Principles of Political Economy - Third Edition Part III Chapter 13 The Theory of Effective Demand and The Neoclassical Synthesis Model

CHAPTER 13 THE THEORY OF EFFECTIVE DEMAND AND THE NEOCLASSICAL SYNTHESIS MODEL Goals and Objectives In this chapter , we will do the following . Define Say Law of Markets and its role in classical economic theory Describe Maynard Keynes created a revolution in theory Analyze the Cross model and the multiplier effect Build the aggregate aggregate supply ( AS ) model to explain the price level and level of aggregate output Apply the AS model to several historical cases from economic history Identify the Neoclassical Synthesis Model and the critique of it This chapter introduces the reader to theory . One major goal is to describe how the key variables from the previous chapter are

732 DANIEL SAROS determined using theoretical models . To really understand these theoretical models , however , it is helpful to explain how the field of developed in the first place . This chapter thus explains the way in Maynard Keynes led a revolution in economic thought in the . Keynes laid the groundwork for what became known as . To understand Keynes role in the history of economic thought , it is necessary to understand his critique of the classical theory of the aggregate economy and one of its key elements known as Say Law of Markets . Once Keynes role is made clear , it will be easier to understand his theory of output and employment . This theory is represented in the Cross model and Keynes concept of the spending multiplier . We will also build the aggregate aggregate supply ( AS ) model so as to provide an explanation , not only for aggregate output and employment , but also for the general level of prices . Using the AS model , we will use it to understand actual changes in aggregate output and the price level that occurred during different periods in economic history . Say Law and the Classical Theory It might strike the reader as strange that economics is divided into two separate fields referred to separately as and This division has not always existed . During the eighteenth and early nineteenth centuries , the discipline was simply referred to as political Economists generally regarded questions at the individual level and questions at the societal level as questions to be treated together . During the revolution of the late nineteenth century ,

PRINCIPLES 733 however , some economists became very much preoccupied with questions of efficiency and individual optimization . Larger questions having to do with economic growth , the general level of prices , and overall employment became increasingly separate from this specialized study of atomistic behavior . In 1936 , this bifurcation intensified Maynard Keynes published his famous book titled , The General Theory of Employment , Interest , and Money . Published shortly after the Great Depression , Keynes offered a theory to explain how aggregate output , employment , and prices are determined . His explanation sharply contrasted with early neoclassical theories of how individual markets function . In his critique of early neoclassical theory , Keynes referred to the theory as the classical theory . Keynes decision to do so stemmed in part from the fact that early neoclassical theory had a orientation that was very similar to the orientation of the classical theories of Adam Smith and David Ricardo . His decision also stemmed from his critique of one aspect of classical economics that was central to early neoclassical thinking , referred to as Say Law of Markets . According to Say Law of Markets ( or Say Law , for short ) every supply creates its own demand . That is , if a commodity is produced , it will generate enough factor income for the owners of land , labor , and capital to purchase the produced commodity . After all , the price of the commodity may be divided into its component parts of rent , wages , and profits . Hence , these incomes will be sufficient to realize the price of the commodity . The stunning implication of this simple argument at the level of the aggregate economy is that enough income will always exist to purchase the entire

734 DANIEL SAROS output of commodities . Therefore , no general or periods of overproduction are possible . Using nothing but logic , one can conclude that major depressions should never occur . If they do occur , they must be caused by some interference with the free of commodities and money , and government interference is a likely culprit . Say Law thus supported the orientation of classical economics and early neoclassical economics later . Another way to understand the classical theory of output and employment is to consider the way in which competition in the labor market will lead to a full employment equilibrium outcome , as depicted in Figure Figure Classical Theory of Employment and Output . Lyn ?

If the market wage ( is above the equilibrium wage ( then a surplus of labor or unemployment exists . Competition will force the market wage down until the PRINCIPLES 735 market wage coincides with the equilibrium wage . The surplus will be eliminated and the quantity of labor demanded will equal the available labor force ( With the economy operating at full employment , the economy will be able to produce at the full employment level of ( The full employment is shown in Figure using the aggregate production function . The aggregate production function exhibits diminishing returns to labor , which assumes that all other factors of production ( land and capital ) are held constant . Of course , all available land and capital will be fully employed as well , assuming that the markets for these resources have cleared as well . Given the available production technology and the fully employed resources , the economy will produce the potential . John Maynard Keynes General Theory of Employment , Interest , and Money john Maynard Keynes was in neoclassical economic theory . In fact , Keynes critique of neoclassical theory was not intended to undermine it entirely . Instead , Keynes regarded that theory as applicable to a special case only , namely the case of an economy operating at full employment . That is , once the economy operates at full employment , then all of the efficiency conclusions of neoclassical theory apply once again . Keynes theory was intended to be a more general theory of how the aggregate economy functions , however , and so it offered a framework for thinking about periods during which the economy failed to achieve full employment . To make this argument , Keynes had to attack that central tenet of classical economic theory known as Say Law . The simple flow diagram in Figure helps to illustrate Keynes argument ?

736 DANIEL SAROS Figure Keynes Objection to Say Law of Markets I Households Business Enterprises . Consumption Investment Expenditure i saving As Figure shows , business enterprises make payments to households in exchange for the resources households sell to businesses . Households receive factor income for the land , labor , and rent that businesses purchase . The businesses use these factors of production to produce finished commodities . The households then spend this factor income on the finished commodities , but it is here that we deviate from our earlier discussion of the neoclassical circular flow model from Chapter . Obviously , households will choose to save some of their income and not spend it . The classical economists and early neoclassical economists understood this point well . They argued that the saving that occurred would into the loanable funds market where it would be transferred to individuals and firms who would invest it . These investments in new capital goods would add to the demand for consumer goods and ensure that all of the finished commodities were sold . Of course , these borrowers would pay interest to the lenders for the use

PRINCIPLES 737 of the borrowed funds , but the circular flow would be maintained and Say Law would hold . Keynes rejected this version of the circular flow on the grounds that the saving that occurred would not all be transformed into the investment demand for capital goods . For Keynes , the failure of all savings to become investment had different possible sources . Without going into the details , the primary reasons had to do with the rate of Consider the loanable funds market as shown in Figure . Figure The Loanable Funds Market and the Equilibrium Rate If a surplus of savings exists , then in the classical theory , the market rate of interest ( i ) will fall to the equilibrium level of i and clear the loanable funds market . Aggregate saving will equal aggregate investment . If , however , other forces are acting on the rate of interest that prevent it from falling , then the surplus of savings will persist and not all savings will be invested . As a result , not all finished

733 DANIEL SAROS commodities will be sold due to insufficient investment demand . Alternatively , it might be that the market clearing level of the rate of interest ( i ) does not occur at a market rate of interest that is greater than or equal to zero due to a very large supply of savings and a relatively low level of investment demand . In that case , the market rate of interest will not be able to fall enough to clear the market for loanable funds and the surplus of savings will persist . In this case as well , an excess supply of finished commodities or a glut will occur . The result will be falling production as firms scale back production , falling employment as they lay off workers , and falling prices due to the excess supplies of commodities . All these results were observed during the Great Depression , which is exactly what Keynes developed his theory of effective demand to explain with the hope of ending depressions by means of enlightened government economic policy . The Consumption Function and the Saving Function To understand the theory that Keynes developed , it is necessary to begin with the construction of some foundational elements . We first introduce the consumption function and show how it is represented graphically . The consumption function suggests that a positive relationship exists between the level of current consumption expenditures that households are planning and the current level of disposable income . That is , as households acquire more disposable income , their level of consumption rises , other factors held constant ( Planned consumption thus depends on the disposable income of households . That is , is a function of DI or ( DI ) Alternatively , is the dependent variable and DI is the independent variable , according to

PRINCIPLES 739 this theory . This relationship can be represented mathematically as follows DI In the consumption function , represents autonomous consumption . Autonomous consumption is the level of consumption expenditures that households choose even if their DI falls to zero ( an amount that is independent of income ) Such expenditures might be possible if households rely on their savings to finance consumer expenditures . Borrowing would be another way in which consumer expenditures might be positive even when DI equals zero . The consumption function also includes , which represents the marginal propensity to consume ( The refers to the additional consumption expenditures that households choose for each additional dollar of disposable income received . Figure reveals that the level of autonomous consumption determines the vertical intercept of the consumption function in the graph . Similarly , the represents the slope of the consumption function in the graph .

