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Understanding Aggregate Demand and Supply: Monetarist vs. Keynesian Perspectives

This chapter explores the determination of income and prices through the lens of aggregate demand and supply. It contrasts the Monetarist and Keynesian views, highlighting key concepts such as the Equation of Exchange and the factors affecting consumption, investment, government spending, and net exports. The chapter also discusses the impact of expectations, interest rates, and crowding out in the context of fiscal policy. Additionally, it examines shifters of aggregate supply, the self-correcting mechanism, and the dynamic relationship between inflation and unemployment as illustrated by the Phillips Curve.

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Understanding Aggregate Demand and Supply: Monetarist vs. Keynesian Perspectives

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  1. ECN 304 Chapter 24 Determination of Income and Prices

  2. Key Topics Aggregate Demand Monetarist view: Y = (1/P) M x V shifter: M Keynesian view: Y = C + I + G + NX real balances exchange rates shifters: I, G, T, NX, M, expectations Crowding out: is it complete? Aggregate Supply; shifters Equilibrium

  3. Aggregate Demand Definition The economy’s desired spending on all final goods and services at various price levels Yad = C + I + G + NX P Yad

  4. Aggregate Demand The Monetarist View Equation of Exchange: M x V = P x Y Y = (1/P) M x V For given M and V, increasing P by 20% reduces Y by 20% P Yad

  5. Aggregate Demand The Monetarist View: Shifters Y = (1/P) M x V Increasing M shifts the Aggregate Demand to the right P Yad

  6. Aggregate Demand The Keynesian View • Yad = C + I + G + NX • Consumption, C, depends on • real income, Y • expectations • interest rates • Business investment, I, depends on • expectations • interest rates

  7. Aggregate Demand The Keynesian View (cont.) • Yad = C + I + G + NX • Government spending, G, depends on • Congress’ decisions • Net eXports, NX = exports - imports, • domestic price level • foreign price level • exchange rate

  8. Aggregate Demand The Keynesian View: Slope • real balances effect • P  (M/P)i C, I, NX Yad • exchange-rate effect • P  (P/Pforeign) NX Yad

  9. Aggregate Demand The Keynesian View: Shifters • Government spending • G  Yad • Expectations • C, I  Yad • Taxes • T  (Y - T)  C  Yad

  10. Aggregate Demand The Keynesian View: Shifters • Money supply • M  i   I  Yad • Foreign price levels • Pforeign  NX  Yad

  11. The Crowding-Out Debate Monetarist Critique of Keynesian View • Monetarist view: • Only M can change aggregate demand • Increased G “crowds out” C, I, and NX completely • G  Yad   i C, I, NX  Yad • Keynesian view: crowding out is partial • In a recession, there may be crowding in.

  12. The Aggregate Supply Definition The quantity of final goods and services that the economy wants to sell at various prices, during a given period P Yas

  13. The Aggregate Supply Slope At higher prices, producers receive more profit per unit sold and are willing to produce more goods P Yas

  14. The Aggregate Supply Shifters • Wage rates • Other input costs • Technology • Taxes that affect MC • Taxes on profits P Yas

  15. Equilibrium: Short Run If Yad > Yas, P rises P Yas

  16. Aggregate Supply: Long Run The Natural Rate of Output • Labor supply = Labor demand • When inflation expectations are accurate P Yas Yn

  17. Aggregate Supply: Long Run • High Y creates wage inflation • Higher wages shift the aggregate supply curve • Wage inflation stops when Y = Yn P Yas Yn Long-run Aggr. Supply is vertical

  18. Views of theSelf-Correcting Mechanism • Activists (often Keynsians) • mechanism is slow, especially in recession • Keynes: “In the long run we are all dead.” • Nonactivists (often monetarists) • mechanism is quick • fiscal and monetary policy are slow and unreliable.

  19. Does the Natural Rate Change? Real business cycle theory • Quick adjustment to natural rate. • Changes in Y are due to changes in the natural rate, Yn. • Implies prices should rise during a recession, but they don’t.

  20. Does the Natural Rate Change? Hysteresis • Some unemployment becomes permanent. • unemploymenthomelessness • long periods of unemployment don’t look good on a résumé.

  21. The Phillips Curve Inflation Rate • Early view: stable curve • Modern view: expected inflation raises the Phillips curve. Unemployment Rate 0

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