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Chapter 8 . Aggregate Demand. AS Vertical. The A g g r e g a t e S u p p l y C u r v e. Zero unemployment No excess capacity. Prices. Prices rise. An increase in Demand. Prices do Not change. AS Horizontal. Unemployment & excess capacity. Output. Output can not increase.

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chapter 8

Chapter 8

Aggregate Demand

© 2004 Claudia Garcia - Szekely

the a g g r e g a t e s u p p l y c u r v e

AS Vertical

The Aggregate Supply Curve

Zero unemployment No excess capacity

Prices

Prices

rise

An increase in Demand

Prices do

Not change

AS Horizontal

Unemployment & excess capacity

Output

Output can not increase

Output Increases

the keynesian model
TheKeynesian Model
  • Firms have excess capacity
  • An increase in demand causes an increase in production and a very small or NO increase in prices

Aggregate Supply curve is a horizontal line

the keynesian model4
The Keynesian Model
  • Is a Short Run (Unemployment) model.
  • Assumes that Aggregate Demand determines the level of production.
  • Focuses on how variables that affect Aggregate Demand are interrelated.
  • Develops tools for the government to manage the amount of spending in the economy
the keynesian model5
The Keynesian Model
  • Concern is finding a short term solution to unemployment
  • Concern is NOT inflation

Developed within of the urgency to get the economy out of the Great Depression

in the keynesian world

AS Vertical

In the Keynesian world

Or Inflation

At Full Employment

Prices

Prices

rise

The economy suffers either Unemployment

An increase in Demand

But not both at the same time

Prices do

Not change

AS Horizontal

Below full employment

Output

Output can not increase

Output Increases

circular flow diagram

to

pay

Exports

Stocks, Funds

Bonds, CD’s,

Life Insurance

Consumption

Saving

Investment

Circular Flow Diagram

National Income

Government

Taxes

Rest of World

Government Spending

Firms

Households

Imports

Total Production

slide8

Spending Leakages

NI

Taxes

Imports

Households

Firms

GDP

Saving

slide9

Spending Injections

NI

Government spending

Exports

Households

Firms

GDP

Consumption

Investment

the components of aggregate demand
The Components of Aggregate Demand

1. Consumption

2. Investment

3. Government Spending

4. Net Exports

slide11

1.Consumption

Expenditures in consumer goods are 70% of GDP

disposable income is income available for consumption
Disposable Income is Income available for consumption.
  • Income generated from production is used to:
    • Buy goods and services: C.
    • Save: S
    • Pay taxes: Tx
  • The government pays “income transfers” to households.
    • Social Security
    • Welfare
    • Unemployment benefits
adding net taxes
Adding Net Taxes
  • The government collects taxes
  • The government pays Transfers
  • We are only interested in the NET effect on Incomes.

Use Tx for Taxes

Use Tr for Transfers

Use T for Net Taxes = Tx - Tr

national income

National Income

National Income

Your Income

The sum of the incomes that all individuals in the economy earn in the form of wages, interest, rents, and profits: Income before taxes

disposable income y d

After Tax Income

Disposable Income (Yd)

The sum of the incomes of all the individuals in the economy after all taxes have been paid and all transfer payments from the government have been added

Yd = GDP - Taxes + Transfers

what determines the level of consumption
What determines the level of Consumption?

All other factors which affect Consumption

As income increases, consumption increases

C=bYd

  • Disposable Income Yd
  • Wealth
  • Prices
  • Expectations

Induced consumption

Autonomous

Component of consumption

C=a

C = a + bYd

Add these two components

consumption has two components
Consumption has two components

C=bYd

Inducedby changes in Disposable Income

C= a

Autonomous

Independent from Disposable Income: responds to changes in wealth, prices and expectations

C =a+ bYd

consumption has two components20
Consumption has two components

C =a+ bYd

1175

1025

Slope

875

Consumption Billions

725

575

425

a: Intercept

300

500

700

900

1100

1300

Real Disposable Income Billions

calculating the slope b in c a b y d

B

$180 billion

A

$200

billion

Calculating the slope “b” in C = a + bYd

Choose any two points

Calculate slope of this line

MPC = 180/200=0.9

A 200b increase in income induces a180b increase in consumption.

