflationary pressures, with little gain to GDP.
With the AD/AS framework in mind, many economists might readily believe that the Reagan tax cuts of 1981, which took effect just after two serious recessions, were beneficial economic policy. Similarly, the Bush tax cuts of 2001 and the Obama tax cuts of 2009 were enacted during recessions. However, some of the same economists who favor tax cuts in time of recession would be much more dubious about identical tax cuts at a time the economy is performing well and cyclical unemployment is low.
Video - Shifts in Aggregate Demand and Supply
The use of government spending and tax cuts can be a useful tool to affect aggregate demand and it will be discussed in greater detail in the Government Budgets and Fiscal Policy chapter and The Impacts of Government Borrowing. Other policy tools can shift the aggregate demand curve as well. For example, as discussed in the Monetary Policy and Bank Regulation chapter, the Federal Reserve can affect interest rates and the availability of credit. Higher interest rates tend to discourage borrowing and thus reduce both household spending on big-ticket items like houses and cars and investment spending by business. Conversely, lower interest rates will stimulate consumption and investment demand. Interest rates can also affect exchange rates, which in turn will have effects on the export and import components of aggregate demand.
Spelling out the details of these alternative policies and how they affect the components of aggregate demand can wait for The Keynesian Perspective chapter. Here, the key lesson is that a shift of the aggregate demand curve to the right leads to a greater real GDP and to upward pressure on the price level. Conversely, a shift of aggregate demand to the left leads to a lower real GDP and a lower price level. Whether these changes in output and price level are relatively large or relatively small, and how the change in equilibrium relates to potential GDP, depends on whether the shift in the AD curve is happening in the relatively flat or relatively steep portion of the AS curve.
The AD curve will shift out as the components of aggregate demand—C, I, G, and X–M—rise. It will shift back to the left as these components fall. These factors can change because of different personal choices, like those resulting from consumer or business confidence, or from policy choices like changes in government spending and taxes. If the AD curve shifts to the right, then the equilibrium quantity of output and the price level will rise. If the AD curve shifts to the left, then the equilibrium quantity of output and the price level will fall. Whether equilibrium output changes relatively more than the price level or whether the price level changes relatively more than output is determined by where the AD curve intersects with the AS curve.
The AD/AS diagram superficially resembles the microeconomic supply and demand diagram on the surface, but in reality, what is on the horizontal and vertical axes and the underlying economic reasons for the shapes of the curves are very different. Long-term economic growth is illustrated in the AD/AS framework by a gradual shift of the aggregate supply curve to the right. A recession is illustrated when the intersection of AD and AS is substantially below potential GDP, while an expanding economy is illustrated when the intersection of AS and AD is near potential GDP.
How would a dramatic increase in the value of the stock market shift the AD curve? What effect would the shift have on the equilibrium level of GDP and the price level?
Suppose Mexico, one of our largest trading partners and purchaser of a large quantity of our exports, goes into a recession. Use the AD/AS model to determine the likely impact on our equilibrium GDP and price level.
A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this?
Many financial analysts and economists eagerly await the press releases for the reports on the home price index and consumer confidence index. What would be the effects of a negative report on both of these? What about a positive report?
11.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation
The AD/AS model can convey a number of interlocking relationships between the four macroeconomic goals of growth, unemployment, inflation, and a sustainable balance of trade. Moreover, the AD/AS framework is flexible enough to accommodate both the Keynes’ law approach that focuses on aggregate demand and the short run, while also including the Say’s law approach that focuses on aggregate supply and the long run. These advantages are considerable.
Every model is a simplified version of the deeper reality and, in the context of the AD/AS model, the three macroeconomic goals arise in ways that are sometimes indirect or incomplete. In this module, we consider how the AD/AS model illustrates the three macroeconomic goals of economic growth, low unemployment, and low inflation.
11.5.1 Growth and Recession in the AD/AS Diagram
In the AD/AS diagram, long-run economic growth due to productivity increases over time will be represented by a gradual shift to the right of aggregate supply. The vertical line representing potential GDP (or the “full employment level of GDP”) will gradually shift to the right over time as well. A pattern of economic growth over three years, with the AS curve shifting slightly out to the right each year, was shown earlier in [link] (a). However, the factors that determine the speed of this long-term economic growth rate—like investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growth—do not appear directly in the AD/AS diagram.
In the short run, GDP falls and rises in every economy, as the economy dips into recession or expands out of recession. Recessions are illustrated in the AD/AS diagram when the equilibrium level of real GDP is substantially below potential GDP, as occurred at the equilibrium point E0 in [link]. On the other hand, in years of resurgent economic growth the equilibrium will typically be close to potential GDP, as shown at equilibrium point E1 in that earlier figure.
11.5.2 Unemployment in the AD/AS Diagram
Two types of unemployment were described in the Unemployment chapter. Cyclical unemployment bounces up and down according to the short-run movements of GDP. Over the long run, in the United States, the unemployment rate typically hovers around 5% (give or take one percentage point or so), when the economy is healthy.
In many of the national economies across Europe, the rate of unemployment in recent decades has only dropped to about 10% or a bit lower, even in good economic years. This baseline level of unemployment that occurs year-in and year-out is called the natural rate of unemployment and is determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market. Potential GDP can imply different unemployment rates in different economies, depending on the natural rate of unemployment for that economy.
In the AD/AS diagram, cyclical unemployment is shown by how close the economy is to the potential or full employment level of GDP. Returning to [link], relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP, as in the equilibrium point E1. Conversely, high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram, as at the equilibrium point E0. The factors that determine the natural rate of unemployment are not shown separately in the AD/AS model, although they are implicitly part of what determines potential GDP or full employment GDP in a given economy.
11.5.3 Inflationary Pressures in the AD/AS Diagram
Inflation fluctuates in the short run. Higher inflation rates have typically occurred either during or just after economic booms: for example, the biggest spurts of inflation in the U.S. economy during the twentieth century followed the wartime booms of World War I and World War II. Conversely, rates of inflation generally decline during recessions. As an extreme example, inflation actually became negative—a situation called “deflation”—during the Great Depression.
Even during the relatively short recession of 1991–1992, the rate of inflation declined from 5.4% in 1990 to 3.0% in 1992. During the relatively short recession of 2001, the rate of inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of 2007–2009, the rate of inflation declined from 3.8% in 2008 to –0.4% in 2009. Some countries have experienced bouts of high inflation that lasted for years. In the U.S. economy since the mid–1980s, inflation does not seem to have had any long-term trend to be substantially higher or lower; instead, it has stayed in the range of 1–5% annually.
The AD/AS framework implies two ways that inflationary pressures may arise. One possible trigger is if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the AS curve. In Figure 11.8 (a), there is a shift of aggregate demand to the right; the new equilibrium E1 is clearly at a higher price level than the original equilibrium E0. In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods, because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.
An alternative source of inflationary pressures can occur due to a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor—and causes the aggregate supply curve to shift back to the left. In Figure 11.8 (b), the shift of the SRAS curve to the left also increases the price level from P0 at the original equilibrium (E0) to a higher price level of P1 at the new equilibrium (E1). In effect, the rise in input prices ends up, after the final output is produced and sold, being passed along in the form of a higher price level for outputs.
The AD/AS diagram shows only a one-time shift in the price level. It does not address the question of what would cause inflation either to vanish after a year, or to sustain itself for several years. There are two explanations for why inflation may persist over time. One way that continual inflationary price increases can occur is if the government continually attempts to stimulate aggregate demand in a way that keeps pushing the AD curve when it is already in the steep portion of the SRAS curve.
A second possibility is that, if inflation has been occurring for several years, a certain level of inflation may come to be expected. For example, if consumers, workers, and businesses all expect prices and wages to rise by a certain amount, then these expected rises in the price level can become built into the annual increases of prices, wages, and interest rates of the economy. These two reasons are interrelated, because if a government fosters a macroeconomic environment with inflationary pressures, then people will grow to expect inflation. However, the AD/AS diagram does not show these patterns of ongoing or expected inflation in a direct way.
11.5.4 Importance of the Aggregate Demand/Aggregate Supply Model
Macroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts. For example, start with the three macroeconomic goals of growth, low inflation, and low unemployment. Aggregate demand has four elements: consumption, investment, government spending, and exports less imports.
Aggregate supply reveals how businesses throughout the economy will react to a higher price level for outputs. Finally, a wide array of economic events and policy decisions can affect aggregate demand and aggregate supply, including government tax and spending decisions; consumer and business confidence; changes in prices of key inputs like oil; and technology that brings higher levels of productivity.
The aggregate demand/aggregate supply model is one of the fundamental diagrams in this course because it provides an overall framework for bringing these factors together in one diagram. Indeed, some version of the AD/AS model will appear in every chapter in the rest of this book.
Cyclical unemployment is relatively large in the AD/AS framework when the equilibrium is substantially below potential GDP.
Cyclical unemployment is small in the AD/AS framework when the equilibrium is near potential GDP.
