Principles of Economics - 3e Chapter 25 The Keynesian Perspective

The Pe vi , FIGURE Signs of a Recession Home foreclosures were just one of the many signs and symptoms of the recent Great Recession . During that time , many businesses closed and many people lost their jobs , Credit of Foreclosure by Andrew Creative Commons , BY ) CHAPTER OBJECTIVES In this chapter , you will learn about Aggregate Demand in Analysis The Building Blocks of Analysis The Phillips Curve The Perspective on Market Forces Introduction to the Perspective BRING IT HOME The Great Recession The Great Recession hit the economy hard , According to the Bureau of Labor Statistics ( the number of unemployed Americans rose from million in May 2007 to million in October 2009 . During that time , the US . Census Bureau estimated that approximately small businesses closed . Mass layoffs peaked in February 2009 when employers gave workers notice . productivity and output fell as well . Job losses , declining home values , declining incomes , and uncertainty about the future caused consumption expenditures to decrease . According to the , household spending dropped by 78 , Home foreclosures and the meltdown in markets called for immediate action by Congress , the President , and the Federal Reserve Bank . For example , the government implemented programs such as the American Restoration and Recovery Act to help millions of people by providing tax credits for , paying

610 25 The Perspective cash for , and extending unemployment . From cutting back on spending , for unemployment , and losing homes , millions of people were affected by the recession . While the United States is now on the path to recovery , people will feel the impact for many years to come . What caused this recession and what prevented the economy from spiraling further into another depression ?

looked to the lessons learned from the 19305 Great Depression and to John Maynard Keynes models to analyze the causes and solutions to the country economic woes . The perspective is the subject of this chapter . We have learned that the level of economic activity , for example output , employment , and spending , tends to grow over time . In The Perspective we learned the reasons for this trend . The Perspective pointed out that the economy tends to cycle around the trend . In other words , the economy does not always grow at its average growth rate . Sometimes economic activity grows at the trend rate , sometimes it grows more than the trend , sometimes it grows less than the trend , and sometimes it actually declines . You can see this cyclical behavior in Figure . AMA , I I I I I I I I I I I I I I I I I I 1930 1935 1940 1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 Year FIGURE Real Domestic Product , Percent Changes The chart tracks the percent change in Real since 1930 . The magnitude of both and peaks was quite large between 1930 and 1945 . Source Bureau of Economic Analysis , National Economic Accounts , This empirical reality raises two important questions How can we explain the cycles , and to what extent can we moderate them ?

This chapter ( on the perspective ) and The Neoclassical Perspective explore those questions from two different points of view , building on what we learned in The Aggregate Aggregate Supply Model . Click to view content ( books pages ke ers Percent Change of US . Real Gross Domestic Product . Access for free at

Aggregate Demand in Analysis 611 Aggregate Demand in Analysis LEARNING OBJECTIVES By the end of this section , you will be able to Explain real , recessionary gaps , and gaps Recognize the model Identify the determining factors consumption expenditure and investment expenditure Analyze the factors that determine government spending and net exports The perspective focuses on aggregate demand . The idea is simple produce output only if they expect it to sell . Thus , while the availability of the factors determines a nation potential , the amount of goods and services that actually sell , known as real , depends on how much demand exists across the economy . Figure illustrates this point . AD AD , I i , Real FIGURE The Model The View of the Model uses an curve , which is horizontal at levels of output below potential and vertical at output . Thus , when beginning from potential output , any decrease in AD affects only output , but not prices . Any increase in AD affects only prices , not output . Keynes argued that , for reasons we explain shortly , aggregate demand is not it can change unexpectedly . Suppose the economy starts where AD intersects at and . Because is potential output , the economy is at full employment . Because AD is volatile , it can easily fall . Thus , even if we start at , falls , then we ourselves in what Keynes termed a recessionary gap . The economy is in equilibrium but with less than full employment , as in Figure shows . Keynes believed that the economy would tend to stay in a recessionary gap , with its attendant unemployment , for a period of time . In the same way ( although we do not show it in the ) if AD increases , the economy could experience an gap , where demand is attempting to push the economy past potential output . Consequently , the economy experiences . The key policy implication for either situation is that government needs to step in and close the gap , increasing spending during and decreasing spending during booms to return aggregate demand to match potential output . Recall from The Demand Model that aggregate demand is total spending , on domestic goods and services . Aggregate demand ( AD ) is actually what economists call total planned expenditure . Read the appendix on The Model for more on this . You may also remember that aggregate demand is the sum of four components consumption expenditure , investment expenditure , government spending , and spending on net exports ( exports minus imports ) In the following sections , we will examine each component through the perspective . What Determines Consumption Expenditure ?

