11.6Keynes’ Law and Say’s Law in the AD/AS Model
unemployment. Aggregate has four elements: consumption, investment, government spending, and less . Aggregate supply reveals how businesses throughout the economy will react to a higher level for outputs. Finally, a wide array of economic events and policy decisions can affect aggregate and aggregate supply, including government tax and spending decisions; consumer and business confidence; changes in prices of key like oil; and that brings higher levels of productivity. The is one of the fundamental diagrams in this course (like the diagram that we introduced in the Choice in a World of chapter and the supply and diagram in the 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
LEARNING OBJECTIVES By the end of this section, you will be able to:
- Identify the , the , and the in the aggregate / aggregate supply
- Use an as a diagnostic test to understand the current state of the economy
We can use the AD/AS to illustrate both that supply creates its own and that creates its own supply. Consider the SRAS curve's three zones which identifies: the , the , and the .
FIGURE 11.11Keynes, Neoclassical, and Intermediate Zones in the Aggregate Supply CurveNear the Ek, in the 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 level. In the , AD largely determines the quantity of output. Near the En, in the 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 level. In the , the near-vertical SRAS curve close to the level of largely determines the quantity of output. In the around Ei, movement in AD to the right will increase both the output level and the 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 right-hand side. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like En where output is at or near potential GDP, then the size of potential GDP pretty much determines the level of output in the economy. Since the equilibrium is near potential GDP, cyclical unemployment is low in this economy, although structural unemployment may remain an issue. In the neoclassical zone, shifts of aggregate demand to the right or the left have little effect on the level of output or employment. The only way to increase the size of the real GDP in the neoclassical zone is for AS to shift to the right. However, shifts in AD in the neoclassical zone will create pressures to change the price level. Finally, consider the SRAS curve's intermediate zone in . If the AD curve crosses this portion of the SRAS curve at an point like Ei, then we might expect unemployment and to move in opposing directions. For instance, a shift of AD to the right will move output closer to and thus reduce unemployment, but will also lead to a higher level and upward pressure on . Conversely, a shift of AD to the left will move output further from and raise unemployment, but will also lead to a lower level and downward pressure on . 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 most of the time, and so they view the as a theoretical abstraction. Conversely, hard-line argue that economies are in the 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. BRING IT HOME The Pandemic-Induced Recession: Supply or Demand? We mentioned earlier that a pandemic could cause a shock in the short- or long-run aggregate supply curve by temporarily reducing labor supply and slowing or stopping production of goods and services. Pandemics can also affect aggregate demand. When people are hesitant to spend or travel, or if they are not allowed to spend or travel because of social restrictions, this will affect spending in the economy. Consumers spend less at restaurants, hotels, and travel, among other areas, while firms stop investing because of the lack of demand and an uncertain future. Both actions lead to a leftward shift in the aggregate demand curve. While there is some debate over whether the pandemic-induced recession that the U.S. economy experienced in 2020 was primarily a supply- or demand-driven one, most likely, it is a combination of both. In March and April 2020, workers left the labor market en masse, and later in the year, they were hesitant to return due to health and safety concerns. Many people were also forced to cancel travel plans or voluntarily did so out of concern for their safety, further reducing aggregate demand. These changes caused deep cuts in the global economy that continued to be felt two years after the initial pandemic-induced shocks.
Key Terms
aggregate (AD) the amount of total spending on domestic goods and services in an economy the total spending on domestic goods and services at each level a that shows what determines total supply or total for the economy, and how total and total supply interact at the macroeconomic level aggregate supply (AS) the total quantity of output (i.e. ) firms will produce and sell the total quantity of output (i.e. ) that firms will produce and sell at each level 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 Keynes’ law “demand creates its own supply” Keynesian zone portion of the SRAS curve where GDP is far below potential and the SRAS curve is flat 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 positive short run relationship between the price level for output and real GDP, holding the prices of inputs fixed 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
emphasize , which holds that supply creates its own . Keynesian economists emphasize , which holds that creates its own supply. Many mainstream economists take a Keynesian perspective, emphasizing the importance of aggregate , for the , and a , emphasizing the importance of aggregate supply, for the .
11.2 Building a Model of Aggregate Demand and Aggregate Supply
The upward-sloping shows the positive relationship between the level and the level of in the . Aggregate supply slopes up because when the level for outputs increases, while the level of remains fixed, the opportunity for additional profits encourages more . The aggregate supply curve is near-horizontal on the left and near-vertical on the right. In the , 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, , , and economic institutions. The downward-sloping 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
Text from Principles of Macroeconomics 3e, OpenStax, licensed CC BY-NC-SA 4.0. Access for free at openstax.org.
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