The natural rate of unemployment, as determined by the labor market institutions of the economy, is built into what is meant by potential GDP, but does not otherwise appear in an AD/AS diagram.
Pressures for inflation to rise or fall are shown in the AD/AS framework when the movement from one equilibrium to another causes the price level to rise or to fall.
The balance of trade does not appear directly in the AD/AS diagram, but it appears indirectly in several ways. Increases in exports or declines in imports can cause shifts in AD. Changes in the price of key imported inputs to production, like oil, can cause shifts in AS.
The AD/AS model is the key model used in this book to understand macroeconomic issues.
What impact would a decrease in the size of the labor force have on GDP and the price level according to the AD/AS model?
Suppose, after five years of sluggish growth, the economy of the European Union picks up speed. What would be the likely impact on the U.S. trade balance, GDP, and employment?
Suppose the Federal Reserve begins to increase the supply of money at an increasing rate. What impact would that have on GDP, unemployment, and inflation?
11.6 Keynes’ Law and Say’s Law in the AD/AS Model
The AD/AS model can be used to illustrate both Say’s law that supply creates its own demand and Keynes’ law that demand creates its own supply. Consider the three zones of the SRAS curve as identified in Figure: the Keynesian zone, the neoclassical zone, and the intermediate zone.
Focus first on the Keynesian zone, that portion of the SRAS curve on the far left which is relatively flat. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ek, then certain statements about the economic situation will follow. In the Keynesian zone, the equilibrium level of real GDP is far below potential GDP, the economy is in recession, and cyclical unemployment is high. If aggregate demand shifted to the right or left in the Keynesian zone, it will determine the resulting level of output (and thus unemployment). However, inflationary price pressure is not much of a worry in the Keynesian zone, since the price level does not vary much in this zone.
Now, focus your attention on the neoclassical zone of the SRAS curve, which is the near-vertical portion on the right-hand side. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like En where output is at or near potential GDP, then the size of potential GDP pretty much determines the level of output in the economy. Since the equilibrium is near potential GDP, cyclical unemployment is low in this economy, although structural unemployment may remain an issue. In the neoclassical zone, shifts of aggregate demand to the right or the left have little effect on the level of output or employment. The only way to increase the size of the real GDP in the neoclassical zone is for AS to shift to the right. However, shifts in AD in the neoclassical zone will create pressures to change the price level.
Finally, consider the intermediate zone of the SRAS curve in Figure 11.9. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ei, then we might expect unemployment and inflation to move in opposing directions. For instance, a shift of AD to the right will move output closer to potential GDP and thus reduce unemployment, but will also lead to a higher price level and upward pressure on inflation. Conversely, a shift of AD to the left will move output further from potential GDP and raise unemployment, but will also lead to a lower price level and downward pressure on inflation.
This approach of dividing the SRAS curve into different zones works as a diagnostic test that can be applied to an economy, like a doctor checking a patient for symptoms. First, figure out what zone the economy is in and then the economic issues, tradeoffs, and policy choices will be clarified. Some economists believe that the economy is strongly predisposed to be in one zone or another. Thus, hard-line Keynesian economists believe that the economies are in the Keynesian zone most of the time, and so they view the neoclassical zone as a theoretical abstraction. Conversely, hard-line neoclassical economists argue that economies are in the neoclassical zone most of the time and that the Keynesian zone is a distraction. The Keynesian Perspective and The Neoclassical Perspective should help to clarify the underpinnings and consequences of these contrasting views of the macroeconomy.
FROM HOUSING BUBBLE TO HOUSING BUST
Economic fluctuations, whether those experienced during the Great Depression of the 1930s, the stagflation of the 1970s, or the Great Recession of 2008–2009, can be explained using the AD/AS diagram. Short-run fluctuations in output occur due to shifts of the SRAS curve, the AD curve, or both. In the case of the housing bubble, rising home values caused the AD curve to shift to the right as more people felt that rising home values increased their overall wealth. Many homeowners took on mortgages that exceeded their ability to pay because, as home values continued to go up, the increased value would pay off any debt outstanding. Increased wealth due to rising home values lead to increased home equity loans and increased spending. All these activities pushed AD to the right, contributing to low unemployment rates and economic growth in the United States. When the housing bubble burst, overall wealth dropped dramatically, wiping out the recent gains. This drop in the value of homes was a demand shock to the U.S. economy because of its impact directly on the wealth of the household sector, and its contagion into the financial that essentially locked up new credit. The AD curve shifted to the left as evidenced by the rising unemployment of the Great Recession.
Understanding the source of these macroeconomic fluctuations provided monetary and fiscal policy makers with insight about what policy actions to take to mitigate the impact of the housing crisis. From a monetary policy perspective, the Federal Reserve lowered short-term interest rates to between 0% and 0.25 %, to loosen up credit throughout the financial system. Discretionary fiscal policy measures included the passage of the Emergency Economic Stabilization Act of 2008 that allowed for the purchase of troubled assets, such as mortgages, from financial institutions and the American Recovery and Reinvestment Act of 2009 that increased government spending on infrastructure, provided for tax cuts, and increased transfer payments. In combination, both monetary and fiscal policy measures were designed to help stimulate aggregate demand in the U.S. economy, pushing the AD curve to the right.
While most economists agree on the usefulness of the AD/AS diagram in analyzing the sources of these fluctuations, there is still some disagreement about the effectiveness of policy decisions that are useful in stabilizing these fluctuations. We discuss the possible policy actions and the differences among economists about their effectiveness in more detail in The Keynesian Perspective, Monetary Policy and Bank Regulation, and Government Budgets and Fiscal Policy.
The SRAS curve can be divided into three zones. Keynes’ law says demand creates its own supply, so that changes in aggregate demand cause changes in real GDP and employment. Keynes’ law can be shown on the horizontal Keynesian zone of the aggregate supply curve. The Keynesian zone occurs at the left of the SRAS curve where it is fairly flat, so movements in AD will affect output, but have little effect on the price level.
Say’s law says supply creates its own demand.
Changes in aggregate demand have no effect on real GDP and employment, only on the price level. Say’s law can be shown on the vertical neoclassical zone of the aggregate supply curve.
The neoclassical zone occurs at the right of the SRAS curve where it is fairly vertical, and so movements in AD will affect the price level, but have little impact on output. The intermediate zone in the middle of the SRAS curve is upward-sloping, so a rise in AD will cause higher output and price level, while a fall in AD will lead to a lower output and price level.
If the economy is operating in the neoclassical zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP?
If the economy is operating in the Keynesian zone of the SRAS curve and aggregate demand falls, what is likely to happen to real GDP?
What is the Keynesian zone of the SRAS curve? How much is the price level likely to change in the Keynesian zone?
What is the neoclassical zone of the SRAS curve? How much is the output level likely to change in the neoclassical zone?
What is the intermediate zone of the SRAS curve? Will a rise in output be accompanied by a rise or a fall in the price level in this zone?
11.7 Aggregate Demand in Keynesian Analysis
THE GREAT RECESSION
The 2008-2009 Great Recession hit the U.S. economy hard. According to the Bureau of Labor Statistics (BLS), the number of unemployed Americans rose from 6.8 million in May 2007 to 15.4 million in October 2009. During that time, the U.S. Census Bureau estimated that approximately 170,000 small businesses closed. Mass layoffs peaked in February 2009 when employers gave 326,392 workers notice. U.S. productivity and output fell as well. Job losses, declining home values, declining incomes, and uncertainty about the future caused consumption expenditures to decrease. According to the BLS, household spending dropped by 7.8%.
Home foreclosures and the meltdown in U.S. financial markets called for immediate action by Congress, the President, and the Federal Reserve Bank. For example, the government implemented programs such as the American Restoration and Recovery Act to help millions of people by providing tax credits for homebuyers, paying “cash for clunkers,” and extending unemployment benefits. From cutting back on spending, filing for unemployment, and losing homes, millions of people were affected by the recession. While the United States is now on the path to recovery, people will feel the impact for many years to come.
What caused this recession and what prevented the economy from spiraling further into another depression? Policymakers looked to the lessons learned from the 1930s Great Depression and to John Maynard Keynes' models to analyze the causes and find solutions to the country’s economic woes. The Keynesian perspective is the subject of this chapter.
The Keynesian perspective focuses on aggregate demand. The idea is simple: firms produce output only if they expect it to sell. Thus, while the availability of the factors of production determines a nation’s potential GDP, the amount of goods and services that actually sell, known as real GDP, depends on how much demand exists across the economy. Figure 11.10 illustrates this point.
Keynes argued that, for reasons we explain shortly, aggregate demand is not stable—that it can change unexpectedly. Suppose the economy starts where AD intersects SRAS at P0 and Yp. Because Yp is potential output, the economy is at full employment. Because AD is volatile, it can easily fall. Thus, even if we start at Yp, if AD falls, then we find ourselves in what Keynes termed a recessionary gap. The economy is in equilibrium but with less than full employment, as Y1 in Figure shows. Keynes believed that the economy would tend to stay in a recessionary gap, with its attendant unemployment, for a significant period of time.
