Question

3) Aggregate supply, Aggregate Demand (Use graphs for all your answers)

a) Derive the AD curve from the IS-LM model.

b) Discuss what affects the slope of the short-run AS and how. Page 3 of 3

c) In the AS-AD model how does a tax cut affect the natural rate of output, the output level, and the level of prices? (Explain both cases of a long-run and a short-run AS curve).

d) Discuss the notion of the crowding-out of private investment when the government decides to conduct expansionary fiscal policy. (8.3 marks)

Answer 1

a) To start with we derive the aggregate demand curve from the IS-LM model and explain the position and the slope of the aggregate demand curve.

The aggregate demand curve shows the inverse relation between the aggregate price level and the level of national income. Now we may established this relation on the basis of the IS-LM model.

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Suppose we hold the nominal money supply constant. Now if the price level (P) rises, the supply of real money balances (M/P) falls. As a result the LM curve shifts upwards to the left.

This leads to a rise in r and a fall in Y as shown in part (a) of Fig. 11.1.

We see that as the price level rises from P0 to P1 the income level falls to from Y0 to Y1. This inverse relationship between Y and P is captured by the aggregate demand curve, as shown in part (b) of Fig. 11.1.

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Thus the aggregate demand curve is a locus of points showing alternative combinations of P and Y that are consistent with the general equilibrium of the goods market and money market, i.e., equilibrium r and Y — shown by the intersection of the IS and LM curves.

The aggregate demand curve shifts due to any event that shifts the IS curve or the LM curve (when P remains constant). For instance, if M increases Y rises if P remains constant. As a result aggregate demand curve shifts to the right as shown in part (a) of Fig. 11.2. The converse is also true. A fall in M reduces Y and shifts the aggregate demand curve to the left.

Similarly for a constant price level, an increase in G or a cut in T shifts the aggregate demand curve to the right, as shown in part (b) of Fig. 11.2. The converse is also true. A fall in G or an increase in T lowers Y or shifts the aggregate demand curve to the left.

b) The basic IS-LM model is presented on the basis of the assumption that the price level remains fixed. So like the Keynesian model of income determination it is a fix-price model. And thus it shows the behaviour of the economy in the short run.

If we allow the price level to move up or down in order to ensure that the economy produces its full employment (potential) output, we can use the IS-LM model to describe the behaviour of the economy in the long run. Recall that the full employment level of output is also called the natural rate of output which is consistent with the natural rate of unemployment.

In Fig. 11.3 the LM curve is drawn for a fixed price level, P0. The short-run equilibrium of the economy is at point S, where the IS curve intersects the LM curve. This is short-run equilibrium of the Keynesian type because it is a situation of underemployment equilibrium.

At point S the economy’s output (income) is less than its natural rate. In Fig. 11.3(b) we see that at the price level P0, the quantity of output is below the natural rate. As in the Keynesian model, the aggregate demand for goods and services is not adequate to permit the economy turn out its potential output.

In both diagrams point S indicates short-run equilibrium because the price level remains fixed at P0. However, such a situation cannot persist for long. Sooner or later prices have to fall due to the persistence of demand deficiency. Price flexibility does the trick here. The economy ultimately moves back to its natural rate.

As soon as the price level falls to P1 the economy reaches its long-run equilibrium, at point L. Fig. 11.3(b) shows that at point L, aggregate demand equals the full employment (potential) output. In Fig. 11.3(a) the same long-run equilibrium is achieved by shifting the LM curve to the right. The LM curve shifts due to the fall in P1 which, in its turn, increases real money balances (M/P).

In both the figures point S is the Keynesian equilibrium where P remains fixed. This point shows that output deviates from its natural rate. In contrast L is the classical equilibrium. In this case price flexibility ensures automatic full employment.

The Keynesian model is based on the assumption that the price level remains fixed. So output adjusts in response to changes in aggregate level demand for goods and services.

In contrast the classical model is based on the assumption that output remains fixed at the full employment level and price adjusts in response to changes in aggregate demand. The comparison is shown in Fig. 11.4. If the aggregate demand curve shifts to the left, in the short run output falls to Y0, price remain­ing the same at P0. But in the long run price P0 to P1 output remaining the falls from same.

Thus in the short run the price level remains fixed and output adjusts. This is the Keynesian adjustment mechanism. In the long run the economy moves from point E to L.

c)  Effects of Cutting Tax Rates on AD and AS

The striking feature of the Classical model is the Supply-determined nature of the real output and employment. This property of the model follows from the vertical aggregate supply curve. The vertical aggregate supply curve illustrates the supply-determined nature of output. Supply-side economics proved that if tax rates are reduced, the aggregate supply will increase by such a huge amount that the tax collection will increase.