Fit line closest to most points

1900

MPC = DC/DYd

1700

1500

Real Consumer Spending

1360

DC

1300

1180

The slope is the Marginal Propensity to Consume

1100

900

DYd

0

900

1100

1300

1500

1700

1900

Real Disposable Income

for each 100 increase in income americans spend 90 90 of the increase in income will be consumed
For each $100 increase in income, Americans spend $90:

90% of the increase in income will be consumed.

MPC = 0.9 or 90%

When income drops by $100, decrease savings (their own or borrowed) by $10

When income rises by $100, increase savings by $10

For each $100 decrease in income, consumption decreases only by $90

Only 90% of the decrease in income translates into a reduction in consumption.

slide24

$300 b

$400 b

Choose any two points

C =a+ 0.75Yd

C =a+ bYd

1175

1025

Slope

875

Consumption Billions

725

575

425

300

500

700

900

1100

1300

Real Disposable Income Billions

slide25

725-525=a

725 =a+ 0.75(700)

200=a

725 =a+ 525

C =a+ 0.75Yd

C =200+ 0.75Yd

1175

1025

875

Consumption Billions

725

Choose any point

575

425

200

a: Intercept

300

500

700

900

1100

1300

Real Disposable Income Billions

Value of Consumption when Disposable Income = 0

same intercept a different slope mpc
SameIntercept“a” different slope “MPC”

2750

C1

Larger Increase in consumption

1,350

Larger MPC*

C0

1400

C1

2150

C0

1100

a

a

Smaller MPC

1500

Y0

3000

Y1

Smaller Increase in consumption

1,050

different intercept a same slope mpc
Different intercept “a”same slope “MPC”

3300

C1

same Increase in consumption

1,050

Same MPC

2250

C0

C1

2150

Same Increase in consumption

1,050

a*

C0

1100

a

Same MPC

1500

Y0

3000

Y1

saving s

Saving (S)

We will assume that income not consumed is saved

Stocks, Funds

Bonds, CD’s,

Life Insurance

Saving

Yd - C = S

consumption c mirror saving s
Consumption (C) Mirror Saving (S)

C = a+ MPC* Yd

If Disposable Income is zero:

C = a + MPC*0

C = a

S= Yd – C

S= 0 - a

When Disposable income is zero,

C = a S = - a

Intercept of Consumption Function is: a

Intercept of Saving Function is:– a

the saving function
The Saving Function

S

S = -a + ?

- a

Intercept of Saving Function is – a

slide31

DS = DYd – DC

20 = 200 - 180

C

Causes a $20

Increase in S

3420

Causes a $180

Increase in C

3240

A $200 increase in income

3600

3800

With an extra $200 in income

Consumers

Use $180 to consume

Put $20 into savings

The MPS= DS/DYd= 20/200 = 0.1 or 10%

the slope of the savings function mps
The Slope of the Savings Function: MPS

Saving

MPS = DS/DYd

380

Causes a $20

Increase in S

360

A $200 increase in income

3600

3800

The MPS = 20/200 = 10%

the marginal propensity to save
The Marginal Propensity to Save
  • Is the proportion of an increasein income that is saved..
  • Is the proportion of an decreasein income by which saving decrease
  • Is a percentage or a number between o and 1.
mps 1 mpc
MPS = 1 - MPC
  • If the MPC = 90%, you will consume 90% of any increase in income…
  • If you consume 90% of any increase in income, you save the rest: 10%

MPC + MPS = 100%

MPC = 0.9 then MPS = 0.1

MPC + MPS = 1

the saving function35

The Saving Function

S = -a + (1- MPC)* Y

S = -a + MPS* Y

The Marginal Propensity to Save: The slope of the S line.

Value of Saving when Y(Income) is 0: The intercept of the S line.

slide36

Given the Consumption function,

Find the value of consumption for each of these values of Y:

C = 200+0.75Y

C = 200+0.75*25,000

C = 200+0.75*19,000

C = 200+0.75*10,000

C = 200+0.75*5,000

18,950

14,450

7,700

3,950

Y

25,000

5,000

10,000

19,000

events that cause a movement along the consumption function

Events that cause a movement along the Consumption Function?

C

Changes in Disposable Income ONLY!

18,950

14,450

7,700

3,950

Yd

25,000

5,000

10,000

19,000

the consumption function

The Consumption Function

C = a + MPC* Yd

Consumption responds to changes in after tax income

Consumption responds to changes in wealth, prices and expectations

Changes in income: Movement Along the C line.

