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ECON10003 Lecture Notes - Lecture 9: Aggregate Demand, Real Wages, Reduced Form

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School
University of Melbourne
Department
Economics
Course
ECON10003
Professor
Graham Richards

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WEEK 5 MACROECONOMICS
Classical Model: in terms of output generated by a fully employed economy. When aggregate demand increased,
wages and prices adjusted, rather than output and employment. Price is at real wage. Say’s Law is believed- supply
created its own demand. A deficiency in aggregate demand could not be a reason why the economy couldn’t move to
full employment.
Keynesian Model: a decrease in aggregate demand will cause employment and output to fall, rather than wage and
price adjustment. Now, government incentive to secure and increase in aggregate demand, output and employment.
Appropriate to the short-run where quantities adjust more quickly than prices. Output has adjusted to aggregate
demand at a given general price level.
Fixed Costs: Eventually, to meet a higher level of demand, the price will increase to meet the increased MC of the
extra output (from higher rates of depreciation of over-utilised capital and over time rates for employees). For
Keynesian model, take the assumption the general price level is fixed- implying there is no difference between a real
and nominal variable as prices are fixed and there is no inflation.
Planned Aggregate Expenditure: Output is determined and adjusted by planned aggregate expenditure or demand.
Firms produce on expectation to be able to sell. The PAE consists of consumption expenditure by household sector
(C), investment expenditure by firms (I), government expenditure (G)- both consumption and investment, and net
exports (X – M). Unintended increases or decreases in stocks will see actual aggregate expenditure differ from
planned aggregate expenditure.
The Equilibrium Condition exists when output (Y) is just equal to the planned aggregate expenditure. Firms are not
experiencing unintended increases or decreases in stocks of finished goods.
The Two-sector Model sees PAE equal to planned household consumption (C) and planned firm investments (I).
Variables are autonomously determined- independently of income/output (a bar is placed over these variables).
Structural Models consist of both an equilibrium condition and behavioural equations. E.g.
‘c’ is called the Marginal Propensity to Consume (MPC) and represents the proportional of a one unit increase in
income that is devoted to an increase in consumption expenditure.
Reduced form equation: +
The 45 Line Diagram represents these equations above in a simple diagram. It can be used to show the concept of
equilibrium in the model, the process of adjustment to equilibrium and the characteristics of a dis-equilibrium.
The Consumption Function shows a fundamental “psychological law” that as income rises, so too does consumption
expenditure by an amount dependent on the marginal propensity to consume (c). In the two-sector economy, income
can be used or disposed of only by using or saving it. So:
Therefore, we can say , and that actual savings must always equal actual investment.
Leakages and injections: Investments (as well as government expenditure (G) and exports (X)) are examples of
injections and savings (as well as taxation (T) and imports (M)) are examples of leakages(withdrawals) in the circular
flow of income. Injections into the circular flow are those parts of aggregate expenditure not dependent on current
income (e.g. ) and leakages from the circular flow are those parts of current income not devoted to current expenditure
(e.g. savings).
Paradox of Thrift: The intention by people to save more will be met with output and income falling leaving savings
unchanged.
Adding a Government Sector: With government expenditure (G) and Taxation (less transfer payments) (T), both
autonomously determined. .Consumption expenditure is now explicitly a function of disposable income (Yd) where
Yd = (Y – T). Government expenditure increased aggregate expenditure and in turn increases the equilibrium level of
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Document Summary

Classical model: in terms of output generated by a fully employed economy. When aggregate demand increased, wages and prices adjusted, rather than output and employment. Say"s law is believed- supply created its own demand. A deficiency in aggregate demand could not be a reason why the economy couldn"t move to full employment. Keynesian model: a decrease in aggregate demand will cause employment and output to fall, rather than wage and price adjustment. Now, government incentive to secure and increase in aggregate demand, output and employment. Appropriate to the short-run where quantities adjust more quickly than prices. Output has adjusted to aggregate demand at a given general price level. Fixed costs: eventually, to meet a higher level of demand, the price will increase to meet the increased mc of the extra output (from higher rates of depreciation of over-utilised capital and over time rates for employees).

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Related Questions

Classical or Keynesian? Put a “C” for Classical or a “K” for Keynesian in the space provided.

_____A. Believed the total money supply in an economy was fixed and controlled by the central bank. _____B. Believed in fiscal policy as a tool to manipulate the performance of the economy.

_____C. Stressed the self-adjusting tendencies of the economy.

_____D. Believed in the flexibility of wages and prices.

_____E. Believed the aggregate supply curve for output was completely fixed.

_____F. Believed output was solely determined by supply factors.

_____G. Viewed the economy as unstable as a result of the instability of aggregate demand.

_____H. Believed that if economy was left alone to operate full employment would be reached.

_____I. Would argue for wage-price controls as a governmental policy for manipulating the economy. _____J. Believed governmental policy could bring about equilibrium in the money and output markets. _____K. Believed money wages would adjust quickly to equate supply and demand.