Consumption expenditure is spending by households and individuals on durable goods , goods , and services . Durable goods are items that last and provide value over time , such as automobiles . goods are things like you consume them , they are gone . Recall from The

612 25 The Perspective Perspective that services are intangible things consumers buy , like healthcare or entertainment . Keynes three factors that affect consumption Disposable income For most people , the single most powerful determinant of how much they consume is how much income they have in their pay , also known as disposable income , which is income after taxes . Expected future income Consumer expectations about future income also are important in determining consumption . If consumers feel optimistic about the future , they are more likely to spend and increase overall aggregate demand . News of recession and troubles in the economy will make them pull back on consumption . Wealth or credit When households experience a rise in wealth , they may be willing to consume a higher share of their income and to save less . When the stock market rose dramatically in the late , for example , savings rates declined , probably in part because people felt that their wealth had increased and there was less need to save . How do people spend beyond their income , when they perceive their wealth increasing ?

The answer is borrowing . On the other side , when the stock market declined about 40 from March 2008 to March 2009 , people felt far greater uncertainty about their economic future , so savings rates increased while consumption declined . Finally , Keynes noted that a variety of other factors combine to determine how much people save and spend . If household preferences about saving shift in a way that encourages consumption rather than saving , then AD will shift out to the right . LINK up Visit this website ( Diane ) for more information about how the recession affected various groups of people . What Determines Investment Expenditure ?

We call spending on new capital goods investment expenditure . Investment falls into four categories producer durable equipment and software , nonresidential structures ( such as factories , and retail locations ) changes in inventories , and residential structures ( such as homes , townhouses , and apartment buildings ) Businesses conduct the first three types of investment , while households conduct the last . Keynes treatment of investment focuses on the key role of expectations about the future in business decisions . When a business decides to make an investment in physical assets , like plants or equipment , or in intangible assets , like skills or a research and development project , that considers both the expected investment ( future expectations ) and the investment costs ( interest rates ) Expectations of future The clearest driver of investment is expectations for future . When we expect an economy to grow , businesses perceive a growing market for their products . Their higher degree of business will encourage new investment . For example , in the second half of the , investment levels surged from 18 of in 1994 to 21 in 2000 . However , when a recession started in 2001 , investment levels quickly sank back to 18 of by 2002 . Interest rates also play a role in determining how much investment a will make . Just as individuals need to borrow money to purchase homes , so businesses need when they purchase big ticket items . The cost of investment thus includes the interest rate . Even if the has the funds , the interest rate measures the opportunity cost of purchasing business capital . Lower interest rates stimulate investment spending and higher interest rates reduce it . Many factors can affect the expected on investment . For example , if the energy prices decline , then investments that use energy as an input will yield higher . If government offers special incentives Access for free at

Aggregate Demand in Analysis 613 for investment ( for example , through the tax code ) then investment will look more attractive conversely , if government removes special investment incentives from the tax code , or increases other business taxes , then investment will look less attractive . As Keynes noted , business investment is the most variable of all the components of aggregate demand . What Determines Government Spending ?

The third component of aggregate demand is federal , state , and local government spending . Although we usually view the United States as a market economy , government still plays a role in the economy . As we discuss in Environmental Protection and Negative and Positive and Public , government provides important public services such as national defense , transportation infrastructure , and education . Keynes recognized that the government budget offered a powerful tool for aggregate demand . Not only could more government spending stimulate AD ( or less government spending reduce it ) but lowering or raising tax rates could consumption and investment spending . Keynes concluded that during extreme times like deep , only the government had the power and resources to move aggregate demand . For example , during the 2020 recession , the federal government gave money to state and local governments and to households to support the economy when many and governments needed to shut down or suffered a large decline in revenue and needed to lay . What Determines Net Exports ?