In the same way (although we do not show it in the figure), if AD increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output. Consequently, the economy experiences inflation. The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during booms to return aggregate demand to match potential output.
Recall from The Aggregate Supply-Aggregate Demand Model that aggregate demand is total spending, economy-wide, on domestic goods and services. (Aggregate demand (AD) is actually what economists call total planned expenditure. Read the appendix on The Expenditure-Output Model for more on this.) You may also remember that aggregate demand is the sum of four components: consumption expenditure, investment expenditure, government spending, and spending on net exports (exports minus imports). In the following sections, we will examine each component through the Keynesian perspective.
11.7.1 What Determines Consumption Expenditure?
Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are items that last and provide value over time, such as automobiles. Nondurable goods are things like groceries—once you consume them, they are gone. Recall from The Macroeconomic Perspective that services are intangible things consumers buy, like healthcare or entertainment.
Keynes identified three factors that affect consumption:
- Disposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay, also known as disposable income, which is income after taxes.
- Expected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.
- Wealth or credit: When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. When the U.S. stock market rose dramatically in the late 1990s, for example, U.S. savings rates declined, probably in part because people felt that their wealth had increased and there was less need to save. How do people spend beyond their income, when they perceive their wealth increasing? The answer is borrowing. On the other side, when the U.S. stock market declined about 40% from March 2008 to March 2009, people felt far greater uncertainty about their economic future, so savings rates increased while consumption declined.
Finally, Keynes noted that a variety of other factors combine to determine how much people save and spend. If household preferences about saving shift in a way that encourages consumption rather than saving, then AD will shift out to the right.
11.7.2 What Determines Investment Expenditure?
We call spending on new capital goods investment expenditure. Investment falls into four categories: producer’s durable equipment and software, nonresidential structures (such as factories, offices, and retail locations), changes in inventories, and residential structures (such as single-family homes, townhouses, and apartment buildings). Businesses conduct the first three types of investment, while households conduct the last.
Keynes’s treatment of investment focuses on the key role of expectations about the future in influencing business decisions. When a business decides to make an investment in physical assets, like plants or equipment, or in intangible assets, like skills or a research and development project, that firm considers both the expected investment benefits (future profit expectations) and the investment costs (interest rates).
- Expectations of future profits: The clearest driver of investment benefits is expectations for future profits. When we expect an economy to grow, businesses perceive a growing market for their products. Their higher degree of business confidence will encourage new investment. For example, in the second half of the 1990s, U.S. investment levels surged from 18% of GDP in 1994 to 21% in 2000. However, when a recession started in 2001, U.S. investment levels quickly sank back to 18% of GDP by 2002.
- Interest rates also play a significant role in determining how much investment a firm will make. Just as individuals need to borrow money to purchase homes, so businesses need financing when they purchase big ticket items. The cost of investment thus includes the interest rate. Even if the firm has the funds, the interest rate measures the opportunity cost of purchasing business capital. Lower interest rates stimulate investment spending and higher interest rates reduce it.
Many factors can affect the expected profitability on investment. For example, if the energy prices decline, then investments that use energy as an input will yield higher profits. If government offers special incentives for investment (for example, through the tax code), then investment will look more attractive; conversely, if government removes special investment incentives from the tax code, or increases other business taxes, then investment will look less attractive. As Keynes noted, business investment is the most variable of all the components of aggregate demand.
11.7.3 What Determines Government Spending?
The third component of aggregate demand is federal, state, and local government spending. Although we usually view the United States as a market economy, government still plays a significant role in the economy. As we discuss in Environmental Protection and Negative Externalities and Positive Externalitites and Public Goods, government provides important public services such as national defense, transportation infrastructure, and education.
Keynes recognized that the government budget offered a powerful tool for influencing aggregate demand. Not only could more government spending stimulate AD (or less government spending reduce it), but lowering or raising tax rates could influence consumption and investment spending. Keynes concluded that during extreme times like deep recessions, only the government had the power and resources to move aggregate demand.
11.7.4 What Determines Net Exports?
Recall that exports are domestically produced products that sell abroad while imports are foreign produced products that consumers purchase domestically. Since we define aggregate demand as spending on domestic goods and services, export expenditures add to AD, while import expenditures subtract from AD.
Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries. What is happening in the countries' economies that would be purchasing those exports heavily affects the level of demand for a nation's exports. For example, if major importers of American-made products like Canada, Japan, and Germany have recessions, exports of U.S. products to those countries are likely to decline. Conversely, the amount of income in the domestic economy directly affects the quantity of a nation's imports: more income will bring a higher level of imports.
Relative prices of goods in domestic and international markets can also affect exports and imports. If U.S. goods are relatively cheaper compared with goods made in other places, perhaps because a group of U.S. producers has mastered certain productivity breakthroughs, then U.S. exports are likely to rise. If U.S. goods become relatively more expensive, perhaps because a change in the exchange rate between the U.S. dollar and other currencies has pushed up the price of inputs to production in the United States, then exports from U.S. producers are likely to decline.
Table 11.1 summarizes the reasons we have explained for changes in aggregate demand.
| Reasons for a Decrease in Aggregate Demand | Reasons for an Increase in Aggregate Demand |
|---|---|
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- Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports.
- Consumption will change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.
- Investment will change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment.
- Investment will also change when interest rates rise or fall.
- Political considerations determine government spending and taxes.
- Exports and imports change according to relative growth rates and prices between two economies.
- In the Keynesian framework, which of the following events might cause a recession? Which might cause inflation? Sketch AD/AS diagrams to illustrate your answers.
- A large increase in the price of the homes people own.
- Rapid growth in the economy of a major trading partner.
- The development of a major new technology offers profitable opportunities for business.
- The interest rate rises.
- The good imported from a major trading partner become much less expensive.
- In a Keynesian framework, using an AD/AS diagram, which of the following government policy choices offer a possible solution to recession? Which offer a possible solution to inflation? a. A tax increase on consumer income. b. A surge in military spending. c. A reduction in taxes for businesses that increase investment. d. A major increase in what the U.S. government spends on healthcare.
- Name some economic events not related to government policy that could cause aggregate demand to shift.
11.8 The Building Blocks of Keynesian Analysis
Now that we have a clear understanding of what constitutes aggregate demand, we return to the Keynesian argument using the model of aggregate demand/aggregate supply (AD/AS). (For a similar treatment using Keynes’ income-expenditure model, see the appendix on The Expenditure-Output Model.)
Keynesian economics focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects. The Keynesian view of recession is based on two key building blocks. First, aggregate demand is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment. Second, the macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices, which are wages and prices that do not respond to decreases or increases in demand. We will consider these two claims in turn, and then see how they are represented in the AD/AS model.
The first building block of the Keynesian diagnosis is that recessions occur when the level of demand for goods and services is less than what is produced when labor is fully employed. In other words, the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of GDP consistent with full employment. Suppose the stock market crashes, as in 1929, or suppose the housing market collapses, as in 2008. In either case, household wealth will decline, and consumption expenditure will follow. Suppose businesses see that consumer spending is falling. That will reduce expectations of the profitability of investment, so businesses will decrease investment expenditure.
This seemed to be the case during the Great Depression, since the physical capacity of the economy to supply goods did not alter much. No flood or earthquake or other natural disaster ruined factories in 1929 or 1930. No outbreak of disease decimated the ranks of workers. No key input price, like the price of oil, soared on world markets. The U.S. economy in 1933 had just about the same factories, workers, and state of technology as it had had four years earlier in 1929—and yet the economy had shrunk dramatically. This also seems to be what happened in 2008.
As Keynes recognized, the events of the Depression contradicted Say’s law that “supply creates its own demand.” Although production capacity existed, the markets were not able to sell their products. As a result, real GDP was less than potential GDP.
11.8.1 Wage and Price Stickiness
Keynes also pointed out that although AD fluctuated, prices and wages did not immediately respond as economists often expected. Instead, prices and wages are “sticky,” making it difficult to restore the economy to full employment and potential GDP. Keynes emphasized one particular reason why wages were sticky: the coordination argument. This argument points out that, even if most people would be willing—at least hypothetically—to see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline, a market-oriented economy has no obvious way to implement a plan of coordinated wage reductions. Unemployment proposed a number of reasons why wages might be sticky downward, most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers.
Some modern economists have argued in a Keynesian spirit that, along with wages, other prices may be sticky, too. Many firms do not change their prices every day or even every month. When a firm considers changing prices, it must consider two sets of costs. First, changing prices uses company resources: managers must analyze the competition and market demand and decide the new prices, they must update sales materials, change billing records, and redo product and price labels. Second, frequent price changes may leave customers confused or angry—especially if they discover that a product now costs more than they expected. These costs of changing prices are called menu costs—like the costs of printing a new set of menus with different prices in a restaurant. Prices do respond to forces of supply and demand, but from a macroeconomic perspective, the process of changing all prices throughout the economy takes time.