Changes in wealth, prices and expectations: Shift C line

Yd = GDP - Taxes + Transfers

factors that shift the consumption function
Factors that shift the consumption function
  • Changes in wealth

Example: value of stocks, bonds, consumer durables, homes.

When stock prices go down, consumer wealth decreases in value.

Consumers feel poorer (even though incomes may be the same!) and slow down purchases

A downward shift in the Consumption Line: a smaller intercept.

factors that shift the consumption function40
Factors that shift the consumption function
  • Changes in consumer expectations:

Pessimistic expectations about future: employment, incomes, wealth.

Consumers slow down purchases (even though incomes may be the same!)

A downward shift in the Consumption Line: a smaller intercept.

factors that shift the consumption function41
Factors that shift the consumption function
  • Prices

When overall prices rise (an increase in the CPI) consumer’s wealth lose buying power.

This drop in the purchasing power of saved dollars make consumers feel poorer and they slow down purchases.

  • Real Wealth Decrease

A downwardshift in the Consumption Line: a smaller intercept.

factors that shift the consumption function42

Interest Rates are NOT in the list!

Factors that shift the consumption function

Changes in wealth

value of stocks, bonds, consumer durables, homes.

Changes in consumer expectations

Pessimistic expectations decrease autonomous consumption.

Changes in Prices

Affect the purchasing power of assets.

Shift Consumption line

Statistical studies: interest rates have no effect on Consumption

We will assume that changes in interest rates do not shift C

slide43

C0

Wealth

Expectations

Prices

C1

a = 300

Smaller intercept

a = 200

S1

S0

-a = -200

Higher intercept

-a = -300

slide44

C1

Wealth

Expectations

Prices

C0

Larger intercept

S0

S1

Lower intercept

slide45

C0

2170

Income Increase:

Wages Increase

Profits Increase

Interest Increase

Rents Increase

Consumption Increase

Move UP Along C

2080

1200

1300

S0

1200

1300

-870

Move UP Along S

-880

Savings Increase

slide46

Calculate the MPC

  • Calculate the Intercept (a)
  • Write the equation of the Consumption function
  • Write down the formula for the Savings function
  • What is the value of Consumption when Income is 10,000
  • Calculate Savings when Income is 10,000
  • At what value of Y is Consumption equal to Income?
  • At what value of Y is Saving equal to zero?
write the equation for this consumption function

We know that C = 700 when Y =1,000.

700 = a + 2/3 (1,000) solve fora= 700 – 2,000/3 = 700 – 666.67 = 33.33

To get the equation, we choose any two points:

Write the equation for this consumption function

1200

C = 33.33 + 2/3Y

1100

MPC

=200/300

= 2/3

1000

900

900

200

800

700

700

300

600

1000

1300

600

800

1000

1200

1400

1600

To calculate the intercept (a), use the MPC and the consumption function: C = a + 2/3 Yd

slide48

C = 33.34 + 2/3 * Y

C

Set C =Y:

33.34 + 2/3*Y= Y

Solve for Y = 100

C= Y

What is the value of Y such that Saving = 0?

What is the value of Y such that C=Y?

33.34

Y

Y= 100

S

S = -33.34 + 1/3*Y

S= 0

Y

Y= 100

Y=

Set S =0:

-33.34 + 1/3*Y= 0

Solve for Y = 100

-33.34

slide49

1175

1025

875

Consumption Billions

725

575

425

300

500

700

900

1100

1300

Real Disposable Income Billions

slide50

Label Vertical Axis

Consumption Function

Value of Y when C = Y

C=

Value of S when C = Y

Intercept

Label Horizontal Axis

Label Vertical Axis

Y=

Savings Function

S=

Y=

Label Horizontal Axis

Intercept

slide51

Calculate the MPC

  • Calculate the Intercept
  • Write down the formula for the Consumption function.
  • Fill in the missing Consumption Values
  • What is the value of Consumption when Income is 10,000
  • Fill in the value of Savings in the table
  • At what value of Y is Consumption equal to Income?
  • Write down the formula for the Savings function
slide52

Calculate the MPC =800 /1000

  • Calculate the Intercept = 600
  • Write down the formula for the Consumption function = 600 +0.8 Y
  • What is the value of Consumption when Income is 10,000 = 600 + 0.8*10,000
  • At what value of Y is Consumption equal to Income? At 3,000
  • Write down the formula for the Savings function = -600 + 0.2Y
slide53

Using C function from previous slide, fill in the missing values/labels

C= Y

What is the value of Y such that Saving = 0?