Recall that exports are domestically produced products that sell abroad while imports are foreign produced products that consumers purchase domestically . Since we aggregate demand as spending on domestic goods and services , export expenditures add to AD , while import expenditures subtract from AD . Two sets of factors can cause shifts in export and import demand changes in relative growth rates between countries and changes in relative prices between countries . What is happening in the countries economies that would be purchasing those exports heavily affects the level of demand for a nation exports . For example , if major importers of products like Canada , Japan , and Germany have , exports of products to those countries are likely to decline . Conversely , the amount of income in the domestic economy directly affects the quantity of a nation imports more income will bring a higher level of imports . Relative prices of goods in domestic and international markets can also affect exports and imports . If goods are relatively cheaper compared with goods made in other places , perhaps because a group of producers has mastered certain productivity breakthroughs , then exports are likely to rise . If goods become relatively more expensive , perhaps because a change in the exchange rate between the dollar and other currencies has pushed up the price of inputs to production in the United States , then exports from producers are likely to decline . Table summarizes the reasons we have explained for changes in aggregate demand .

614 25 The Perspective Reasons for a Decrease in Aggregate Demand Reasons for an Increase in Aggregate Demand Consumption Consumption Rise in taxes Decrease in taxes Fall in income Increase in income Rise in interest rates Fall in interest rates Desire to save more Desire to save less Decrease in wealth Rise in wealth Fall in future expected income Rise in future expected income Investment Investment Fall in expected rate of return Rise in expected rate of return Rise in interest rates Drop in interest rates Drop in business Rise in business Government Government Reduction in government spending Increase in government spending Increase in taxes Decrease in taxes Net Exports Net Exports Decrease in foreign demand Increase in foreign demand Relative price increase of goods Relative price drop of goods TABLE of Aggregate Demand The Building Blocks of Analysis LEARNING OBJECTIVES By the end of this section , you will be able to Evaluate the view of through an understanding of sticky wages and prices and the importance of aggregate demand Explain the coordination argument , menu costs , and externality Analyze the impact of the expenditure multiplier Now that we have a clear understanding of what constitutes aggregate demand , we return to the argument using the model of aggregate supply ( For a similar treatment using Keynes model , see the appendix on The ' Model . economics focuses on explaining why and depressions occur and offering a policy prescription for minimizing their effects . The view of recession is based on two key building blocks . First , aggregate demand is not always automatically high enough to provide with an incentive to hire enough workers to reach full employment . Second , the may adjust only slowly to shifts in aggregate demand because of sticky wages and prices , which are wages and prices that do not respond to decreases or increases in demand . We will consider these two claims in turn , and then see how they are represented in the model . The building block of the diagnosis is that occur when the level of demand for goods and services is less than what is produced when labor is fully employed . In other words , the intersection of aggregate supply and aggregate demand occurs at a level of output less than the level of consistent with full employment . Suppose the stock market crashes , as in 1929 , or suppose the housing market collapses , as in 2008 . In either case , household wealth will decline , and consumption expenditure will follow . Suppose Access for tree at