740 DANIEL SAROS Figure The Consumption Because the is assumed to be fixed at every level of DI , the slope is constant and the consumption curve graphs as a straight line . To consider a simple example , suppose that the consumption function is . In this case , even if is equal to zero , the households will spend 200 billion . Also , for every of additional DI that the households receive , they will consume an additional . It is worth noting that only a change in can cause a movement along the consumption curve in the graph whereas a change in autonomous consumption will shift the consumption curve up or down . Various factors can shift the consumption curve up or down . One example is a change in household wealth , which is distinct from disposable income . The reader might recall that is a flow variable . That is , it is measured per period of time ( per year ) Household wealth , on the other hand , is a stock variable and is measured at a point in time . If

PRINCIPLES 741 households experience a reduction in household wealth due to a recession that causes asset values ( stock prices ) to fall , then the consumption expenditures will fall at every level of disposable income and the consumption curve will shift in a downward direction . Alternatively , an economic boom that raises household wealth will cause the consumption curve to rise at every income level and will lead to an upward shift . just like we can represent the level of planned household consumption expenditures , we can also represent the level of planned household saving as the level of disposable income changes . The saving function suggests that a positive relationship exists between planned household saving and disposable income . That is , as households acquire more disposable income , their level of saving rises , other factors held constant ( Planned saving thus depends on the disposable income of households . That is , is a function of or ( DI ) Alternatively , is the dependent variable and DI is the independent variable , according to this theory . This relationship can be represented mathematically as follows , In the saving function , represents autonomous saving . Autonomous saving is the level of saving that households choose even if their DI falls to zero ( an amount that is independent of income ) Such saving might occur if saving is negative . That is , households do not save but actually borrow or draw down past savings . The saving function also includes ADI , which represents the marginal propensity to save ( The refers to the additional saving that households

742 DANIEL SAROS choose for each additional dollar of disposable income received . Figure reveals that the level of autonomous saving determines the vertical intercept of the saving function in the graph . Similarly , the represents the slope of the saving function in the graph . Figure Tne Saving Function Because the is assumed to be fixed at every level of DI , the slope is constant and the saving curve graphs as a straight line . To consider a simple example , suppose that the saving function is . In this case , even if is equal to zero , the households will save 200 billion . Also , for every of additional DI that the households receive , they will save an additional . It is worth noting that only a change in can cause a movement along the saving curve in the graph whereas a change in autonomous saving will shift the saving curve up or down . Various factors can shift the saving curve up or down . A rise in household wealth will lead to a fall in

PRINCIPLES 743 saving ( as consumption rises ) and shift the saving curve downward . A fall in household wealth will lead to a rise in saving and shift the saving curve upward . As in the case of consumption , planned saving by households represents a flow variable . It is worth taking a moment to on the relationship between the vertical intercepts of the consumption and saving functions . In both cases , the level of , which implies that . This equation further implies that when , In other words , the vertical intercept of the saving curve is the negative of the vertical intercept of the consumption curve . Therefore , whenever the consumption curve shifts upward , the saving curve will shift downwards , and vice versa . Figure shows how a shift of the consumption curve will lead to an opposite change in the saving curve . Figure 13 of Consumption Relaxing the tion One should also consider the relationship between the

744 DANIEL SAROS and the . Suppose we add the two measures together as follows In other words , the sum of the and the is always equal to . This result is very intuitive . If the households receive of additional DI and they consume of it , then the remaining must be saved . Now that We understand the essential building blocks of Keynes theory , we need to consider a national income accounts identity that relates disposable income ( DI ) to consumption ( and saving ( DI We then consider the case in which and thus DI . To represent this case graphically , we introduce a reference line that has a 45 degree angle relative to the horizontal axis as shown in Figure .

PRINCIPLES 745 Figure The Building Blocks of Keynes Theory 100 150 131 As Figure indicates , at each level of DI , the level of that corresponds to it is found on the reference line . That is , the horizontal distance to that level of will be exactly the same as the vertical distance from that level of up to the 45 degree line . Another way to think about this reference line is that it has a slope equal to and a vertical intercept equal to zero , much like the equation in the case that is placed on the vertical axis and is placed on the horizontal axis . Of course , saving is not expected to equal zero at every level of DI and so this case is not a realistic one . When we place the reference line on a graph with the planned consumption curve as in Figure , however , we see that the difference between the two lines carries a special meaning .

746 DANIEL SAROS Figure The Consumption and the Reference Line soo . Saving 1000 DI ( in billions of ) As Figure shows , at a level of DI of 1000 billion , the reference line allows us to represent that amount vertically . It is then much easier to see which part of the DI is spent on consumption and which part remains for saving . In this case , 800 billion is consumed and 200 billion is saved . In general , at every level of DI at which the line is below the reference line , positive saving exists . The reader will notice that the lines intersect at a single point . At this point , planned consumer spending equals DI , which is true for all points on the reference line . When planned consumer spending equals DI , We refer to this income level as the income level . In other words , households have just enough DI to finance their consumption expenditures , no more and no less . Finally , if DI is at a low enough level that the line is above the reference line , then planned household consumption expenditures exceed DI and the households must be borrowing or relying on past savings to finance the excess consumption .

PRINCIPLES 747 We can also consider how the graph of the consumption function relates to the graph of the saving function . Figure depicts the relationship between the two graphs . Figure The Saving Function and the Income Level ( in billions of ) At the income level of 40 billion in the top graph , DI and thus . Therefore , the bottom graph shows the saving function crossing the DI axis at 40 billion , indicating a level of saving equal to zero at that level of . As we move to the right of the income level in the top graph , we see that saving becomes positive and continues to grow as the gap between the two lines becomes larger . Therefore , in the bottom graph , the level of saving becomes positive and continues to grow when DI rises above 40 billion . Let suppose we are given the following consumption function

743 DANIEL SAROS 20 It turns out that it is possible to derive the saving function from this information . Recall that . Substituting the consumption function into this equation yields . Solving for yields 20 , which may be simplified as follows It should be clear that we can use a shortcut method to obtain the saving function from the consumption function . If we begin with the consumption function and negate the vertical intercept of 20 , then we obtain the vertical intercept of for the saving function . Furthermore , if we subtract the of from , then we obtain the of since the two marginal always add up to . The Cross Model for a Private , Closed Economy It should be clear that Keynes radically departed from the early neoclassical economic theory in which he was trained . In Keynes theory , like households , business enterprises , and the government , take center stage . Individual economic agents do not play an important role in the theory . Also , because households and businesses tend to behave in a collective fashion ( consuming more when rises or investing less when business expectations turn sour ) mass psychology becomes the primary explanation for these behaviors rather than individual rationality and serves as an alternative conceptual point of For example , households have a propensity to consume so much more when DI rises . Nevertheless , the unidirectional logic of

PRINCIPLES 749 neoclassical theory is preserved in Keynes That is , one variable affects another in a single causal direction only . For example , a rise in causes a rise in consumer spending , but not vice versa . Based on this theoretical foundation , it is now possible to develop the basic theory of output and employment . The Cross model , which is also sometimes referred to as the aggregate expenditures model , uses these theoretical tools to explain the equilibrium levels of aggregate output and employment that emerge . To keep the model simple , we initially assume that the economy is private and closed . That is , only households and businesses exist . Because it is a purely private economy , no government exists . Because it is a closed economy , no foreign trade exists . The price level is also assumed to be constant and so the Cross model does not explain prices , only output and employment . Finally , it is assumed that is equal to real . In the national income accounts , the income that American households have for consumption and saving ( is not equal to real due to the presence of depreciation , net foreign factor income , taxes , and transfer payments . With a closed , private economy without depreciation , no such adjustments need to be made , and is equal to real . To build the Cross model , we need to explain the determination of planned investment spending . As explained previously , the level of planned investment spending is determined in the loanable funds market . Savers lend funds to borrowers at interest , and their competitive interaction determines a particular quantity of loanable funds exchanged . These loanable funds are invested in new production plants and equipment . If we

750 DANIEL SAROS assume that the level of planned investment spending is independent of the level of real , then we can represent its determination in the loanable funds market as shown in Figure below . Figure The Determination of Planned Investment Spending As the reader can see in the graph on the right , investment spending ( is equal to lo and is thus constant at all levels of real ( It is now possible to write two equations representing the two types of planned expenditures in this simple economy . The consumption function representing the planned consumption of households may be written as The reader should notice that real ( has replaced in the consumption function . The reason , of course , is the assumption that real is equal to in this

PRINCIPLES 751 economy . The second equation indicates that investment spending ( is constant , as previously noted . If we combine these two types of planned spending , we can obtain a planned aggregate expenditures ( A ) function as follows A This planned aggregate expenditures function may be written as follows by rearranging the terms A ( In this function , 10 represents autonomous spending . That is , households and businesses will select this level of planned spending regardless of the level of real . The second portion , represents induced spending . Induced spending is planned aggregate spending that is directly related to the level of real . If we place the planned consumer spending ( curve and the planned aggregate expenditures ( A ) curve on the same graph , we obtain the graph shown in Figure .

752 DANIEL SAROS Figure The Planned Aggregate Expenditures Curve As the reader can see , the planned aggregate expenditures curve has a vertical intercept equal to the level of autonomous spending . The vertical distance between A and is constant and equal to 10 at every level of DI . The slope of the aggregate expenditures curve is also equal to the because the A and curves are parallel to one another . Armed with this new tool , we can represent the equilibrium level of real on the graph . Figure shows that the equilibrium level of real occurs at the intersection of the aggregate expenditures curve and the reference line .

PRINCIPLES 753 Figure The Determination of Equilibrium Real At this point , planned aggregate spending equals real aggregate output and so all plans are perfectly satisfied by the level of production . The reason this level of real is the equilibrium level can be understood by considering what will occur if the economy is not producing at this point . Suppose that the level of real output is above in the graph . In that case , planned aggregate spending is below the level of real output as shown on the line . That is , A . As a result , firms will be producing more than households and firms wish to purchase . As a result , business inventories will build up as a result of the excess supply of commodities . The consequence will be a drop in the level of production as firms cut production . Real will then fall towards the equilibrium level . Conversely , if the level of real is below in the graph , then planned aggregate spending is above the level of real output as show on the line . That is , A . As a result , firms will be producing less than households and firms wish to purchase . As a result ,

754 DANIEL SAROS business inventories will be depleted as a result of the excess demand for commodities . The consequence will be a rise in the level of production as firms raise production . Real will then rise towards the equilibrium level . It is also possible to calculate the equilibrium real given a specific consumption function and level of investment . For example , suppose that the following two equations represent an economy 200 I 100 Given this information , it is possible to obtain the planned aggregate expenditures function by simply adding the two equations together A 300 To obtain the equilibrium real for this economy , we need to use the equilibrium condition Plugging in the planned aggregate expenditures function and solving for , we obtain the equilibrium level of real . 300 1200 Figure represents the solution graphically .

