Introduction to Economics International Relations and International Organization
Week 6: Lecture 11 - Extensions of the AS/AD model
Expenditure multipliers (p. 655-659)
The multiplier and the price level
In the very short run, when the price level is fixed, change in investment and exports are not
smoothed by shock absorbers; instead they are amplified. To study the simultaneous determination
of real GDP and the price level, we use the aggregate supply-aggregate demand model. To
understand how aggregate demand adjusts, we also need the equilibrium expenditure model. The
key to understanding the relationship between:
- Aggregate expenditure (curve): relationship between aggregate planned expenditure and real GDP
&
- Aggregate demand (curve): relationship between aggregate quantity demanded and the price level
When the price level changes, aggregate planned expenditure changes and the quantity of real GDP
demanded changes. The aggregate demand curve slopes downward. Two main reasons:
1. Wealth effect: the higher the price level, the smaller is the purchasing power of people’s real
wealth. The higher the price level, ceteris paribus, the higher is saving and the lower are
consumption expenditure and aggregate planned expenditure
2. Substitution effects: a rise in the price level today makes current goods and services more
expensive relative to future goods and services, and results in a delay in purchases - an intertemporal
substitution. A rise in the UK price level, ceteris paribus, make UK imports increase and UK exports
decrease - an international substitution.
-> the aggregate demand curve slopes downward, because demand increases as prices decrease
Each point on the aggregate demand curve corresponds to a point of equilibrium expenditure.
Whereas the aggregate demand curve slopes downward, the AE curve slopes upward: a higher real
GDP means higher aggregate (planned) expenditure.
When any influence on aggregate planned expenditure other than the price level changes, both the
aggregate expenditure curve and the aggregate demand curve shift. But how do we know by how
much the AD curve shifts? The multiplier determines the answer. The larger the multiplier, the larger
is the shift in the aggregate demand curve that results from a change in autonomous expenditure.
We can discover the following general economic principle: “If some factor other than a change in the
price level increases autonomous expenditure, the AE curve shifts upward and the AD curve shifts
rightward. The size of AD curve shift equals change in autonomous expenditure times the multiplier.”
Aggregate demand and short-run aggregate supply determine equilibrium real GDP and the price
level. We’ve now discovered that a change in investment (or in any component of autonomous
expenditure) changes aggregate demand and shifts the AD curve. The magnitude of the shift
depends of the multiplier. Whether a change in autonomous expenditure ultimately results in a
change in real GDP, a change in the price level, or a combination, depends on aggregate supply:
1. Increase in aggregate demand in the short run: an increase in investment increases aggregate
expenditure and shifts the AE curve upward. However, the price level does not stay the same but
rises, and the higher price level shifts the AE curve downward. Thus, when prices are flexible in the
short run, the multiplier is smaller than when the price level is fixed. The steeper the slope of the SAS
curve, the larger is the increase in the price level and the smaller is the multiplier effect on real GDP.
2. Increase in aggregate demand in the long run: an increase in investment shifts the AE curve
upward and the AD curve rightward. In the short run, the economy grows. In the long run, the
economy wage rate rises, the SAS curve shifts upward, the price level rises, the AE curve shifts back
and real GDP decreases. In the long run, the multiplier is zero; real GDP remains the same, but then
with higher prices.
, Introduction to Economics International Relations and International Organization
The business cycle, inflation and deflation (p. 672-673)
The business cycle
The business cycle is easy to describe but hard to explain, and business cycle theory remains
unsettled and a source of controversy. There are two approaches, but we focus on mainstream
business cycle theory:
- Potential GDP grows at a steady rate while aggregate demand grows at a fluctuating rate;
- Because the money wage rate is sticky, if aggregate demand grows faster than potential GDP, real
GDP moves above potential GDP and an inflationary gap emerges.
- If AD grows more slowly than potential GDP, real GDP moves below potential GDP and a
recessionary gap emerges. If aggregate demand decreases, real GDP also decreases in a recession.