Decrease in tax rate effects both AD and AS. The AD curve shifts to the right to AD1 (Fig. 11.16)

AS curve also shifts to the right to AS1. But shift in AD > shift in AS. This is because due to decrease in tax rate, the incentive to work increases. However, the effect of such incentive is very small and that is why, shift in AS, that is (potential GDP), is very small. Initially the economy is in equilibrium at point E.

Output → Y0, Price level → P0

If there is reduction in the tax rates:

In the short run it will affect AD, that is, there will be AD effect. The AD curve shifts to the right to AD1.

At the given price P0 the economy is in equilibrium at point E1, output increases by a large amount to Y’2. As a result, total tax revenues will fall by a lesser amount than the fall in the tax rate.—This is purely AD effect. But in the Long run. Economy moves to point E2. GDP increases but by a lesser amount Y0Y1 < Y0Y’2

Result:

Total tax collections fall, the deficit increases, because the Revenue of the Government increases by a small amount.

Reason:

Tax collection depends on the income level. Greater the income i.e., GDP, greater is the tax collection. Since income increases by a lesser amount, tax collection will increase by a lesser amount. On the other hand increase in AD is greater than increase in AS, as a result, prices will increase to P1.

In-spite of these fact supply-side policies are preferred because it is only the supply-side policies which can permanently increase the output. The demand policies are useful only for short-term results. That is why many economists strongly favour supply-side policies. Many economists also believe that if along with the tax cut, the Government spending is also reduced then the effect on the deficit will be neutral.

Over very long periods, movement in AD can be either large or small, depending mostly on movements in the money-supply. The output is determined by AS, and Prices are determined by the movement of AD relative to the movement of AS.

If Shift in AD > shift in AS → Price rise will be very high.

Shift in AD < shift in AS → Price rise will be less.

On comparing the price level in 1980 with the price level in 1990, it is found that the increase in price in 1990 is greater than the increase in price in 1980. This is because the extent of shift in AD in 1990 is greater than the shift in AD in 1980. This reveals that prices rise whenever increase in AD is greater than increase in AS.

d)

When government conducts an expansionary fiscal policy (i.e. increases in government spending or decreases in tax rate, it may run afoul of the crowding out effect. Expansionary fiscal policy means an increase in the budget deficit. The government is spending more money than it has in income. Where does government obtain the necessary funds to cover it’s increased deficit? The answer is borrowing.

A larger budget deficit will increase demand for financial capital. The supply of funds in financial markets is the sum of private saving, government saving, and net investment by foreigners into domestic financial markets. If private saving and net foreign investment remain the same, then less financial capital will be available for private investment in physical capital. When government borrowing soaks up available financial capital and leaves less for private investment in physical capital (i.e. increased budget deficit means a reduction in government saving), the result is crowding out.

Let’s look at the details of how crowding out occurs. A larger federal budget deficit requires increased government borrowing in financial markets. How will this affect interest rates in financial markets? In Figure 1, the original equilibrium (E0) where the demand curve (D0) for financial capital intersects with the supply curve (S0) occurs at an interest rate of 5% and an equilibrium quantity equal to 20% of GDP. However, as the government budget deficit increases, the demand curve for financial capital shifts from D0 to D1. The new equilibrium (E1) occurs at an interest rate of 6% and an equilibrium quantity of 21% of GDP.

Higher interest rates tend to reduce private investment in physical capital. The new factory that made sense when a company could borrow the necessary funding at 5%, no longer makes sense at an interest rate of 6%.

Now an important question then how much crowding out occurs. The answer is it depends. Crowding out seems to occur less during recession since banks have savings to lend, but limited borrowers. The degree of crowding out also depends on the amount of private saving and inflows of foreign financial investment.

Effects of Crowding Out

If the purpose of expansionary fiscal policy was to stimulate GDP and employment, the extent to which crowding out occurs will limit the stimulus. If say a $100 billion increase in government spending results in a $50 billion decrease in private investment spending, then the net increase to total expenditure is $50 billion instead of $100 billion. Crowding out reduces the effects of a fiscal stimulus.

However, the long run effects, emphasized by neoclassical economists, are more serious. Recall that economic growth is caused by investment in physical capital. If crowding out causes a reduction in private investment, it also leads to a reduction in economic growth over the long term. This is another reason why neoclassicals favor business tax cuts over government spending increases since business tax cuts tend to stimulate private investment.