What is the value of Y such that C=Y?

S= 0

Y=

investment
Investment

The acquisition of capital goods

capitalism
Capitalism
  • In a capitalist, market economy,private businesses make almost all investment decisions:
    • How many factories to build, how many computers to purchase, and so on.
  • To speed up the process of capital formation, the government must persuade private businesses to invest more. But how?
determinants of investment under government control
Determinants of Investment: Under Government Control?
  • Interest Rates:
    • Business borrow to finance investment.
    • Consumers borrow to purchase new homes.

As interest rates drop, more investment projects become profitable and investment increases.

  • Tax Incentives:
    • If directly tied to capital formation will increase investment.
determinants of investment
Determinants of Investment
  • Technical Change:
    • Creates a boom in investment as firms rush to adopt new technologies (Microchip, Internet, Faster Computers, bio - fuels)
    • Open new business opportunities: Firms build new factories, stores, offices and equipment to take advantage of these opportunities (Internet Cafes)
  • Expectations about the strength of demand:
    • High sustained level of sales and expectations of growing economy boost investment
determinants of investment61
Political Stability and the rule of law:

Business cannot be conducted without a guarantee that property rights and laws will be respected. (Danger of communist take over, public unrest, will negatively affect investment)

The government exists to increase the personal wealth and political power of its officials and the ruling class at the expense of the wider population, without pretense of honest service.

Determinants of Investment

Dictatorship

Democracy

Monarchy

Theocracy

Kleptocracy

Political Stability can be achieved with many types of Government

investment includes
Investment Includes…
  • Residential Construction
    • Consumer purchases of new houses and condominiums.
  • Non-residential Construction
    • Factories, Office buildings.
  • Firms’ purchases of equipment
    • software, tools, etc.
  • Changes in Inventories: unsold goods are included as investment.
slide63

Inventories are of two kinds:

  • Planned (desired) inventories.
    • Firms build up inventories to be able to fulfill future orders.
  • Unplanned (unwanted) inventories.
    • Firms end up with unsold inventories because sales decreased unexpectedly.
investment under the firm s control
Investment: Under the firm’s Control
  • Firms control how much to spend in Investment goods
  • Firms control Planned inventories

Firms control Planned Investment

investment does not change with income

Investment responds to Interest Rates, expectations, technology and taxes

Investmentdoes not change with income

Total PLANNED Expenditures on Capital goods and desired inventories

Planned Investment Spending

Investment SHIFTS with Interest Rates, expectations, technology, taxes

Income / GDP

firms have no control over how much ends up as inventories
Firms have NO control over how much ends up as inventories.
  • Changes in inventories depend on demand:
    • If demand dropped below what firms expected, inventories rise
    • If demand was as firms expected, inventories do not change
    • If demand increases above what firms expected, inventories fall.

Firms DO NOT control Actual Investment

aggregate expenditures equation
Aggregate Expenditures Equation:

Describes the behavior of Consumers

C = a + bY

Describes how much Firms plan to invest

I = Iplanned

AE = C + Planned Investment + G + NX

aggregate expenditures vs gdp
Aggregate Expenditures vs. GDP

AE = C + Iplanned+ G + NX

AE = Planned Expenditures

AE = C + Purchase of Capital Goods + wanted inventories+ G + NX

GDP = C + Iactual+ G + NX

GDP = Actual Expenditures

GDP = C + Purchase Capital Goods + wanted + unwanted inventories+ G + NX

slide69

3. Government Spending

Government expenditures are determined by the budget process: The president, Congress and the Senate.

  • Expenditures by federal, state and local governments.
    • Include final, intermediate and capital goods purchased by the government.
    • Exclude transfer payments (social security, unemployment benefits, etc)

Government expenditures are not a function of income.

government spending does not change with income
Government Spending does not change with income

Planned and Actual G expenditures are the same

Total PLANNED Expenditures by all levels of government as dictated by the budget

G

Government Spending

Income / GDP

aggregate expenditures equation71
Aggregate Expenditures Equation:

Describes the behavior of Consumers

C = a + bY

Describes how much Firms plan to invest

I = Iplanned

G= Budgeted Spending

GDP = C + Iactual+ G + NX

AE = C + Iplanned+ G + NX

slide72

4. Exports

  • Exports: Sales of US goods to other countries.
    • Incomes abroad: as other countries grow, they increase purchases of U.S. goods: exports rise
    • Relative prices: if prices in U.S. fall relative to prices abroad, U.S. goods become cheaper for foreigners and U.S exportsrise.
    • Exchange rates (see discussion next).
slide73