Growth, inflation and the business
cycle arise from the relentless
increases in potential GDP, faster
increases in aggregate demand and
fluctuations in the pace of aggregate
demand growth.
This mainstream theory comes in a number of special forms that differ regarding the source of
fluctuations in aggregate demand growth and the source of money wage rate stickiness:
- Keynesian cycle theory: fluctuations in investment driven by fluctuations in business confidence -
summarised by the phrase ‘animal spirits’ - are the main source of fluctuations in aggregate demand
- Monetarist cycle theory: fluctuations in both investment and consumption expenditure, driven by
fluctuations in the growth rate of the quantity of money, are the main source of fluctuations in AD
-> the two theories above simply assume that the money wage rate is rigid, and don’t explain that
rigidity. The following two theories do:
- New classical cycle theory: the rational expectation of the price level, determined by potential GDP
and expected aggregate demand, determines the money wage rate and position of the SAS curve. In
this theory, only unexpected fluctuations in AD bring fluctuations in real GDP around potential GDP
- New Keynesian cycle theory: the fact that today’s money wage rates were negotiated at many past
dates, which means that past rational expectations at the current price level influence the money
wage rate and the position of the SAS curve. In this theory, both unexpected and currently expected
fluctuations in AD bring fluctuations in real GDP around potential GDP
Mainstream cycle theories don’t rule out the possibility that occasionally an aggregate supply shock
might occur. An oil price rise, widespread drought or other natural disasters could bring a recession,
but supply shocks are not the normal source of fluctuations in mainstream theories. In contrast, real
business cycle theory (the second current of theories) puts supply shocks at centre stage.
The business cycle, inflation and deflation (p. 677-682)
Inflation cycles
In the long run, inflation is a monetary phenomenon. It occurs if the quantity of money grows faster
than potential GDP. But in the short run, many factors can start an inflation, and real GDP and the
price level interact. We distinguish between two sources of inflation:
Week 6: Lecture 11 - Extensions of the AS/AD model
Expenditure multipliers (p. 655-659)
The multiplier and the price level
In the very short run, when the price level is fixed, change in investment and exports are not
smoothed by shock absorbers; instead they are amplified. To study the simultaneous determination
of real GDP and the price level, we use the aggregate supply-aggregate demand model. To
understand how aggregate demand adjusts, we also need the equilibrium expenditure model. The
key to understanding the relationship between:
- Aggregate expenditure (curve): relationship between aggregate planned expenditure and real GDP
&
- Aggregate demand (curve): relationship between aggregate quantity demanded and the price level
When the price level changes, aggregate planned expenditure changes and the quantity of real GDP
demanded changes. The aggregate demand curve slopes downward. Two main reasons:
1. Wealth effect: the higher the price level, the smaller is the purchasing power of people’s real
wealth. The higher the price level, ceteris paribus, the higher is saving and the lower are
consumption expenditure and aggregate planned expenditure
2. Substitution effects: a rise in the price level today makes current goods and services more
expensive relative to future goods and services, and results in a delay in purchases - an intertemporal
substitution. A rise in the UK price level, ceteris paribus, make UK imports increase and UK exports
decrease - an international substitution.
-> the aggregate demand curve slopes downward, because demand increases as prices decrease
Each point on the aggregate demand curve corresponds to a point of equilibrium expenditure.
Whereas the aggregate demand curve slopes downward, the AE curve slopes upward: a higher real
GDP means higher aggregate (planned) expenditure.
When any influence on aggregate planned expenditure other than the price level changes, both the
aggregate expenditure curve and the aggregate demand curve shift. But how do we know by how
much the AD curve shifts? The multiplier determines the answer. The larger the multiplier, the larger
is the shift in the aggregate demand curve that results from a change in autonomous expenditure.
