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/l/tradedeficit) on whether or not trade deficit is good for the economy. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 10 \| The International Trade and Capital Flows 261 The sheer size and persistence of the U.S. trade deficits and inflows of foreign capital since the 1980s are a legitimate cause for concern. The huge U.S. economy will not be destabilized by an outflow of international capital as easily as, say, the comparatively tiny economies of Thailand and Indonesia were in 1997–1998. Even an economy that is not knocked down, however, can still be shaken. American policymakers should certainly be paying attention to those cases where a pattern of extensive and sustained current account deficits and foreign borrowing has gone badly—if only as a cautionary tale. Are trade surpluses always beneficial? Considering Japan since the 1990s. Perhaps no economy around the world is better known for its trade surpluses than Japan. Since 1990, the size of these surpluses has often been near $100 billion per year. When Japan’s economy was growing vigorously in the 1960s and 1970s, many, especially non-economists, described its large trade surpluses either a cause or a result of its robust economic health. However, from a standpoint of economic growth, Japan’s economy has been teetering in and out of recession since 1990, with real GDP growth averaging only about 1% per year, and an unemployment rate that has been creeping higher. Clearly, a whopping trade surplus is no guarantee of economic good health. Instead, Japan’s trade surplus reflects that Japan has a very high rate of domestic savings, more than the Japanese economy can invest domestically, and so it invests the extra funds abroad. In Japan’s slow economy, consumption of imports is relatively low, and the growth of consumption is relatively slow. Thus, Japan’s exports continually exceed its imports, leaving the trade surplus continually high. Recently, Japan’s trade surpluses began to deteriorate. In 2013, Japan ran a trade deficit due to the high cost of imported oil. By 2015, Japan again had a surplus. 10.6 \| The Difference between Level of Trade and the Trade Balance By the end of this section, you will be able to: Identify three factors that influence a country's level of trade • • Differentiate between balance of trade and level of trade A
nation’s level of trade may at first sound like much the same issue as the balance of trade, but these two are actually quite separate. It is perfectly possible for a country to have a very high level of trade—measured by its exports of goods and services as a share of its GDP—while it also has a near-balance between exports and imports. A high level of trade indicates that the nation exports a good portion of its production. It is also possible for a country’s trade to be a relatively low share of GDP, relative to global averages, but for the imbalance between its exports and its imports to be quite large. We emphasized this general theme earlier in Measuring Trade Balances, which offered some illustrative figures on trade levels and balances. A country’s level of trade tells how much of its production it exports. We measure this by the percent of exports out of GDP. It indicates the degree of an economy's globalization. Some countries, such as Germany, have a high level of trade—they export almost 50% of their total production. The balance of trade tells us if the country is running a trade surplus or trade deficit. A country can have a low level of trade but a high trade deficit. (For example, the United States only exports 13% of GDP, but it has a trade deficit of over $500 billion.) Three factors strongly influence a nation’s level of trade: the size of its economy, its geographic location, and its history of trade. Large economies like the United States can do much of their trading internally, while small economies like Sweden have less ability to provide what they want internally and tend to have higher ratios of exports and imports to GDP. Nations that are neighbors tend to trade more, since costs of transportation and communication 262 Chapter 10 \| The International Trade and Capital Flows are lower. Moreover, some nations have long and established patterns of international trade, while others do not. Consequently, a relatively small economy like Sweden, with many nearby trading partners across Europe and a long history of foreign trade, has a high level of trade. Brazil and India, which are fairly large economies that have often sought to inhibit trade in recent decades, have lower levels of trade; whereas, the United States and Japan are extremely large economies that have comparatively few nearby trading partners. Both countries actually have quite low levels of trade by world standards. The ratio of exports to GDP in either the United States or in Japan is about half of the world average. The balance of
trade is a separate issue from the level of trade. The United States has a low level of trade, but had enormous trade deficits for most years from the mid-1980s into the 2000s. Japan has a low level of trade by world standards, but has typically shown large trade surpluses in recent decades. Nations like Germany and the United Kingdom have medium to high levels of trade by world standards, but Germany had a moderate trade surplus in 2015, while the United Kingdom had a moderate trade deficit. Their trade picture was roughly in balance in the late 1990s. Sweden had a high level of trade and a moderate trade surplus in 2015, while Mexico had a high level of trade and a moderate trade deficit that same year. In short, it is quite possible for nations with a relatively low level of trade, expressed as a percentage of GDP, to have relatively large trade deficits. It is also quite possible for nations with a near balance between exports and imports to worry about the consequences of high levels of trade for the economy. It is not inconsistent to believe that a high level of trade is potentially beneficial to an economy, because of the way it allows nations to play to their comparative advantages, and to also be concerned about any macroeconomic instability caused by a long-term pattern of large trade deficits. The following Clear It Up feature discusses how this sort of dynamic played out in Colonial India. Are trade surpluses always beneficial? Considering Colonial India. India was formally under British rule from 1858 to 1947. During that time, India consistently had trade surpluses with Great Britain. Anyone who believes that trade surpluses are a sign of economic strength and dominance while trade deficits are a sign of economic weakness must find this pattern odd, since it would mean that colonial India was successfully dominating and exploiting Great Britain for almost a century—which was not true. Instead, India’s trade surpluses with Great Britain meant that each year there was an overall flow of financial capital from India to Great Britain. In India, many heavily criticized this financial capital flow as the “drain,” and they viewed eliminating the financial capital drain as one of the many reasons why India would benefit from achieving independence. Final Thoughts about Trade Balances Trade deficits can be a good or a bad sign for an economy, and trade surpluses can be a good or a bad sign. Even a trade balance of zero—which just means that a nation is neither a net borrower nor lender in the international economy—can be either a good or
bad sign. The fundamental economic question is not whether a nation’s economy is borrowing or lending at all, but whether the particular borrowing or lending in the particular economic conditions of that country makes sense. It is interesting to reflect on how public attitudes toward trade deficits and surpluses might change if we could somehow change the labels that people and the news media affix to them. If we called a trade deficit “attracting foreign financial capital”—which accurately describes what a trade deficit means—then trade deficits might look more attractive. Conversely, if we called a trade surplus “shipping financial capital abroad”—which accurately captures what a trade surplus does—then trade surpluses might look less attractive. Either way, the key to understanding trade balances is to understand the relationships between flows of trade and flows of international payments, and what these relationships imply about the causes, benefits, and risks of different kinds of trade balances. The first step along this journey of understanding is to move beyond knee-jerk reactions to terms like “trade surplus,” This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 10 \| The International Trade and Capital Flows 263 “trade balance,” and “trade deficit.” More than Meets the Eye in the Congo Now that you see the big picture, you undoubtedly realize that all of the economic choices you make, such as depositing savings or investing in an international mutual fund, do influence the flow of goods and services as well as the flows of money around the world. You now know that a trade surplus does not necessarily tell us whether an economy is performing well or not. The Democratic Republic of the Congo ran a trade surplus in 2013, as we learned in the beginning of the chapter. Yet its current account balance was –$2.8 billion. However, the return of political stability and the rebuilding in the aftermath of the civil war there has meant a flow of investment and financial capital into the country. In this case, a negative current account balance means the country is being rebuilt—and that is a good thing. 264 Chapter 10 \| The International Trade and Capital Flows KEY TERMS balance of trade (trade balance) the gap, if any, between a nation’s exports and imports current account balance a broad measure of the balance of trade that includes trade in goods and services, as well as international flows of income and foreign aid exports of goods
and services as a percentage of GDP the dollar value of exports divided by the dollar value of a country’s GDP financial capital the international flows of money that facilitates trade and investment merchandise trade balance the balance of trade looking only at goods national savings and investment identity the total of private savings and public savings (a government budget surplus) unilateral transfers “one-way payments” that governments, private entities, or individuals make that they sent abroad with nothing received in return KEY CONCEPTS AND SUMMARY 10.1 Measuring Trade Balances The trade balance measures the gap between a country’s exports and its imports. In most high-income economies, goods comprise less than half of a country’s total production, while services comprise more than half. The last two decades have seen a surge in international trade in services; however, most global trade still takes the form of goods rather than services. The current account balance includes the trade in goods, services, and money flowing into and out of a country from investments and unilateral transfers. 10.2 Trade Balances in Historical and International Context The United States developed large trade surpluses in the early 1980s, swung back to a tiny trade surplus in 1991, and then had even larger trade deficits in the late 1990s and early 2000s. As we will see below, a trade deficit necessarily means a net inflow of financial capital from abroad, while a trade surplus necessarily means a net outflow of financial capital from an economy to other countries. 10.3 Trade Balances and Flows of Financial Capital International flows of goods and services are closely connected to the international flows of financial capital. A current account deficit means that, after taking all the flows of payments from goods, services, and income together, the country is a net borrower from the rest of the world. A current account surplus is the opposite and means the country is a net lender to the rest of the world. 10.4 The National Saving and Investment Identity The national saving and investment identity is based on the relationship that the total quantity of financial capital supplied from all sources must equal the total quantity of financial capital demanded from all sources. If S is private saving, T is taxes, G is government spending, M is imports, X is exports, and I is investment, then for an economy with a current account deficit and a budget deficit: Supply of financial capi al = Demand for financial capi al S + (M – X) = I + (G – T) A recession tends to
increase the trade balance (meaning a higher trade surplus or lower trade deficit), while economic boom will tend to decrease the trade balance (meaning a lower trade surplus or a larger trade deficit). This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 10 \| The International Trade and Capital Flows 265 10.5 The Pros and Cons of Trade Deficits and Surpluses Trade surpluses are no guarantee of economic health, and trade deficits are no guarantee of economic weakness. Either trade deficits or trade surpluses can work out well or poorly, depending on whether a government wisely invests the corresponding flows of financial capital. 10.6 The Difference between Level of Trade and the Trade Balance There is a difference between the level of a country’s trade and the balance of trade. The government measures its level of trade by the percentage of exports out of GDP, or the size of the economy. Small economies that have nearby trading partners and a history of international trade will tend to have higher levels of trade. Larger economies with few nearby trading partners and a limited history of international trade will tend to have lower levels of trade. The level of trade is different from the trade balance. The level of trade depends on a country’s history of trade, its geography, and the size of its economy. A country’s balance of trade is the dollar difference between its exports and imports. Trade deficits and trade surpluses are not necessarily good or bad—it depends on the circumstances. Even if a country is borrowing, if it invests that money in productivity-boosting investments it can lead to an improvement in long-term economic growth. SELF-CHECK QUESTIONS 1. 2. If foreign investors buy more U.S. stocks and bonds, how would that show up in the current account balance? If the trade deficit of the United States increases, how is the current account balance affected? 3. State whether each of the following events involves a financial flow to the Mexican economy or a financial flow out of the Mexican economy: a. Mexico imports services from Japan b. Mexico exports goods to Canada c. U.S. investors receive a return from past financial investments in Mexico 4. In what way does comparing a country’s exports to GDP reflect its degree of globalization? 5. At one point Canada’s GDP was $1,800 billion and its exports were $542 billion. What was Canada’s export ratio
at this time? 6. The GDP for the United States is $18,036 billion and its current account balance is –$484 billion. What percent of GDP is the current account balance? 7. Why does the trade balance and the current account balance track so closely together over time? 8. State whether each of the following events involves a financial flow to the U.S. economy or away from the U.S. economy: a. Export sales to Germany b. Returns paid on past U.S. financial investments in Brazil c. Foreign aid from the U.S. government to Egypt d. Imported oil from the Russian Federation e. Japanese investors buying U.S. real estate 9. How does the bottom portion of Figure 10.3, showing the international flow of investments and capital, differ from the upper portion? 10. Explain the relationship between a current account deficit or surplus and the flow of funds. 11. Using the national savings and investment identity, explain how each of the following changes (ceteris paribus) will increase or decrease the trade balance: a. A lower domestic savings rate b. The government changes from running a budget surplus to running a budget deficit c. The rate of domestic investment surges 266 Chapter 10 \| The International Trade and Capital Flows If a country is running a government budget surplus, why is (T – G) on the left side of the saving-investment 12. identity? 13. What determines the size of a country’s trade deficit? If domestic investment increases, and there is no change in the amount of private and public saving, what must 14. happen to the size of the trade deficit? 15. Why does a recession cause a trade deficit to increase? 16. Both the United States and global economies are booming. Will U.S. imports and/or exports increase? 17. For each of the following, indicate which type of government spending would justify a budget deficit and which would not. a. b. c. d. Increased federal spending on Medicare Increased spending on education Increased spending on the space program Increased spending on airports and air traffic control 18. How did large trade deficits hurt the East Asian countries in the mid 1980s? (Recall that trade deficits are equivalent to inflows of financial capital from abroad.) 19. Describe a scenario in which a trade surplus benefits an economy and one in which a trade surplus is occurring in an economy that performs poorly. What key factor or factors are making the difference in the outcome that results from a
trade surplus? 20. The United States exports 14% of GDP while Germany exports about 50% of its GDP. Explain what that means. 21. Explain briefly whether each of the following would be more likely to lead to a higher level of trade for an economy, or a greater imbalance of trade for an economy. a. Living in an especially large country b. Having a domestic investment rate much higher than the domestic savings rate c. Having many other large economies geographically nearby d. Having an especially large budget deficit e. Having countries with a tradition of strong protectionist legislation shutting out imports REVIEW QUESTIONS If imports exceed exports, is it a trade deficit or a 22. trade surplus? What about if exports exceed imports? 27. What are the main components of the national savings and investment identity? 23. What is included in the current account balance? In recent decades, has the U.S. 24. usually been in deficit, surplus, or balanced? trade balance 25. Does a trade surplus mean an overall inflow of financial capital to an economy, or an overall outflow of financial capital? What about a trade deficit? 28. When is a trade deficit likely to work out well for an economy? When is it likely to work out poorly? 29. Does a trade surplus help to guarantee strong economic growth? 30. What three factors will determine whether a nation has a higher or lower share of trade relative to its GDP? 26. What are the two main sides of the national savings and investment identity? 31. What is the difference between trade deficits and balance of trade? This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 10 \| The International Trade and Capital Flows 267 CRITICAL THINKING QUESTIONS 32. Occasionally, a government official will argue that a country should strive for both a trade surplus and a healthy inflow of capital from abroad. Explain why such a statement is economically impossible. 38. If you observed a country with a rapidly growing trade surplus over a period of a year or so, would you be more likely to believe that the country's economy was in a period of recession or of rapid growth? Explain. 33. A government official announces a new policy. The country wishes to eliminate its trade deficit, but will strongly encourage financial investment from foreign firms. Explain why such a statement is contradictory. If a country is a big exporter, is it more exposed to 34. global financial crises? If countries reduced trade barriers
, would the 35. international flows of money increase? 39. Occasionally, a government official will argue that a country should strive for both a trade surplus and a healthy inflow of capital from abroad. Is this possible? 40. What account balance or GDP growth? Why? is more important, a country’s current 41. Will nations that are more involved in foreign trade tend to have higher trade imbalances, lower trade imbalances, or is the pattern unpredictable? 42. Some economists warn that the persistent trade deficits and a negative current account balance that the United States has run will be a problem in the long run. Do you agree or not? Explain your answer. 44. Imagine that the U.S. economy finds itself in the following situation: a government budget deficit of $100 billion, total domestic savings of $1,500 billion, and total domestic physical capital investment of $1,600 billion. According to the national saving and investment identity, what will be the current account balance? What will be the current account balance if investment rises by $50 billion, while the budget deficit and national savings remain the same? Is it better for your country to be an international 36. lender or borrower? 37. Many think that the size of a trade deficit is due to a lack of competitiveness of domestic sectors, such as autos. Explain why this is not true. PROBLEMS 43. In 2001, the United Kingdom's economy exported goods worth £192 billion and services worth another £77 billion. It imported goods worth £225 billion and services worth £66 billion. Receipts of income from abroad were £140 billion while income payments going abroad were £131 billion. Government transfers from the United Kingdom to the rest of the world were £23 agencies billion, while various U.K government received payments of £16 billion from the rest of the world. a. Calculate the U.K. merchandise trade deficit for 2001. b. Calculate the current account balance for 2001. c. Explain how you decided whether payments on foreign investment and government transfers counted on the positive or the negative side of the current account balance for the United Kingdom in 2001. 268 Chapter 10 \| The International Trade and Capital Flows 46. Imagine that the economy of Germany finds itself in the following situation: the government budget has a surplus of 1% of Germany’s GDP; private savings is 20% of GDP; and physical investment is 18% of GDP. a. Based on the national saving and investment identity, what is
the current account balance? If the government budget surplus falls to zero, how will this affect the current account balance? b. 45. Table 10.7 provides some hypothetical data on macroeconomic accounts for three countries represented by A, B, and C and measured in billions of currency units. In Table 10.7, private household saving is SH, tax revenue is T, government spending is G, and investment spending is I. A B C SH T G I 700 00 600 800 500 500 350 400 600 500 650 450 Table 10.7 Macroeconomic Accounts a. Calculate the trade balance and the net inflow of foreign saving for each country. b. State whether each one has a trade surplus or deficit (or balanced trade). c. State whether each is a net lender or borrower internationally and explain. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 269 11 \| The Aggregate Demand/ Aggregate Supply Model Figure 11.1 New Home Construction At the peak of the housing bubble, many people across the country were able to secure the loans necessary to build new houses. (Credit: modification of work by Tim Pierce/Flickr Creative Commons) From Housing Bubble to Housing Bust The United States experienced rising home ownership rates for most of the last two decades. Between 1990 and 2006, the U.S. housing market grew. Homeownership rates grew from 64% to a high of over 69% between 2004 and 2005. For many people, this was a period in which they could either buy first homes or buy a larger and more expensive home. During this time mortgage values tripled. Housing became more accessible to Americans and was considered to be a safe financial investment. Figure 11.2 shows how new single family home sales peaked in 2005 at 107,000 units. 270 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model Figure 11.2 New Single Family Houses Sold From the early 1990s up through 2005, the number of new single family houses sold rose steadily. In 2006, the number dropped dramatically and this dramatic decline continued through 2011. By 2014, the number of new houses sold had begun to climb back up, but the levels are still lower than those of 1990. (Source: U.S. Census Bureau) The housing bubble began to show signs of bursting in 2005, as delinquency and late payments began to grow and an oversupply of new homes on the market became apparent
. Dropping home values contributed to a decrease in the overall wealth of the household sector and caused homeowners to pull back on spending. Several mortgage lenders were forced to file for bankruptcy because homeowners were not making their payments, and by 2008 the problem had spread throughout the financial markets. Lenders clamped down on credit and the housing bubble burst. Financial markets were now in crisis and unable or unwilling to even extend credit to credit-worthy customers. The housing bubble and the crisis in the financial markets were major contributors to the Great Recession that led to unemployment rates over 10% and falling GDP. While the United States is still recovering from the impact of the Great Recession, it has made substantial progress in restoring financial market stability through implementing aggressive fiscal and monetary policy. The economic history of the United States is cyclical in nature with recessions and expansions. Some of these fluctuations are severe, such as the economic downturn that occurred during the Great Depression in the 1930s which lasted several years. Why does the economy grow at different rates in different years? What are the causes of the cyclical behavior of the economy? This chapter will introduce an important model, the aggregate demand–aggregate supply model, to begin our understanding of why economies expand and contract over time. Introduction to the Aggregate Supply–Aggregate Demand Model In this chapter, you will learn about: • Macroeconomic Perspectives on Demand and Supply • Building a Model of Aggregate Supply and Aggregate Demand • Shifts in Aggregate Supply • Shifts in Aggregate Demand • How the AS–AD Model Incorporates Growth, Unemployment, and Inflation • Keynes’ Law and Say’s Law in the AS–AD Model 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, This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 271 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 By the end of this section, you will be able to: • Explain Say’s Law and understand why it primarily applies in the long run • Explain Keynes’ Law and understand why it primarily applies in the short run 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. 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 early nineteenth century French economist 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. We alluded to this earlier in our discussion of the National Income approach to measuring GDP. 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. Keynes’ Law and the Macroeconomics of Demand The alternative to Say’s law, with its emphasis on supply, is Keynes’ law: “Demand creates its own supply.” As a 272 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 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 influential work The General Theory of Employment, Interest, and Money during the 1930s Great Depression, he pointed out that during the Depression, the economy's capacity 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 closed, 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. 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. We need to take into account both supply and demand. 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. 11.2 \| Building a Model of Aggregate Demand and Aggregate Supply By the end
of this section, you will be able to: • Explain the aggregate supply curve and how it relates to real GDP and potential GDP • Explain the aggregate demand curve and how it is influenced by price levels • • • Define short run aggregate supply and long run aggregate supply Interpret the aggregate demand/aggregate supply model Identify the point of equilibrium in the aggregate demand/aggregate supply model 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. We call this 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. The Aggregate Supply Curve and Potential GDP Firms make decisions about what quantity to supply based on the profits they expect to earn. They determine profits, in turn, by the price of the outputs they sell and by the prices of the inputs, like labor or raw materials, that they need to buy. Aggregate supply (AS) refers to the total quantity of output (i.e. real GDP) firms will produce and sell. The This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 273 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 11.3 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. Figure 11.3 The Aggregate Supply Curve Aggregate supply (AS) slopes up, because as the price level for outputs rises, with the price of inputs remaining fixed, firms have an incentive to produce more to earn higher profits. The potential GDP line shows the maximum that the economy can produce with full employment of workers and physical capital. The diagram's horizontal axis shows real GDP—that is, the level of GDP adjusted for inflation. The vertical axis shows the price level, which measures the average price of all goods and services produced in the economy. In other words, the price level in the AD-AS model is what we called the GDP Deflator in The Macroeconomic Perspective. Remember that
the price level is different from the inflation rate. Visualize the price level as an index number, like the Consumer Price Index, while the inflation rate is the percentage change in the price level over time. As the price level rises, real GDP rises as well. Why? The price level on the vertical axis represents prices for final goods or outputs bought in the economy—i.e. 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. In other words, an aggregate supply curve shows how producers as a group will respond to an increase in aggregate demand. An AS curve's slope 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 we define as the amount of real GDP 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 assuming 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. As the GDP increases, however, some 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 AS curve's intermediate area, 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 real GDP in response to a given rise in the price level will not be as large. (Read the following Clear It Up feature to learn why the AS curve crosses potential GDP.) 274 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model Why does AS cross potential GDP? Economists typically draw the aggregate supply
curve 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 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. 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. We will further explain this distinction 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 11.4 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 comprise aggregate demand: consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M): C + I + G + X – M. Figure 11.4 The Aggregate Demand Curve Aggregate demand (AD) slopes down, showing that, as the price level rises, the amount of total spending on domestic goods and services declines. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 275 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. 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 11.4 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 Table 11.1 shows information on aggregate supply, aggregate demand, and the price level for the
imaginary country of Xurbia. What information does Table 11.1 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 110 120 130 140 150 160 170 $700 $690 $680 $670 $660 $650 $640 $600 $640 $680 $720 $740 $760 $770 Table 11.1 Price Level: Aggregate Demand/Aggregate Supply 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 11.5 which provides a visual to aid in your analysis. 276 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model Figure 11.5 The AD/AS Curves AD and AS curves created from the data in Table 11.1. 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. 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 large quantity of output. As the price level rises, aggregate supply rises and aggregate demand falls until the equilibrium point is reached. Figure 11.6 combines the AS curve from Figure 11.3 and the AD curve from Figure 11.4 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. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 277 Figure 11.6 Aggregate Supply and Aggregate Demand The equilibrium, where aggregate supply (AS) equals aggregate demand (AD), occurs 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 AS and AD macro or micro? These aggregate supply and demand models 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 278 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model distant cousins from different branches of the economics family tree. 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 the AS curve shows and long run changes in aggregate supply which the vertical line at potential GDP defines. 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, we may also refer to what we have been calling the AS curve as the short run aggregate supply (SRAS) curve. We may also refer to the vertical line at potential GDP as the long run aggregate supply (LRAS) curve. 11.3 \| Shifts in Aggregate Supply By the end of this section, you will be able to: • Explain how productivity growth changes the aggregate supply curve • Explain how changes in input prices change the aggregate supply curve 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, producers supply a greater quantity of real GDP. When the AS curve shifts to the left, then at every price level, producers supply a lower quantity
