Aggregate Demand, Aggregate Supply, and the Self-Correcting Economy

1. Aggregate Demand, Aggregate Supply, and the Self-Correcting Economy Chapter 7

2. Flexible Prices and the AD Curve • What is meant by the “Keynes effect” of a change in the aggregate price level? How does this shift the LM curve for a given IS curve? • What happens to real income due to the Keynes effect? • What is meant by the “Pigou effect” of a change in the price level on real wealth? How does this shift the IS curve for a given LM curve? • What happens to the level of income when the price level changes when (a) only the Keynes effect influences real income versus (b) when both the Keynes effect and the Pigou effect influence real income? • What happens to the slope of the AD curve when the Pigou effect is added to the Keynes effect?

3. Shifts versus Movement Along the AD Curve • Why does a change in the price level result in a movement along the AD curve even though it shifts the LM (and possibly the IS) curve(s)? • How does a change in the money supply, fiscal policy, or any other autonomous spending affect the AD curve? • How does a flatter IS curve (higher multiplier or more interest sensitive investment demand) affect the slope of the AD curve? • What is the slope of the AD curve if the economy experiences a “liquidity trap?” • Why does the effect of a change in AD on price versus output depend on the slope of the AS curve?

4. Deriving the Short-run Aggregate Supply Curve When the Nominal Wage is Rigid • What is meant by an aggregate production function that relates aggregate output as a function of labor, capital, and technology? • Why is technology a broad term that relates to the development of ideas, organization, managerial innovation, etc.? • How is the demand for labor derived from the production function under the assumption that firms maximize profits? Why is the marginal physical product of labor at each real wage rate?

5. SAS continued • How is the real wage related to the nominal wage and the price level? • What determines the supply of labor in the economy? How does it relate to the real wage in the economy? • Why in the long-run will the labor market “clear” toward equilibrium at full employment? • But, why in the short-run is it possible for a higher price level to lower the real wage and increase employment and output?

6. The LAS and SAS Curves • Why does a higher price level shift up the short-run aggregate supply curve, SAS, as the nominal wage rate adjusts to the higher price level? (See figure 7-6) • Although the SAS is upward sloping, why is the long-run aggregate supply curve, LAS, vertical? • Why is the real wage unchanged along the LAS curve? • What determines employment and real wages at the natural rate of employment and output?

7. Fiscal and Monetary Expansion in the Short Run and Long Run • How does the initial effect of fiscal policy on expansion in AD that increases the price level have on the real wage, employment, and output for a given (sticky) nominal wage? • Why does fiscal policy have no cyclical effect on output in the long-run? • Can the same conclusions also be reached regarding the short-run versus long-run effects of monetary policy?

8. Neoclassical Macroeconomics and the Role of Keynes • Why according to the neoclassical model would output occur along the LAS curve at all times? • Why according to the neoclassical school is fiscal policy primarily a tool that affects the allocation of resources? • Why does the money supply determine the price level in the long-run but not the rate of output and employment? • Why, according to the neoclassical school, is a change in real output from full employment equilibrium only due to a supply shock or an unexpected change in demand?

9. The Keynes’s Revolution: The Failure of Self-Correction (Three areas of dispute) • In the goods market, why doesn’t a reduction in planned investment automatically result in less saving and more consumption as the interest rate falls? (Say’s Law) • In the money market, why isn’t the velocity of money constant as predicted by the Classical school? (The Quantity Theory of Money) • In the labor market, why doesn’t the level of employment always occur at the natural rate in the short-run? • Why did Keynes say that “in the long-run we are all dead.”

10. The Effect of Lower Prices During Recession • How can the Pigou effect be offset by the destabilizing effect on expectations when prices are falling? (Effect of deflation on postponing the purchase of goods.) • What is the redistribution effect of lower prices on aggregate demand? • How has deflation deepened Japan’s dilemma and recently led to concern that it could impact the U.S. economy?

11. The Great Depression • Why was aggregate demand so low during the Great Depression? • Is there any evidence that monetary policy was ineffective during the Great Depression due to a liquidity trap? • Did the economy’s SAS curve shift downward to provide self-correction or did it remain stationary during the Great Depression? • Were nominal wages rigid and did real wages fluctuate counter cyclically as predicted by the Keynesian model?