Key Terms

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 what happens at the micro level; an example would be where, because of the coordination argument, 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.

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.