We can discover the following general economic principle: “If some factor other than a change in the
price level increases autonomous expenditure, the AE curve shifts upward and the AD curve shifts
rightward. The size of AD curve shift equals change in autonomous expenditure times the multiplier.”
Aggregate demand and short-run aggregate supply determine equilibrium real GDP and the price
level. We’ve now discovered that a change in investment (or in any component of autonomous
expenditure) changes aggregate demand and shifts the AD curve. The magnitude of the shift
depends of the multiplier. Whether a change in autonomous expenditure ultimately results in a
change in real GDP, a change in the price level, or a combination, depends on aggregate supply:
1. Increase in aggregate demand in the short run: an increase in investment increases aggregate
expenditure and shifts the AE curve upward. However, the price level does not stay the same but
rises, and the higher price level shifts the AE curve downward. Thus, when prices are flexible in the
short run, the multiplier is smaller than when the price level is fixed. The steeper the slope of the SAS
curve, the larger is the increase in the price level and the smaller is the multiplier effect on real GDP.
2. Increase in aggregate demand in the long run: an increase in investment shifts the AE curve
upward and the AD curve rightward. In the short run, the economy grows. In the long run, the
economy wage rate rises, the SAS curve shifts upward, the price level rises, the AE curve shifts back
and real GDP decreases. In the long run, the multiplier is zero; real GDP remains the same, but then
with higher prices.
, Introduction to Economics International Relations and International Organization
The business cycle, inflation and deflation (p. 672-673)
The business cycle
The business cycle is easy to describe but hard to explain, and business cycle theory remains
unsettled and a source of controversy. There are two approaches, but we focus on mainstream
business cycle theory:
- Potential GDP grows at a steady rate while aggregate demand grows at a fluctuating rate;
- Because the money wage rate is sticky, if aggregate demand grows faster than potential GDP, real
GDP moves above potential GDP and an inflationary gap emerges.
- If AD grows more slowly than potential GDP, real GDP moves below potential GDP and a
recessionary gap emerges. If aggregate demand decreases, real GDP also decreases in a recession.
Growth, inflation and the business
cycle arise from the relentless
increases in potential GDP, faster
increases in aggregate demand and
fluctuations in the pace of aggregate
demand growth.
This mainstream theory comes in a number of special forms that differ regarding the source of
fluctuations in aggregate demand growth and the source of money wage rate stickiness:
- Keynesian cycle theory: fluctuations in investment driven by fluctuations in business confidence -
summarised by the phrase ‘animal spirits’ - are the main source of fluctuations in aggregate demand
- Monetarist cycle theory: fluctuations in both investment and consumption expenditure, driven by
fluctuations in the growth rate of the quantity of money, are the main source of fluctuations in AD
-> the two theories above simply assume that the money wage rate is rigid, and don’t explain that
rigidity. The following two theories do:
- New classical cycle theory: the rational expectation of the price level, determined by potential GDP
and expected aggregate demand, determines the money wage rate and position of the SAS curve. In
this theory, only unexpected fluctuations in AD bring fluctuations in real GDP around potential GDP
- New Keynesian cycle theory: the fact that today’s money wage rates were negotiated at many past
dates, which means that past rational expectations at the current price level influence the money
wage rate and the position of the SAS curve. In this theory, both unexpected and currently expected
fluctuations in AD bring fluctuations in real GDP around potential GDP
Mainstream cycle theories don’t rule out the possibility that occasionally an aggregate supply shock
might occur. An oil price rise, widespread drought or other natural disasters could bring a recession,
but supply shocks are not the normal source of fluctuations in mainstream theories. In contrast, real
business cycle theory (the second current of theories) puts supply shocks at centre stage.
The business cycle, inflation and deflation (p. 677-682)
Inflation cycles
In the long run, inflation is a monetary phenomenon. It occurs if the quantity of money grows faster
than potential GDP. But in the short run, many factors can start an inflation, and real GDP and the
price level interact. We distinguish between two sources of inflation:
