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Aggregate Demand & Supply II

Objectives
After working through this topic you should be able to:
· Understand the meaning and derivation of the Extreme Keynesian
aggregate supply curve
· Understand the meaning and derivation of the General Keynesian
aggregate supply curve
· Understand the meaning and derivation of the Classical aggregate
supply curve
· Explain the effects of demand management policy in each case
· Explain the way the three approaches can be synthesised
· Explain the importance of price expectations for the proper definition
of a full employment equilibrium

Key Concepts
Extreme Keynesian AS curve synthesis AS analysis
General Keynesian AS curve price expectations
Classical AS curve full employment equilibrium
demand management
real effects

Introduction
In this topic, we will complete the derivation of the AD/AS model by
considering how the aggregate supply curve is derived. The key point
is that there are three separate (but linked) AS curves to consider,
each one corresponding to one of the three assumptions about
workers’ price expectation discussed in the last topic. Complete
money illusion gives rise to the Extreme Keynesian AS curve,
imperfect foresight underpins the General Keynesian curve, whilst
with perfect foresight the Classical AS curve holds true. The
implications for the effectiveness of demand management are
explored in each of the three cases.

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Aggregate Supply: The Extreme Keynesian Case
The extreme Keynesian aggregate supply curve is derived using the
complete money illusion assumption that the value of p' is zero.
Therefore no matter how the price level changes it does not influence
workers decisions to supply labour at any given money wage rate.
The derivation of the aggregate supply curve in this case is illustrated
in Figure 10-1 below.
In quadrant A there is a labour market with money wages on the
vertical axis; quadrant B shows an aggregate production function;
quadrant C is just a 450 line; and quadrant D is the area where the
aggregate supply curve is charted.
Y Y
B C

Y1
Y0

N Y0 Y1 Y

W P
NS0
D

A
W1 ASEK

W0
P1
P0
ND1

ND0
N0 N1 N Y

Figure 10-1: Derivation of the Extreme Keynesian AS Curve

Starting with price level P0 it is possible to specify the labour demand


(ND0) and labour supply (Ns0) curves in quadrant A. At the
equilibrium money wage (W0), and hence real wage (W0/P0), an
equilibrium volume of employment is determined, N0. Taking N0 up
to quadrant B allows a level of output (Y0) to be identified. Charting
this around quadrant C, allows the combination P0,Y0 to be identified
in quadrant D. This is a point on the aggregate supply curve because
at this juncture the labour market is in equilibrium.

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Take a 10% higher actual price level, P1. In quadrant A the labour
demand curve shifts out to the right (ND1). Firms are more willing to
take on workers at every money wage because there are greater
profits to be made. Workers, however, do not recognise that prices
have increased because the coefficient of adjustment is zero; the
labour supply curve remains fixed at Ns0. There is a minimal increase
in the equilibrium money wage, say by 2%, to W1, which is less than
the increase in the price level. Consequently the real wage falls and
the equilibrium volume of employment increases to N 1. In quadrant B
employment N1 can be shown to generate output Y 1. And this allows
combination P1,Y1 to be charted in quadrant D as another point
where the labour market is in equilibrium. Connecting the two points
in quadrant D allows a positively sloped extreme Keynesian
aggregate supply curve to be specified. As the price level increases so
too does the level of total output.
There are two particular points to remember from the preceding
analysis:
· the existence of complete money illusion allows the real wage to
fall (rise) as the price level increases (decreases)
· it is only when the real wage rate falls (rises) that the volume of
employment/output increases (decreases).

Activity 1
Illustrate and explain the effect on the Extreme Keynesian AS curve
of an increase in (marginal) labour productivity. (Hint: what is the
effect on the demand for labour curve?)