The Building Blocks of Analysis 615 businesses see that consumer spending is falling or face restrictions from a pandemic that curtail their operations . That will reduce expectations of the of investment , so businesses will decrease investment expenditure . This seemed to be the case during the Great Depression , since the physical capacity of the economy to supply goods did not alter much . No or earthquake or other natural disaster ruined factories in 1929 or 1930 . No outbreak decimated the ranks of workers . No key input price , like the price of oil , soared on world markets . The economy in 1933 had just about the same factories , workers , and state of technology as it had had four years earlier in yet the economy had shrunk dramatically . This also seems to be what happened in 2008 . As Keynes recognized , the events of the Depression contradicted Say law that supply creates its own Although production capacity existed , the markets were not able to sell their products . As a result , real was less than potential . LINK up Visit this website ( expenditures ) for raw data used to calculate . Wage and Price Stickiness Keynes also pointed out that although AD , prices and wages did not immediately respond as economists often expected . Instead , prices and wages are sticky , making it to restore the economy to full employment and potential . Keynes emphasized one particular reason why wages were sticky the coordination argument . This argument points out that , even if most people would be least see a decline in their own wages in bad economic times as long as everyone else also experienced such a decline , a economy has no obvious way to implement a plan of coordinated wage reductions . proposed a number of reasons why wages might be sticky downward , most of which center on the argument that businesses avoid wage cuts because they may in one way or another depress morale and hurt the productivity of the existing workers . Some modern economists have argued in a spirit that , along with wages , other prices may be sticky , too . Many do not change their prices every day or even every month . When a considers changing prices , it must consider two sets of costs . First , changing prices uses company resources managers must analyze the competition and market demand and decide the new prices , they must update sales materials , change billing records , and redo product and price labels . Second , frequent price changes may leave customers confused or if they discover that a product now costs more than they expected . These costs of changing prices are called menu the costs of printing a new set of menus with different prices in a restaurant . Prices do respond to forces of supply and demand , but from a perspective , the process of changing all prices throughout the economy takes time . To understand the effect of sticky wages and prices in the economy , consider Figure 2514 ( a ) illustrating the overall labor market , while Figure 2514 ( illustrates a market for a good or service . The original equilibrium ( in each market occurs at the intersection of the demand curve ( and supply curve ( So ) When aggregate demand declines , the demand for labor shifts to the left ( to ) in Figure ( a ) and the demand for goods shifts to the left ( to ) in Figure ( However , because of sticky wages and prices , the wage remains at its original level ( for a period of time and the price remains at its original level ( As a result , a situation of excess the quantity supplied exceeds the quantity demanded at the existing wage or in markets for both labor and goods , and is less than in both Figure 2514 ( a ) and Figure ( When many labor markets and many goods markets all across the economy themselves in this position , the economy is in a recession that is , can not sell what they wish to produce at the existing market price and do not wish to hire all who are willing to work at the existing market wage . The

616 25 The Perspective Clear It Up feature discusses this problem in more detail . Labor Output ( a ) Sticky wages in the labor market ( Sticky prices in the goods market FIGURE Sticky Prices and Falling Demand in the Labor and Goods Market In both ( a ) and ( demand shifts left from Do to . However , the wage in ( a ) and the price in ( do not immediately decline . In ( a ) the quantity demanded of labor at the original wage ( is 00 , but with the new demand curve for labor ( it will be 01 . Similarly , in ( the quantity demanded of goods at the original price ( is 00 , but at the new demand curve ( it will be 01 . An excess supply of labor will exist , which we call unemployment . An excess supply of goods will also exist , where the quantity demanded is substantially less than the quantity supplied . Thus , sticky wages and sticky prices , combined with a drop in demand , bring about unemployment and recession . i CLEAR IT UP Why Was the Pace of Wage Adjustments Slow ?

The recovery after the Great Recession in the United States was slow . In fact , many workers at , Dominos , and threatened to strike for higher wages . Their plight was part of a larger trend in job growth and pay in the recovery . occupations ( 21 ) occupations ( 19 ) occupations ( 20 ) occupations ( 60 ) occupations ( 58 ) occupations ( 22 ) a ) Jobs lost in the recession ( Jobs gained in the FIGURE Jobs in the Data in the aftermath of the Great Recession suggests that jobs lost were in occupations , while jobs gained were in occupations . Access for free at

The Building Blocks of Analysis 617 The National Employment Law Project compiled data from the Bureau of Labor Statistics and found that , during the Great Recession , 60 of job losses were in occupations . Most of them were replaced during the recovery period with jobs in the service , retail , and food industries . Figure illustrates this data . Wages in the service , retail , and food industries are at or near minimum wage and tend to be both downwardly and upwardly sticky . Wages are downwardly sticky due to minimum wage laws . They may be upwardly sticky if competition in labor markets enables employers to avoid raising wages that would reduce their . At the same time , however , the Consumer Price Index increased 11 between 2007 and 2012 , pushing real wages down . The Two Assumptions in the Model Figure is the diagram which illustrates these two importance of aggregate demand in causing recession and the stickiness of wages and prices . Note that because of the stickiness of wages and prices , the aggregate supply curve is than either supply curve ( labor or good ) In fact , and prices were so sticky that they did not fall at all , the aggregate supply curve would be completely below potential , as Figure shows . This outcome is an important example of a externality , where what happens at the macro level is different from and inferior to what happens at the micro level . For example , a should respond to a decrease in demand for its product by cutting its price to increase sales . However , if all experience a decrease in demand for their products , sticky prices in the aggregate prevent aggregate demand from rebounding ( which we would show as a movement along the AD curve in response to a lower price level ) The original equilibrium of this economy occurs where the aggregate demand function ( ADO ) intersects with AS . Since this intersection occurs at potential ( the economy is operating at full employment . When aggregate demand shifts to the left , all the adjustment occurs through decreased real . There is no decrease in the price level . Since the occurs at , the economy experiences substantial unemployment . Price Level , Vi Yr Real FIGURE A Perspective of Recession This rates the two key assumptions behind economics . A recession begins when aggregate demand declines from ADO to . The recession persists because of the assumption of wages and prices , which makes the flat below potential . If that were not the case , the price level would fall also , raising and recession . Instead the intersection occurs in the flat portion of the curve where is less than potential . The Expenditure Multiplier A key concept in economics is the expenditure multiplier . The expenditure multiplier is the idea that not only does spending affect the equilibrium level of , but that spending is powerful . More precisely , it means that a change in spending causes a more than proportionate change in .