PRINCIPLES 755 Figure The Calculation of Equilibrium Real in the Cross Model 1200 The graph shows that the equilibrium level of real occurs at the intersection of the reference line and the planned aggregate expenditures curve . Solving the two equations simultaneously yields the solution . It turns out that it is possible to think about the determination of the equilibrium real from another angle . That is , by using the saving function and considering the level of investment spending , it is possible to arrive at a different but related equilibrium condition . To understand this point , consider the equilibrium condition that we have been using up to this point A The reader should recall that planned aggregate spending ( A ) is the sum of planned consumer spending ( and planned investment spending ( Real or

756 DANIEL SAROS real income ( is either consumed ( or saved ( If we break down each term in the equation into its component parts , we obtain the following It is easy to see that the level of consumer spending may be subtracted from both sides of this equation to yield a new equilibrium condition In equilibrium then , planned investment and saving must be equal . Figure represents this solution graphically and relates it to the Cross model that we have already discussed . Figure The Approach to the Determination of Equilibrium Because planned investment is constant at all levels of , it is represented as a horizontal line in the graph . The saving curve , on the other hand , slopes upward for

PRINCIPLES 757 reasons already discussed . The equilibrium level of real occurs at the intersection of the two lines . The intuition behind the movement to equilibrium in this graph is a little different from the intuition behind the movement to equilibrium in the Cross model . In the graph , saving may be thought of as a leakage from the spending stream that creates real . Planned investment , on the other hand , is an injection into the spending stream . Planned investment thus raises equilibrium real , and saving reduces equilibrium real . If the two forces exactly balance , then real should remain stable . The manner in which these two forces act on real may be depicted as in Figure . Figure Injections of Investment and of Saving Planned ( Injection ) Saving ( Leakage ) Real i In Figure , if the level of real is below the equilibrium level of , then planned investment exceeds saving . With the injection larger than the leakage , the

753 DANIEL SAROS result is a rise in real and a movement towards the equilibrium level . On the other hand , if the level of real is above the equilibrium level of , then saving exceeds planned investment . With the leakage larger than the injection , the result is a fall in real and a movement towards the equilibrium level . It is also possible to arrive at the answer algebraically using the same information we used when discussing the Cross model . Because we know the shortcut method of deriving the saving function from the consumption function , we can write the saving function alongside the consumption function as follows 200 0253 Given that I 100 , we use the new equilibrium condition as follows I 100 We then solve for to obtain 1200 The reader will note that this equilibrium real is the same as the one calculated in the Cross model . Figure shows the solution in a graph .

PRINCIPLES 759 Figure The Calculation of Real the investment Graph The reader might be a bit confused by the claim that saving equals investment only in equilibrium . After all , it was argued in Chapter 12 that is always equal to the sum of consumer spending , investment spending , government spending , and net export spending . In a closed , private economy without government spending or net exports , should always equal consumer spending plus investment spending . Therefore , if is the sum of consumer spending and saving , then saving should always equal investment spending . The reason for the apparent contradiction is that the equilibrium condition only refers to planned investment whereas the measurement of includes actual investment . In other words , saving will always equal actual investment , which includes both planned investment spending and inventory ( unplanned ) investment spending . At the same time , saving may not equal planned investment spending . Figure clarifies this point .

760 DANIEL SAROS Figure A National Income Accounts Saving Actual A A , A i As the reader can observe from Figure , if exceeds the equilibrium level of , then saving exceeds planned investment . At the same time , saving is still equal to actual investment because the part of what is saved that is not intentionally invested is unintentionally invested in inventories . That is , not all commodities are sold and so firms will add these commodities to their inventories , which counts as unplanned inventory investment . Therefore , the national income accounts identity holds , but the equilibrium condition , which requires that saving equals planned investment , does not hold . It is now possible to clearly distinguish the model of output and employment from the classical model . Figure shows clearly that the level of planned aggregate expenditure determines the equilibrium level of , which is likely to be below the full employment ( at a point in time .

PRINCIPLES 761 Figure The Theory of Employment and Output Furthermore , as businesses adjust production in the movement to equilibrium , they also adjust their . Employment , therefore , moves towards an equilibrium level of that corresponds to the equilibrium level of real as shown on the production function . Employment also ends up below the full employment level of . Hence , Keynes theory is one of unemployment equilibrium , and it reveals the case of full employment to be a special case . That is , aggregate planned spending would need to be just high enough to produce the full employment as the equilibrium . Keynes could , therefore , argue that his theory was a more general theory than the classical theory of employment and output . The Paradox of Thrift An interesting application of the model allows us to understand what mean by the paradox

762 DANIEL SAROS of thrift . In Chapter we learned that an increase in saving leads to greater capital accumulation and an expansion of production possibilities . When considering short run , however , saving may lead to a very different result . Suppose that all households decide to increase saving at every level of . In other words , autonomous saving rises . When this change occurs , the saving curve shifts upward as shown in Figure . Figure Application The Paradox Initially , saving rises at , but this increase in saving causes a discrepancy between saving and planned investment spending . Specifically , saving rises above planned investment spending . With the leakage of saving being higher than the injection of planned investment , real begins to fall . The drop in real causes a movement along the new saving curve . In other words , induced saving declines . The reduction in saving continues until it once again equals planned investment

PRINCIPLES 763 and the economy returns to equilibrium at . The problem for the economy is that the high level of saving has led to a recession ( falling real ) rather than to economic growth , as suggested by the production possibilities model . Furthermore , and rather paradoxically , even though all households decided to save more , aggregate saving returns to the same level that previously The reason is that the recession has led to falling incomes , which reduces saving . This example illustrates What neoclassical economists refer to as the fallacy of composition . People often assume that when one person acts in a particular way and achieves it that the same will hold true for groups of people . To use a classic example , an individual attending a sporting event might stand up to obtain a better view of the field . This strategy works , but if everyone has the same idea , then when all stand , no one has a better view than before . Similarly , one household might save more of its income successfully , but if all households do the same , then no one is able to save more . The Multiplier Effect Now that the Cross model has been developed , We can consider one of Keynes most important contributions to our understanding of the manner in which changes in spending affect the overall economy . The multiplier effect refers to the way in which an increase in a specific component of spending , such as investment spending , raises real by a multiple of the spending increase . To illustrate this point , we will consider the most volatile component of aggregate spending and the impact of changes in it on real . Investment spending tends to be highly

764 DANIEL SAROS volatile for a number of reasons . It is by business expectations about future profits , interest rates , technological change , and taxes on profit income . Suppose that business expectations about future profitability improve significantly . With businesses feeling more optimistic about the future of the economy , a collective rush to invest in new capital takes place . Keynes referred to such impulses during periods of business optimism as animal spirits . The consequence is a rise in demand in the loanable funds market . Such an increase leads to a rise in the equilibrium level of loanable funds exchanged and to a rise in planned investment spending as shown in Figure . Figure The Investment Multiplier in the Aggregate Expenditures Model The rise in planned investment raises the aggregate expenditures curve as shown in Figure . The result is a higher level of equilibrium real and the economy experiences an economic boom . Interestingly , the graph on the right in Figure suggests that the level of real

PRINCIPLES 765 rises by more than the rise in planned investment . Because the slope of the reference line is equal to and the difference between the old and new A curves is equal to the change in planned investment , the first move up along the reference line would indicate a rise in real equal to the rise in planned investment spending . As the reader can see in the graph , however , real rises by more than this amount . Hence , a multiplier effect is implicit in the Cross model . It is worth asking why this change occurs . Intuitively , when businesses engage in new investment spending , they raise real by the amount of the investment spending . This spending is received as income by the households though . Once received , the households spend a portion of the additional income , which is determined by the marginal propensity to consume . That additional expenditure is received by the households as well , and part of it is spent . This cycle continues indefinitely but the spending that occurs in the successive rounds becomes smaller and smaller due to the saving that occurs in each round . Ultimately , aggregate real rises by a finite amount but also by a multiple of the initial amount of investment spending . It is possible to derive a formula that tells us the exact impact that a change in investment spending has on real , other factors held constant . Let define the investment multiplier as the ratio of the change in real to the change in planned investment spending . By taking into account the way in which the households engage in an infinite series of consumer spending rounds , we can prove that the multiplier is positively related to the marginal propensity to consume as shown below .