of real GDP. This module discusses two of the most important factors that can lead to shifts in the AS curve: productivity growth and changes in input prices. 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 11.7 (a) shows an outward shift in productivity over two time periods. The AS curve shifts out from SRAS0 to SRAS1 to SRAS2, and the equilibrium shifts from E0 to E1 to E2. Note that with increased productivity, workers can produce more GDP. Thus, full employment corresponds to a higher level of potential GDP, which we show as a rightward shift in LRAS from LRAS0 to LRAS1 to LRAS2. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 279 Figure 11.7 Shifts in Aggregate Supply (a) The rise in productivity causes the SRAS curve to shift to the right. The original equilibrium E0 is at the intersection of AD and SRAS0. When SRAS shifts right, then the new equilibrium E1 is at the intersection of AD and SRAS1, and then yet another equilibrium, E2, is at the intersection of AD and SRAS2. Shifts in SRAS to the right, lead to a greater level of output and to downward pressure on the price level. (b) A higher price for inputs means that at any given price level for outputs, a lower real GDP will be produced so aggregate supply will shift to the left from SRAS0 to SRAS1. The new equilibrium, E1, has a reduced quantity of output and a higher price level than the original
equilibrium (E0). 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 we typically measure 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. Recall how in Choice in a World of Scarcity, we said that a nation's production possibilities frontier is fixed in the short run, but shifts out in the long run? This is the same phenomenon using a different model. 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 labor 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 11.7 (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 oil price led to a situation like that which we presented earlier in Figure 11.7 (a), where
the outward shift of SRAS to the right allowed the economy to expand, unemployment to fall, and inflation to decline. 280 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 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 we use 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. Note that, unlike changes in productivity, changes in input prices do not generally cause LRAS to shift, only SRAS. 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, SRAS and LRAS would both shift to the left because there would be fewer workers available to produce goods at any given price. 11.4 \| Shifts in Aggregate Demand By the end of this section, you will be able to: Identify ways in which business confidence and consumer confidence can affect aggregate demand • Explain how imports influence aggregate demand • • Explain how government policy can change aggregate demand • Evaluate why economists disagree on the topic of tax cuts As we 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 consumer or firm behavior 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? The short answer is yes, because aggregate demand is defined as total demand for domestically produced goods and services. When an American buys a foreign product, for example, it gets counted along with all the other consumption. Thus, 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 we write the demand equation, 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. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 281 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. each month. The The University of Michigan publishes a survey of consumer confidence and constructs an index of consumer at http://www.sca.isr.umich.edu confidence (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 economists consider close to a healthy state. reported survey results then are The Organization for Economic Development and Cooperation (OECD) publishes one measure of business confidence: the "business tendency surveys". The OECD collects business opinion survey data for 21 countries on future selling
prices and employment, among other business climate elements. 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 economists associate a rise in confidence 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 Figure 11.8 (a) shows. 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. Figure 11.8 (b) shows 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. Visit this website (http://openstaxcollege.org/l/consumerconfid) for data on consumer confidence. Visit this website (http://openstaxcollege.org/l/businessconfid) for data on business confidence. 282 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model Figure 11.8 Shifts in Aggregate Demand (a) An increase in consumer confidence or business confidence can shift AD to the right, from AD0 to AD1. When AD shifts to the right, the new equilibrium (E1) will have a higher quantity of output and also a higher price level compared with the original equilibrium (E0). In this example, the new equilibrium (E1) is also closer to potential GDP. An increase in government spending or a cut in taxes that leads to a rise
in consumer spending can also shift AD to the right. (b) A decrease in consumer confidence or business confidence can shift AD to the left, from AD0 to AD1. When AD shifts to the left, the new equilibrium (E1) will have a lower quantity of output and also a lower price level compared with the original equilibrium (E0). In this example, the new equilibrium (E1) is also farther below potential GDP. A decrease in government spending or higher taxes that leads to a fall in consumer spending can also shift AD to the left. 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 11.8 (a), while lower government spending will cause AD to shift to the left, as in Figure 11.8 (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. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 283 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 2001 recession, for example, the U.S. Congress enacted a tax cut into law. At such times, the political rhetoric often focuses on how people experiencing hard times need relief from taxes. The aggregate supply and aggregate demand framework, however, offers a complementary rationale, as Figure 11.9 illustrates. 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. Figure 11.9 Recession and Full Employment in the AD/AS Model Whether the economy is in a recession is illustrated in the AD/AS model by how close the equilibrium is to the potential GDP line as indicated by the vertical LRAS line. In this example, the level of output Y0 at the equilibrium E0 is relatively far from the potential GDP line, so it can represent an economy in recession, well below the full employment level of GDP. In contrast, the level of output Y1 at the equilibrium E1 is relatively close to potential GDP, and so it would represent an economy with a lower unemployment rate. 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 tax cut package through Congress early in 2001. More recently in 2017, Donald Trump has pushed for tax cuts to stimulate the economy. Disputes over tax cuts often ignite at the state and local level as well. What side do economists take? 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 equally large government spending cuts accompany the tax cuts. Economists differ, as does any broad cross-section of the public, on how large government spending should be and what programs the government might cut back. A second issue, more 284 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model relevant to the discussion in this chapter, concerns how close the economy is to the full employment output level. In a recession, when the AD and AS curves intersect 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 performing 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 1981 Reagan tax cuts, which took effect just after two serious recessions, were beneficial economic policy. Similarly, Congress enacted the 2001 Bush tax cuts and the 2009 Obama tax cuts during recessions. However, some of the same economists who favor tax cuts during recession would be much more dubious about identical tax cuts at a time the economy is performing well and cyclical unemployment is low. Government spending and tax rate changes can be useful tools to affect aggregate demand. We will discuss these 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 we will discus in the Monetary Policy and Bank Regulation chapter, the Federal Reserve can affect interest rates and credit availability. Higher interest rates tend to discourage borrowing and thus reduce both household spending on bigticket 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. Clarifying 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 AS curve's relatively flat or relatively steep portion. 11.5 \| How the AD/AS Model Incorporates Growth, Unemployment, and Inflation By the end of this section, you will be able to: • Use the aggregate demand/aggregate supply model to show periods of economic growth and recession • Explain how unemployment and inflation impact the aggregate demand/aggregate supply model • Evaluate the importance of the aggregate demand/aggregate supply model The AD/AS model can convey a number of interlocking relationships
between the three macroeconomic goals of growth, unemployment, and low inflation. 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. 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. Earlier Figure 11.7 (a) showed a pattern of economic growth over three years, with the AS curve shifting slightly out to the right each year. 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. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 285 The AD/AS diagram illustrates recessions when the equilibrium level of real GDP is substantially below potential GDP, as we see at the equilibrium point E0 in Figure 11.9. From another standpoint, in years of resurgent economic growth the equilibrium will typically be close to potential GDP, as equilibrium point E1 in that earlier figure shows. Unemployment in the AD/AS Diagram We described two types of unemployment in the Unemployment chapter. Short run variations in unemployment (cyclical unemployment) are caused by the business cycle as the economy expands and contracts. 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 unemployment
rate in recent decades has only dropped to about 10% or a bit lower, even in good economic years. We call this baseline level of unemployment that occurs year-in and year-out the natural rate of unemployment and we determine it 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. The AD/AS diagram shows cyclical unemployment by how close the economy is to the potential or full GDP employment level. Returning to Figure 11.9, 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. Although we do not show the factors that determine the natural rate of unemployment separately in the AD/AS model, they are implicitly part of what determines potential GDP or full employment GDP in a given economy. 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 1991-1992 recession, the inflation rate declined from 5.4% in 1990 to 3.0% in 1992. During the relatively short 2001 recession, the rate of inflation declined from 3.4% in 2000 to 1.6% in 2002. During the deep recession of 2007–2009, the inflation rate 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. Instead, it has stayed in the 1–5% range 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 AS curve's steep portion. In Figure 11.10 (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. 286 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model Figure 11.10 Sources of Inflationary Pressure in the AD/AS Model (a) A shift in aggregate demand, from AD0 to AD1, when it happens in the area of the SRAS curve that is near potential GDP, will lead to a higher price level and to pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1) than the original equilibrium. (b) A shift in aggregate supply, from SRAS0 to SRAS1, will lead to a lower real GDP and to pressure for a higher price level and inflation. The new equilibrium (E1) is at a higher price level (P1), while the original equilibrium (E0) is at the lower price level (P0). 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 11.10 (b), the SRAS curve's shift 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, passing 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 SRAS curve
's steep portion. A second possibility is that, if inflation has been occurring for several years, people might begin to expect a certain level of inflation. If they do, then these expectations will cause prices, wages and interest rates to increase annually by the amount of the inflation expected. 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. 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 (like the budget constraint diagram that we introduced in the Choice in a World of Scarcity chapter and the supply and demand This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 287 diagram in the Demand and Supply chapter) because it provides an overall framework for bringing these factors together in one diagram. Some version of the AD/AS model will appear in every chapter in the rest of this book. 11.6 \| Keynes’ Law and Say’s Law in the AD/AS Model By the end of this section, you will be able to: • Identify the neoclassical zone, the intermediate zone, and the Keynesian zone in the aggregate demand/aggregate supply model • Use an aggregate demand/aggregate supply model as a diagnostic test to understand the current state of the economy We can use the AD/AS model to illustrate both Say’s law that supply creates its own demand and Keynes’ law that demand creates its own supply. Consider the SRAS curve's three zones which Figure 11.11 identifies: the Keynesian zone, the neoc
lassical zone, and the intermediate zone. Figure 11.11 Keynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve Near the equilibrium Ek, in the Keynesian zone at the far left of the SRAS curve, small shifts in AD, either to the right or the left, will affect the output level Yk, but will not much affect the price level. In the Keynesian zone, AD largely determines the quantity of output. Near the equilibrium En, in the neoclassical zone at the SRAS curve's far right, small shifts in AD, either to the right or the left, will have relatively little effect on the output level Yn, but instead will have a greater effect on the price level. In the neoclassical zone, the near-vertical SRAS curve close to the level of potential GDP largely determines the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will increase both the output level and the price level, while a movement in AD to the left would decrease both the output level and the price level. 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 righthand 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. 288 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 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 SRAS curve's intermediate zone in Figure 11.11. 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 we can apply to an economy, like a doctor checking a patient for symptoms. First, figure out in what zone the economy is. This will clarify the economic issues, tradeoffs, and policy choices. 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 We can explain economic fluctuations, whether those experienced during the 1930s Great Depression, the 1970s stagflation, or the 2008-2009 Great Recession, can be explained using the AD/AS diagram. Shortrun 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 rise, 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 home values 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 Great Recession's rising unemployment. 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 in The Keynesian Perspective, Monetary Policy and Bank about Regulation, and Government Budgets and Fiscal Policy. their effectiveness in more detail This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 289 KEY TERMS aggregate demand (AD) the amount of total spending on domestic goods and services in an economy aggregate demand (AD) curve the total spending on domestic goods and services at each price level aggregate demand/aggregate supply model 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 aggregate supply (AS) the total quantity of output (i.e. real GDP) firms will produce and sell aggregate supply (AS) curve the total quantity of output (i.e. real GDP) that firms will produce and sell at each price level full-employment GDP another name for potential GDP, when the economy is producing at its potential and unemployment is at the natural rate of