To understand the effect of sticky wages and prices in the economy, consider Figure 11.11 (a) illustrating the overall labor market, while Figure 11.11 (b) illustrates a market for a specific good or service. The original equilibrium (E0) in each market occurs at the intersection of the demand curve (D0) and supply curve (S0). When aggregate demand declines, the demand for labor shifts to the left (to D1) in Figure 11.11 (a) and the demand for goods shifts to the left (to D1) in Figure 11.11 (b). However, because of sticky wages and prices, the wage remains at its original level (W0) for a period of time and the price remains at its original level (P0).
As a result, a situation of excess supply—where the quantity supplied exceeds the quantity demanded at the existing wage or price—exists in markets for both labor and goods, and Q1 is less than Q0 in both Figure 11.11 (a) and Figure 11.11 (b). When many labor markets and many goods markets all across the economy find themselves in this position, the economy is in a recession; that is, firms cannot sell what they wish to produce at the existing market price and do not wish to hire all who are willing to work at the existing market wage. The Clear It Up feature discusses this problem in more detail.
WHY IS THE PACE OF WAGE ADJUSTMENTS SLOW?
The recovery after the Great Recession in the United States has been slow, with wages stagnant, if not declining. In fact, many low-wage workers at McDonalds, Dominos, and Walmart have threatened to strike for higher wages. Their plight is part of a larger trend in job growth and pay in the post–recession recovery.
The National Employment Law Project compiled data from the Bureau of Labor Statistics and found that, during the Great Recession, 60% of job losses were in medium-wage occupations. Most of them were replaced during the recovery period with lower-wage jobs in the service, retail, and food industries. Figure 11.12 illustrates this data.
Wages in the service, retail, and food industries are at or near minimum wage and tend to be both downwardly and upwardly “sticky.” Wages are downwardly sticky due to minimum wage laws. They may be upwardly sticky if insufficient competition in low-skilled labor markets enables employers to avoid raising wages that would reduce their profits. At the same time, however, the Consumer Price Index increased 11% between 2007 and 2012, pushing real wages down.
11.8.2 The Two Keynesian Assumptions in the AD/AS Model
Figure 11.13 is the AD/AS diagram which illustrates these two Keynesian assumptions—the importance of aggregate demand in causing recession and the stickiness of wages and prices. Note that because of the stickiness of wages and prices, the aggregate supply curve is flatter than either supply curve (labor or specific good). In fact, if wages and prices were so sticky that they did not fall at all, the aggregate supply curve would be completely flat below potential GDP, as Figure shows. This outcome is an important example of a macroeconomic externality, where what happens at the macro level is different from and inferior to what happens at the micro level. For example, a firm should respond to a decrease in demand for its product by cutting its price to increase sales. However, if all firms experience a decrease in demand for their products, sticky prices in the aggregate prevent aggregate demand from rebounding (which we would show as a movement along the AD curve in response to a lower price level).
The original equilibrium of this economy occurs where the aggregate demand function (AD0) intersects with AS. Since this intersection occurs at potential GDP (Yp), the economy is operating at full employment. When aggregate demand shifts to the left, all the adjustment occurs through decreased real GDP. There is no decrease in the price level. Since the equilibrium occurs at Y1, the economy experiences substantial unemployment.
11.8.3 The Expenditure Multiplier
A key concept in Keynesian economics is the expenditure multiplier. The expenditure multiplier is the idea that not only does spending affect the equilibrium level of GDP, but that spending is powerful. More precisely, it means that a change in spending causes a more than proportionate change in GDP.
\[\frac{\Delta Y}{\Delta Spending} > 1\]
The reason for the expenditure multiplier is that one person’s spending becomes another person’s income, which leads to additional spending and additional income so that the cumulative impact on GDP is larger than the initial increase in spending. The appendix on The Expenditure-Output Model provides the details of the multiplier process, but the concept is important enough for us to summarize here. While the multiplier is important for understanding the effectiveness of fiscal policy, it occurs whenever any autonomous increase in spending occurs. Additionally, the multiplier operates in a negative as well as a positive direction. Thus, when investment spending collapsed during the Great Depression, it caused a much larger decrease in real GDP. The size of the multiplier is critical and was a key element in discussions of the effectiveness of the Obama administration’s fiscal stimulus package, officially titled the American Recovery and Reinvestment Act of 2009.
- Keynesian economics is based on two main ideas: (1) aggregate demand is more likely than aggregate supply to be the primary cause of a short-run economic event like a recession; (2) wages and prices can be sticky, and so, in an economic downturn, unemployment can result.
- The latter is an example of a macroeconomic externality.
- While surpluses cause prices to fall at the micro level, they do not necessarily at the macro level.
- Instead the adjustment to a decrease in demand occurs only through decreased quantities.
- One reason why prices may be sticky is menu costs, the costs of changing prices.
- These include internal costs a business faces in changing prices in terms of labeling, recordkeeping, and accounting, and also the costs of communicating the price change to (possibly unhappy) customers.
- Keynesians also believe in the existence of the expenditure multiplier—the notion that a change in autonomous expenditure causes a more than proportionate change in GDP.
- From a Keynesian point of view, which is more likely to cause a recession: aggregate demand or aggregate supply, and why?
- Why do sticky wages and prices increase the impact of an economic downturn on unemployment and recession?
- Explain what economists mean by “menu costs.”
11.9 The Keynesian Perspective on Market Forces
Ever since the birth of Keynesian economics in the 1930s, controversy has simmered over the extent to which government should play an active role in managing the economy. In the aftermath of the human devastation and misery of the Great Depression, many people—including many economists—became more aware of vulnerabilities within the market-oriented economic system. Some supporters of Keynesian economics advocated a high degree of government planning in all parts of the economy.
However, Keynes himself was careful to separate the issue of aggregate demand from the issue of how well individual markets worked. He argued that individual markets for goods and services were appropriate and useful, but that sometimes that level of aggregate demand was just too low. When 10 million people are willing and able to work, but one million of them are unemployed, he argued, individual markets may be doing a perfectly good job of allocating the efforts of the nine million workers—the problem is that insufficient aggregate demand exists to support jobs for all 10 million. Thus, he believed that, while government should ensure that overall level of aggregate demand is sufficient for an economy to reach full employment, this task did not imply that the government should attempt to set prices and wages throughout the economy, nor to take over and manage large corporations or entire industries directly.
Even if one accepts the Keynesian economic theory, a number of practical questions remain. In the real world, can government economists identify potential GDP accurately? Is a desired increase in aggregate demand better accomplished by a tax cut or by an increase in government spending? Given the inevitable delays and uncertainties as governments enact policies into law, is it reasonable to expect that the government can implement Keynesian economics? Can fixing a recession really be just as simple as pumping up aggregate demand? Government Budgets and Fiscal Policy will probe these issues. The Keynesian approach, with its focus on aggregate demand and sticky prices, has proved useful in understanding how the economy fluctuates in the short run and why recessions and cyclical unemployment occur. In The Neoclassical Perspective, we will consider some of the shortcomings of the Keynesian approach and why it is not especially well-suited for long-run macroeconomic analysis.
THE GREAT RECESSION
The lessons learned during the 1930s Great Depression and the aggregate expenditure model that John Maynard Keynes proposed gave the modern economists and policymakers of today the tools to effectively navigate the treacherous economy in the latter half of the 2000s. In “How the Great Recession Was Brought to an End", Alan S. Blinder and Mark Zandi wrote that the actions taken by today’s policymakers stand in sharp contrast to those of the early years of the Great Depression.
Today’s economists and policymakers were not content to let the markets recover from recession without taking proactive measures to support consumption and investment. The Federal Reserve actively lowered short-term interest rates and developed innovative ways to pump money into the economy so that credit and investment would not dry up. Both Presidents Bush and Obama and Congress implemented a variety of programs ranging from tax rebates to “Cash for Clunkers” to the Troubled Asset Relief Program to stimulate and stabilize household consumption and encourage investment.
Although these policies came under harsh criticism from the public and many politicians, they lessened the impact of the economic downturn and may have saved the country from a second Great Depression.
- The Keynesian prescription for stabilizing the economy implies government intervention at the macroeconomic level—increasing aggregate demand when private demand falls and decreasing aggregate demand when private demand rises.
- This does not imply that the government should be passing laws or regulations that set prices and quantities in microeconomic markets.
- Does Keynesian economics require government to set controls on prices, wages, or interest rates?
- List three practical problems with the Keynesian perspective.
- How did the Keynesian perspective address the economic market failure of the Great Depression?
11.10 The Neoclassical Perspective
The Great Recession ended in June 2009 after 18 months, according to the National Bureau of Economic Research (NBER). The NBER examines a variety of measures of economic activity to gauge the economy's overall health. These measures include real income, wholesale and retail sales, employment, and industrial production. In the years since the official end of this historic economic downturn, it has become clear that the Great Recession was two-pronged, hitting the U.S. economy with the collapse of the housing market and the failure of the financial system's credit institutions, further contaminating global economies. While the stock market rapidly lost trillions of dollars of value, consumer spending dried up, and companies began cutting jobs, economic policymakers were struggling with how to best combat and prevent a national, and even global economic collapse. In the end, policymakers used a number of controversial monetary and fiscal policies to support the housing market and domestic industries as well as to stabilize the financial sector. Some of these initiatives included:
Federal Reserve Bank purchase of both traditional and nontraditional assets off banks' balance sheets. By doing this, the Fed injected money into the banking system and increased the amounts of funds available to lend to the business sector and consumers. This also dropped short-term interest rates to as low as zero percent, which had the effect of devaluing U.S. dollars in the global market and boosting exports.