4. imports

  • Imports: Purchases of foreign goods by Americans.
    • Incomes in the US: As the U.S. economy grows Americans purchase more goods from abroad: Imports rise
    • Relative prices: as prices in the U.S. increase relative to prices abroad, Americans find foreign goods cheaper and imports increase
    • Exchange rates (See discussion below).
slide74

4. Net Exports

  • U.S. GDP/National Income:
    • When US incomes rise, importsincrease: NX (X-M) drops
  • GDP of other countries:
    • When GDP abroad increases, US exportsriseas foreigners buy more American goods: NX (X-M) rise
  • Relative Prices

When U.S. prices rise:

    • American goods become more expensive and exportsdropas foreigners buy fewer American goods.
    • Foreign goods become cheaper and importsincreaseas Americans buy more foreign goods.

NX (X-M) drop

  • Exchange Rates
slide75

Weakerdollar

Skittles

One Dollar buys fewer Euros

U$1

NX(X-M) increase

1Euro

0.5 Euro

Germans pay

U.S. Goods are cheaper to Germans

U.S. Exportsincrease when the dollar becomes weaker.

slide76

Weaker dollar

German Chocolate

One Euro buys more Dollars

1Euro

NX(X-M) increase

1U$

2 U$

Americans pay

Foreign goods are more expensive to Americans

U.S. Imports decrease when the dollar becomes weaker.

weaker dollar increase exports and decrease imports
Weaker dollar increase exports and decrease imports

Net Exports = X-M

Net Exports increase

AE increase

slide78

Weaker Yuan

Goods

1 Yuan

One Yuan buys fewer Dollars

NX(X-M) increase

1 Dollar

0.5 Dollar

Americans pay

Chinese Goods are cheaperto Americans

ChineseExports increase when the Yuan is weaker.

slide79

Weaker Yuan

Skittles

1Dollar

One Dollar buys more Yuan

NX(X-M) increase

1Yuan

2 Yuan

Chinese pay

U.S. goods are more expensive to Chinese

Chinese Imports decrease when the Yuan is weaker.

slide80

Stronger dollar

Skittles

U$1

One Dollar buys more Euros

NX(X-M) decrease

1Euro

2 Euro

Germans pay

U.S. goods are more expensive to Foreigners

U.S. Exports decrease when the dollar becomes stronger.

slide81

Stronger dollar

Chocolates

One Euro buys fewer Dollars

1Euro

NX(X-M) decrease

1U$

0.5 U$

Americans pay

Foreign goods are cheaper to Americans

U.S. Imports increase when the dollar becomes stronger.

imports increase with income
Imports increase with Income

Imports

Imports

M1

M0

U.S Income / GDP

Y1

Y0

changes in net exports
Changes in Net Exports

NX shifts with changes in:

Incomes Abroad

Relative Prices

Exchange Rates

Net exports

As U.S. Incomes increase, Imports Increase and NX (X-M) drops

NX

U.S. Income / GDP

aggregate expenditures equation84
Aggregate Expenditures Equation:

How much Consumers will buy

C0 = a + bY0

How much Firms plan to invest (buy)

I = I0 (planned)

Describes how much Government will buy

G = G0

Describes how much foreigners will buy

NX = NX0

AE0 = C0 + I0+ G0 + NX0

slide85

C

AE

C = a + bY

I

G

NX

Y

I = Iplanned

Y

Y

Y

G = G

NX

slide86

Move

Along

National Income, Taxes and Transfers, Wealth, CPI, Expectations

Shift or Move Along

C = a + bYd

Shift

Interest rates, Tax incentives, Technical change, Expectations, Political Stability

I = Iplanned

Shift

Only Shift

G = G

Government Budget

Shift

Relative Prices U.S/Abroad, Incomes U.S/Abroad, Exchange Rates

Move

Along

NX = NX

Shift

slide87

Taxes

National Income, Taxes and Transfers, Wealth, CPI, Expectations

Transfers

C = a + bYd

Tax Incentives

Interest rates, Tax incentives, Technical change, Expectations, Political Stability