618 25 The Perspective AY The reason for the expenditure multiplier is that one person spending becomes another person income , which leads to additional spending and additional income so that the cumulative impact on is larger than the initial increase in spending . The appendix on The ' Model provides the details of the multiplier process , but the concept is important enough for us to summarize here . While the multiplier is important for understanding the effectiveness of policy , it occurs whenever any autonomous increase in spending occurs . Additionally , the multiplier operates in a negative as well as a positive direction . Thus , when investment spending collapsed during the Great Depression , it caused a much larger decrease in real . The size of the multiplier is critical and was a key element in discussions of the effectiveness of the Obama administration stimulus package , titled the American Recovery and Reinvestment Act of 2009 . The Phillips Curve LEARNING OBJECTIVES By the end of this section , you will be able to Explain the Phillips curve , noting its impact on the theories of economics Graph a Phillips curve Identify factors that cause the instability of the Phillips curve Analyze the policy for reducing unemployment and The model that we have used so far is fully consistent with Keynes original model . More recent research , though , has indicated that in the real world , an aggregate supply curve is more curved than the right angle that we used in this chapter . Rather , the AS curve is very at levels of output far below potential ( the zone ) very steep at levels of output above potential ( the neoclassical zone ) and curved in between ( the intermediate zone ) Figure illustrates this . The typical aggregate supply curve leads to the concept of the Phillips curve . Neoclassical zone ID ( PI zone EK ZONE ( Yn Real FIGURE Keynes , Neoclassical , and Intermediate Zones in the Aggregate Supply Curve Near the equilibrium Ek , in the zone at the curve far left , small shifts in AD , either to the right or the left , will affect the output level , but will not much affect the price level . In the zone , AD largely determines the quantity of output . Nearthe equilibrium En , in the neoclassical zone , at the curve far right , small shifts in AD , either to the right or the left , will have relatively little effect on the output level Yn , but instead will have a greater effect on the price level . In the neoclassical zone , the curve close to the level of potential ( as Access for free at

The Phillips Curve 619 represented by the line ) largely determines the quantity of output . In the intermediate zone around equilibrium Ei , movement in AD to the right will increase both the output level and the price level , while a movement in AD to the left would decrease both the output level and the price level . The Discovery of the Phillips Curve In the , Phillips , an economist at the London School of Economics , was studying the analytical framework . The theory implied that during a recession pressures are low , but when the level of output is at or even pushing beyond potential , the economy is at greater risk for . Phillips analyzed 60 years of British data and did that tradeoff between unemployment and , which became known as the Phillips curve . Figure shows a theoretical Phillips curve , and the following Work It Out feature shows how the pattern appears for the United States . Inflation Rate . 0123456759 Unemployment Rate FIGURE A Phillips Curve Tradeoff between Unemployment and Inflation A Phillips curve illustrates a tradeoff between the unemployment rate and the inflation rate . If one is higher , the other must be lower . For example , point A illustrates a inflation rate and a unemployment . If the government attempts to reduce inflation to , then it will experience a rise in unemployment to , as point shows . The Phillips Curve for the United States ep . Go to this website to see the 2005 Economic Report of the President . ep . Scroll down and locate Table in the Appendices . This table is titled Changes in special consumer price indexes , ep . Download the table in Excel by selecting the option and then selecting the location in which to save the file . ep . Open the downloaded Excel . ep . View the third column ( labeled Year to year ) This is the inflation rate , measured by the percentage mange in the Consumer Price Index . ep . Return to the website and scroll to locate the Appendix Table Civilian unemployment rate , ep . Download the table in Excel . ep . Open the downloaded Excel and view the second column . This is the overall unemployment rate .