The Congress and the President also passed several pieces of legislation that would stabilize the financial market. The Troubled Asset Relief Program (TARP), passed in late 2008, allowed the government to inject cash into troubled banks and other financial institutions and help support General Motors and Chrysler as they faced bankruptcy and threatened job losses throughout their supply chain. The American Recovery and Reinvestment Act in early 2009 provided tax rebates to low- and middle-income households to encourage consumer spending.
Four years after the end of the Great Recession, the economy has yet to return to its pre-recession levels of productivity and growth. Annual productivity increased only 1.9% between 2009 and 2012 compared to its 2.7% annual growth rate between 2000 and 2007, unemployment remains above the natural rate, and real GDP continues to lag behind potential growth. The actions the government has taken to stabilize the economy are still under scrutiny and debate about their effectiveness continues. In this chapter, we will discuss the neoclassical perspective on economics and compare it to the Keynesian perspective. At the end of the chapter, we will use the neoclassical perspective to analyze the actions the government has taken in the Great Recession.
In Chicago, Illinois, the highest recorded temperature was 105° in July 1995, while the lowest recorded temperature was 27° below zero in January 1958. Understanding why these extreme weather patterns occurred would be interesting. However, if you wanted to understand the typical weather pattern in Chicago, instead of focusing on one-time extremes, you would need to look at the entire pattern of data over time.
A similar lesson applies to the study of macroeconomics. It is interesting to study extreme situations, like the 1930s Great Depression or what many have called the 2008-2009 Great Recession. If you want to understand the whole picture, however, you need to look at the long term. Consider the unemployment rate. The unemployment rate has fluctuated from as low as 3.5% in 1969 to as high as 9.7% in 1982 and 9.6% in 2009. Even as the U.S. unemployment rate rose during recessions and declined during expansions, it kept returning to the general neighborhood of 5.0–5.5%. When the nonpartisan Congressional Budget Office carried out its long-range economic forecasts in 2010, it assumed that from 2015 to 2020, after the recession has passed, the unemployment rate would be 5.0%. From a long-run perspective, the economy seems to keep adjusting back to this rate of unemployment.
As the name “neoclassical” implies, this perspective of how the macroeconomy works is a “new” view of the “old” classical model of the economy. The classical view, the predominant economic philosophy until the Great Depression, was that short-term fluctuations in economic activity would rather quickly, with flexible prices, adjust back to full employment. This view of the economy implied a vertical aggregate supply curve at full employment GDP, and prescribed a “hands off” policy approach. For example, if the economy were to slip into recession (a leftward shift of the aggregate demand curve), it would temporarily exhibit a surplus of goods. Falling prices would eliminate this surplus, and the economy would return to full employment level of GDP. No active fiscal or monetary policy was needed. In fact, the classical view was that expansionary fiscal or monetary policy would only cause inflation, rather than increase GDP. The deep and lasting impact of the Great Depression changed this thinking and Keynesian economics, which prescribed active fiscal policy to alleviate weak aggregate demand, became the more mainstream perspective.
11.11 The Building Blocks of Neoclassical Analysis
The neoclassical perspective on macroeconomics holds that, in the long run, the economy will fluctuate around its potential GDP and its natural rate of unemployment. This chapter begins with two building blocks of neoclassical economics: (1) potential GDP determines the economy's the size and (2) wages and prices will adjust in a flexible manner so that the economy will adjust back to its potential GDP level of output.
The key policy implication is this:
The government should focus more on long-term growth and on controlling inflation than on worrying about recession or cyclical unemployment. This focus on long-run growth rather than the short-run fluctuations in the business cycle means that neoclassical economics is more useful for long-run macroeconomic analysis and Keynesian economics is more useful for analyzing the macroeconomic short run. Let's consider the two neoclassical building blocks in turn, and how we can embody them in the aggregate demand/aggregate supply model.
11.11.1 The Importance of Potential GDP in the Long Run
Over the long run, the level of potential GDP determines the size of real GDP. When economists refer to “potential GDP” they are referring to that level of output that an economy can achieve when all resources (land, labor, capital, and entrepreneurial ability) are fully employed. While the unemployment rate in labor markets will never be zero, full employment in the labor market refers to zero cyclical unemployment. There will still be some level of unemployment due to frictional or structural unemployment, but when the economy is operating with zero cyclical unemployment, economists say that the economy is at the natural rate of unemployment or at full employment.
Economists benchmark actual or real GDP against the potential GDP to determine how well the economy is performing. As explained in Economic Growth, we can explain GDP growth by increases and investment in physical capital and human capital per person as well as advances in technology. Physical capital per person refers to the amount and kind of machinery and equipment available to help people get work done. Compare, for example, your productivity in typing a term paper on a typewriter to working on your laptop with word processing software. Clearly, you will be able to be more productive using word processing software. The technology and level of capital of your laptop and software has increased your productivity. More broadly, the development of GPS technology and Universal Product Codes (those barcodes on every product we buy) has made it much easier for firms to track shipments, tabulate inventories, and sell and distribute products. These two technological innovations, and many others, have increased a nation's ability to produce goods and services for a given population. Likewise, increasing human capital involves increasing levels of knowledge, education, and skill sets per person through vocational or higher education. Physical and human capital improvements with technological advances will increase overall productivity and, thus, GDP.
To see how these improvements have increased productivity and output at the national level, we should examine evidence from the United States. The United States experienced significant growth in the twentieth century due to phenomenal changes in infrastructure, equipment, and technological improvements in physical capital and human capital. The population more than tripled in the twentieth century, from 76 million in 1900 to over 300 million in 2016. The human capital of modern workers is far higher today because the education and skills of workers have risen dramatically. In 1900, only about one-eighth of the U.S. population had completed high school and just one person in 40 had completed a four-year college degree. By 2010, more than 87% of Americans had a high school degree and over 29% had a four-year college degree as well. In 2014, 40% of working-age Americans had a four-year college degree. The average amount of physical capital per worker has grown dramatically. The technology available to modern workers is extraordinarily better than a century ago: cars, airplanes, electrical machinery, smartphones, computers, chemical and biological advances, materials science, health care—the list of technological advances could run on and on. More workers, higher skill levels, larger amounts of physical capital per worker, and amazingly better technology, and potential GDP for the U.S. economy has clearly increased a great deal since 1900.
This growth has fallen below its potential GDP and, at times, has exceeded its potential. For example from 2008 to 2009, the U.S. economy tumbled into recession and remains below its potential. At other times, like in the late 1990s, the economy ran at potential GDP—or even slightly ahead.
Figure 11.14 shows the actual data for the increase in real GDP since 1960. The slightly smoother line shows the potential GDP since 1960 as estimated by the nonpartisan Congressional Budget Office. Most economic recessions and upswings are times when the economy is 1–3 percent below or above potential GDP in a given year. Clearly, short-run fluctuations around potential GDP do exist, but over the long run, the upward trend of potential GDP determines the size of the economy.
In the aggregate demand/aggregate supply model, we show potential GDP as a vertical line. Neoclassical economists who focus on potential GDP as the primary determinant of real GDP argue that the long-run aggregate supply curve is located at potential GDP—that is, we draw the long-run aggregate supply curve as a vertical line at the level of potential GDP, as Figure 11.15 shows. A vertical LRAS curve means that the level of aggregate supply (or potential GDP) will determine the economy's real GDP, regardless of the level of aggregate demand. Over time, increases in the quantity and quality of physical capital, increases in human capital, and technological advancements shift potential GDP and the vertical LRAS curve gradually to the right. Economists often describe this gradual increase in an economy's potential GDP as a nation's long-term economic growth.
11.11.2 The Role of Flexible Prices
How does the macroeconomy adjust back to its level of potential GDP in the long run? What if aggregate demand increases or decreases? Economists base the neoclassical view of how the macroeconomy adjusts on the insight that even if wages and prices are “sticky”, or slow to change, in the short run, they are flexible over time. To understand this better, let's follow the connections from the short-run to the long-run macroeconomic equilibrium.
The aggregate demand and aggregate supply diagram in Figure 11.16 shows two aggregate supply curves. We draw the original upward sloping aggregate supply curve (SRAS0) is a short-run or Keynesian AS curve. The vertical aggregate supply curve (LRASn) is the long-run or neoclassical AS curve, which is located at potential GDP. The original aggregate demand curve, labeled AD0, so that the original equilibrium occurs at point E0, at which point the economy is producing at its potential GDP.