766 DANIEL SAROS AI Figure provides the details of the proof for any interested readers . Our main purpose , however , is to understand the intuition behind the formula and to learn how to use it to calculate changes in real . To understand how to use the formula , let assume that planned investment spending rises by 100 . If the is , then we can calculate the investment multiplier by plugging the into the formula as follows AI Because investment spending rises by 100 , we can write the equation as follows 100 By solving for the change in , it is clear that real will rise by 400 billion in this case . Alternatively , the multiplier implies that for every of additional investment spending , real will rise by . The Cross Model of an Open , Mixed Economy In this section , we would like to expand the Cross model to include international trade and government activity . To account for these types of expenditure , we will make some simplifying assumptions . First , we will assume that net exports are exogenously given as follows In other words , net exports are at the same level

PRINCIPLES 767 regardless of the level of real as shown in Figure . Figure The Net Export Curve As Figure shows , net exports may be positive ( equal to zero ( or negative ( The reader should recall that net exports equal exports ( minus imports ( As explained in Chapter 12 , if net exports are positive , then a trade surplus exists ( If net exports are negative , then a trade deficit exists ( If net exports are equal to zero , then balanced trade exists ( Although trade deficits have been common in the United States since the , at an earlier time in its history , the ran trade surpluses . Trade surpluses were common in the in the late nineteenth and early twentieth centuries as a result of large agricultural surpluses due to high productivity in agriculture . The surplus commodities were exported and made possible a

763 DANIEL SAROS period of sustained trade surpluses as shown in Figure Figure The Balance from ( 800 600 400 200 Trade Balance 400 In the Cross model , we can now add net exports to the consumption function and level of planned investment spending to obtain the aggregate expenditures function as follows A I A ( As the reader can see , autonomous spending now includes net export spending . Otherwise , the aggregate expenditures function is the same . Because net exports may be positive , negative , or equal to zero , the vertical intercept may be above , below , or the same as the aggregate expenditures curve for the closed , private economy . Figure shows the case of a trade surplus and the impact that it has on the position of the

PRINCIPLES 769 aggregate expenditures curve relative to that of a closed , private economy . Figure Net Exports as a Component of Aggregate Expenditures ( open ) I A ( closed ) As the figure shows , the opening of the economy shifts the aggregate expenditures curve upward due to the trade surplus that results . The impact of trade on the equilibrium real should also be clear . Figure shows what happens when the economy runs a trade surplus or a trade deficit .

770 DANIEL SAROS Figure Equilibrium in an Open , Private Economy A A , A , trade surplus ) A ( closed or balanced nude ) A I , trade deficit ) As Figure shows , a trade surplus raises the aggregate expenditures curve and increases the equilibrium real . A trade deficit , on the other hand , lowers the aggregate expenditures curve and reduces the equilibrium real . Balanced trade leaves the aggregate expenditures curve unchanged and leaves the equilibrium real unchanged . The case of balanced trade demonstrates that the spending by foreigners on the economy exports is exactly canceled by the spending of domestic buyers on imports from other countries in terms of the impact on real . This analysis also allows us to draw a conclusion about the desirability of a trade surplus and the disadvantage of a trade deficit . Trade deficits appear to be harmful because they lower the nations equilibrium real and employment level . Trade surpluses , on the other hand , appear to be beneficial because they raise the nations aggregate output and employment .

PRINCIPLES 771 It is important to consider the various factors that lead to trade surpluses and trade Income levels in other countries certainly play a role . If trading partners undergo economic and incomes are rising , then foreigners will buy more exports and the trade balance will improve ( net exports will rise ) If trading partners experience and incomes are falling , then foreigners will buy fewer exports and the trade balance will worsen ( net exports will fall ) A second factor affecting the trade balance is tariff policy . A tariff is simply a tax on imported commodities . If tariffs are imposed , then prices of imports rise and the quantity of imports will decline . This change should improve the trade balance , possibly causing a trade surplus . At the same time , however , other nations might retaliate by imposing their own tariffs , which might reduce the nations exports . In that case , the overall impact on net exports appears to be uncertain . Such retaliatory tariffs were imposed during the after the Congress passed the Tariff Act and sparked a trade war . Finally , it is also possible that a change in the foreign exchange value of a nation currency might alter the trade balance . For example , if the domestic currency , then the nations exports will become cheaper for foreigners . The result might be a rise in net exports and a trade surplus . A depreciating currency might then raise output and employment . A potential problem that might arise , however , is retaliatory action taken by foreign central banks . If foreign central banks decide to intervene in the foreign exchange market and deliberately devalue their currencies hoping to acquire a similar competitive trade advantage , then the result

772 DANIEL SAROS might be a net appreciation of the domestic currency . The nations exports might then become more expensive for foreigners and net exports will fall . This kind of competitive devaluation of currencies occurred in the 19303 as well , as different nations struggled to stimulate their domestic economies during the worldwide Great Depression . Let now add government spending to the picture by considering the case of an open , mixed economy . A mixed economy simply refers to an economy with both a private sector and a public sector . First , we will assume that government spending is exogenously given as follows Go In other words , government spending is at the same level regardless of the level of real as shown in Figure . Figure The Government Expenditures Curve

PRINCIPLES 773 Government spending is assumed to be determined by legislators and a whole host of political factors that neoclassical economists do not attempt to explain . Nevertheless , we can now add government spending to the consumption function , the level of planned investment spending , and the level of net exports to obtain the aggregate expenditures function as follows A I A ( Autonomous expenditure has increased by the amount of the government spending . As Figure shows , the addition of government spending increases the vertical intercept of the aggregate expenditures curve by the amount of the government spending . Figure Government a Component of Aggregate Expenditures ?

A I ( open ) A I ( open ) assumes . Figure shows that the addition of government spending raises the equilibrium real above the level that would exist in a private , open economy .

774 DANIEL SAROS Figure Equilibrium in an Open , Mixed Economy A ?

A ( mixed , open ) A ( open ) Yr Ym It should be rather obvious now why Keynes advocated increased government spending during the Great Depression . By increasing government spending , it is possible to increase aggregate output and employment . With a purely private economy stuck at an unemployment equilibrium , government spending can move the economy closer to full employment . Alternatively , reducing government spending during a recession would only worsen the situation by reducing aggregate output and employment in an already weak economy . We also need to incorporate the other side of the mixed economy , which is the ability of the government to impose taxes . To keep the model relatively simple , we will assume that the government collects a lump sum tax ( from the households each year . That is , the government does not tax incomes at a particular rate like 20 but rather declares that it will collect a lump sum

PRINCIPLES 775 amount of 200 billion from the households regardless of aggregate income . We thus add the following equation to identify this constant amount of taxes collected . Because taxes are collected , it is no longer the case that and disposable income ( are equal to one another . To obtain DI , it is now necessary to subtract the lump sum tax from aggregate income ( That is , the following equation now holds DI Since household consumption depends on disposable income , we need to rewrite the consumption function taking into account the lump sum tax . The consumption function is as follows Ca DI Ca , Ca ( Co ( The reader should recall that the consumption function was the following Therefore , the addition of the lump sum tax causes the consumption function to have a smaller vertical intercept by the amount of the times the lump sum tax , as shown in Figure .

776 DANIEL SAROS Figure Lump Sum Taxation and Consumption , CU ' The reason that the lump sum tax lowers consumption at every level of real by this amount is that the households lose the tax amount as part of their income . Because households consume part of their income and save part of their income , when they lose the tax amount , they reduce their consumption by the amount that would have been consumed had they been able to keep this income . That is , they reduce their consumption by the times the amount of the tax . We can now add the consumption function to the other spending components to obtain the aggregate expenditures function as follows A ' A ( It should be clear that autonomous expenditure has changed yet again . This time it has been reduced by the amount of the times the lump sum tax . The consequence of this change is that the aggregate

PRINCIPLES 777 expenditures curve shifts downward by this amount as shown in Figure . Figure 13 29 Consumption as a Component of Aggregate Expenditures ( I ( without taxes ) A , A A ( taxes ) Now we can also see the impact that a lump sum tax will have on the equilibrium real . When the lump sum tax is imposed , it shifts the aggregate expenditures curve down , which causes the equilibrium real to fall as shown in Figure .

773 DANIEL SAROS Figure Equilibrium in an Open , Mixed Economy with Lump Sum Taxation A ?

A ( without taxes ) A , I ( Yr Yr It is easy to see why a neoclassical economist would oppose a tax increase during a recession . Higher taxes discourage consumption which reduces aggregate spending . The drop in spending leads to lower output and employment and thus harms an already weak economy . On the other hand , a tax cut can stimulate consumer spending , which will raise aggregate spending , output , and employment . The addition of the lump sum tax completes our Cross model and allows us to analyze a wide range of possible changes to the aggregate economy . We can also solve algebraically for the equilibrium real if we have enough information . To show how to find this solution , let assume the following about the economy 200 100 no 100 200

PRINCIPLES 779 To 100 We can also write the complete aggregate expenditures function as follows A ( Plugging in the known information into the aggregate expenditures function yields the following A ( 200 ( 100 ) 100 100 200 ) Now recall the equilibrium condition and solve for . A 1300 Figure provides a graph that corresponds to this solution . Figure The Calculation of Equilibrium Real in the Expanded Cross 1300

780 DANIEL SAROS The Lump Sum Tax Multiplier just as a change in investment spending leads to a multiplier effect as explained in the last section , it is also possible to identify a multiplier effect stemming from the change in lump sum taxes . The reasoning is similar . When taxes are increased , households lose disposable income . They reduce consumer spending , which causes incomes to fall more . The additional reduction in incomes leads to a great drop in consumer spending , and on and on . As before , with each successive round , consumer spending falls by smaller and smaller amounts because not all the lost income would have been consumed anyway at each step . It is possible to derive a formula that tells us the exact impact that a change in lump sum taxes has on real , other factors held constant . Let define the lump sum tax multiplier as the ratio of the change in real to the change in lump sum taxes . By taking into account the way in which the households engage in an infinite series of consumer spending rounds , we can prove that the lump sum tax multiplier is negatively related to the marginal propensity to consume as shown below . AY AT Figure provides the details of the proof for any interested readers . Our main purpose , however , is to understand the intuition behind the formula and to learn how to use it to calculate changes in real . To understand how to use the formula , let assume that lump sum taxes rise by 100 . If the is , then we can calculate the lump sum tax multiplier by plugging the into the formula as follows

PRINCIPLES 731 AT , Because lump sum taxes rise by 100 , we can write the equation as follows ?