unemployment intermediate zone portion of the SRAS curve where GDP is below potential but not so far below as in the Keynesian zone; the SRAS curve is upward-sloping, but not vertical in the intermediate zone Keynesian zone portion of the SRAS curve where GDP is far below potential and the SRAS curve is flat Keynes’ law “demand creates its own supply” long run aggregate supply (LRAS) curve vertical line at potential GDP showing no relationship between the price level for output and real GDP in the long run neoclassical economists economists who generally emphasize the importance of aggregate supply in determining the size of the macroeconomy over the long run neoclassical zone portion of the SRAS curve where GDP is at or near potential output where the SRAS curve is steep potential GDP the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions Say’s law “supply creates its own demand” short run aggregate supply (SRAS) curve real GDP, holding the prices of inputs fixed positive short run relationship between the price level for output and stagflation an economy experiences stagnant growth and high inflation at the same time KEY CONCEPTS AND SUMMARY 11.1 Macroeconomic Perspectives on Demand and Supply 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. 11.2 Building a Model of Aggregate Demand and Aggregate Supply 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, 290 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model we show the aggregate supply 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: (a) the wealth effect, which means that a higher price level leads to lower real wealth, which reduces the level of consumption; (b) 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 (c) 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. 11.3 Shifts in Aggregate Supply 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. 11.4 Shifts in Aggregate Demand 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. We can illustrate long-term economic growth in the AD/AS framework by a gradual shift of the aggregate
supply curve to the right. We illustrate a recession when the intersection of AD and AS is substantially below potential GDP, while we illustrate an expanding economy when the intersection of AS and AD is near potential GDP. 11.5 How the AD/AS Model Incorporates Growth, Unemployment, and Inflation 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 economists mean by potential GDP, but does not otherwise appear in an AD/AS diagram. The AD/AS framework shows pressures for inflation to rise or fall 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 we use in this book to understand macroeconomic issues. 11.6 Keynes’ Law and Say’s Law in the AD/AS Model We can divide the SRAS curve into three zones. Keynes’ law says demand creates its own supply, so that changes in aggregate demand cause changes in real GDP and employment. We can show Keynes’ law 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. We can show Say’s law 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. This OpenStax book is available for free at http://cnx.org/content/col
12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 291 SELF-CHECK QUESTIONS 1. Describe the mechanism by which supply creates its own demand. 2. Describe the mechanism by which demand creates its own supply. 3. 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? 4. In the AD/AS model, what prevents the economy from achieving equilibrium at potential output? 5. Suppose the U.S. Congress passes significant immigration reform that makes it more difficult 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. 6. 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? 7. 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? 8. 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. 9. A policymaker claims that tax cuts led the economy out of a recession. Can we use the AD/AS diagram to show this? 10. 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. 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? 12. Suppose, after five years of sluggish growth, the European Union's economy picks up speed. What would be the likely impact on the U.S. trade balance, GDP, and employment? 13. 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? If the economy is operating in the neoclassical zone of the SRAS curve and aggregate demand falls, what is 14. 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 15. to happen to real GDP? REVIEW QUESTIONS 16. What is Say’s law? 17. What is Keynes’ law? 18. Do neoclassical economists believe in Keynes’ law or Say’s law? 19. Does Say’s law apply more accurately in the long run or the short run? What about Keynes’ law? 20. What is on the horizontal axis of the AD/AS diagram? What is on the vertical axis? 21. What is the economic reason why the SRAS curve slopes up? 22. What are the components of the aggregate demand (AD) curve? 292 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 23. What are the economic reasons why the AD curve slopes down? 32. How is long-term growth illustrated in an AD/AS model? 24. Briefly explain the reason for the near-horizontal shape of the SRAS curve on its far left. 25. Briefly explain the reason for the near-vertical shape of the SRAS curve on its far right. 26. What is potential GDP? 27. 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. 28. 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? 29. What is stagflation? 33. How is recession illustrated in an AD/AS model? 34. How is cyclical unemployment illustrated in an AD/AS model? 35. How is illustrated in an AD/AS model? the natural rate of unemployment 36. How is pressure for inflationary price increases shown in an AD/AS model? 37. What are some of the ways in which exports and imports can affect the AD/AS model? 38. What is the Keynesian zone of the SRAS curve? How much is the price level likely to change in the Keynesian zone? 30. Name some factors that could cause AD to shift, and say whether they would shift AD to the right or to the left. 39. What is the neoclassical zone of the SRAS curve? How much is the output level likely to change in the neoclassical zone? 31. Would a shift of AD to the right
tend to make the equilibrium quantity and price level higher or lower? What about a shift of AD to the left? 40. 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? CRITICAL THINKING QUESTIONS 41. Why would an economist choose either the neoclassical perspective or the Keynesian perspective, but not both? 42. On a microeconomic demand curve, a decrease in price causes an increase in quantity demanded because the product in question is now relatively less expensive than substitute products. Explain why aggregate demand does not increase for the same reason in response to a decrease in the aggregate price level. In other words, what causes total spending to increase if it is not because goods are now cheaper? Economists expect 43. that as the labor market continues to tighten going into the latter part of 2015 that workers should begin to expect wage increases in 2015 and 2016. Assuming this occurs and it was the only development in the labor market that year, how would this affect the AS curve? What if it was also accompanied by an increase in worker productivity? 44. If new government regulations require firms to use a cleaner technology that is also less efficient than what they previously used, what would the effect be on output, the price level, and employment using the AD/ AS diagram? 45. During spring 2016 the Midwestern United States, which has a large agricultural base, experiences aboveaverage rainfall. Using the AD/AS diagram, what is the effect on output, the price level, and employment? 46. Hydraulic fracturing (fracking) has the potential to significantly increase the amount of natural gas produced in the United States. If a large percentage of factories and utility companies use natural gas, what will happen to output, the price level, and employment as fracking becomes more widely used? 47. Some politicians have suggested tying the minimum wage to the consumer price index (CPI). Using the AD/AS diagram, what effects would this policy most likely have on output, the price level, and employment? This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 293 48. If households decide to save a larger portion of their income, what effect would this have on the output, employment, and price level in the short run? What about the long run? 49. If firms become more
optimistic about the future of the economy and, at the same time, innovation in 3-D printing makes most workers more productive, what is the combined effect on output, employment, and the price-level? If Congress cuts taxes at 50. the same time that businesses become more pessimistic about the economy, what is the combined effect on output, the price level, and employment using the AD/AS diagram? 51. Suppose the level of structural unemployment increases. How would you illustrate the increase in structural unemployment in the AD/AS model? Hint: How does structural unemployment affect potential GDP? 52. If foreign wealth-holders decide that the United States is the safest place to invest their savings, what would the effect be on the economy here? Show graphically using the AD/AS model. 53. The AD/AS model is static. It shows a snapshot of the economy at a given point in time. Both economic growth and inflation are dynamic phenomena. Suppose economic growth is 3% per year and aggregate demand is growing at the same rate. What does the AD/AS model say the inflation rate should be? 54. Explain why the short-run aggregate supply curve might be fairly flat in the Keynesian zone of the SRAS curve. How might we tell if we are in the Keynesian zone of the AS? 55. Explain why the short-run aggregate supply curve might be vertical in the neoclassical zone of the SRAS curve. How might we tell if we are in the neoclassical zone of the AS? 56. Why might it be important for policymakers to know which in zone of the SRAS curve the economy is? 57. In your view, is the economy currently operating in the Keynesian, intermediate or neoclassical portion of the economy’s aggregate supply curve? 58. Are Say’s law and Keynes’ mutually exclusive? law necessarily 294 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model PROBLEMS 59. Review the problem in the Work It Out titled "Interpreting the AD/AS Model." Like the information provided in that feature, Table 11.2 shows information on aggregate supply, aggregate demand, and the price level for the imaginary country of Xurbia. Price Level 110 120 130 140 150 160 170 AD 700 690 680 670 660 650 640 AS 600 640 680 720 740 760 770 Table 11.2 Price Level: AD/AS a. Plot the AD/AS diagram from the data. Identify b. the equilibrium. Imagine
that, as a result of a government tax cut, aggregate demand becomes higher by 50 at every price level. Identify the new equilibrium. c. How will the new equilibrium alter output? How will it alter the price level? What do you think will happen to employment? 60. The imaginary country of Harris Island has the aggregate supply and aggregate demand curves as Table 11.3 shows. Price Level 100 120 140 160 180 AD 700 600 500 400 300 AS 200 325 500 570 620 Table 11.3 Price Level: AD/AS a. Plot the AD/AS diagram. Identify the equilibrium. b. Would you expect unemployment economy to be relatively high or low? in this c. Would you expect concern about inflation in this d. economy to be relatively high or low? Imagine that consumers begin to lose confidence about the state of the economy, and so AD becomes lower by 275 at every price level. Identify the new aggregate equilibrium. e. How will the shift in AD affect the original output, price level, and employment? This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model 295 61. Table 11.4 describes Santher's economy. Price Level AD AS 50 60 70 80 90 1,000 950 900 850 800 250 580 750 850 900 Table 11.4 Price Level: AD/AS a. Plot the AD/AS curves and identify the equilibrium. b. Would you expect unemployment economy to be relatively high or low? in this c. Would you expect prices to be a relatively large d. or small concern for this economy? Imagine that input prices fall and so AS shifts to the right by 150 units. Identify the new equilibrium. e. How will the shift in AS affect the original output, price level, and employment? 296 Chapter 11 \| The Aggregate Demand/Aggregate Supply Model This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 12 \| The Keynesian Perspective 297 12 \| The Keynesian Perspective Figure 12.1 Signs of a Recession Home foreclosures were just one of the many signs and symptoms of the recent Great Recession. During that time, many businesses closed and many people lost their jobs. (Credit: modification of work by Taber Andrew Bain/Flickr Creative Commons) 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. 298 Chapter 12 \| The Keynesian Perspective Introduction to the Keynesian Perspective In this chapter, you will learn about: • Aggregate Demand in Keynesian Analysis • The Building Blocks of Keynesian Analysis • The Phillips Curve • The Keynesian Perspective on Market Forces We have learned that the level of economic activity, for example output, employment, and spending, tends to grow over time. In The Keynesian Perspective we learned the reasons for this trend. The Macroeconomic Perspective pointed out that the economy tends to cycle around the long-run trend. In other words, the economy does not always grow at its average growth rate. Sometimes economic activity grows at the trend rate, sometimes it grows more than the trend, sometimes it grows less than the trend, and sometimes it actually declines. You can see this cyclical behavior in Figure 12.2. Figure 12.2 U.S. Gross Domestic Product, Percent Changes 1930–2014 The chart tracks the percent change in GDP since 1930. The magnitude of both recessions and peaks was quite large between 1930 and 1945
. (Source: Bureau of Economic Analysis, “National Economic Accounts”) This empirical reality raises two important questions: How can we explain the cycles, and to what extent can we moderate them? This chapter (on the Keynesian perspective) and The Neoclassical Perspective explore those questions from two different points of view, building on what we learned in The Aggregate Demand/Aggregate Supply Model. 12.1 \| Aggregate Demand in Keynesian Analysis By the end of this section, you will be able to: • Explain real GDP, recessionary gaps, and inflationary gaps • Recognize the Keynesian AD/AS model • • Analyze the factors that determine government spending and net exports Identify the determining factors of both consumption expenditure and investment expenditure 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 This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 12 \| The Keynesian Perspective 299 goods and services that actually sell, known as real GDP, depends on how much demand exists across the economy. Figure 12.3 illustrates this point. Figure 12.3 The Keynesian AD/AS Model The Keynesian View of the AD/AS Model uses an SRAS curve, which is horizontal at levels of output below potential and vertical at potential output. Thus, when beginning from potential output, any decrease in AD affects only output, but not prices. Any increase in AD affects only prices, not output. 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 12.3 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. 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 300 Chapter 12 \| The Keynesian Perspective 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. Visit this website (http://openstaxcollege.org/l/Diane_Rehm) for more information about how the recession affected various groups of people. 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. 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 (http://cnx.org/content/m63688/latest/) and Positive Externalitites and Public Goods (http://cnx.org/content/m63697/latest/), government provides important public services such as national defense, transportation infrastructure, and education. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 12 \| The Keynesian Perspective 301 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. 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 12.1 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 Consumption • Rise in taxes • Fall in income • Rise in interest rates • Desire to save more • Decrease in wealth Consumption • Decrease in taxes • Increase in income • Fall in interest rates • Desire to save less • Rise in wealth • Fall in future expected income • Rise in future expected income Investment • Fall in expected rate of return Investment • Rise in expected rate of return • Rise in interest rates • Drop in interest rates • Drop in business confidence • Rise in business confidence Government • Reduction in government spending Government • Increase in government spending • Increase in taxes • Decrease in taxes Net Exports • Decrease in foreign demand Net Exports • Increase in foreign demand • Relative price increase of U.S. goods • Relative price drop of U.S. goods Table 12.1 Determinants of Aggregate Demand 302 Chapter 12 \| The Keynesian Perspective 12.2 \| The Building Blocks of Keynesian Analysis By the end of this section, you will be able to: • Evaluate the Keynesian view of recessions through an understanding of sticky wages and prices and the importance of aggregate demand • Explain the coordination argument, menu costs, and macroeconomic externality • Analyze the impact of the expenditure multiplier 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’ incomeexpenditure 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. Visit this website (http://openstaxcollege.org/l/expenditures) for raw data used to calculate GDP. 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 This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 12 \| The Keynesian Perspective 303 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 12.4 (a) illustrating the overall labor market, while Figure 12.4 (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 12.4 (a) and the demand for goods shifts to the left (to D1) in Figure 12.4 (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 12.4 (a) and Figure 12.4 (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. Figure 12.4 Sticky Prices and Falling Demand in the Labor and Goods Market In both (a) and (b), demand shifts left from D0 to D1. However, the wage in (a) and the price in (b) do not immediately decline. In (a), the quantity demanded of labor at the original wage (W0