Demand Management

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To address this issue it is necessary to combine the aggregate demand
and extreme Keynesian aggregate supply curves. See Figure 10-2
below.
Price
level
(P)
ASEK

P1
P0

AD1
AD0

Y0 Y1 Output (Y)

Figure 10-2: Expansionary Policy in the Extreme Keynesian Case

On the vertical axis is the price level (P), on the horizontal axis are
units of output (Y). The aggregate supply curve is represented by
ASEK, and the initial aggregate demand curve by AD0. This derives a
price level P0 and output Y0 where the goods, money and labour
markets are all in simultaneous equilibrium.
Suppose the authorities think that output Y0 is too low, and wish to
increase it to Y1 by means of an expansionary fiscal and/or monetary
policy. Such an expansionary policy will shift the aggregate demand
curve to the right to AD1. Consequently the level of output will rise
to Y1, at the cost of a higher price level P1. Actually the higher price
level, which is entirely unanticipated by workers i.e. complete money
illusion, is necessary to allow the real wage rate to fall and the
equilibrium volume of employment to increase.
If a contractionary demand management policy is pursued the
aggregate demand curve will shift to the left causing the level of
output and the price level to fall.
The important thing to remember is that:
· in an extreme Keynesian world demand management policies have
‘real’ effects on the economy in terms of the equilibrium levels
of employment and output.

Aggregate Supply: The General Keynesian Case


This time it is assumed that workers form price expectations with
imperfect foresight; i.e. O < p' < 1. There are many reasons why
workers may not fully adjust their price expectations when the
general price level varies, and these are covered in some length in
Dornbusch and Fischer. The reader is directed to this source to
follow up on this issue.

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To derive the General Keynesian Aggregate Supply Curve the four
quadrant diagram is once again utilised - see Figure 10-3 below.
Y Y
B C

Y1
Y0

N Y0 Y1 Y

W P
NS1
NS0
D

W1 A
ASGK

W0
P1
P0
ND1

ND0
N0 N1 N Y

Figure 10-3: Derivation of the General Keynesian AS Curve

The key to the diagram is again contained in quadrant A. Starting


with price level P0 the labour demand (ND0) and labour supply
(Ns0) curves are specified; the equilibrium money and real wage
rates are identified (i.e. W0 and W0/P0 respectively); and the
equilibrium volume of employment is determined (N0).
Employment N0 generates output Y0 (see quadrant B); and in
quadrant D it can be shown that combination P 0,Y0 is consistent
with equilibrium in the labour market.
Suppose that the price level rises by 10% to P1. The labour
demand curve shifts out to the right to N D1 taking full account of
the 10% increase in prices. This time, however, the labour supply
curve is effected by the change in prices. Say that the value of p' is
0.6. Workers perceive that the actual price level has increased, but
only by 6%. They therefore suppose that future prices will be 6%
higher i.e. they suffer from some degree of money illusion.
With workers expecting a higher future price level the result is that
for every money wage rate workers are willing to supply less
labour i.e. at each money wage the real wage is perceived to have

Aggregate Demand & Supply II 122


fallen. This can be represented by a leftward shift in the labour
supply curve to Ns1. But the leftward shift of labour supply is less
than proportional than the rightward shift of labour demand.
Overall the money wage increases (by less than 10%) to W1, the
real wage rate falls (i.e. W0/P0 > W1/P1), and the equilibrium
volume of employment increases to N1. Taking N1 up to the
aggregate production function shows the associated level of
output Y1; and in quadrant D combination P1,Y1 can be charted.
Connecting P0,Y0 and P1,Y1 allows the general Keynesian
aggregate supply curve which is positively sloped to be derived.
This general Keynesian aggregate supply curve is steeper than the
extreme Keynesian curve. This is because that, in comparison to
the Extreme Keynesian case, a given increase in the price level
generates a greater increase in money wages, a smaller fall in the
real wage, and a smaller increase in employment/output.
Again it is important to remember two aspects of the preceding
analysis:
· the existence of partial money illusion allows the real wage to fall
(rise) as the price level increases (decreases)
· as the real wage falls (rises) the equilibrium volume of
employment/output increases (decreases).

Demand Management
This issue is illustrated by reference to Figure 10-4 below. The
general Keynesian aggregate supply curve is represented by ASGK;
the initial aggregate demand curve is shown as AD0.
Price
level ASGK
(P)

P1

P0

AD1
AD0

Y0 Y1 Output (Y)

Figure 10-4: Expansionary Policy in the General Keynesian Case

The economy has its goods, money and labour markets in


equilibrium at price level P0, output Y0. Suppose the government
attempts to increase output by an expansionary demand
management policy. This is represented by a rightward shift in the

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aggregate demand curve (AD0 to AD1). As a result the equilibrium
price level rises to P1 and output to Y1.
Again the increase in the price level, which is partially
unanticipated by workers, is necessary to generate a fall in the real
wage rate and a higher equilibrium level of employment and
output. But in this case for any given increase in aggregate
demand, the rise in the price level is larger and the gain in output
smaller than in the extreme Keynesian scenario. In the case of a
contractionary demand management policy the price level and
output will fall.
It is important to state that:
· in the general Keynesian case demand management policies can
have ‘real’ effects on the equilibrium levels of employment and
output in an economy.