_____L. Believed consumer and laborer has complete knowledge on real price levels and can make rational decisions.

_____M. Believed supply factors more important controlling factors in the economy than demand factors. _____N. Believed that “in the long-run we are all dead!”

_____O. Aggregate demand affects output and employment.

_____ P. Believed that workers know the price level , the money wage, and therefore know the real wage. _____Q. Believed that interest rates would adjust to keep shocks from affecting aggregate demand. _____R. Believed that changes in desired business investment expenditures were one of the major factors responsible for changes in income.

_____S. Believed that consumption was dependent on the level of income plotted graphically on a consumption function.

_____T. Stressed business expectations as a factor in determining the level of investment.

Please help wtih these economics questions. I'll give the best answer to the person who justifies their answer.. or someone who does well in economics and knows the subject area well.

Which of the following statements is not true about Say's Law?

A. People produce more goods than they want for their own use only if they seek to trade them for other goods.

B. Markets would be regularly hit by severe shortages and surpluses.

C. Desired expenditures will equal actual expenditures.

D. Surpluses will be eliminated by falling prices and shortages will be eliminated by increasing prices.


Which of the following is not an assumption of the classical model?

A. Buyers and sellers react to changes in relative prices.

B. Households want to maximize economic well being.

C. Wages and prices will move freely in the upward direction but not the downward direction.

D. No single buyer or seller of a commodity can affect its price.


Money illusion is

A. when people think they are better off when their income increases even though prices have increased by the same amount.

B. when people are motivated by self-interest.

C. could not exist if the economy did not have competitive markets.

D. a basic condition that all classical economists assume people have.


Saving is not a problem in the classical model because

A. interest rates were flexible and savings were channeled into investment.

B. savers and investors were the same people.

C. the classical economists assumed that saving was beneficial to people for retirement.

D. saving would be spent by consumers eventually.


Which of the following statements is true?

A. There is an inverse relationship between investment and the interest rate.

B. There is no relationship between investment and the interest rate.

C. There is a direct relationship between investment and the interest rate.

D. Investment is always less than savings.


In the classical model, high unemployment due to either a demand or a supply shock

A. will return to its normal level quickly as wages adjust.

B. will persist if due to a supply shock but not if due to a demand shock.

C. can persist for an indefinite period of time.

D. never exists because unemployment can never deviate from its normal level.


The classical model makes little distinction between the long-run and short-run because

A. the model has not been fully developed yet.

B. prices adjust so fast that the economy is quickly moving towards the long-run.

C. the classical economists knew that we are always operating in the short run.

D. current changes influence the long run, so it is not possible to plan for the future.


In the classical model

A. the level of real GDP per year does not depend on the level of aggregate demand.

B. the level of GDP is demand determined.

C. the level of GDP determines prices independent of demand.

D. changes in aggregate supply affect the price level, not real GDP.


Which of the following is a true statement?

A. Classical economists believed output adjusted more than prices when aggregate demand fell while Keynes believed prices adjusted more than output.

B. Classical economists believed price adjusted more than output when aggregate demand fell while Keynes believed output adjusted more than prices.

C. A decrease in aggregate demand has no short-run effects according to the classical economists, but had significant effects according to Keynes.

D. A decrease in aggregate demand was not possible according to the classical economists, but was possible according to Keynes.


Which of the following is not a reason why GDP can be expanded beyond a level consistent with its long-run growth path in modern Keynesian analysis?

A. Prices and wages are flexible allowing for needed adjustments.

B. In the short-run existing workers can work more hours.

C. The existing capital stock can be used more intensively.

D. Higher prices induce firms to hire more workers.


A recessionary gap can be caused by

A. a decrease in aggregate supply holding aggregate demand constant.

B. an increase in aggregate demand holding aggregate supply constant.

C. an increase in the long run aggregate supply curve holding the aggregate demand constant.

D. a decrease in both aggregate demand and aggregate supply.



Determine the effect on either the aggregate demand curve (is it a rightward or a leftward shift?), the aggregate short-term supply curve, and the long-term aggregate supply curve (does the upward sloping portions of the SAS curve shift left or right, or does the vertical portion of the LAS curve shift to the right or the left?). Also determine the effect on the price level, the real output level, and employment/unemployment. Explain and express this graphically using the AS/AD macro model.


In late 2004, oil prices increased sharply while the rate of growth in labor productivity declined. The combination of these two factors should shift the short-run aggregate supply curve up (left). The increase in oil prices, when combined with the slowdown in productivity growth, will likely result in higher costs for firms at each output level. To offset these higher costs, firms increase their prices at each output level, causing the short-run aggregate supply curve to shift up (left).