Chapter 7:
More on macroeconomic
theory and policy
Aggregate demand (AD) and
aggregate supply (AS)
• Assumptions of AD-AS model
– prices, wages and interest rates variable
– level of income determined by interaction of AD and AS
• Comparison with microeconomic demand and supply
– now dealing with general price level (P) and total
production or income (Y)
• Comparison with Keynesian models (Box 3-1)
• Graphical illustration:
Figure 7-1 Aggregate demand and aggregate supply (Textbook page 155)
Aggregate demand curve (AD)
• Slope (why AD curve slopes downward, ie why negative,
inverse relationship between P & Y?)
– wealth effect (real balance effect)
– interest rate effect
– international trade effect
Figure 7-2 Why the aggregate demand curve slopes downward
(Textbook page 157)
• Position (what can cause the AD curve to shift?)
– all non-price determinants of C, I, G, X and Z
– change in autonomous C
– change in I
– change in G
– change in (X – Z)
– examples on pp 158-159
Aggregate supply curve (AS)
• Slope of AS curve
– short run: upward (positive) slope
– long run: vertical
Figure 7-3 The long-run
aggregate supply curve (Textbook
page 161)
• Upward slope of short-run AS curve
– if P changes, real wage changes; therefore employment
and production change
– RW=W/P, e.g w=R100 & P=R10, then RW=100/10=10
– If P falls to R5, then RW=100/5=20; production and
employment declines
– If P rises to R20, then RW=100/20=5; production and
employment increases
• Position of AS curve
– determined by prices and productivity of factors of
production and other inputs in the production process
– examples on pp 160-161
• Vertical slope of long-run AS curve
– if P changes, real wage remains constant;
therefore employment and production change
– RW=W/P, e.g w=R100 & P=R10, then
RW=100/10=10
– If P falls to R5 and w to R50, then
RW=50/5=10; production and employment
remain unchanged
– If P rises to R20 and w to R200, then
RW=200/20=10; production and employment
remains the same
Changes in aggregate demand (AD)
• Increase in AD
– illustrated by rightward shift of AD curve
– Y increases
– P increases
– trade-off situation
– Because lower unemployment is accompanied by
inflation
• Graphical illustration
Figure 7-4 Expansionary
monetary and fiscal policy in
the AD-AS framework
(Textbook page 162)
• Decrease in AD
– illustrated by leftward shift of AD curve
– Y decreases
– P decreases
– Again a trade-off situation
– Because lower inflation is accompanied by high
unemployment
Changes in short run aggregate
supply (AS)
• Decrease in AS
– illustrated by leftward (upward) shift of AS curve
– Y decreases
– P increases
– Stagflation (Inflation + Unemployment)
• Graphical illustration:
Figure 7-5 An increase in the price
of imported oil in the AD-AS
framework (Textbook page 164)
• Increase in AS
– illustrated by rightward (downward) shift of AS curve
– Y increases
– P decreases
– ideal situation
– Lower inflation and lower unemployment
• Graphical illustration:
Figure 7-6 An increase in
productivity without any
increase in remuneration
(Textbook page 165)
Monetary transmission mechanism
• How do changes in the monetary sector affect the rest of
the economy?
• Essentially, how do changes in interest rates affect the
economy?
• Inverse relationship between interest rates and investment
spending
• Δi → ΔI → ΔA → ΔY
• Keynesian model: change in interest rate changes
investment spending and therefore aggregate spending
and total production and income
• AD-AS model: AS also plays a role
ΔY
• Δi → ΔI → ΔA → ΔAD →
ΔP
• AS determines split between ΔY and ΔP
• Graphical illustration:
Figure 7-7 The monetary transmission
mechanism (Textbook page 167)
Expanded transmission mechanism
• Interest rates do not affect the economy only via investment
• Transmission mechanism has various channels
– interest rate channel
– exchange rate channel
– asset price channel
– credit channel
Monetary and fiscal policy
• Expansionary monetary policy – decrease repo rate
• Restrictive monetary policy – increase repo rate
• Expansionary fiscal policy – increase G, reduce t
• Restrictive fiscal policy – decrease G, increase t
• Policy lags
– recognition lag: same for monetary and fiscal policy
– decision lag: long for fiscal policy, short for monetary
policy
– implementation lag: long for fiscal policy, short for
monetary policy
– impact lag: longer for monetary policy than for fiscal
policy
• Relative effectiveness of Fiscal and Monetary policy
– Combination of both recommended
– fiscal policy for stimulation
– monetary policy for contraction
Schools of economic thought:
overview
• Classical economics
– Say’s law: supply creates its own demand
– emphasis on supply
• Keynes
– Great Depression
– focus on aggregate demand
• Monetarists
– inflation
– focus on quantity of money
• Supply-side economists
– stagflation
– emphasis on supply side
• New classical economists
– rational expectations
• Post Keynesian economists
– go back to Keynes
• New Keynesian economists
– elements of new classical school and Keynesian
school
Monetarism
• Milton Friedman
• Classical dichotomy
– separation of monetary sector and real sector
• Believe in
– inherent stability of free-market system
– minimum government participation in the economy
– inflation is caused by excessive increases in the
quantity of money (quantity theory of money)
• Quantity theory of money
– MV = PY
– change in P caused by change in M
– based on certain assumptions
Supply-side economics
• Emphasis on supply side (Reaganomics, Thatcherism)
• Favour market forces; oppose government intervention
• Cut government spending
• Privatisation
• Deregulation
• Lower tax rates
New classical economics
• Robert Lucas
• Importance of microeconomic foundations
• Rational expectations
• Markets always clear
• Oppose government intervention
New Keynesian economics
• Microeconomic foundations important
• Many accept rational expectations
• Emphasise market imperfections
• Favour policy intervention