) is Q0, but with the new demand curve for labor (D1), it will be Q1. Similarly, in (b), the quantity demanded of goods at the original price (P0) is Q0, but at the new demand curve (D1) it will be Q1. An excess supply of labor will exist, which we call unemployment. An excess supply of goods will also exist, where the quantity demanded is substantially less than the quantity supplied. Thus, sticky wages and sticky prices, combined with a drop in demand, bring about unemployment and recession. 304 Chapter 12 \| The Keynesian Perspective 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. Figure 12.5 Jobs Lost/Gained in the Recession/Recovery Data in the aftermath of the Great Recession suggests that jobs lost were in mid-wage occupations, while jobs gained were in low-wage occupations. 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 12.5 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. The Two Keynesian Assumptions in the AD/AS Model Figure 12.6 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 12.6 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 This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 12 \| The Keynesian Perspective 305 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. Figure 12.6 A Keynesian Perspective of Recession This figure illustrates the two key assumptions behind Keynesian economics. A recession begins when aggregate demand declines from AD0 to AD1. The recession persists because of the assumption of fixed wages and prices, which makes the SRAS flat below potential GDP. If that were not the case, the price level would fall also, raising GDP and limiting the recession. Instead the intersection E1 occurs in the flat portion of the SRAS curve where GDP is less than potential. 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. ΔY ΔSpending > 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. 12.3 \| The Phillips Curve By the end of this section, you will be able to: • Explain the Phillips curve, noting its impact on the theories of Keynesian economics • Graph a Phillips curve • • Analyze the Keynesian policy for reducing unemployment and inflation Identify factors that cause the instability of the Phillips curve The simplified AD/AS model that we have used so far is fully consistent with Keynes’s original model. More recent research, though, has indicated that in the real world, an aggregate supply curve is more curved than the right angle that we used in this chapter. Rather, the real-world AS curve is very flat at levels of output far below potential (“the Keynesian zone”), very steep at levels of output above potential (“the neoclassical zone”) and curved in between (“the intermediate zone”). Figure 12.7 illustrates this. The typical aggregate supply curve leads to the concept of the Phillips curve. 306 Chapter 12 \| The Keynesian Perspective Figure 12.7 Keynes, Neoclassical, and Intermediate Zones in the Aggregate Supply Curve Near the equilibrium Ek, in the Keynesian zone at the SRAS curve's far left, small shifts in AD, either to the right or the left, will affect the output level Yk, but will not much affect the price level. In the Keynesian zone, AD largely determines the quantity of output. Near the equilibrium En, in the neoclassical zone, at the SRAS curve's far right, small shifts in AD, either to the right or the left, will have relatively little effect on the output level Yn, but instead will have a greater effect on the price level. In the neoclassical zone, the near-vertical SRAS curve close to the level of potential GDP (as represented by the LRAS line) largely determines the quantity of output. In the intermediate zone around equilibrium Ei, movement in AD to the right will increase both the output level and the price level, while a movement in AD to the left would decrease both the output level and the price level. The Discovery of the Phillips Curve In the 1950s,
A.W. Phillips, an economist at the London School of Economics, was studying the Keynesian analytical framework. The Keynesian theory implied that during a recession inflationary pressures are low, but when the level of output is at or even pushing beyond potential GDP, the economy is at greater risk for inflation. Phillips analyzed 60 years of British data and did find that tradeoff between unemployment and inflation, which became known as the Phillips curve. Figure 12.8 shows a theoretical Phillips curve, and the following Work It Out feature shows how the pattern appears for the United States. Figure 12.8 A Keynesian Phillips Curve Tradeoff between Unemployment and Inflation A Phillips curve illustrates a tradeoff between the unemployment rate and the inflation rate. If one is higher, the other must be lower. For example, point A illustrates a 5% inflation rate and a 4% unemployment. If the government attempts to reduce inflation to 2%, then it will experience a rise in unemployment to 7%, as point B shows. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 12 \| The Keynesian Perspective 307 The Phillips Curve for the United States Step 1. Go to this website (http://1.usa.gov/1c3psdL) to see the 2005 Economic Report of the President. Step 2. Scroll down and locate Table B-63 in the Appendices. This table is titled “Changes in special consumer price indexes, 1960–2004.” Step 3. Download the table in Excel by selecting the XLS option and then selecting the location in which to save the file. Step 4. Open the downloaded Excel file. Step 5. View the third column (labeled “Year to year”). This is the inflation rate, measured by the percentage change in the Consumer Price Index. Step 6. Return to the website and scroll to locate the Appendix Table B-42 “Civilian unemployment rate, 1959–2004. Step 7. Download the table in Excel. Step 8. Open the downloaded Excel file and view the second column. This is the overall unemployment rate. Step 9. Using the data available from these two tables, plot the Phillips curve for 1960–69, with unemployment rate on the x-axis and the inflation rate on the y-axis. Your graph should look like Figure 12.9. Figure 12.9 The Phillips Curve from 1960–1969 This chart shows the negative relationship between unemployment and inflation. Step 10
. Plot the Phillips curve for 1960–1979. What does the graph look like? Do you still see the tradeoff between inflation and unemployment? Your graph should look like Figure 12.10. 308 Chapter 12 \| The Keynesian Perspective Figure 12.10 U.S. Phillips Curve, 1960–1979 The tradeoff between unemployment and inflation appeared to break down during the 1970s as the Phillips Curve shifted out to the right. Over this longer period of time, the Phillips curve appears to have shifted out. There is no tradeoff any more. The Instability of the Phillips Curve During the 1960s, economists viewed the Phillips curve as a policy menu. A nation could choose low inflation and high unemployment, or high inflation and low unemployment, or anywhere in between. Economies could use fiscal and monetary policy to move up or down the Phillips curve as desired. Then a curious thing happened. When policymakers tried to exploit the tradeoff between inflation and unemployment, the result was an increase in both inflation and unemployment. What had happened? The Phillips curve shifted. The U.S. economy experienced this pattern in the deep recession from 1973 to 1975, and again in back-to-back recessions from 1980 to 1982. Many nations around the world saw similar increases in unemployment and inflation. This pattern became known as stagflation. (Recall from The Aggregate Demand/Aggregate Supply Model that stagflation is an unhealthy combination of high unemployment and high inflation.) Perhaps most important, stagflation was a phenomenon that traditional Keynesian economics could not explain. Economists have concluded that two factors cause the Phillips curve to shift. The first is supply shocks, like the mid-1970s oil crisis, which first brought stagflation into our vocabulary. The second is changes in people’s expectations about inflation. In other words, there may be a tradeoff between inflation and unemployment when people expect no inflation, but when they realize inflation is occurring, the tradeoff disappears. Both factors (supply shocks and changes in inflationary expectations) cause the aggregate supply curve, and thus the Phillips curve, to shift. In short, we should interpret a downward-sloping Phillips curve as valid for short-run periods of several years, but over longer periods, when aggregate supply shifts, the downward-sloping Phillips curve can shift so that unemployment and inflation are both higher (as in the 1970s and early 1980s) or both lower (as in the early 1990s or first decade of the 2000s). Keynesian Policy for Fighting Unemployment and In
flation Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate demand curve to the right. For example, if aggregate demand was originally at ADr in Figure 12.11, so that the economy was in recession, the appropriate policy would be for government to shift aggregate demand to the right from ADr to ADf, where the economy would be at potential GDP and full employment. Keynes noted that while it would be nice if the government could spend additional money on housing, roads, and other amenities, he also argued that if the government could not agree on how to spend money in practical ways, then it could spend in impractical ways. For example, Keynes suggested building monuments, like a modern This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 12 \| The Keynesian Perspective 309 equivalent of the Egyptian pyramids. He proposed that the government could bury money underground, and let mining companies start digging up the money again. These suggestions were slightly tongue-in-cheek, but their purpose was to emphasize that a Great Depression is no time to quibble over the specifics of government spending programs and tax cuts when the goal should be to pump up aggregate demand by enough to lift the economy to potential GDP. Figure 12.11 Fighting Recession and Inflation with Keynesian Policy If an economy is in recession, with an equilibrium at Er, then the Keynesian response would be to enact a policy to shift aggregate demand to the right from ADr toward ADf. If an economy is experiencing inflationary pressures with an equilibrium at Ei, then the Keynesian response would be to enact a policy response to shift aggregate demand to the left, from ADi toward ADf. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. The result would be downward pressure on the price level, but very little reduction in output or very little rise in unemployment. If aggregate demand was originally at ADi in Figure 12.11, so that the economy was experiencing inflationary rises in the price level, the appropriate policy would be for government to shift aggregate demand to the left, from ADi toward
ADf, which reduces the pressure for a higher price level while the economy remains at full employment. In the Keynesian economic model, too little aggregate demand brings unemployment and too much brings inflation. Thus, you can think of Keynesian economics as pursuing a “Goldilocks” level of aggregate demand: not too much, not too little, but looking for what is just right. 12.4 \| The Keynesian Perspective on Market Forces By the end of this section, you will be able to: • Explain the Keynesian perspective on market forces • Analyze the role of government policy in economic management 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. 310 Chapter 12 \| The Keynesian Perspective 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. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 12 \| The Keynesian Perspective 311 KEY TERMS contractionary fiscal policy tax increases or cuts in government spending designed to decrease aggregate demand and reduce inflationary pressures coordination argument downward wage and price flexibility requires perfect information about the level of lower compensation acceptable to other laborers and market participants disposable income income after taxes expansionary fiscal policy tax cuts or increases in government spending designed to stimulate aggregate demand and move the economy out of recession expenditure multiplier Keynesian concept that asserts that a change in autonomous spending causes a more than proportionate change in real GDP inflationary gap equilibrium at a level of output above potential GDP macroeconomic externality occurs when what happens at the macro level is different from and inferior to what happens at the micro level; an example would be where upward sloping supply curves for firms become a flat aggregate supply curve, illustrating that the price level cannot fall to stimulate aggregate demand menu costs costs firms face in changing prices Phillips curve the tradeoff between unemployment and inflation real GDP the amount of
goods and services actually sold in a nation recessionary gap equilibrium at a level of output below potential GDP sticky wages and prices a situation where wages and prices do not fall in response to a decrease in demand, or do not rise in response to an increase in demand KEY CONCEPTS AND SUMMARY 12.1 Aggregate Demand in Keynesian Analysis 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. 12.2 The Building Blocks of Keynesian Analysis 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. 312 Chapter 12 \| The Keynesian Perspective 12.3 The Phillips Curve A Phillips curve shows the tradeoff between unemployment and inflation in an economy. From a Keynesian viewpoint, the Phillips curve should slope down so that higher unemployment means lower inflation, and vice versa. However, a downward-sloping Phillips curve is a short-term relationship that may shift after a few years. Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that would shift the aggregate
demand curve to the right. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response would be contractionary fiscal policy, using tax increases or government spending cuts to shift AD to the left. 12.4 The Keynesian Perspective on Market Forces 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. SELF-CHECK QUESTIONS In the Keynesian framework, which of the following events might cause a recession? Which might cause 1. inflation? Sketch AD/AS diagrams to illustrate your answers. a. A large increase in the price of the homes people own. b. Rapid growth in the economy of a major trading partner. c. The development of a major new technology offers profitable opportunities for business. d. The interest rate rises. e. 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 2. 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. 3. Use the AD/AS model to explain how an inflationary gap occurs, beginning from the initial equilibrium in Figure 12.6. 4. Suppose the U.S. Congress cuts federal government spending in order to balance the Federal budget. Use the AD/ AS model to analyze the likely impact on output and employment. Hint: revisit Figure 12.6. 5. How would a decrease in energy prices affect the Phillips curve? 6. Does Keynesian economics require government to set controls on prices, wages, or interest rates? 7. List three practical problems with the Keynesian perspective. REVIEW QUESTIONS 8. Name some economic events not related to government policy that could cause aggregate demand to shift. 10. From a Keynesian point of view, which is more likely to cause a recession: aggregate demand or aggregate supply, and why? 9. Name some government policies that could cause aggregate demand to shift. This OpenSt