By solving for the change in real , we can demonstrate that real will fall by 300 billion in this case . Alternatively , the multiplier implies that for every of additional taxes , real will fall by . Alternatively , a tax cut would lead to a rise in real . Two points are worth mentioning . First , the lump sum tax multiplier is always negative . The reason is that a rise in taxes causes an opposite change in real . This negative relationship exists because higher taxes reduce consumer spending and lower the equilibrium . Second , the lump sum tax multiplier is smaller in absolute value than the investment multiplier ?

The reader will recall that the investment multiplier was equal to with the same marginal propensity to consume . The reason for the smaller absolute impact of the lump sum tax multiplier is that when the households receive a lump sum tax cut of , say , 100 billion , they will only spend a fraction of it as determined by the . Successive rounds of additional consumer spending then follow . Conversely , when businesses invest an additional 100 billion , the entire 100 billion is spent in the first round , which then leads to successive rounds of additional consumer spending . Because the initial impact of the additional investment spending is larger than the initial impact of the tax cut , the overall impact of an increase in investment spending is significantly larger than the overall impact of a lump sum tax cut .

782 DANIEL SAROS Aggregate Demand Up to this point , we have only considered how the levels of aggregate output and employment are determined . In this section , we want to begin building an explanation of the general level of prices . The aggregate aggregate supply ( AS ) model was developed for this purpose . The model can be understood as an extension of the Cross model . We begin by introducing the aggregate demand curve ( AD ) curve and then explain how it relates to the Cross model . The AD curve , shown in Figure , asserts that an inverse relationship exists between the general price level ( and the level of real ( that is consistent with equilibrium in the market for goods and services . Figure The Aggregate Demand ( AD ) Curve The general level of prices may be thought of as a price

PRINCIPLES 783 index such as the consumer price index or the . Even though the AD curve looks much like a market demand curve , it is actually quite different . It turns out that the law of demand does not apply in this When we discussed the market demand curve in Chapter , it was argued that the market demand curve slopes downward for two main reasons . First , when the price of an individual commodity falls , consumers substitute away from relatively more expensive commodities whose prices have not changed . This effect , which causes a movement along the demand curve , was referred to as the substitution effect . The downward slope of the AD curve can not be explained in a similar fashion . When the general price level falls , for example , all commodity prices in the economy are falling and so it does not make sense to talk about substitution away from relatively more expensive domestically produced commodities . It is true that does not necessarily mean that all prices are falling at the same rate . Nevertheless , a drop in a price index does not allow us to detect variation in the reduction of prices across commodities and so this explanation will not suffice as an explanation of the downward sloping AD curve . Second , when the price of an individual commodity falls , consumers experience a rise in their real incomes . That is , the purchasing power of their nominal incomes increases . Feeling richer , they increased their quantity demanded of the commodity whose price fell as well as the quantities demanded of all other commodities . This effect , which also contributes to the movement along the demand curve , was referred to as the income effect . The downward slope of the AD curve can not be explained in a similar fashion . When a period of generalized

784 DANIEL SAROS occurs , for example , input prices fall in addition to product prices . The result is that factor incomes decline . With nominal incomes declining along with commodity prices , real incomes are likely to remain the same on average . Therefore , we should not expect an income effect at the aggregate level . Because the law of demand can not explain the downward slope of the AD curve , we require a different explanation for its downward slope . To understand its shape , we will first explain the relationship of the AD curve to the Cross model . Suppose that the price level falls . We will claim , for reasons not yet explained , that this drop in the price level causes aggregate expenditure to rise as shown in Figure . Figure The Derivation ofthe Aggregate Demand Curve As shown in Figure , the aggregate expenditures curve shifts upward and raises the level of equilibrium real . The consequence is a negative relationship

PRINCIPLES 785 between the general price level and the level of real . The AD curve thus slopes downward . An explanation must be provided , of course , for the negative relationship between the price level and aggregate expenditure . Neoclassical economists provide three main explanations for this negative The first explanation for the negative relationship between aggregate expenditures and the general price level is referred to as the wealth effect or the effect after the classical economist , According to this line of thinking , when the price level falls , even though households do not experience a rise in their real incomes , they do experience a rise in their real wealth . Because other factors are held constant , including nominal wealth ( home prices , stock prices ) households experience a rise in the purchasing power of their wealth . As a result , they increase their consumption expenditures , which stimulates aggregate expenditure and raises the equilibrium real . The result is a downward sloping AD curve . The second explanation for the negative relationship between aggregate expenditures and the general price level is referred to as the international substitution effect . According to this line of thinking , when the price level falls , even though no substitution away from relatively more expensive domestically produced commodities occurs , substitution away from relatively more expensive foreign commodities does occur . That is , the drop in the general price level only refers to domestically produced commodities with everything else remaining constant , including prices of foreign commodities . As a result , imports decline and net exports rise . Exports also rise because foreign buyers

786 DANIEL SAROS now substitute towards relatively cheaper commodities in this nation . The aggregate expenditures curve thus shifts upward and the equilibrium real rises . The result is a downward sloping AD curve . A final explanation for the negative relationship between aggregate expenditures and the general price level is referred to as the effect . It is also sometimes referred to as the Keynes effect because Keynes was the first to identify it . According to this effect , when the price level falls , people decide to hold less money because they need less money to engage in transactions . As a result , they lend their excess money holdings , which pushes down the rate of interest . The fall in the rate of interest stimulates investment spending and raises aggregate expenditure . As a result , equilibrium real rises . The result is a downward sloping AD curve . We are now able to discuss the factors that tend to shift the AD curve . Suppose that for a given price level of , the economy is at an equilibrium real of in the Cross model as shown in Figure .

PRINCIPLES 787 Figure of Aggregate Demand An Example Now suppose that planned investment spending rises . The aggregate expenditures curve shifts upward , which raises the equilibrium real to . Because the price level has not changed , the equilibrium real will be higher at the same price level in the graph of the AD curve . This change implies a movement off of the AD curve and to the right . Because such movements to the right would occur at any given price level when the level of investment rises , it should be clear that the entire AD curve shifts rightward when investment spending increases . The reader might also note that the AD curve shifts rightward by more than the amount of the increase in investment spending due to the multiplier effect , which is consistent with Figure . That is , the change in equilibrium output at the current price level more than exceeds the change in investment spending . Although this example concentrates on a shift of the AD curve due to a change in investment spending , a change

783 DANIEL SAROS in any component of aggregate expenditure will have a similar impact on the position of the AD curve . In general , a rise in consumer spending , investment spending , government spending , or net export spending will shift the AD curve rightward . Similarly , a reduction in consumer spending , investment spending , government spending , or net export spending will shift the AD curve leftward . To be more specific , consider factors that might consumer spending . A rise ( fall ) in nominal wealth will stimulate ( depress ) consumer spending and shift the AD curve rightward ( leftward ) The reader should notice that this effect is not the same as the wealth effect that produced a downward sloping AD curve . The reason is that in this scenario , it is a change in nominal wealth that causes a change in real wealth , rather than a change in the general price level that causes a change in real wealth . Another factor that might alter consumer spending is a change in taxes on household income . If taxes are reduced , then this change will stimulate consumer spending and raise aggregate expenditure . The higher equilibrium real will show up as a shift of the AD curve to the right . A tax increase would have the opposite effects . Changes in investment spending are likely to have different causes . One major factor investment spending is the rate of interest . If the rate of interest falls , then businesses will borrow more because they are more likely to profit from new investment projects . The rise in investment spending will raise aggregate expenditure and equilibrium real . The result will be a rightward shift of the AD curve . A rise in the interest rate would have the opposite impact and lead

PRINCIPLES 789 to a leftward shift of the AD curve . Other factors that might affect the level of investment include changes in expected profitability . The expected profits from new investment might change to due to changes in the state of the economy , changes in production technology , or changes in business taxes . If business expectations improve , new technologies are developed , or business taxes are cut , then expected profits rise , investment rises , aggregate expenditure rises , and the AD curves shifts rightward . A reduction in expected profits due to the opposite conditions would shift AD to the left . A change in government spending has a direct effect on the position of the AD curve as well . If government spending rises , then aggregate expenditure rises . The equilibrium real rises , and the AD curve shifts rightward . If government spending falls , then the opposite effects occur , and the AD curve shifts leftward . A change in net export spending will also the position of the AD curve . If trading partners experience economic and incomes are rising , then net exports will rise , raising aggregate expenditures and equilibrium real . As a result , the AD curve will shift rightward . If trading partners experience , then the effects are the opposite and the AD curve shifts leftward . Changes in tariff policy and changes in the foreign exchange value of the domestic currency may also shift the AD curve , although the effects are uncertain due to the possibility of retaliatory tariffs or competitive currency devaluation . Without retaliation , the imposition of tariffs or the devaluation of the currency will discourage imports , raise net exports , raise aggregate spending , and raise equilibrium real . The consequence will be a rightward shift of the AD curve . A

790 DANIEL SAROS reduction in tariff rates or an appreciation of the domestic currency would have the opposite effect if trading partners do not alter their policies , and the AD curve would shift leftward . Aggregate Supply Our discussion of aggregate demand has suggested that aggregate spending is the primary determinant of the amount of output produced in the economy . It seems to ignore one other factor that arguably plays a major role in the determination of output production cost . To capture the role of cost of production in the determination of aggregate output , we turn to the aggregate supply side of the economy . Figure shows a graph of the aggregate supply curve ( AS ) curve . Figure The Aggregate Supply ( AS ) Curve and Rising Production Costs The graph suggests that a positive relationship exists between the general price level and the level of real

PRINCIPLES 791 that businesses are willing and able to produce at each price level . The aggregate supply ( AS ) curve looks much like a market supply curve , and the explanation of its shape is similar . That is , as the price level rises , per unit profit rises and so firms expand production , but the increase in production drives up unit costs , which brings the expansion to a halt unless the price level rises further . As production rises , the per unit cost of real output rises due to diminishing returns to labor . The price level must rise to cover the higher per unit cost . Referring to Figure , when the economy is operating below the full employment ( increases in real do not put much upward pressure on input prices or unit costs due to the great deal of excess capacity in the economy . As a result , the general price level does not tend to rise much . As the economy approaches the full employment level of , however , efficient resources become more and more difficult to As a result , less efficient resources must be hired and unit production costs begin to rise . The general price level must , therefore , rise to compensate for the higher unit production costs . That is , businesses raise prices as their production costs per unit increase . A related reason for the rise in per unit production costs as real rises has to do with diminishing returns to labor . With the aggregate stocks of capital and land being relatively fixed during this relatively short time period , the increase in employment raises production but at a decreasing rate . Therefore , it is necessary to hire increasing numbers of workers to raise the production of real by one unit . Hence , unit production costs also rise for this reason and contribute to the upward slope of the AS curve .