620 25 The Perspective Step . Using the data available from these two tables , plot the Phillips curve for , with unemployment rate on the and the inflation rate on the . Your graph should look like Figure . Inflation Rate ( Unemployment Rate ( FIGURE The Phillips Curve from This chart shows the negative relationship between unemployment and inflation . Step 10 . Plot the Phillips curve for . What does the graph look like ?

Do you still see the tradeoff between inflation and unemployment ?

Your graph should look like Figure . Inflation Rate ( I 10 12 Unemployment Rate ( FIGURE Phillips Curve , The tradeoff between unemployment and inflation appeared to break down during the as the Phillips Curve shifted out to the right . Over this longer period of time , the Phillips curve appears to have shifted out . There is no tradeoff any more . The Instability of the Phillips Curve During the , economists viewed the Phillips curve as a policy menu . A nation could choose low and high unemployment , or high and low unemployment , or anywhere in between . Economies could use and monetary policy to move up or down the Phillips curve as desired . Then a curious thing happened . When tried to exploit the tradeoff between and unemployment , the result was an increase in both and unemployment . What had happened ?

The Phillips curve shifted . Access for free at The Phillips Curve 621 The economy experienced this pattern in the deep recession from 1973 to 1975 , and again in back from 1980 to 1982 . Many nations around the world saw similar increases in unemployment and . This pattern became known as . Recall from The Aggregate Aggregate Sup Model that is an unhealthy combination of high unemployment and high . Perhaps most important , was a phenomenon that traditional economics could not explain . Economists have concluded that two factors cause the Phillips curve to shift . The is supply shocks , like the oil crisis , which first brought into our vocabulary . The second is changes in expectations about . In other words , there may be a tradeoff between and unemployment when people expect no , but when they realize is occurring , the tradeoff disappears . Both factors ( supply shocks and changes in expectations ) cause the aggregate supply curve , and thus the Phillips curve , to shift . In short , we should interpret a Phillips curve as valid for periods of several years , but over longer periods , when aggregate supply shifts , the Phillips curve can shift so that unemployment and are both higher ( as in the 19705 and early ) or both lower ( as in the early or decade of the 20005 ) Policy for Fighting Unemployment and Inflation argues that the solution to a recession is expansionary policy , such as tax cuts to stimulate consumption and investment , or direct increases in government spending that would shift the aggregate demand curve to the right . For example , if aggregate demand was originally at in so that the economy was in recession , the appropriate policy would be for government to shift aggregate demand to the right from to , where the economy would be at potential and full employment . Keynes noted that while it would be nice if the government could spend additional money on housing , roads , and other amenities , he also argued that if the government could not agree on how to spend money in practical ways , then it could spend in impractical ways . For example , Keynes suggested building monuments , like a modern equivalent of the Egyptian pyramids . He proposed that the government could bury money underground , and let mining companies start digging up the money again . These suggestions were slightly , but their purpose was to emphasize that a Great Depression is no time to quibble over the of government spending programs and tax cuts when the goal should be to pump up aggregate demand by enough to lift the economy to potential . Real FIGURE Fighting Recession and Inflation with Policy If an economy is in recession , with an equilibrium at Er , then the response would be to enact a policy to shift aggregate demand to the right from toward . If an economy is experiencing inflationary pressures with an equilibrium at Ei , then the