ax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 12 \| The Keynesian Perspective 313 11. Why do sticky wages and prices increase the impact of an economic downturn on unemployment and recession? 12. Explain what economists mean by “menu costs.” 13. What tradeoff does a Phillips curve show? 14. Would you expect to see long-run data trace out a stable downward-sloping Phillips curve? 15. What is the Keynesian prescription for recession? For inflation? 16. How did the Keynesian perspective address the economic market failure of the Great Depression? CRITICAL THINKING QUESTIONS 17. In its recent report, The Conference Board’s Global Economic Outlook 2015, updated November 2014 (http://www.conference-board.org/data/ globaloutlook.cfm), projects China’s growth between 2015 and 2019 to be about 5.5%. International Business Times (http://www.ibtimes.com/us-exports-china-havethat grown-294-over-past-decade-1338693) China is the United States’ third largest export market, with exports to China growing 294% over the last ten years. Explain what impact China has on the U.S. economy. reports 18. What may happen if growth in China continues or contracts? 19. Does it make sense that wages would be sticky downwards but not upwards? Why or why not? 20. Suppose the economy is operating at potential GDP when it experiences an increase in export demand. How might the economy increase production of exports to meet this demand, given that the economy is already at full employment? 21. Do you think the Phillips curve is a useful tool for analyzing the economy today? Why or why not? 22. Return to the table from the Economic Report of the President in the earlier Work It Out feature titled “The Phillips Curve for the United States.” How would you expect government spending to have changed over the last six years? Explain what types of policies 23. the federal government may have implemented to restore aggregate demand and the potential obstacles policymakers may have encountered. 314 Chapter 12 \| The Keynesian Perspective This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 315 13 \| The Neoclassical Perspective Figure 13.1 Impact of the Great Recession We can see the
impact of the Great Recession in many areas of the economy that impact our daily lives. One of the most visible signs was in the housing market where many people were forced to abandon their homes and other buildings, including ones midway through construction. (Credit: modification of work by A McLin/Flickr Creative Commons) Navigating Unchartered Waters 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 316 Chapter 13 \| The Neoclassical Perspective 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. Introduction to the Neoclassical Perspective In this chapter, you will learn about: • The Building Blocks of Neoclassical Analysis • The Policy Implications of the Neoclassical Perspective • Balancing Keynesian and Neoclassical Models 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 onetime 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. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 317 13.1 \| The Building Blocks of Neoclassical Analysis By the end of this section, you will be able to: • Explain the importance of potential GDP in the long run • Analyze the role of flexible prices • • Evaluate different ways for measuring the speed of macroeconomic adjustment Interpret a neoclassical model of aggregate demand and aggregate supply 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. 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 318 Chapter 13 \| The Neoclassical Perspective 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 13.2 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% 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. Figure 13.2 Potential and Actual GDP (in 2009 Dollars) Actual GDP falls below potential GDP during and after recessions, like the recessions of 1980 and 1981–82, 1990–91, 2001, and 2008–2009 and continues below potential GDP through 2016. In other cases, actual GDP can be above potential GDP for a time, as in the late 1990s. 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 13.3 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. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 319 Figure 13.3 A Vertical AS
Curve In the neoclassical model, we draw the aggregate supply curve as a vertical line at the level of potential GDP. If AS is vertical, then it determines the level of real output, no matter where we draw the aggregate demand curve. Over time, the LRAS curve shifts to the right as productivity increases and potential GDP expands. 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 13.4 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. 320 Chapter 13 \| The Neoclassical Perspective Figure 13.4 The Rebound to Potential GDP after AD Increases The original equilibrium (E0), at an output level of 500 and a price level of 120, happens at the intersection of the aggregate demand curve (AD0) and the short-run aggregate supply curve (SRAS0). The output at E0 is equal to potential GDP. Aggregate demand shifts right from AD0 to AD1. The new equilibrium is E1, with a higher output level of 550 and an increase in the price level to 125. With unemployment rates unsustainably low, eager employers bid up wages, which shifts short-run aggregate supply to the left, from SRAS0 to SRAS1. The new equilibrium (E2) is at the same original level of output, 500, but at a higher price level of 130. Thus, the long-run aggregate supply curve (LRASn), which is vertical at the level of potential GDP, determines the level of real GDP in this economy in the long run. 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 13.5 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 This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 321 vertical at the level of potential GDP, ultimately determines this economy's real GDP. Figure 13.5 A Rebound Back to Potential GDP from a Shift to the Left in Aggregate Demand The original equilibrium (E0), at an output level of 500 and a price level of 120, happens at the intersection of the aggregate demand curve (AD0) and the short-run aggregate supply curve (SRAS0). The output at E0 is equal to potential GDP. Aggregate demand shifts left, from AD0 to AD1. The new equilibrium is at E1, with a lower output level of 450 and downward pressure on the price level of 115. With high unemployment rates, wages are held down. Lower wages are an economy-wide decrease in the price of a key input, which shifts short-run aggregate supply to the right, from SRAS0 to SRAS1. The new equilibrium (E2) is at the same original level of output, 500, but at a lower price level of 110. 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. 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 322 Chapter 13 \| The Neoclassical Perspective 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. 13.2 \| The Policy Implications of the Neoclassical Perspective By the end of this section, you will be able to: • Discuss why and how economists measure inflation expectations • Analyze the impacts
of fiscal and monetary policy on aggregate supply and aggregate demand • Explain the neoclassical Phillips curve, noting its tradeoff between inflation and unemployment • Identify clear distinctions between neoclassical economics and Keynesian economics 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 This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 323 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. this website (https://www.clevelandfed.org/newsroom-and-events/publications/economic-commentary/ Visit economic-commentary-archives/2009-economic-commentaries/ec-20090809-a-new-approach-to-gauginginflation-expectations.aspx)
to read “The Federal Reserve Bank of Cleveland’s Economic Commentary: A New Approach to Gauging Inflation Expectations” by Joseph G. Haubrich for more information about how economists forecast expected inflation. 324 Chapter 13 \| The Neoclassical Perspective 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 13.6 (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 13.6 (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. Figure 13.6 From a Long-Run AS Curve to a Long-Run Phillips Curve (a) With a vertical LRAS curve, shifts in aggregate demand do not alter the level of output but do lead to changes in the price level. Because output is unchanged between the equilibria E0, E1, and E2, all unemployment in this economy will be due to the natural rate of unemployment. (b) If the natural rate of unemployment is 5%, then the Phillips curve will be vertical. That is, regardless of changes in the price level, the unemployment rate remains at 5%. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 325 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 13.1. How do you interpret that information? Year 1970 1975 1980 1985 1990 1995 2000 Table 13.1 Inflation Rate Unemployment Rate 2% 3% 2% 1% 1% 4% 5% 4% 3% 4
% 6% 4% 2% 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 13.7. Figure 13.7 Inflation Rates Step 2. What patterns do you see in the data? You should notice that there 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 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. 326 Chapter 13 \| The Neoclassical Perspective 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. this website (http://openstaxcollege.org/l/modeledbehavior) to read about Visit intervention. the effects of economic 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 This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 327 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 13.8 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 13.8 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. Figure 13.8 How Aggregate Demand Determines the Price Level in the Long Run As aggregate demand shifts to the right, from AD0 to AD1 to AD2, real GDP in this economy and the level of unemployment do not change. However, there is inflationary
pressure for a higher price level as the equilibrium changes from E0 to E1 to E2. Visit this website (http://openstaxcollege.org/l/inflatemploy) to read about how inflation and unemployment are related. 328 Chapter 13 \| The Neoclassical Perspective 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 longrun 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. 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. Summary of Neoclassical Economics versus Keynesian Economics Table 13.2 summarizes the key differences between the two schools of thought. Summary Neoclassical Economics Keynesian Economics Focus: long-term or short term Long-term Prices and wages:
sticky or flexible? Flexible Short-term Sticky Economic output: Primarily determined by aggregate demand or aggregate supply? Aggregate supply Aggregate demand Aggregate supply: vertical or upward-sloping? Phillips curve vertical or downward-sloping Vertical Vertical Table 13.2 Neoclassical versus Keynesian Economics Upward-sloping Downward sloping This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 329 Summary Neoclassical Economics Keynesian Economics Is aggregate demand 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 aggregate demand to eliminate cyclical unemployment Is aggregate demand a useful tool for ending recession? At best, only in the short-run temporary sense, but may just increase inflation instead Yes Table 13.2 Neoclassical versus Keynesian Economics 13.3 \| Balancing Keynesian and Neoclassical Models By the end of this section, you will be able to: • Evaluate how neoclassical economists and Keynesian economists react to recessions • Analyze the interrelationship between the neoclassical and Keynesian economic 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. 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 330 Chapter 13 \| The Neoclassical Perspective 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. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 331 KEY TERMS adaptive expectations the theory that people look at past experience and gradually adapt their beliefs and behavior as circumstances change expected inflation a future rate of inflation that consumers and firms build into current decision making neoclassical perspective the philosophy that, in the long run, the business cycle will fluctuate around the potential, or full-employment, level of output physical capital per person the amount and kind of machinery and equipment available to help a person produce a good or service rational expectations the theory that people form the most accurate possible expectations about the future that they can, using all information available to them KEY CONCEPTS AND SUMMARY 13.1 The Building Blocks of Neoclassical Analysis 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. 13.2 The Policy Impl
ications of the Neoclassical Perspective 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. 13.3 Balancing Keynesian and Neoclassical Models 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. 332 Chapter 13 \| The Neoclassical Perspective SELF-CHECK QUESTIONS 1. Do rational expectations tend to look back at past experience while adaptive expectations look ahead to the future? Explain your answer. 2. Legislation proposes that the government should use macroeconomic policy to achieve an unemployment rate of zero percent, by increasing aggregate demand for as much and as long as necessary to accomplish this goal. From a neoclassical perspective, how will this policy affect output and the price level in the short run and in the long run? Sketch
an aggregate demand/aggregate supply diagram to illustrate your answer. Hint: revisit Figure 13.4. 3. Would it make sense to argue that rational expectations economics is an extreme version of neoclassical economics? Explain. 4. Summarize the Keynesian and Neoclassical models. REVIEW QUESTIONS 5. Does neoclassical economics focus on the long term or the short term? Explain your answer. 6. Does neoclassical economics view prices and wages as sticky or flexible? Why? 7. What shape is the long-run aggregate supply curve? Why does it have this shape? 8. What is the difference between rational expectations and adaptive expectations? A neoclassical 9. and a Keynesian economist 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? 10. Do neoclassical economists tend to focus more on long term economic growth or on recessions? Explain briefly. 11. Do neoclassical economists tend to focus more on cyclical unemployment or on inflation? Explain briefly. CRITICAL THINKING QUESTIONS If most people have rational expectations, how 17. long will recessions last? 18. Explain why the neoclassical economists believe that the government does not need to do much about unemployment. Do you agree or disagree? Explain. 12. Do neoclassical economists see a value in tolerating a little more inflation if it brings additional economic output? Explain your answer. 13. If aggregate supply is vertical, what role does aggregate demand play in determining output? In determining the price level? 14. What is the shape of the neoclassical long-run Phillips curve? What assumptions do economists make that lead to this shape? 15. 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. 16. 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. from all Economists 19. theoretical persuasions criticized the American Recovery and Reinvestment Act. The “Stimulus Package” was arguably a Keynesian measure so why would a Keynesian economist be critical of it? Why would neoclassical
economists be critical? Is it a logical contradiction to be a neoclassical 20. Keynesian? Explain. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 13 \| The Neoclassical Perspective 333 PROBLEMS 21. Use Table 13.3 to answer the following questions. Price Level Aggregate Supply Aggregate Demand 90 95 100 105 110 Table 13.3 3,000 3,000 3,000 3,000 3,000 3,500 3,000 2,500 2,200 2,100 a. Sketch an aggregate supply and aggregate demand diagram. is d. e. b. What is the equilibrium output and price level? c. right, what aggregate demand shifts If aggregate demand shifts equilibrium output? If equilibrium output? In this scenario, would you suggest using aggregate demand to alter the level of output or to control any inflationary increases in the price level? left, what is 334 Chapter 13 \| The Neoclassical Perspective This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 14 \| Money and Banking 335 14 \| Money and Banking Figure 14.1 Cowrie Shell or Money? Is this an image of a cowrie shell or money? The answer is: Both. For centuries, people used the extremely durable cowrie shell as a medium of exchange in various parts of the world. (Credit: modification of work by “prilfish”/Flickr Creative Commons) The Many Disguises of Money: From Cowries to Bitcoins Here is a trivia question: In the history of the world, what item did people use for money over the broadest geographic area and for the longest period of time? The answer is not gold, silver, or any precious metal. It is the cowrie, a mollusk shell found mainly off the Maldives Islands in the Indian Ocean. Cowries served as money as early as 700 B.C. in China. By the 1500s, they were in widespread use across India and Africa. For several centuries after that, cowries were the means for exchange in markets including southern Europe, western Africa, India, and China: everything from buying lunch or a ferry ride to paying for a shipload of silk or rice. Cowries were still acceptable as a way of paying taxes in certain African nations in the early twentieth century. What made cowries work so well as money? First