792 DANIEL SAROS The next question that arises deals with the factors that shift the AS curve . Basically , a change in any variable that affects per unit production cost , other than a change in the level of real , will shift the AS curve . A rise in per unit production cost will shift the AS curve to the left because at each level of real , the prices that firms require will need to be higher . A fall in per unit production cost will shift the AS curve to the right because at each level of real , the prices that firms require will be lower . For example , a change in the nominal wage rate will shift the AS curve . It is assumed that when the price level changes , all other variables are held constant , including input prices like wages . If the nominal wage rate rises , then at any given level of real , per unit costs will be higher . The result is a leftward shift of the AS curve as shown in Figure . Figure of Aggregate Supply An Example Alternatively , a reduction in the nominal wage would

PRINCIPLES 793 shift the AS curve to the right because per unit cost would be lower at every level of real . A variety of other factors will also shift the AS curve , but each factor works by the per unit production cost of firms . For example , if the nominal prices of land and capital rise , then the AS curve will shift leftward because unit costs are higher . If other input prices fall , then the AS curve will shift Factor supplies will also affect the position of the AS curve . If factor supplies ( the supplies of land , labor , and capital ) rise , then input prices will fall and the AS curve will shift to the right . If the factor supplies fall , then input prices will rise and the AS curve will shift to the Other factors include the prices of imported For example , if the price of imported oil rises , then unit production costs will rise and shift AS to the left . If import prices fall , then the AS curve will shift to the right . Changes in the foreign exchange value of the domestic currency will also affect unit cost by making imported inputs more or less expensive . For example , if the domestic currency appreciates , then imported inputs become cheaper for domestic producers . Their unit costs fall , and the AS curve shifts to the right . If the domestic currency , then imported inputs become more expensive for domestic producers and unit costs rise . The AS curve would then shift to the left . Changes in labor productivity are also likely to affect unit cost and the position of the AS Labor productivity is measured in terms of output per worker ( Where is the number of units of output and is the number of employed workers . Labor cost per unit may be measured in terms total wages per unit produced

794 DANIEL SAROS ( where is the wage rate . It should be clear that a rise in productivity ( will cause a drop in labor cost per unit ( Hence , a rise in labor productivity will shift the AS curve to the right . If productivity falls , then unit labor cost will rise and shift the AS curve to the left . The degree of monopoly power in input markets may also unit Because monopoly markets produce higher prices than competitive markets , if monopoly power grows in a major input market , then unit costs rise , and the AS curve shifts to the left . If government antitrust action breaks up a monopoly in an input market , on the other hand , then input prices will fall and unit costs will fall as well . The AS curve would then shift to the right . Finally , changes in business taxes and tax credits may also per unit production If business taxes are cut , then unit cost will fall , and the AS curve will shift to the right . If business taxes are increased , then unit labor cost will rise and the AS curve will shift to the left . Alternatively , if the government increases its subsidies or tax credits for business , then in effect unit cost will fall , and the AS curve will shift to the right . If the government cuts its subsidies or tax credits to business then in effect unit cost will rise , and the AS curve will shift to the left . Equilibrium and Historical Applications of the Model Now that the aggregate demand and aggregate supply sides of the model have been developed , we can combine them to explain how equilibrium occurs . equilibrium occurs when the

PRINCIPLES 795 general price level and the level of real reach levels from which there is no inherent tendency to change . Figure depicts an economy that has reached a equilibrium state where and are the equilibrium general price level and the equilibrium real , respectively . Figure Equilibrium We want to ask how the economy reaches the equilibrium outcome . It may be tempting to fall back on the explanation that we offered when we discussed the movement to equilibrium in an individual market as in Chapter . In this model , however , we need to refer to the factors that cause movements along the AD and AS curves . For example , suppose that the price level is at in Figure . In this case , aggregate spending is relatively low compared with what businesses wish to produce at this price level . If businesses are producing and aggregate spending leads to a lower equilibrium in the Cross model , then firms will

796 DANIEL SAROS experience a rise in inventories ( unplanned investment ) They will then cut production . As they cut production , a movement down along the AS curve occurs . The release of relatively inefficient resources causes unit production cost to fall and the price level begins to decline . As the price level falls , three effects on the aggregate demand side occur that stimulate aggregate expenditure . When falls , households experience a rise in real wealth and consume more . Also when falls , foreigners begin to buy more of this nation exports and domestic buyers buy fewer imports . These factors increase net export spending . Finally , when falls , the amount of money people wish to hold falls , which leads to more lending , lower interest rates , and higher investment spending . All three factors cause a movement down along the AD curve . Eventually , the economy will arrive at the equilibrium outcome . Alternatively , suppose that the economy begins with a price level of . In this case , businesses do not want to produce much real output given the low price level that just covers their low unit costs . On the other hand , aggregate spending is rather high , leading to a high equilibrium in the Cross model . Aggregate output will begin to rise as inventories are depleted as a result of the high aggregate spending . As output begins to rise , the effects of diminishing returns to labor and the employment of less efficient resources causes unit costs to creep upwards . Businesses will raise prices to keep up with rising unit costs . As prices rise , three effects on the aggregate demand side begin to take effect . As rises , households experience a reduction in their real wealth , which leads to lower consumer spending . As rises , foreigners substitute away from the

PRINCIPLES 797 nation exports and domestic buyers substitute towards imports . Both effects reduce net export spending . Finally , as rises , people wish to hold more money for transactions purposes and so they lend less . The result is a rise in the rate of interest , which discourages investment spending . All three effects cause a movement up along the AD curve . Eventually , the economy will arrive at the equilibrium outcome . The AS model can be easily applied to specific periods in history to obtain a sense of how and why the price level and level of real changed . For example , prior to World War II , the economy frequently experienced periods of during . The that have occurred since World War II have generally not been characterized by . The AS model can help us to understand why has become less common in the economy . Figure shows a horizontal section of the AS curve , which implies that when AD declines during a recession , the price level does not fall .

793 DANIEL SAROS Figure A Horizontal Aggregate Supply Curve Real During these types of , only real declines . To understand why a horizontal aggregate supply curve might exist , we need to consider how conditions changed in the and . In particular , it became more difficult to reduce wages during a recession for a number of reasons , including the passage of a federal minimum wage law in 1938 and the growing power of industrial unions in major industries that negotiated high wage rates . With unit labor costs becoming more rigid , businesses could not reduce them during a recession and so they hesitated to cut prices . Other factors contributing to sticky prices might have been business concerns about menu costs ( costs associated with price cuts ) and efforts to avoid price wars with oligopolistic competitors . The tendency for prices to be downwardly means that prices tend to increase , but once they rise , they tend not to fall again . Let consider what occurred in the during the

PRINCIPLES 799 19605 . This decade was marked by rapid economic growth but also a rising price level . Factors that contributed to these changes were rising government spending related to America involvement in the Vietnam War and President poverty reduction programs . The rise in government spending led to a rightward shift of the AD curve as shown in Figure . Figure Case inflation The rise in aggregate demand increased the general price level and the level of real . Because the economy was near the full employment ( the rise in aggregate demand pushed the unemployment rate below the natural rate of unemployment and had a strong impact . When is the result of a rise in aggregate demand , economists generally refer to it as a case of Next let consider what occurred in the during the

800 DANIEL SAROS 19305 . This decade was characterized by a severe reduction in real as well as a falling price level or . The main factor contributing to these changes was a drop in aggregate demand as shown in Figure Figure Case Great Depression After the stock market crash of 1929 , investment spending and consumer spending fell significantly . The failures of many American banks contributed significantly to the reduction in investment spending as well . As real output fell and unemployment rose , unit costs declined and the price level fell . The price level and level of real output eventually reached and , respectively . If the economy had been subject to downwardly prices , then the price level would have remained at and the real output would have fallen to . Interestingly , such price stickiness would have made the collapse of output and employment worse during the Great Depression . The falling price level

PRINCIPLES 801 actually took some of the pressure off of real output as aggregate demand fell . The reason that since World War II have been less severe is not the result of sticky prices . Instead , it is because reductions in aggregate demand have been smaller as governments and central banks have become more aggressive about preventing economic collapses . During the 19705 , the economy experienced the unpleasant coincidence of a rising price level and falling real output . Figure shows that a leftward shift of the AS curve was responsible for this recession . Figure Case ' Inflation When occurs at the same time as falling real , the situation is referred to as . It is the worst of both worlds ( and recession ) The reason that the AS curve shifted leftwards in the had to do with a sudden rise in unit production cost .