Now, imagine that some economic event boosts aggregate demand: perhaps a surge of export sales or a rise in business confidence that leads to more investment, perhaps a policy decision like higher government spending, or perhaps a tax cut that leads to additional aggregate demand. The short-run Keynesian analysis is that the rise in aggregate demand will shift the aggregate demand curve out to the right, from AD0 to AD1, leading to a new equilibrium at point E1 with higher output, lower unemployment, and pressure for an inflationary rise in the price level.
In the long-run neoclassical analysis, however, the chain of economic events is just beginning. As economic output rises above potential GDP, the level of unemployment falls. The economy is now above full employment and there is a labor shortage. Eager employers are trying to bid workers away from other companies and to encourage their current workers to exert more effort and to work longer hours. This high demand for labor will drive up wages. Most employers review their workers salaries only once or twice a year, and so it will take time before the higher wages filter through the economy. As wages do rise, it will mean a leftward shift in the short-run Keynesian aggregate supply curve back to SRAS1, because the price of a major input to production has increased. The economy moves to a new equilibrium (E2). The new equilibrium has the same level of real GDP as did the original equilibrium (E0), but there has been an inflationary increase in the price level.
This description of the short-run shift from E0 to E1 and the long-run shift from E1 to E2 is a step-by-step way of making a simple point: the economy cannot sustain production above its potential GDP in the long run. An economy may produce above its level of potential GDP in the short run, under pressure from a surge in aggregate demand. Over the long run, however, that surge in aggregate demand ends up as an increase in the price level, not as a rise in output.
The rebound of the economy back to potential GDP also works in response to a shift to the left in aggregate demand. Figure 11.17 again starts with two aggregate supply curves, with SRAS0 showing the original upward sloping short-run Keynesian AS curve and LRASn showing the vertical long-run neoclassical aggregate supply curve. A decrease in aggregate demand—for example, because of a decline in consumer confidence that leads to less consumption and more saving—causes the original aggregate demand curve AD0 to shift back to AD1. The shift from the original equilibrium (E0) to the new equilibrium (E1) results in a decline in output. The economy is now below full employment and there is a surplus of labor. As output falls below potential GDP, unemployment rises. While a lower price level (i.e., deflation) is rare in the United States, it does happen occasionally during very weak periods of economic activity. For practical purposes, we might consider a lower price level in the AD–AS model as indicative of disinflation, which is a decline in the inflation rate. Thus, the long-run aggregate supply curve LRASn, which is vertical at the level of potential GDP, ultimately determines this economy's real GDP.
Again, from the neoclassical perspective, this short-run scenario is only the beginning of the chain of events. The higher level of unemployment means more workers looking for jobs. As a result, employers can hold down on pay increases—or perhaps even replace some of their higher-paid workers with unemployed people willing to accept a lower wage. As wages stagnate or fall, this decline in the price of a key input means that the short-run Keynesian aggregate supply curve shifts to the right from its original (SRAS0 to SRAS1). The overall impact in the long run, as the macroeconomic equilibrium shifts from E0 to E1 to E2, is that the level of output returns to potential GDP, where it started. There is, however, downward pressure on the price level. Thus, in the neoclassical view, changes in aggregate demand can have a short-run impact on output and on unemployment—but only a short-run impact. In the long run, when wages and prices are flexible, potential GDP and aggregate supply determine real GDP's size.
11.11.3 How Fast Is the Speed of Macroeconomic Adjustment?
How long does it take for wages and prices to adjust, and for the economy to rebound to its potential GDP? This subject is highly contentious. Keynesian economists argue that if the adjustment from recession to potential GDP takes a very long time, then neoclassical theory may be more hypothetical than practical. In response to John Maynard Keynes' immortal words, “In the long run we are all dead,” neoclassical economists respond that even if the adjustment takes as long as, say, ten years the neoclassical perspective remains of central importance in understanding the economy.
One subset of neoclassical economists holds that wage and price adjustment in the macroeconomy might be quite rapid. The theory of rational expectations holds that people form the most accurate possible expectations about the future that they can, using all information available to them. In an economy where most people have rational expectations, economic adjustments may happen very quickly.
To understand how rational expectations may affect the speed of price adjustments, think about a situation in the real estate market. Imagine that several events seem likely to push up home values in the neighborhood. Perhaps a local employer announces that it plans to hire many more people or the city announces that it will build a local park or a library in that neighborhood. The theory of rational expectations points out that even though none of the changes will happen immediately, home prices in the neighborhood will rise immediately, because the expectation that homes will be worth more in the future will lead buyers to be willing to pay more in the present. The amount of the immediate increase in home prices will depend on how likely it seems that the announcements about the future will actually happen and on how distant the local jobs and neighborhood improvements are in the future. The key point is that, because of rational expectations, prices do not wait on events, but adjust immediately.
At a macroeconomic level, the theory of rational expectations points out that if the aggregate supply curve is vertical over time, then people should rationally expect this pattern. When a shift in aggregate demand occurs, people and businesses with rational expectations will know that its impact on output and employment will be temporary, while its impact on the price level will be permanent. If firms and workers perceive the outcome of the process in advance, and if all firms and workers know that everyone else is perceiving the process in the same way, then they have no incentive to go through an extended series of short-run scenarios, like a firm first hiring more people when aggregate demand shifts out and then firing those same people when aggregate supply shifts back. Instead, everyone will recognize where this process is heading—toward a change in the price level—and then will act on that expectation. In this scenario, the expected long-run change in the price level may happen very quickly, without a drawn-out zigzag of output and employment first moving one way and then the other.
The theory that people and firms have rational expectations can be a useful simplification, but as a statement about how people and businesses actually behave, the assumption seems too strong. After all, many people and firms are not especially well informed, either about what is happening in the economy or about how the economy works. An alternate assumption is that people and firms act with adaptive expectations: they look at past experience and gradually adapt their beliefs and behavior as circumstances change, but are not perfect synthesizers of information and accurate predictors of the future in the sense of rational expectations theory. If most people and businesses have some form of adaptive expectations, then the adjustment from the short run and long run will be traced out in incremental steps that occur over time.
The empirical evidence on the speed of macroeconomic adjustment of prices and wages is not clear-cut. The speed of macroeconomic adjustment probably varies among different countries and time periods. A reasonable guess is that the initial short-run effect of a shift in aggregate demand might last two to five years, before the adjustments in wages and prices cause the economy to adjust back to potential GDP. Thus, one might think of the short run for applying Keynesian analysis as time periods less than two to five years, and the long run for applying neoclassical analysis as longer than five years. For practical purposes, this guideline is frustratingly imprecise, but when analyzing a complex social mechanism like an economy as it evolves over time, some imprecision seems unavoidable.
- The neoclassical perspective argues that, in the long run, the economy will adjust back to its potential GDP level of output through flexible price levels.
- Thus, the neoclassical perspective views the long-run AS curve as vertical.
- A rational expectations perspective argues that people have excellent information about economic events and how the economy works and that, as a result, price and other economic adjustments will happen very quickly.
- In adaptive expectations theory, people have limited information about economic information and how the economy works, and so price and other economic adjustments can be slow.
Do rational expectations tend to look back at past experience while adaptive expectations look ahead to the future? Explain your answer.
Does neoclassical economics focus on the long term or the short term? Explain your answer.
Does neoclassical economics view prices and wages as sticky or flexible? Why?
What shape is the long-run aggregate supply curve? Why does it have this shape?
What is the difference between rational expectations and adaptive expectations?
A neoclassical economist and a Keynesian economist are studying the economy of Vineland. It appears that Vineland is beginning to experience a mild recession with a decrease in aggregate demand. Which of these two economists would likely advocate that the government of Vineland take active measures to reverse this decline in aggregate demand? Why?
11.12 The Policy Implications of the Neoclassical Perspective
To understand the policy recommendations of the neoclassical economists, it helps to start with the Keynesian perspective. Suppose a decrease in aggregate demand causes the economy to go into recession with high unemployment. The Keynesian response would be to use government policy to stimulate aggregate demand and eliminate the recessionary gap. The neoclassical economists believe that the Keynesian response, while perhaps well intentioned, will not have a good outcome for reasons we will discuss shortly. Since the neoclassical economists believe that the economy will correct itself over time, the only advantage of a Keynesian stabilization policy would be to accelerate the process and minimize the time that the unemployed are out of work. Is that the likely outcome?
Keynesian macroeconomic policy requires some optimism about the government's ability to recognize a situation of too little or too much aggregate demand, and to adjust aggregate demand accordingly with the right level of changes in taxes or spending, all enacted in a timely fashion. After all, neoclassical economists argue, it takes government statisticians months to produce even preliminary estimates of GDP so that politicians know whether a recession is occurring—and those preliminary estimates may be revised substantially later. Moreover, there is the question of timely action. The political process can take more months to enact a tax cut or a spending increase. Political or economic considerations may determine the amount of tax or spending changes. Then the economy will take still more months to put into effect changes in aggregate demand through spending and production. When economists and policy makers consider all of these time lags and political realities, active fiscal policy may fail to address the current problem, and could even make the future economy worse. The average U.S. post-World War II recession has lasted only about a year. By the time government policy activates, the recession will likely be over. As a consequence, the only result of government fine-tuning will be to stimulate the economy when it is already recovering (or to contract the economy when it is already falling). In other words, an active macroeconomic policy is likely to exacerbate the cycles rather than dampen them. Some neoclassical economists believe a large part of the business cycles we observe are due to flawed government policy. To learn about this issue further, read the following Clear It Up feature.