I = Iplanned

Fiscal Policy

G = G

Government Spending

Government Spending

Relative Prices U.S/Abroad, Incomes U.S/Abroad, Exchange Rates

NX = NX

slide88

National Income, Taxes and Transfers, Wealth, CPI, Expectations

C = a + bYd

Interest Rates

Interest rates, Tax incentives, Technical change, Expectations, Political Stability

I = Iplanned

Monetary Policy

G = G

Government Spending

Relative Prices U.S/Abroad, Incomes U.S/Abroad, Exchange Rates

Relative Prices U.S/Abroad, Incomes U.S/Abroad, Exchange Rates

NX = NX

the effect of changes in exchange rates

The Effect of Changes in Exchange Rates

More on Strong Dollar

© 2004 Claudia Garcia - Szekely

what comes first the chicken or the egg
What comes first: The chicken or the Egg?

Demand Side economics

Supply Side Economics

Firms produce more and hire more workers thus generating the necessary additional demand

Consumers and the government buy morethus generating the necessary incentive for producers to produce more and hire more workers

what comes first the chicken or the egg92

Or should we cut payroll taxes?

Should we cut taxes on businesses?

What comes first? The chicken or the Egg?

Demand Side

Supply Side

Firms produce more and hire more workers thus generating the necessary additional demand?

Consumers and the government buy more thus generating the necessary incentive for producers to produce more and hire more workers?

slide93

“Only suppliers can supply us with goods and services; the demand side can’t will a product or service into existence, no matter how hard it tries. Society therefore advances economically when it reduces tax and regulatory barriers to the creation of goods and services”

Supply Side View

slide94

“The market will take care of everything,” they tell us. If we just cut more regulations and cut more taxes – especially for the wealthy – our economy will grow stronger. Sure, they say, there will be winners and losers. But if the winners do really well, then jobs and prosperity will eventually trickle down to everybody else. And, they argue, even if prosperity doesn’t trickle down, well, that’s the price of liberty.


Now, it’s a simple theory. And we have to admit, it’s one that speaks to our rugged individualism and our healthy skepticism of too much government. That’s in America’s DNA. And that theory fits well on a bumper sticker.

But here’s the problem: It doesn’t work. It has never worked. It didn’t work when it was tried in the decade before the Great Depression. It’s not what led to the incredible postwar booms of the 50s and 60s. And it didn’t work when we tried it during the last decade.

Barack Obama

neo keynesian model phillips curve trade offs
Neo-Keynesian Model: Phillips Curve Trade-Offs

Neo-Keynesian modification to the supply curve: an upward sloping portion where unemployment decrease as output rises BUT prices also rise.

  • It never occurred to the Keynesians that we would have both unemployment and inflation at the same time.
  • But eventually, inflation became a problem long before the economy reached full employment. Why?
unions reaction to a growing economy
Unions: Reaction to a growing economy

The decline in unemployment causes higher rates of inflation

Growth rate increases (still the economy is below full employment)

Firms need to increase production: hire more, Unemployment rate falls

Feeling more secure, workers turn their attention away from job security to wage demands: wages increase

With demand rising, firms do not want to lose workers and they can pass wage increases to price increases w/o losing sales.

unions reaction to a recession
Unions: reaction to a recession

Higher unemployment may slow down the inflation rate.

Growth rate falls

Production decreases: Unemployment rises.

Workers’ priority is now job security: accept smaller wage increases.

Smaller wage rate increases make it possible for firms to moderate price increases

the a g g r e g a t e s u p p l y c u r v e98
The Aggregate Supply Curve

Full Employment: No increase in output, only prices and wages increase

At “low” output levels, there is excess capacity

and unemployment

Prices and wages are “sticky”

As output increase unemployment decreases, prices and wages increase

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Unemployed workers:wages lowExcess capacity: easy to produce more

No Unemployment: wages rise fasterNo excess capacity: Firms cannot produce more

Lower Unemployment: wages riseLess excess capacity: costs rise as firms produce more

Only Prices

rise

Minimal Unemployment no excess capacity

Lower Unemployment and less excess capacity

At Full Employment: Supply must shift for output to increase.

Prices Increase

Prices do not change

Unemployment and Excess Capacity

Output can not increase

Output Increases

Output Increases

During Recessions: Demand drives Output

Recovery: Increase in Output less than increase in demand…

At Full Employment: Demand has NO effect on output.

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At or near Full Employment: Tax cuts for small firms

During Recessions: Incentives to spend more

For Keynes, running budget deficits during a slump was a lesser evil than slashing budgets and letting unemployment rise.