622 25 The Perspective response would be to enact a policy response to shift aggregate demand to the left , from ADi toward ADI . The other side of policy occurs when the economy is operating above potential . In this situation , unemployment is low , but rises in the price level are a concern . The response would be policy , using tax increases or government spending cuts to shift AD to the left . The result would be downward pressure on the price level , but very little reduction in output or very little rise in unemployment . If aggregate demand was originally at ADi in Figure , so that the economy was experiencing rises in the price level , the appropriate policy would be for government to shift aggregate demand to the left , from ADi toward , which reduces the pressure for a higher price level while the economy remains at full employment . In the economic model , too little aggregate demand brings unemployment and too much brings . Thus , you can think of economics as pursuing a Goldilocks level of aggregate demand not too much , not too little , but looking for what is just right . The Perspective on Market Forces LEARNING OBJECTIVES By the end of this section , you will be able to Explain the perspective on market forces Analyze the role of government policy in economic management Ever since the birth of economics in the , controversy has simmered over the extent to which government should play an active role in managing the economy . In the aftermath of the human devastation and misery of the Great Depression , many many more aware of vulnerabilities within the economic system . Some supporters of economics advocated a high degree of government planning in all parts of the economy . However , Keynes himself was careful to separate the issue of aggregate demand from the issue of how well individual markets worked . He argued that individual markets for goods and services were appropriate and useful , but that sometimes that level of aggregate demand was just too low . When 10 million people are willing and able to work , but one million of them are unemployed , he argued , individual markets may be doing a perfectly of allocating the efforts of the nine million problem is that aggregate demand exists to for all 10 million . Thus , he believed that , while government should ensure that overall level of aggregate demand is for an economy to reach full employment , this task did not imply that the government should attempt to set prices and wages throughout the economy , nor to take over and manage large corporations or entire industries directly . Even if one accepts the economic theory , a number questions remain . In the real world , can government economists identify potential accurately ?

Is a desired increase in aggregate demand better accomplished by a tax cut or by an increase in government spending ?

Given the inevitable delays and uncertainties as governments enact policies into law , is it reasonable to expect that the government can implement economics ?

Can a recession really bejust as simple as pumping up aggregate demand ?

Government Budgets and Fiscal Policy will probe these issues . The approach , with its focus on aggregate demand and sticky prices , has proved useful in understanding how the economy in the short run and why and cyclical unemployment occur . In The Neoclassical Pers , we will consider some of the shortcomings of the approach and why it is not especially for long run analysis . BRING IT HOME The Recession and the Perspective The recession of 2020 was unique . Unlike the Great Recession of discussed in most Access for free at

The Perspective on Market Forces 623 of this chapter , it was not started by the burst of a housing bubble . It was started by a virus that caused sickness and death for millions of people worldwide and required substantial social policy in order to control its spread . In some ways , the latest recession was influenced by fluctuations in aggregate demand . At its depth in April 2020 , over 20 million people were unemployed , causing a massive decline in consumption and aggregate demand . As businesses were forced to shutter or move their operations online , many were pessimistic or uncertain about the future state of the economy , causing investment to decline . The federal government attempted to correct this aggregate demand shock through small business loans , direct aid to state and local governments , expanded unemployment insurance , and stimulus checks . As a result of all these measures , the economy was able to bounce back somewhat over the remainder of 2020 . However , even at the start of 2022 , millions of people remained out of work as new variants threatened to upend the economy once again . The perspective would have economic policy continue to focus on aggregate and restoring in the economy . President proposals largely reflect these goals , but with millions of workers still out of the labor market and a virus that is still not contained , it remains to be seen policy prescriptions will be enough medicine to economy back to normalcy .

624 25 Key Terms Key Terms policy tax increases or cuts in government spending designed to decrease aggregate demand and reduce pressures coordination argument downward wage and price requires perfect information about the level of lower compensation acceptable to other laborers and market participants disposable income income after taxes expansionary policy tax cuts or increases in government spending designed to stimulate aggregate demand and move the economy out of recession expenditure multiplier concept that asserts that a change in autonomous spending causes a more than proportionate change in real gap equilibrium at a level of output above potential externality occurs when what happens at the macro level is different from and inferior to what happens at the micro level an example would be where upward sloping supply curves for firms become a aggregate supply curve , illustrating that the price level can not fall to stimulate aggregate demand menu costs costs face in changing prices Phillips curve the tradeoff between unemployment and real the amount of goods and services actually sold in a nation recessionary gap equilibrium at a level of output below potential sticky wages and prices a situation where wages and prices do not fall in response to a decrease in demand , or do not rise in response to an increase in demand Key Concepts and Summary Aggregate Demand in Analysis Aggregate demand is the sum of four components consumption , investment , government spending , and net exports . Consumption will change for a number of reasons , including movements in income , taxes , expectations about future income , and changes in wealth levels . Investment will change in response to its expected , which in turn is shaped by expectations about future economic growth , the creation of new technologies , the price of key inputs , and tax incentives for investment . Investment will also change when interest rates rise or fall . Political considerations determine government spending and taxes . Exports and imports change according to relative growth rates and prices between two economies . The Building Blocks of Analysis economics is based on two main ideas ( aggregate demand is more likely than aggregate supply to be the primary cause of a economic event like a recession ( wages and prices can be sticky , and so , in an economic downturn , unemployment can result . The latter is an example ofa externality . While surpluses cause prices to fall at the micro level , they do not necessarily at the macro level . Instead the adjustment to a decrease in demand occurs only through decreased quantities . One reason why prices may be sticky is menu costs , the costs of changing prices . These include internal costs a business faces in changing prices in terms of labeling , and accounting , and also the costs of communicating the price change to ( possibly unhappy ) customers . also believe in the existence of the expenditure notion that a change in autonomous expenditure causes a more than proportionate change in . The Phillips Curve A Phillips curve shows the unemployment and in an economy . From a viewpoint , the Phillips curve should slope down so that higher unemployment means lower , and vice versa . However , a Phillips curve is a relationship that may shift after a few years . Access for free at