WHY AND HOW DO ECONOMISTS MEASURE INFLATION EXPECTATIONS?
People take expectations about inflation into consideration every time they make a major purchase, such as a house or a car. As inflation fluctuates, so too does the nominal interest rate on loans to buy these goods. The nominal interest rate is comprised of the real rate, plus an expected inflation factor. Expected inflation also tells economists about how the public views the economy's direction. Suppose the public expects inflation to increase. This could be the result of positive demand shock due to an expanding economy and increasing aggregate demand. It could also be the result of a negative supply shock, perhaps from rising energy prices, and decreasing aggregate supply. In either case, the public may expect the central bank to engage in contractionary monetary policy to reduce inflation, and this policy results in higher interest rates. If, however economists expect inflation to decrease, the public may anticipate a recession. In turn, the public may expect expansionary monetary policy, and lower interest rates, in the short run. By monitoring expected inflation, economists garner information about the effectiveness of macroeconomic policies. Additionally, monitoring expected inflation allows for projecting the direction of real interest rates that isolate for the effect of inflation. This information is necessary for making decisions about financing investments.
Expectations about inflation may seem like a highly theoretical concept, but, in fact the Federal Reserve Bank measures, inflation expectations based upon early research conducted by Joseph Livingston, a financial journalist for the Philadelphia Inquirer. In 1946, he started a twice-a-year survey of economists about their expectations of inflation. After Livingston's death in 1969, the Federal Reserve Bank and other economic research agencies such as the Survey Research Center at the University of Michigan, the American Statistical Association, and the National Bureau of Economic Research continued the survey.
Current Federal Reserve research compares these expectations to actual inflation that has occurred, and the results, so far, are mixed. Economists' forecasts, however, have become notably more accurate in the last few decades. Economists are actively researching how inflation expectations and other economic variables form and change.
11.12.1 The Neoclassical Phillips Curve Tradeoff
The Keynesian Perspective introduced the Phillips curve and explained how it is derived from the aggregate supply curve. The short run upward sloping aggregate supply curve implies a downward sloping Phillips curve; thus, there is a tradeoff between inflation and unemployment in the short run. By contrast, a neoclassical long-run aggregate supply curve will imply a vertical shape for the Phillips curve, indicating no long run tradeoff between inflation and unemployment.
Figure 11.18 (a) shows the vertical AS curve, with three different levels of aggregate demand, resulting in three different equilibria, at three different price levels. At every point along that vertical AS curve, potential GDP and the rate of unemployment remains the same. Assume that for this economy, the natural rate of unemployment is 5%. As a result, the long-run Phillips curve relationship, in Figure 11.18 (b), is a vertical line, rising up from 5% unemployment, at any level of inflation. Read the following Work It Out feature for additional information on how to interpret inflation and unemployment rates
TRACKING INFLATION AND UNEMPLOYMENT RATES
Suppose that you have collected data for years on inflation and unemployment rates and recorded them in a table, such as Table. How do you interpret that information?
| Year | Inflation Rate | Unemployment Rate |
|---|---|---|
| 1970 | 2% | 4% |
| 1975 | 3% | 3% |
| 1980 | 2% | 4% |
| 1985 | 1% | 6% |
| 1990 | 1% | 4% |
| 1995 | 4% | 2% |
| 2000 | 5% | 4% |
- Step 1. Plot the data points in a graph with inflation rate on the vertical
-
axis and unemployment rate on the horizontal axis. Your graph will appear similar to Figure 11.19.
- Step 2. What patterns do you see in the data? You should notice that there
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are years when unemployment falls but inflation rises, and other years where unemployment rises and inflation falls.
- Step 3. Can you determine the natural rate of unemployment from the data or
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from the graph? As you analyze the graph, it appears that the natural rate of unemployment lies at 4%. This is the rate that the economy appears to adjust back to after an apparent change in the economy. For example, in 1975 the economy appeared to have an increase in aggregate demand. The unemployment rate fell to 3% but inflation increased from 2% to 3%. By 1980, the economy had adjusted back to 4% unemployment and the inflation rate had returned to 2%. In 1985, the economy looks to have suffered a recession as unemployment rose to 6% and inflation fell to 1%. This would be consistent with a decrease in aggregate demand. By 1990, the economy recovered back to 4% unemployment, but at a lower inflation rate of 1%. In 1995 the economy again rebounded and unemployment fell to 2%, but inflation increased to 4%, which is consistent with a large increase in aggregate demand. The economy adjusted back to 4% unemployment but at a higher rate of inflation of 5%. Then in 2000, both unemployment and inflation increased to 5% and 4%, respectively.
- Step 4. Do you see the Phillips curve(s) in the data? If we trace the
-
downward sloping trend of data points, we could see a short-run Phillips curve that exhibits the inverse tradeoff between higher unemployment and lower inflation rates. If we trace the vertical line of data points, we could see a long-run Phillips curve at the 4% natural rate of unemployment.
The unemployment rate on the long-run Phillips curve will be the natural rate of unemployment. A small inflationary increase in the price level from AD0 to AD1 will have the same natural rate of unemployment as a larger inflationary increase in the price level from AD0 to AD2. The macroeconomic equilibrium along the vertical aggregate supply curve can occur at a variety of different price levels, and the natural rate of unemployment can be consistent with all different rates of inflation. The great economist Milton Friedman (1912–2006) summed up the neoclassical view of the long-term Phillips curve tradeoff in a 1967 speech: “[T]here is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off.”
In the Keynesian perspective, the primary focus is on getting the level of aggregate demand right in relationship to an upward-sloping aggregate supply curve. That is, the government should adjust AD so that the economy produces at its potential GDP, not so low that cyclical unemployment results and not so high that inflation results. In the neoclassical perspective, aggregate supply will determine output at potential GDP, the natural rate of unemployment determines unemployment, and shifts in aggregate demand are the primary determinant of changes in the price level.
11.12.2 Fighting Unemployment or Inflation?
As we explained in Unemployment, economists divide unemployment into two categories: cyclical unemployment and the natural rate of unemployment, which is the sum of frictional and structural unemployment. Cyclical unemployment results from fluctuations in the business cycle and is created when the economy is producing below potential GDP—giving potential employers less incentive to hire. When the economy is producing at potential GDP, cyclical unemployment will be zero. Because of labor market dynamics, in which people are always entering or exiting the labor force, the unemployment rate never falls to 0%, not even when the economy is producing at or even slightly above potential GDP. Probably the best we can hope for is for the number of job vacancies to equal the number of job seekers. We know that it takes time for job seekers and employers to find each other, and this time is the cause of frictional unemployment. Most economists do not consider frictional unemployment to be a “bad” thing. After all, there will always be workers who are unemployed while looking for a job that is a better match for their skills. There will always be employers that have an open position, while looking for a worker that is a better match for the job. Ideally, these matches happen quickly, but even when the economy is very strong there will be some natural unemployment and this is what the natural rate of unemployment measures.
The neoclassical view of unemployment tends to focus attention away from the cyclical unemployment problem—that is, unemployment caused by recession—while putting more attention on the unemployment rate issue that prevails even when the economy is operating at potential GDP. To put it another way, the neoclassical view of unemployment tends to focus on how the government can adjust public policy to reduce the natural rate of unemployment. Such policy changes might involve redesigning unemployment and welfare programs so that they support those in need, but also offer greater encouragement for job-hunting. It might involve redesigning business rules with an eye to whether they are unintentionally discouraging businesses from taking on new employees. It might involve building institutions to improve the flow of information about jobs and the mobility of workers, to help bring workers and employers together more quickly. For those workers who find that their skills are permanently no longer in demand (for example, the structurally unemployed), economists can design policy to provide opportunities for retraining so that these workers can reenter the labor force and seek employment.
Neoclassical economists will not tend to see aggregate demand as a useful tool for reducing unemployment; after all, with a vertical aggregate supply curve determining economic output, then aggregate demand has no long-run effect on unemployment. Instead, neoclassical economists believe that aggregate demand should be allowed to expand only to match the gradual shifts of aggregate supply to the right—keeping the price level much the same and inflationary pressures low.
If aggregate demand rises rapidly in the neoclassical model, in the long run it leads only to inflationary pressures. Figure 11.20 shows a vertical LRAS curve and three different levels of aggregate demand, rising from AD0 to AD1 to AD2. As the macroeconomic equilibrium rises from E0 to E1 to E2, the price level rises, but real GDP does not budge; nor does the rate of unemployment, which adjusts to its natural rate. Conversely, reducing inflation has no long-term costs, either. Think about Figure 11.20 in reverse, as the aggregate demand curve shifts from AD2 to AD1 to AD0, and the equilibrium moves from E2 to E1 to E0. During this process, the price level falls, but, in the long run, neither real GDP nor the natural unemployment rate changes.
11.12.3 Fighting Recession or Encouraging Long-Term Growth?
Neoclassical economists believe that the economy will rebound out of a recession or eventually contract during an expansion because prices and wage rates are flexible and will adjust either upward or downward to restore the economy to its potential GDP. Thus, the key policy question for neoclassicals is how to promote growth of potential GDP. We know that economic growth ultimately depends on the growth rate of long-term productivity. Productivity measures how effective inputs are at producing outputs. We know that U.S. productivity has grown on average about 2% per year. That means that the same amount of inputs produce 2% more output than the year before. We also know that productivity growth varies a great deal in the short term due to cyclical factors. It also varies somewhat in the long term. From 1953–1972, U.S. labor productivity (as measured by output per hour in the business sector) grew at 3.2% per year. From 1973–1992, productivity growth declined significantly to 1.8% per year. Then, from 1993–2014, productivity growth increased slightly to 2% per year. The neoclassical economists believe the underpinnings of long-run productivity growth to be an economy’s investments in human capital, physical capital, and technology, operating together in a market-oriented environment that rewards innovation. Government policy should focus on promoting these factors.
11.12.4 Summary of Neoclassical Macroeconomic Policy Recommendations
Let’s summarize what neoclassical economists recommend for macroeconomic policy. Neoclassical economists do not believe in “fine-tuning” the economy. They believe that a stable economic environment with a low rate of inflation fosters economic growth. Similarly, tax rates should be low and unchanging. In this environment, private economic agents can make the best possible investment decisions, which will lead to optimal investment in physical and human capital as well as research and development to promote improvements in technology.
11.12.5 Summary of Neoclassical Economics versus Keynesian Economics
Table 11.2 summarizes the key differences between the two schools of thought.
| Summary | Neoclassical Economics | Keynesian Economics |
|---|---|---|
| Focus: long or short-term | Long-term | Short-term |
| Prices and wages: sticky or flexible? | Flexible | Sticky |
| Economic output: Primarily determined by AD or AS? | Aggregate supply | Aggregate demand |
| Aggregate supply: vertical/ upward-sloping? | Vertical | Upward-sloping |
| Phillips curve: vertical/ downward-sloping | Vertical | Downward sloping |
| Is AD a useful tool for controlling inflation? | Yes | Yes |
| What should be the primary area of policy emphasis for reducing unemployment? | Reform labor market institutions to reduce natural rate of unemployment |
Increase AD to eliminate cyclical unemployment |
| Is AD a useful tool for ending recession? | At best, only in short-run temporary sense, but may just increase inflation instead |
Yes |
- Neoclassical economists tend to put relatively more emphasis on long-term growth than on fighting recession, because they believe that recessions will fade in a few years and long-term growth will ultimately determine the standard of living. They tend to focus more on reducing the natural rate of unemployment caused by economic institutions and government policies than the cyclical unemployment caused by recession.
- Neoclassical economists also see no social benefit to inflation. With an upward-sloping Keynesian AS curve, inflation can arise because an economy is approaching full employment. With a vertical long-run neoclassical AS curve, inflation does not accompany any rise in output. If aggregate supply is vertical, then aggregate demand does not affect the quantity of output. Instead, aggregate demand can only cause inflationary changes in the price level. A vertical aggregate supply curve, where the quantity of output is consistent with many different price levels, also implies a vertical Phillips curve.
Do neoclassical economists tend to focus more on long term economic growth or on recessions? Explain briefly.
Do neoclassical economists tend to focus more on cyclical unemployment or on inflation? Explain briefly.
Do neoclassical economists see a value in tolerating a little more inflation if it brings additional economic output? Explain your answer.
If aggregate supply is vertical, what role does aggregate demand play in determining output? In determining the price level?
What is the shape of the neoclassical long-run Phillips curve? What assumptions do economists make that lead to this shape?
11.13 Balancing Keynesian and Neoclassical Models
We can compare finding the balance between Keynesian and Neoclassical models to the challenge of riding two horses simultaneously. When a circus performer stands on two horses, with a foot on each one, much of the excitement for the viewer lies in contemplating the gap between the two. As modern macroeconomists ride into the future on two horses—with one foot on the short-term Keynesian perspective and one foot on the long-term neoclassical perspective—the balancing act may look uncomfortable, but there does not seem to be any way to avoid it. Each approach, Keynesian and neoclassical, has its strengths and weaknesses.
The short-term Keynesian model, built on the importance of aggregate demand as a cause of business cycles and a degree of wage and price rigidity, does a sound job of explaining many recessions and why cyclical unemployment rises and falls. By focusing on the short-run aggregate demand adjustments, Keynesian economics risks overlooking the long-term causes of economic growth or the natural rate of unemployment that exist even when the economy is producing at potential GDP.
The neoclassical model, with its emphasis on aggregate supply, focuses on the underlying determinants of output and employment in markets, and thus tends to put more emphasis on economic growth and how labor markets work. However, the neoclassical view is not especially helpful in explaining why unemployment moves up and down over short time horizons of a few years. Nor is the neoclassical model especially helpful when the economy is mired in an especially deep and long-lasting recession, like the 1930s Great Depression. Keynesian economics tends to view inflation as a price that might sometimes be paid for lower unemployment; neoclassical economics tends to view inflation as a cost that offers no offsetting gains in terms of lower unemployment.
Video - Keynes vs. Neoclassical Economics
Macroeconomics cannot, however, be summed up as an argument between one group of economists who are pure Keynesians and another group who are pure neoclassicists. Instead, many mainstream economists believe both the Keynesian and neoclassical perspectives. Robert Solow, the Nobel laureate in economics in 1987, described the dual approach in this way:
At short time scales, I think, something sort of ‘Keynesian’ is a good approximation, and surely better than anything straight ‘neoclassical.’ At very long time scales, the interesting questions are best studied in a neoclassical framework, and attention to the Keynesian side of things would be a minor distraction. At the five-to-ten-year time scale, we have to piece things together as best we can, and look for a hybrid model that will do the job.
Many modern macroeconomists spend considerable time and energy trying to construct models that blend the most attractive aspects of the Keynesian and neoclassical approaches. It is possible to construct a somewhat complex mathematical model where aggregate demand and sticky wages and prices matter in the short run, but wages, prices, and aggregate supply adjust in the long run. However, creating an overall model that encompasses both short-term Keynesian and long-term neoclassical models is not easy.
NAVIGATING UNCHARTERED WATERS
Were the policies that the government implemented to stabilize the economy and financial markets during the Great Recession effective? Many economists from both the Keynesian and neoclassical schools have found that they were, although to varying degrees. Alan Blinder of Princeton University and Mark Zandi for Moody’s Analytics found that, without fiscal policy, GDP decline would have been significantly more than its 3.3% in 2008 followed by its 0.1% decline in 2009.
They also estimated that there would have been 8.5 million more job losses had the government not intervened in the market with the TARP to support the financial industry and key automakers General Motors and Chrysler. Federal Reserve Bank economists Carlos Carvalho, Stefano Eusip, and Christian Grisse found in their study, Policy Initiatives in the Global Recession: What Did Forecasters Expect? that once the government implemented policies, forecasters adapted their expectations to these policies. They were more likely to anticipate increases in investment due to lower interest rates brought on by monetary policy and increased economic growth resulting from fiscal policy.
The difficulty with evaluating the effectiveness of the stabilization policies that the government took in response to the Great Recession is that we will never know what would have happened had the government not implemented those policies. Surely some of the programs were more effective at creating and saving jobs, while other programs were less so. The final conclusion on the effectiveness of macroeconomic policies is still up for debate, and further study will no doubt consider the impact of these policies on the U.S. budget and deficit, as well as the U.S. dollar's value in the financial market.
- The Keynesian perspective considers changes to aggregate demand to be the cause of business cycle fluctuations. Keynesians are likely to advocate that policy makers actively attempt to reverse recessionary and inflationary periods because they are not convinced that the self-correcting economy can easily return to full employment.
- The neoclassical perspective places more emphasis on aggregate supply. Neoclassical economists believe that long term productivity growth determines the potential GDP level and that the economy typically will return to full employment after a change in aggregate demand. Skeptical of the effectiveness and timeliness of Keynesian policy, neoclassical economists are more likely to advocate a hands-off, or fairly limited, role for active stabilization policy.
- While Keynesians would tend to advocate an acceptable tradeoff between inflation and unemployment when counteracting a recession, neoclassical economists argue that no such tradeoff exists. Any short-term gains in lower unemployment will eventually vanish and the result of active policy will only be inflation.
- When the economy is experiencing a recession, why would a neoclassical economist be unlikely to argue for aggressive policy to stimulate aggregate demand and return the economy to full employment? Explain your answer.
- If the economy is suffering through a rampant inflationary period, would a Keynesian economist advocate for stabilization policy that involves higher taxes and higher interest rates? Explain your answer.