802 DANIEL SAROS Unit costs rose because of the two oil price shocks that increased the price of imported oil in the United States . In 1973 , the War broke out which interrupted the flow of oil to the West . Then in 1979 the revolution in Iran once again led to a disruption of the of oil westward . In both cases , tighter global supplies caused the price of oil to skyrocket , raising production costs and leading to . Because the in this case was the result of an aggregate supply shift , it is often referred to as to distinguish it from the of the Another interesting case occurred during the . The represents the longest economic expansion in economic history . Unlike the , this decade captured the best of both worlds with both rapid growth of real and a relatively stable price level . Figure provides insight into the factors that contributed to this situation . The figure assumes a vertical aggregate supply curve for reasons that are explained in the next section . 24 13 42 Case Full Employment Stable Prices As Figure shows , aggregate demand rose during

PRINCIPLES 803 this decade . A major reason for the rise in AD was the information technology ( IT ) boom that raised the expected profitability of many startup companies . These changes led to a surge of investment in the IT sector . With IT stocks rising in value , households also experienced a rise in nominal and real wealth , which led to a rise in consumer spending . While these changes would normally cause inflation , like the kind observed in the in the , in this case a rise in aggregate supply occurred simultaneously . The reason was that the technological changes in the IT sector also raised labor productivity , which reduced unit labor costs and shifted the AS curve to the right . As Figure indicates , both the rise in AD and the rise in AS contributed to a large increase in real . At the same time , only a small increase in the price level occurred because the rise in AS put downward pressure on prices even as the rise in AD tended to push prices up . The economy of this decade was dubbed The New Economy , which included the claim that the business cycle had been conquered and that uninterrupted and stable economic growth was to be expected forevermore . The experience of the next decade would serve as a reminder that the business cycle has been far from In the year 2000 , it became clear that the good times had ended . A stock market bubble had been forming in the IT sector for years . Asset price bubbles form when asset prices rise significantly above levels that are consistent with the real underlying values of the assets . In the case of the IT sector , irrational exuberance had led to the bidding up of IT stocks far beyond what would be justified by the profitability of the associated companies . When investors finally discovered to what extent the stocks were overvalued , they dumped them , and the

804 DANIEL SAROS prices collapsed . This disruption in the stock market meant that a great deal of paper wealth was destroyed in a short time . The result was a collapse of investment and consumer spending . Aggregate demand thus fell and gave way to the recession of 2001 , like what is depicted in Figure . The 2001 recession was mild , however , and the economy soon recovered . The nations central bank , the Federal Reserve , which controls the nations money supply , took the lead in responding to the crisis . It increased the money supply which pushed interest rates down to very low levels . As interest rates fell , investment spending rose , but this time investments into the housing sector rather than the IT sector . Over the course of the next few years , a boom in home construction occurred . Low mortgage interest rates encouraged the purchase of new homes , which led to soaring home prices . As before , the bidding upward of these prices above their underlying real values implied the formation of an asset price bubble . A factor that contributed greatly to the formation of this asset price bubble was the way large financial institutions encouraged the growth of the market for various financial assets , including backed securities ( When commercial banks grant mortgage loans to home buyers , they typically do so for a period of 15 or even 30 years . In the past , a commercial bank would carefully scrutinize the credit worthiness of the home borrower before granting the loan to ensure that the bank would receive mortgage payments each month until the loan was repaid with interest . The growth of the market for meant that a commercial bank could sell this loan to a large financial

PRINCIPLES 805 institution , like Goldman , which would then bundle together dozens or even hundreds of such mortgage loans that originated in many different places , creating a single financial asset ( a security ) Goldman would then sell the to a large institutional investor like a hedge fund . The asset might be sold many times in the organized market for these securities that arose . The owner of the would receive interest payments from many different homeowners due to its ownership of the asset . The problem that this situation created was that so much money was being made by packaging and selling these specialized assets that less attention was being paid to the credit worthiness of the borrowers . When the loan originator ( the bank that initially grants the loan ) is not the same institution that will suffer if the borrower defaults on the loan , it is much less likely that the loan originator will take the proper care in evaluating the credit worthiness of the borrower . Furthermore , credit rating agencies , like Moody and Standard and Poor , which were supposed to signal to investors how much risk they were assuming by purchasing these securities encountered a conflict of interest . They collected more fees by rating more of these securities . Positive ratings were likely to encourage the growth of the market and keep the market for these securities active . As a result , these agencies tended to be far too optimistic in their valuations and tended to underestimate the degree of risk associated with these securities . The consequence of all these factors was that home buyers eventually began to default on loans in large numbers . These defaults triggered a collapse in the prices of securities . Financial institutions that

806 DANIEL SAROS held these assets on their balance sheets watched as the losses mounted . Driven by fear of additional losses , they contracted their lending . The contraction of lending reduced investment spending . Many businesses were unable to obtain the loans necessary simply to pay employees , and business failures began to increase . The result was a huge collapse of aggregate demand as shown in Figure . Figure Case Great Recession This recession was so extreme that it has been dubbed the Great Recession . It was the worst reduction in real that has occurred since the Great Depression of the . It should be noted , however , that the Great Depression was far worse with a drop in real and an unemployment rate in excess of 25 . By contrast , during the Great Recession , real fell by just over and the unemployment rate was around 10 at its peak . The reason that the Great Recession was not worse than it was stemmed from the massive government and central bank

PRINCIPLES 807 responses to the crisis . The Federal Reserve acted as a lender of last resort and offered emergency loans to large financial institutions . The federal government also passed emergency measures , including a 700 billion Troubled Asset Relief Plan ( TARP ) in late 2008 that bought up hundreds of billions of dollars of toxic assets from banks and other financial institutions while also purchasing equity stakes in the same financial institutions . The federal government also implemented a fiscal stimulus package in early 2009 that included 787 billion of government spending increases and tax cuts . This stimulus package was consistent with the prescription for boosting output and employment during . Although these measures had some impact , economic growth remained sluggish for several years and unemployment remained stubbornly high . The Neoclassical Synthesis Model and the Critique The model that we have investigated up to this point is consistent with the neoclassical interpretation of Keynes theory . Keynes General Theory is a difficult book and is subject to numerous interpretations . After World War II , Paul identified something called the Neoclassical Synthesis model . This model aims to capture what is most valuable in Keynes theory while also retaining much of the classical or early neoclassical model that Keynes rejected as incomplete . Because it retains so much of the early neoclassical perspective , many economists , who adhere to a very different interpretation of Keynes theory , reject the neoclassical synthesis model . We will consider more of the perspective in the next chapter . In this section , however , we will

803 DANIEL SAROS consider how neoclassical economists aim to create a merger or synthesis of neoclassical and ideas . The proposed merger essentially rests on a distinction between the short run and the long run . As the argument goes , Keynes theory best applies to short run changes in aggregate output and employment when nominal wages are sticky . In the long run , however , when nominal wages and other input prices are , it is the classical theory that best applies . To understand this argument , we need to develop a long run aggregate supply curve ( curve to distinguish it from the upward sloping short run aggregate supply curve ( curve that we have been using throughout this chapter . The curve is shown in Figure . Figure The Long Run Aggregate Supply ( Curve Yr The curve is perfectly vertical . The reason is that in the long run with perfect price , all resources

PRINCIPLES 809 will be fully employed . Any unemployment in the markets for land , labor , or capital , will disappear as prices fall and eliminate the unemployment . With each factor of production fully employed , the economy will produce the full employment level of real . Changes in the price level will have no impact on the level of real . The only factors that can shift the curve are changes in the endowment of society resources ( land , labor , and capital ) or changes in the available production technology . Otherwise , the curve will remain where it is . Now lets begin at a point of long run equilibrium as shown in Figure where the AD , and curves all intersect to produce an equilibrium price level of and an equilibrium real output of . Inflation the Neoclassical Synthesis Model , Now suppose that the central bank increases the money

810 . SAROS supply , which pushes the interest rate down and stimulates investment spending . The rise in investment spending increases aggregate demand , shifting the AD curve to the right . According to theory , output rises above the full employment level to and the unemployment rate falls below the natural rate of unemployment . At the same time , the price level rises to due to the rise in per unit cost . The run explanation would stop at this point , but according to the neoclassical synthesis model , in the long run factor prices will begin to rise . As nominal wages and other factor prices rise pushing up unit cost , the curve shifts to the left . The new long run equilibrium then occurs at the intersection of AD , the new curve , and the curve . Output returns to the long run level , and the price level is permanently higher at . Even though Keynes theory provides an explanation for the short run fluctuations , the classical theory provides the long run explanation . Of course , economists are highly critical of the neoclassical synthesis model . The model assumes that if we wait long enough , then wages will adjust to bring about . It was precisely this kind of thinking that Keynes rejected in his General Theory . Keynes famous remark in response to such thinking was that , In the long run , we are all Furthermore , this particular example suggests that money is not neutral in the short run , but it is neutral in the long run . Those who defend the neutrality of money argue that changes in the money supply can not cause changes in real variables , like output and employment . economists have long argued that Keynes theory implies the of money in both the