25 Questions 625 argues that the solution to a recession is expansionary policy , such as tax cuts to stimulate consumption and investment , or direct increases in government spending that would shift the aggregate demand curve to the right . The other side of policy occurs when the economy is operating above potential . In this situation , unemployment is low , but rises in the price level are a concern . The response would be policy , using tax increases or government spending cuts to shift AD to the left . The Perspective on Market Forces The prescription for stabilizing the economy implies government intervention at the aggregate demand when private demand falls and decreasing aggregate demand when private demand rises . This does not imply that the government should be passing laws or regulations that set prices and quantities in markets . Questions . In the framework , which of the following events might cause a recession ?

Which might cause ?

Sketch diagrams to illustrate your answers . a . A large increase in the price of the homes people own . Rapid growth in the economy ofa major trading partner . The development ofa major new technology offers opportunities for business . The interest rate rises . 57 The good imported from a major trading partner become much less expensive . In a framework , using an diagram , which of the following government policy choices offer a possible solution to recession ?

Which offer a possible solution to ?

a . A tax increase on consumer income . A surge in military spending . A reduction in taxes for businesses that increase investment . A major increase in what the government spends on healthcare . Use the model to explain how an gap occurs , beginning from the initial equilibrium in Fi . Suppose the Congress cuts federal government spending in order to balance the Federal budget . Use the model to analyze the likely impact on output and employment . Hint revisit Figure . How would a decrease in energy prices affect the Phillips curve ?

Does economics require government to set controls on prices , wages , or interest rates ?

List three practical problems with the perspective . Review Questions . Name some economic events not related to government policy that could cause aggregate demand to shift . Name some government policies that could cause aggregate demand to shift . 10 . From a point of view , which is more likely to cause a recession aggregate demand or aggregate supply , and why ?

11 . Why do sticky wages and prices increase the impact of an economic downturn on unemployment and recession ?

12 . Explain what economists mean by menu costs . 13 . What tradeoff does a Phillips curve show ?

626 25 Critical Thinking Questions 14 . 15 . 16 . Would you expect to see data trace out a stable Phillips curve ?

What is the prescription for recession ?

For ?

How did the perspective address the economic market failure of the Great Depression ?

Critical Thinking Questions 17 . 18 . 19 . 20 . 21 . 22 . 23 . In its recent report , The Conference Board Global Economic , updated November 2014 ( projects China growth between 2015 and 2019 to be about . International Business Times ( reports that China is the United States third largest export market , with exports to China growing 294 over the last ten years . Explain what impact China has on the economy . What may happen if growth in China continues or contracts ?

Does it make sense that wages would be sticky downwards but not upwards ?

Why or why not ?

Suppose the economy is operating at potential when it experiences an increase in export demand . How might the economy increase production of exports to meet this demand , given that the economy is already at full employment ?

Do you think the Phillips curve is a useful tool for analyzing the economy today ?

Why or why not ?

Return to the table from the Economic Report the earlier Work It Out feature titled The Phillips Curve for the United How would you expect government spending to have changed over the last six years ?

Explain what types of policies the federal government may have implemented to restore aggregate demand and the potential obstacles may have encountered . Access for free at