, they are extremely durable—lasting a century or more. As the late economic historian Karl Polyani put it, they can be “poured, sacked, shoveled, hoarded in heaps” while remaining “clean, dainty, stainless, polished, and milk-white.” Second, parties could use cowries either by counting shells of a certain size, or—for large purchases—by measuring the weight or volume of the total shells they would exchange. Third, it was impossible to counterfeit a cowrie shell, but dishonest people could counterfeit gold or silver coins by making copies with cheaper metals. Finally, in the heyday of cowrie money, from the 1500s into the 1800s, governments, first the Portuguese, then the Dutch and English, tightly controlled collecting cowries. As a result, the supply of cowries grew quickly enough to serve the needs of 336 Chapter 14 \| Money and Banking commerce, but not so quickly that they were no longer scarce. Money throughout the ages has taken many different forms and continues to evolve even today. What do you think money is? Introduction to Money and Banking In this chapter, you will learn about: • Defining Money by Its Functions • Measuring Money: Currency, M1, and M2 • The Role of Banks • How Banks Create Money The discussion of money and banking is a central component in studying macroeconomics. At this point, you should have firmly in mind the main goals of macroeconomics from Welcome to Economics!: economic growth, low unemployment, and low inflation. We have yet to discuss money and its role in helping to achieve our macroeconomic goals. You should also understand Keynesian and neoclassical frameworks for macroeconomic analysis and how we can embody these frameworks in the aggregate demand/aggregate supply (AD/AS) model. With the goals and frameworks for macroeconomic analysis in mind, the final step is to discuss the two main categories of macroeconomic policy: monetary policy, which focuses on money, banking and interest rates; and fiscal policy, which focuses on government spending, taxes, and borrowing. This chapter discusses what economists mean by money, and how money is closely interrelated with the banking system. Monetary Policy and Bank Regulation furthers this discussion. 14.1 \| Defining Money by Its Functions By the end of this section, you will be able to: • Explain the various functions of money • Contrast commodity money and fiat money Money for the sake of money is not an end in itself. You cannot
eat dollar bills or wear your bank account. Ultimately, the usefulness of money rests in exchanging it for goods or services. As the American writer and humorist Ambrose Bierce (1842–1914) wrote in 1911, money is a “blessing that is of no advantage to us excepting when we part with it.” Money is what people regularly use when purchasing or selling goods and services, and thus both buyers and sellers must widely accept money. This concept of money is intentionally flexible, because money has taken a wide variety of forms in different cultures. Barter and the Double Coincidence of Wants To understand the usefulness of money, we must consider what the world would be like without money. How would people exchange goods and services? Economies without money typically engage in the barter system. Barter—literally trading one good or service for another—is highly inefficient for trying to coordinate the trades in a modern advanced economy. In an economy without money, an exchange between two people would involve a double coincidence of wants, a situation in which two people each want some good or service that the other person can provide. For example, if an accountant wants a pair of shoes, this accountant must find someone who has a pair of shoes in the correct size and who is willing to exchange the shoes for some hours of accounting services. Such a trade is likely to be difficult to arrange. Think about the complexity of such trades in a modern economy, with its extensive division of labor that involves thousands upon thousands of different jobs and goods. Another problem with the barter system is that it does not allow us to easily enter into future contracts for purchasing many goods and services. For example, if the goods are perishable it may be difficult to exchange them for other goods in the future. Imagine a farmer wanting to buy a tractor in six months using a fresh crop of strawberries. Additionally, while the barter system might work adequately in small economies, it will keep these economies from This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 14 \| Money and Banking 337 growing. The time that individuals would otherwise spend producing goods and services and enjoying leisure time they spend bartering. Functions for Money Money solves the problems that the barter system creates. (We will get to its definition soon.) First, money serves as a medium of exchange, which means that money acts as an intermediary between the buyer and the seller. Instead of exchanging accounting services for shoes
, the accountant now exchanges accounting services for money. The accountant then uses this money to buy shoes. To serve as a medium of exchange, people must widely accept money as a method of payment in the markets for goods, labor, and financial capital. Second, money must serve as a store of value. In a barter system, we saw the example of the shoemaker trading shoes for accounting services. However, she risks having her shoes go out of style, especially if she keeps them in a warehouse for future use—their value will decrease with each season. Shoes are not a good store of value. Holding money is a much easier way of storing value. You know that you do not need to spend it immediately because it will still hold its value the next day, or the next year. This function of money does not require that money is a perfect store of value. In an economy with inflation, money loses some buying power each year, but it remains money. Third, money serves as a unit of account, which means that it is the ruler by which we measure values. For example, an accountant may charge $100 to file your tax return. That $100 can purchase two pair of shoes at $50 a pair. Money acts as a common denominator, an accounting method that simplifies thinking about trade-offs. Finally, another function of money is that it must serve as a standard of deferred payment. This means that if money is usable today to make purchases, it must also be acceptable to make purchases today that the purchaser will pay in the future. Loans and future agreements are stated in monetary terms and the standard of deferred payment is what allows us to buy goods and services today and pay in the future. Thus, money serves all of these functions— it is a medium of exchange, store of value, unit of account, and standard of deferred payment. Commodity versus Fiat Money Money has taken a wide variety of forms in different cultures. People have used gold, silver, cowrie shells, cigarettes, and even cocoa beans as money. Although we use these items as commodity money, they also have a value from use as something other than money. For example, people have used gold throughout the ages as money although today we do not use it as money but rather value it for its other attributes. Gold is a good conductor of electricity and the electronics and aerospace industry use it. Other industries use gold too, such as to manufacture energy efficient reflective glass for skyscrapers and is used in the medical industry as well
. Of course, gold also has value because of its beauty and malleability in creating jewelry. As commodity money, gold has historically served its purpose as a medium of exchange, a store of value, and as a unit of account. Commodity-backed currencies are dollar bills or other currencies with values backed up by gold or other commodities held at a bank. During much of its history, gold and silver backed the money supply in the United States. Interestingly, antique dollars dated as late as 1957, have “Silver Certificate” printed over the portrait of George Washington, as Figure 14.2 shows. This meant that the holder could take the bill to the appropriate bank and exchange it for a dollar’s worth of silver. 338 Chapter 14 \| Money and Banking Figure 14.2 A Silver Certificate and a Modern U.S. Bill Until 1958, silver certificates were commodity-backed money—backed by silver, as indicated by the words “Silver Certificate” printed on the bill. Today, The Federal Reserve backs U.S. bills, but as fiat money (inconvertible paper money made legal tender by a government decree). (Credit: “The.Comedian”/Flickr Creative Commons) As economies grew and became more global in nature, the use of commodity monies became more cumbersome. Countries moved towards the use of fiat money. Fiat money has no intrinsic value, but is declared by a government to be a country's legal tender. The United States’ paper money, for example, carries the statement: “THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE.” In other words, by government decree, if you owe a debt, then legally speaking, you can pay that debt with the U.S. currency, even though it is not backed by a commodity. The only backing of our money is universal faith and trust that the currency has value, and nothing more. Watch this video (http://openstaxcollege.org/l/moneyhistory) on the “History of Money.” 14.2 \| Measuring Money: Currency, M1, and M2 By the end of this section, you will be able to: • Contrast M1 money supply and M2 money supply • Classify monies as M1 money supply or M2 money supply Cash in your pocket certainly serves as money; however, what about checks or credit cards? Are they money, too? Rather than
trying to state a single way of measuring money, economists offer broader definitions of money based on liquidity. Liquidity refers to how quickly you can use a financial asset to buy a good or service. For example, cash is very liquid. You can use your $10 bill easily to buy a hamburger at lunchtime. However, $10 that you have in your This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 14 \| Money and Banking 339 savings account is not so easy to use. You must go to the bank or ATM machine and withdraw that cash to buy your lunch. Thus, $10 in your savings account is less liquid. The Federal Reserve Bank, which is the central bank of the United States, is a bank regulator and is responsible for monetary policy and defines money according to its liquidity. There are two definitions of money: M1 and M2 money supply. M1 money supply includes those monies that are very liquid such as cash, checkable (demand) deposits, and traveler’s checks M2 money supply is less liquid in nature and includes M1 plus savings and time deposits, certificates of deposits, and money market funds. M1 money supply includes coins and currency in circulation—the coins and bills that circulate in an economy that the U.S. Treasury does not hold at the Federal Reserve Bank, or in bank vaults. Closely related to currency are checkable deposits, also known as demand deposits. These are the amounts held in checking accounts. They are called demand deposits or checkable deposits because the banking institution must give the deposit holder his money “on demand” when the customer writes a check or uses a debit card. These items together—currency, and checking accounts in banks—comprise the definition of money known as M1, which the Federal Reserve System measures daily. A broader definition of money, M2 includes everything in M1 but also adds other types of deposits. For example, M2 includes savings deposits in banks, which are bank accounts on which you cannot write a check directly, but from which you can easily withdraw the money at an automatic teller machine or bank. Many banks and other financial institutions also offer a chance to invest in money market funds, where they pool together the deposits of many individual investors and invest them in a safe way, such as short-term government bonds. Another ingredient of M2 are the relatively small (that is, less than about $100,
000) certificates of deposit (CDs) or time deposits, which are accounts that the depositor has committed to leaving in the bank for a certain period of time, ranging from a few months to a few years, in exchange for a higher interest rate. In short, all these types of M2 are money that you can withdraw and spend, but which require a greater effort to do so than the items in M1. Figure 14.3 should help in visualizing the relationship between M1 and M2. Note that M1 is included in the M2 calculation. Figure 14.3 The Relationship between M1 and M2 Money M1 and M2 money have several definitions, ranging from narrow to broad. M1 = coins and currency in circulation + checkable (demand) deposit + traveler’s checks. M2 = M1 + savings deposits + money market funds + certificates of deposit + other time deposits. The Federal Reserve System is responsible for tracking the amounts of M1 and M2 and prepares a weekly release of information about the money supply. To provide an idea of what these amounts sound like, according to the Federal Reserve Bank’s measure of the U.S. money stock, at the end of February 2015, M1 in the United States was $3 trillion, while M2 was $11.8 trillion. Table 14.1 provides a breakdown of the portion of each type of money that comprised M1 and M2 in February 2015, as provided by the Federal Reserve Bank. 340 Chapter 14 \| Money and Banking Components of M1 in the U.S. (February 2015, Seasonally Adjusted) Currency Traveler’s checks Demand deposits and other checking accounts $ billions $1,271.8 $2.9 $1,713.5 Total M1 $2,988.2 (or $3 trillion) Components of M2 in the U.S. (February 2015, Seasonally Adjusted) M1 money supply Savings accounts Time deposits Individual money market mutual fund balances Total M2 $ billions $2,988.2 $7,712.1 $509.2 $610.8 $11,820.3 (or $11.8 trillion) Table 14.1 M1 and M2 Federal Reserve Statistical Release, Money Stock Measures (Source: Federal Reserve Statistical Release, http://www.federalreserve.gov/RELEASES/h6/current/default.htm#t2tg1link) The lines separating
M1 and M2 can become a little blurry. Sometimes businesses do not treat elements of M1 alike. For example, some businesses will not accept personal checks for large amounts, but will accept traveler’s checks or cash. Changes in banking practices and technology have made the savings accounts in M2 more similar to the checking accounts in M1. For example, some savings accounts will allow depositors to write checks, use automatic teller machines, and pay bills over the internet, which has made it easier to access savings accounts. As with many other economic terms and statistics, the important point is to know the strengths and limitations of the various definitions of money, not to believe that such definitions are as clear-cut to economists as, say, the definition of nitrogen is to chemists. Where does “plastic money” like debit cards, credit cards, and smart money fit into this picture? A debit card, like a check, is an instruction to the user’s bank to transfer money directly and immediately from your bank account to the seller. It is important to note that in our definition of money, it is checkable deposits that are money, not the paper check or the debit card. Although you can make a purchase with a credit card, the financial institution does not consider it money but rather a short term loan from the credit card company to you. When you make a credit card purchase, the credit card company immediately transfers money from its checking account to the seller, and at the end of the month, the credit card company sends you a bill for what you have charged that month. Until you pay the credit card bill, you have effectively borrowed money from the credit card company. With a smart card, you can store a certain value of money on the card and then use the card to make purchases. Some “smart cards” used for specific purposes, like long-distance phone calls or making purchases at a campus bookstore and cafeteria, are not really all that smart, because you can only use them for certain purchases or in certain places. In short, credit cards, debit cards, and smart cards are different ways to move money when you make a purchase. However, having more credit cards or debit cards does not change the quantity of money in the economy, any more than printing more checks increases the amount of money in your checking account. One key message underlying this discussion of M1 and M2 is that money in a modern economy is not just paper bills and coins. Instead, money is closely
linked to bank accounts. The banking system largely conducts macroeconomic policies concerning money. The next section explains how banks function and how a nation’s banking system has the power to create money. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 14 \| Money and Banking 341 Read a brief article (http://openstaxcollege.org/l/Sweden) on the current monetary challenges in Sweden. 14.3 \| The Role of Banks By the end of this section, you will be able to: • Explain how banks act as intermediaries between savers and borrowers • Evaluate the relationship between banks, savings and loans, and credit unions • Analyze the causes of bankruptcy and recessions Somebody once asked the late bank robber named Willie Sutton why he robbed banks. He answered: “That’s where the money is.” While this may have been true at one time, from the perspective of modern economists, Sutton is both right and wrong. He is wrong because the overwhelming majority of money in the economy is not in the form of currency sitting in vaults or drawers at banks, waiting for a robber to appear. Most money is in the form of bank accounts, which exist only as electronic records on computers. From a broader perspective, however, the bank robber was more right than he may have known. Banking is intimately interconnected with money and consequently, with the broader economy. Banks make it far easier for a complex economy to carry out the extraordinary range of transactions that occur in goods, labor, and financial capital markets. Imagine for a moment what the economy would be like if everybody had to make all payments in cash. When shopping for a large purchase or going on vacation you might need to carry hundreds of dollars in a pocket or purse. Even small businesses would need stockpiles of cash to pay workers and to purchase supplies. A bank allows people and businesses to store this money in either a checking account or savings account, for example, and then withdraw this money as needed through the use of a direct withdrawal, writing a check, or using a debit card. Banks are a critical intermediary in what we call the payment system, which helps an economy exchange goods and services for money or other financial assets. Also, those with extra money that they would like to save can store their money in a bank rather than look for an individual who is willing to borrow it from them and then repay them at a later date. Those who want
to borrow money can go directly to a bank rather than trying to find someone to lend them cash. Transaction costs are the costs associated with finding a lender or a borrower for this money. Thus, banks lower transactions costs and act as financial intermediaries—they bring savers and borrowers together. Along with making transactions much safer and easier, banks also play a key role in creating money. Banks as Financial Intermediaries An “intermediary” is one who stands between two other parties. Banks are a financial intermediary—that is, an institution that operates between a saver who deposits money in a bank and a borrower who receives a loan from that bank. Financial intermediaries include other institutions in the financial market such as insurance companies and pension funds, but we will not include them in this discussion because they are not depository institutions, which are institutions that accept money deposits and then use these to make loans. All the deposited funds mingle in one big pool, which the financial institution then lends. Figure 14.4 illustrates the position of banks as financial intermediaries, with deposits flowing into a bank and loans flowing out. Of course, when banks make loans to firms, the banks will try to funnel financial capital to healthy businesses that have good prospects for repaying the loans, not 342 Chapter 14 \| Money and Banking to firms that are suffering losses and may be unable to repay. Figure 14.4 Banks as Financial Intermediaries Banks act as financial intermediaries because they stand between savers and borrowers. Savers place deposits with banks, and then receive interest payments and withdraw money. Borrowers receive loans from banks and repay the loans with interest. In turn, banks return money to savers in the form of withdrawals, which also include interest payments from banks to savers. How are banks, savings and loans, and credit unions related? Banks have a couple of close cousins: savings institutions and credit unions. Banks, as we explained, receive deposits from individuals and businesses and make loans with the money. Savings institutions are also sometimes called “savings and loans” or “thrifts.” They also take loans and make deposits. However, from the 1930s until the 1980s, federal law limited how much interest savings institutions were allowed to pay to depositors. They were also required to make most of their loans in the form of housing-related loans, either to homebuyers or to real-estate developers and builders. institution that its members own and run. Members of each credit A credit
union is a nonprofit financial union decide who is eligible to be a member. Usually, potential members would be everyone in a certain community, or groups of employees, or members of a certain organization. The credit union accepts deposits from members and focuses on making loans back to its members. While there are more credit unions than banks and more banks than savings and loans, the total assets of credit unions are growing. In 2008, there were 7,085 banks. Due to the bank failures of 2007–2009 and bank mergers, there were 5,571 banks in the United States at the end of the fourth quarter in 2014. According to the Credit Union National Association, as of December 2014 there were 6,535 credit unions with assets totaling $1.1 billion. A day of “Transfer Your Money” took place in 2009 out of general public disgust with big bank bailouts. People were encouraged to transfer their deposits to credit unions. This has grown into the ongoing Move Your Money Project. Consequently, some now hold deposits as large as $50 billion. However, as of 2013, the 12 largest banks (0.2%) controlled 69 percent of all banking assets, according to the Dallas Federal Reserve. A Bank’s Balance Sheet A balance sheet is an accounting tool that lists assets and liabilities. An asset is something of value that you own and you can use to produce something. For example, you can use the cash you own to pay your tuition. If you own a home, this is also an asset. A liability is a debt or something you owe. Many people borrow money to buy homes. In this case, a home is the asset, but the mortgage is the liability. The net worth is the asset value minus how much is owed (the liability). A bank’s balance sheet operates in much the same way. A bank’s net worth as bank capital. We also refer to a bank has assets such as cash held in its vaults, monies that the bank holds at the Federal Reserve bank This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 14 \| Money and Banking 343 (called “reserves”), loans that it makes to customers, and bonds. Figure 14.5 illustrates a hypothetical and simplified balance sheet for the Safe and Secure Bank. Because of the twocolumn format of the balance sheet, with the T-shape formed by the vertical line down the middle and the horizontal line
under “Assets” and “Liabilities,” we sometimes call it a T-account. Figure 14.5 A Balance Sheet for the Safe and Secure Bank The “T” in a T-account separates the assets of a firm, on the left, from its liabilities, on the right. All firms use Taccounts, though most are much more complex. For a bank, the assets are the financial instruments that either the bank is holding (its reserves) or those instruments where other parties owe money to the bank—like loans made by the bank and U.S. Government Securities, such as U.S. treasury bonds purchased by the bank. Liabilities are what the bank owes to others. Specifically, the bank owes any deposits made in the bank to those who have made them. The net worth of the bank is the total assets minus total liabilities. Net worth is included on the liabilities side to have the T account balance to zero. For a healthy business, net worth will be positive. For a bankrupt firm, net worth will be negative. In either case, on a bank’s T-account, assets will always equal liabilities plus net worth. When bank customers deposit money into a checking account, savings account, or a certificate of deposit, the bank views these deposits as liabilities. After all, the bank owes these deposits to its customers, when the customers wish to withdraw their money. In the example in Figure 14.5, the Safe and Secure Bank holds $10 million in deposits. Loans are the first category of bank assets in Figure 14.5. Say that a family takes out a 30-year mortgage loan to purchase a house, which means that the borrower will repay the loan over the next 30 years. This loan is clearly an asset from the bank’s perspective, because the borrower has a legal obligation to make payments to the bank over time. However, in practical terms, how can we measure the value of the mortgage loan that the borrower is paying over 30 years in the present? One way of measuring the value of something—whether a loan or anything else—is by estimating what another party in the market is willing to pay for it. Many banks issue home loans, and charge various handling and processing fees for doing so, but then sell the loans to other banks or financial institutions who collect the loan payments. We call the market where financial institutions make loans to borrowers the primary loan market, while the market in which financial institutions buy and sell
these loans is the secondary loan market. One key factor that affects what financial institutions are willing to pay for a loan, when they buy it in the secondary loan market, is the perceived riskiness of the loan: that is, given the borrower's characteristics, such as income level and whether the local economy is performing strongly, what proportion of loans of this type will the borrower repay? The greater the risk that a borrower will not repay loan, the less that any financial institution will pay to acquire the loan. Another key factor is to compare the interest rate the financial institution charged on the original loan with the current interest rate in the economy. If the original loan requires the borrower to pay a low interest rate, but current interest rates are relatively high, then a financial institution will pay less to acquire the loan. In contrast, if the original loan requires the borrower to pay a high interest rate, while current interest rates are relatively low, then a financial institution will pay more to acquire the loan. For the Safe and Secure Bank in this example, the total value of its loans if they sold them to other financial institutions in the secondary market is $5 million. The second category of bank asset is bonds, which are a common mechanism for borrowing, used by the federal and local government, and also private companies, and nonprofit organizations. A bank takes some of the money it has received in deposits and uses the money to buy bonds—typically bonds issued that the U.S. government issues. Government bonds are low-risk because the government is virtually certain to pay off the bond, albeit at a low rate of interest. These bonds are an asset for banks in the same way that loans are an asset: The bank will receive a stream of payments in the future. In our example, the Safe and Secure Bank holds bonds worth a total value of $4 million. The final entry under assets is reserves, which is money that the bank keeps on hand, and that it does not lend or invest in bonds—and thus does not lead to interest payments. The Federal Reserve requires that banks keep a certain percentage of depositors’ money on “reserve,” which means either in their vaults or at the Federal Reserve Bank. We call this a reserve requirement. (Monetary Policy and Bank Regulation will explain how the level of these required reserves are one policy tool that governments have to influence bank behavior.) Additionally, banks may also want to keep a certain amount of reserves on hand in excess of what is required. The Safe and Secure Bank
is holding 344 Chapter 14 \| Money and Banking $2 million in reserves. We define net worth of a bank as its total assets minus its total liabilities. For the Safe and Secure Bank in Figure 14.5, net worth is equal to $1 million; that is, $11 million in assets minus $10 million in liabilities. For a financially healthy bank, the net worth will be positive. If a bank has negative net worth and depositors tried to withdraw their money, the bank would not be able to give all depositors their money. For some concrete examples of what banks do, watch this video (http://openstaxcollege.org/l/makingsense) from Paul Solman’s “Making Sense of Financial News.” How Banks Go Bankrupt A bank that is bankrupt will have a negative net worth, meaning its assets will be worth less than its liabilities. How can this happen? Again, looking at the balance sheet helps to explain. A well-run bank will assume that a small percentage of borrowers will not repay their loans on time, or at all, and factor these missing payments into its planning. Remember, the calculations of the banks' expenses every year include a factor for loans that borrowers do not repay, and the value of a bank’s loans on its balance sheet assumes a certain level of riskiness because some customers will not repay loans. Even if a bank expects a certain number of loan defaults, it will suffer if the number of loan defaults is much greater than expected, as can happen during a recession. For example, if the Safe and Secure Bank in Figure 14.5 experienced a wave of unexpected defaults, so that its loans declined in value from $5 million to $3 million, then the assets of the Safe and Secure Bank would decline so that the bank had negative net worth. What led to the 2008–2009 financial crisis? Many banks make mortgage loans so that people can buy a home, but then do not keep the loans on their books as an asset. Instead, the bank sells the loan. These loans are “securitized,” which means that they are bundled together into a financial security that a financial institution sells to investors. Investors in these mortgage-backed securities receive a rate of return based on the level of payments that people make on all the mortgages that stand behind the security. Securitization offers certain advantages. If a bank makes most of its loans in a local area, then the bank may be financially vulnerable if the
local economy declines, so that many people are unable to make their payments. However, if a bank sells its local loans, and then buys a mortgage-backed security based on home loans in many parts of the country, it can avoid exposure to local financial risks. (In the simple example in the text, banks just own “bonds.” In reality, banks can own a number of financial instruments, as long as these financial investments are safe enough to satisfy the government bank regulators.) From the standpoint of a local homebuyer, securitization offers the benefit that a local bank does not need to have significant extra funds to make a loan, because the bank is only planning to hold that loan for a short time, before selling the loan so that it can pool it into a financial security. This OpenStax book is available for free at http://cnx.org/content/col12190/1.4 Chapter 14 \| Money and Banking 345 However, securitization also offers one potentially large disadvantage. If a bank plans to hold a mortgage loan as an asset, the bank has an incentive to scrutinize the borrower carefully to ensure that the customer is likely to repay the loan. However, a bank that plans to sell the loan may be less careful in making the loan in the first place. The bank will be more willing to make what we call “subprime loans,” which are loans that have characteristics like low or zero down-payment, little scrutiny of whether the borrower has a reliable income, and sometimes low payments for the first year or two that will be followed by much higher payments. Economists dubbed some financial institutions that made subprime loans in the mid-2000s NINJA loans: loans that financial institutions made even though the borrower had demonstrated No Income, No Job, or Assets. Financial institutions typically sold these subprime loans and turned them into financial securities—but with a twist. The idea was that if losses occurred on these mortgage-backed securities, certain investors would agree to take the first, say, 5% of such losses. Other investors would agree to take, say, the next 5% of losses. By this approach, still other investors would not need to take any losses unless these mortgage-backed financial securities lost 25% or 30% or more of their total value. These complex securities, along with other economic factors, encouraged a large expansion of subprime loans in the mid-2000s. The economic stage was now set for a banking crisis.

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