PRINCIPLES 811 short run and the long run . More will be said about the perspective in later chapters . Following the Economic News A news article published in describes how changes in the foreign exchange value of the Icelandic Krona have affected Iceland economy since the global financial crisis of 2008 . The article explains how the Krona approached new lows after the financial crisis , which supported a boom in the tourism industry that drove the recovery in the Icelandic In terms of the AS model , the depreciating Krona helped stimulate aggregate demand . When a nation currency , a nation exports become cheaper and its imports become more expensive . The consequence is a rise in net exports and an increase in aggregate demand . Real output and employment should then rise , as occurred in the case of Iceland . The article explains that eventually the improved performance of the economy led to a higher demand for the Krona , which caused it to steadily appreciate in and then significantly more in 2016 . The article explains that the Icelandic airline , Wow Air , faced increasing competitive pressure as a result of the appreciating Krona , and that the weak financial performance of Iceland airlines was beginning to have a negative effect on the tourism industry . As investors became cautious about Iceland future growth prospects , the exchange value of the Krona began to slide , leading to a sharp depreciation of the Krona , which fell by roughly 10 against the Euro between August and October 2018 , as the article explains . In response to the depreciation of the Krona , the Central Bank of Iceland has been increasing interest rates . Higher interest rates should

812 . SAROS encourage investors to purchase assets in Iceland , which will help the Krona recover . As a result , the author of the article expects upward pressure on the Krona throughout 2019 . Although a currency depreciation tends to simulate aggregate demand , the article explains that the central bank has been raising interest rates because it is concerned about the higher prices of oil imports and increases in labor costs due to an upcoming round of collective wage negotiations . Higher oil prices and high labor costs both reduce aggregate supply , which can be and can cause a reduction in real output , as the AS model implies . Therefore , a currency appreciation can be beneficial to producers because it lowers the prices of imported inputs and may increase aggregate supply . The AS model shows us the various ways that a change in the foreign exchange value of a nation currency might affect its economy . Summary of Key Points . Say Law of Markets states that new production will always generate enough income for its purchase and so general of overproduction are not possible in market capitalist economies . According to . Keynes , Say Law of Markets does not hold in market capitalist economies because not all savings will be invested . The consumption function and the saving function show that consumer spending and saving are positively related to the disposable income of households . The Cross model explains how the economy arrives at an equilibrium level of real as businesses change production in

10 . 11 . 12 . 13 . 14 . 813 PRINCIPLES response to a buildup or depletion of inventories . In the Cross model , the equilibrium condition states that aggregate planned expenditure is equal to real . The paradox of thrift asserts that even if all households increase their saving , aggregate saving will ultimately not change . The multiplier effect refers to the tendency for real to rise by a multiple of a rise in investment spending . In the Cross model , trade surpluses raise equilibrium , trade deficits reduce equilibrium , and balanced trade leaves equilibrium unchanged . In the Cross model , government spending increases or tax cuts raise equilibrium real , whereas government spending reductions or tax increases reduce equilibrium real . The lump sum tax multiplier is negative and has a smaller absolute impact on real than the investment multiplier . The AD curves slopes downward due to the wealth effect , the international substitution effect , and the effect . The AD curve shifts due to changes in consumer spending , investment spending , government spending , and net exports . The AS curve slopes upward due to rising unit costs as less efficient resources are employed and diminishing returns to labor occurs . The AS curve shifts due to changes in all other factors that affect unit costs , such as changes in

814 . SAROS input prices , import prices , the exchange rate , business taxes and credits , monopoly power , labor productivity , and input supplies . 15 . equilibrium occurs at the intersection of the AD and AS curves and determines the equilibrium real and price level . 16 . The neoclassical synthesis model represents a merger of neoclassical economics and economics . List of Key Terms Say Law of Markets Aggregate production function Consumption function Autonomous consumption Marginal propensity to consume ( Saving function Autonomous saving Marginal propensity to save ( Reference line Cross model Aggregate expenditures model Induced spending Planned investment

PRINCIPLES Actual investment Paradox of thrift Induced saving Fallacy of composition Multiplier effect Animal spirits Trade surplus Trade deficit Balanced trade Tariff Competitive devaluation Mixed economy consumption function consumption function Lump sum tax multiplier Aggregate demand ( AD ) curve Substitution effect Income effect Wealth effect International substitution effect 815

816 . SAROS effect Aggregate supply ( AS ) curve equilibrium Sticky prices Menu costs Asset price bubbles ed securities ( Great Recession Neoclassical Synthesis model Long run aggregate supply ( curve Short run aggregate supply ( curve Neutrality of money Problems for Review the consumption function is . What is the saving function ?

Suppose that investment spending falls by 300 billion . If the is , then what is the change in real , according to the multiplier effect ?

PRINCIPLES 817 . Suppose you are given the following information about the economy Investment spending is 400 Government spending is 600 A trade deficit of 250 exists Autonomous consumption is 300 The is A lump sum tax of 275 is imposed Given this information , write the aggregate expenditures function . Then calculate the equilibrium level of real and place your answer on a graph like the one below . A . Suppose that a lump sum tax cut of 125 is imposed on households . If the is , then what will be the overall change in real that results ?

Suppose that the economy begins in equilibrium as depicted in the AS model . Suppose 813 . SAROS that a stock market collapse occurs that reduces household wealth at the same time that monopoly power increases in key input markets . What will happen to the equilibrium levels of prices and real ?

Represent your answer graphically . Suppose that the economy begins in equilibrium as depicted in the AS model . Suppose that the domestic currency . What will happen to the equilibrium levels of prices and real ?

Consider the impact on both AS and AD in your answer . Represent your answer graphically . Suppose that the economy begins in equilibrium as depicted in the AS model . Suppose that labor productivity rises at the same time that taxes on households are reduced . What will happen to the equilibrium levels of prices and real ?

Represent your answer graphically . Figure . The investment Multiplier and the Marginal to Consume and Save Suppose AI occurs . Then AY AI ( AI ) If rises by 100 and the AY AI ( is then the and ( 1111103 . mes by 400 Al A ! PRINCIPLES 819 Figure The Lump Sum Tax Multiplier and the Marginal Propensity to Consume Suppose AT occurs . Then AY ( AT ) AT ) AT ) Exam 16 , If a lump sum AY ( tax of and the is , me me ) the tax multiplier is AT and falls by 300 . LY AT ( Notes See , et al . 1994 ) for a more advanced treatment of the classical model of output and employment . See Hunt ( 2002 ) for a discussion of how Keynes theory relates to the neoclassical flow model . Hunt ( 2002 ) graphically represents the two major causes summarized here . See and ( 2012 ) for a discussion of how Keynes introduced this new entry point . See and ( 2012 ) for a discussion of the logic of theory .

820 10 . 11 . 12 . 13 . 14 . 15 . 16 . DANIEL SAROS See Chiang and Stone ( 2014 ) for the conditions under which saving ends up falling overall . See Bureau of the Census ( 1975 ) Series . Value of Exports and Imports 1790 to 1970 , The calculation of the trade balance includes total merchandise , gold , and silver . Hubbard and ( 2019 ) emphasize differential growth rates across countries , differential price levels across countries , and exchange rates as the major factors influencing the level of net exports . and ( 2008 ) also emphasize tariffs . See and ( 2001 ) who make this point in the context of an example where a tax increase is required to balance the government budget after a government spending increase . Chiang and Stone ( 2014 ) 524 , and and ( 2008 ) 188 , argue that neither the income effect nor the substitution effect can explain the downward slope of the AD curve . See also Case , Fair , and , 550 . These effects are identified in nearly all neoclassical textbooks when the downward sloping AD curve is explained . 2014 ) refers to firms running into limits as the economy approaches its potential . Many textbooks mention changes in commodity prices and changes in nominal wages . See et al . 2014 ) 422 . Hubbard and ( 2019 ) 834 , emphasize changes in the labor force and capital stock . Other books such as ( 2014 ) describe these changes as supply shocks . Prices of imported inputs are also frequently mentioned in textbooks . See ( 2014 ) 562 , and and , 662 . See ( 2014 ) and and

17 . 18 . 19 . 20 . 21 . 22 . 23 . 24 . 25 . 821 PRINCIPLES ( 2008 ) 195 , for a discussion of how productivity changes can influence the AS curve . See Chiang and Stone ( 2014 ) 532 . See Chiang and Stone ( 2014 ) and ( 2008 ) 198 , analyze the in this way . and ( 2008 ) 198 , and ( 2014 ) 588 , provide similar graphs representing this scenario . and ( 2008 ) 199 , include such arguments . Similar arguments may also be found in ( 2014 ) 585 . 2014 ) 585 , also mentions a coordination argument that Keynes made . That is , although workers might accept a wage cut if all workers simultaneously received one , coordinating an wage cut is not possible in a decentralized market economy . The case of inflation is a common one in neoclassical textbooks . See Chiang and Stone ( 2014 ) and ( 2001 ) and Bade and Parkin ( 2013 ) 760 . See and ( 2014 ) 436 , for a similar representation of this case . The case of is also a common one in neoclassical textbooks . See Chiang and Stone ( 2014 ) and ( 2001 ) and Bade and Parkin ( 2013 ) 761 . and ( 2008 ) analyze this case . It is also included as an exercise in et al . 2014 ) 445 . Hubbard and ( 2019 ) analyze the case too but without emphasis on the low rates . and ( 2008 ) 202 , make this connection to the New Economy . Interestingly , history has repeated itself . In the , many respected observers claimed that a new

822 26 . DANIEL SAROS economics had abolished the business cycle thanks to the establishment of the Federal Reserve in 1913 . See Chancellor ( 1999 ) 192 . Iceland economy Sharp depreciation in the krona prompts policy . The Economist Intelligence Unit , Incorporated . New York . 10 2018 .