Question

a) How is the Short Run Aggregate Supply schedule derived?.

b) How does Lucas explain the slope of the SRAS?

c) How do New Keynesian, Monetarist, and New Classical models of aggregate supply differ?

Answer 1

A.

In the short-run, the aggregate supply is graphed as an upward sloping curve. The equation used to determine the short-run aggregate supply is: Y = Y^* + α(P-P_e). In the equation, Y is the production of the economy, Y* is the natural level of production of the economy, the coefficient α is always greater than 0, P is the price level, and P_e is the expected price level from consumers.

The short-run aggregate supply curve is upward sloping because the quantity supplied increases when the price rises. In the short-run, firms have one fixed factor of production (usually capital ). When the curve shifts outward the output and real GDP increase at a given price. As a result, there is a positive correlation between the price level and output, which is shown on the short-run aggregate supply curve.

B.

First explain how new classical theory based on rational expectations explains the emergence of recession in the economy. Consider Fig. 27A.5 where EAD is expected aggregate demand curve which intersects the long-run aggregate supply curve LAS and short-run aggregate supply curve SAS and equilibrium is at potential GDP level Y_F with price level equal to P₀.

Suppose there is unanticipated decrease in the aggre­gate demand due to unexpected decrease in money supply growth by the Central Bank of a country or due to unexpected imposition of a higher tax or unanticipated decline in demand for country’s exports. Since this decline in aggregate demand is unanticipated, wage rate will not rise in the short run.

As a result of unanticipated downward shift in aggregate demand curved to AD₁, the economy will move along the given short-run aggregate supply curve SAS_C With this the price level falls to P₁ and aggregate output (GDP) decreases to Y₁ causing unemployment in the economy.

This indicates the situation of recession in the economy. Now, if the decline in aggregate demand is anticipated, price level will be expected to fall and therefore firms and workers will immediately agree to lower money wage rate. By doing so they will prevent the rise in real wage rate and therefore avoid the increase in unemployment.

Thus it is only unanticipated de­crease in aggregate demand that causes fall in price level and decline in real GDP below the full- employment level causing unemployment to rise. This recession persists until aggregate demand increases to the anticipated level EAD

.

C.

Keynesian Economics, Simplified

The terminology of demand-side economics is synonymous with Keynesian economics. Keynesian economists believe the economy is best controlled by manipulating the demand for goods and services. However, these economists do not completely disregard the role the money supply has in the economy and on affecting the gross domestic product, or GDP. Yet, they do believe it takes a great amount of time for the economic market to adjust to any monetary influence.

Keynesian economists believe in consumption, government expenditures and net exports to change the state of the economy. Fans of this theory may also enjoy the New Keynesian economic theory, which expands upon this classical approach. The New Keynesian theory arrived in the 1980s and focuses on government intervention and the behavior of prices. Both theories are a reaction to depression economics.

Monetarist Economics Made Easy

Monetarists are certain the money supply is what controls the economy, as their name implies. They believe that controlling the supply of money directly influences inflation and that by fighting inflation with the supply of money, they can influence interest rates in the future. Imagine adding more money to the current economy and the effects it would have on business expectations and the production of goods. Now imagine taking money away from the economy. What happens to supply and demand?

Monetarist economics founder Milton Friedman believed the monetary policy was so incredibly crucial to a healthy economy that he publicly blamed the Federal Reserve for causing the Great Depression. He implied it is up to the Federal Reserve to regulate the economy.

Keynesian, Monetarist Theories in Politics

Presidents and other lawmakers have applied multiple economic theories throughout history. Soon after the Great Depression, President Herbert Hoover failed in his approach to balancing the budget, which entailed increasing taxes and spending cuts. President Roosevelt followed next and focused his administration's efforts on increasing demand and lowering unemployment. It is worth noting that Roosevelt's New Deal and other policies increased the supply of money in the economy.

More recently, the 2007-08 financial crisis led President Obama and other lawmakers to address economic problems by bailing out banks and fixing underwater mortgages for government-owned housing. In these instances, it appears elements of Keynesian and Monetarist theories were used to reduce the national debt.

The Classical Model

The Classical model was popular before the Great Depression. It says that the economy is very free flowing and that prices and wages freely adjust to the ups and downs of demand over time. In other words, when times are good, wages and prices quickly go up, and when times are bad wages and prices freely adjust downward.

The major assumption of this model is that the economy is always at full employment, meaning that everyone who wants to work is working and all resources are being fully used to their capacity. The thinking goes something like this: if competition is allowed to work, the economy will automatically gravitate towards full employment or what economists call 'potential output.' Classical economists believe that the economy is self-correcting, which means that when a recession occurs, it needs no help from anyone. So that's the Classical model.