Activity 2
Use a (single) diagram to compare the effect on real output and the
price level of a contractionary monetary policy in the Extreme and
General Keynesian cases. Explain your answer.

Aggregate Demand & Supply II 124


Aggregate Supply: The Classical Case
In the Classical model it is assumed that the value of p' is unity and
workers fully adjust their price expectations for any change in the
actual price level. This assumption has profound implications for the
slope of the classical aggregate supply curve, which is derived in
Figure 10-5 below.
The analysis starts, as before, in quadrant A with a given price level
P0 which specifies the labour demand (N D0) and supply (Ns0) curves.
An equilibrium money wage rate (W0), and hence real wage rate
(W0/P0), determines the equilibrium volume of employment, N0.
Employment N0 generates output Y0 (quadrant B). And, by the
process outlined previously, a combination P0,Y0 is charted in
quadrant D which is consistent with equilibrium in the labour market.
Y Y
B C

Y0

N Y0 Y

W NS1 P
NS0
D

W1 A ASC

W0
P1
P0
ND1

ND0
N0 N Y

Figure 10-5: Derivation of the Classical AS Curve

Suppose the actual price level increases by 10% to P 1. In quadrant A


the labour demand schedule shifts out to the right, taking full account
of the higher price level (ND1). In terms of labour supply workers
fully anticipate the actual price change and adjust their price
expectations accordingly. The labour supply curve shifts into the left,
taking full account of the higher price level (Ns1).

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The result is that the money wage rises by 10% to W 1, the real wage
rate remains constant (i.e. W0/P0 = W1/P1), and the equilibrium
volume of employment remains steady at N0. If employment is steady
so too is the level of output at Y0 (quadrant B).
In quadrant D combination P1,Y0 is charted, and when combined with
P0,Y0 a Classical aggregate supply curve is derived. The Classical
aggregate supply curve is vertical. As the price level rises (falls) the
level of output remains constant.
Two point are important to remember from the preceding analysis.
They are:
· with no money illusion, as the price level rises the real wage rate
remains steady
· with a steady real wage the volume of employment and output
remains the same when the price level varies.

Activity 3
Illustrate and explain the effect on the Classical AS curve of a
reduction in labour supply at every real wage rate.

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Demand Management
In the Classical model demand management has no ‘real’ effects on
the economy in terms of employment or output. The management of
demand can, however, have an important influence on the price level.
Figure 10-6 below illustrates these Classical arguments.
The Classical aggregate supply curve is ASc, and the initial aggregate
demand curve is AD0. The equilibrium starting point is at P0,Y0 where
the goods, money and labour markets are in equilibrium.
Price
level ASC
(P)
P1

P0

AD1
AD0

Y0 Output (Y)

Figure 10-6: Expansionary Policy in the Classical Case

The authorities decide, for whatever reason, to try to increase output


by stimulating demand. An expansionary fiscal and/or monetary
policy shifts the aggregate demand curve to the right (AD 1). The
result is that the price level increases to P 1, but, because the
workforce does not suffer from money illusion, all other real
variables (i.e. the real wage rate, employment and output) remain
constant. The policy of demand management is a complete failure. If
a contractionary policy is pursued the only effect is to reduce the
price level, with all real' variables unchanged.

A Synthesis Aggregate Supply Analysis


It is possible to synthesise the three approaches to the aggregate
supply curve by relating them to different time periods. Hence, after a
disturbance to aggregate demand the Extreme Keynesian curve can
relate to the very short run impact; the General Keynesian curve will
outline the short to medium effects; and the Classical curve can define
the long run results. The synthesis can be illustrated in Figure 10-7
below.

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Price
level ASC
(P) ASGK
P3 D
C ASEK
P2
B
P1
P0 A

AD1
AD0

Y0 Y2 Y1 Output (Y)

Figure 10-7: Expansionary Policy in the Short, Medium & Long Run

There are three aggregate supply curves on this diagram. ASEK is the
Extreme Keynesian curve; ASGK is the General Keynesian curve; and
ASc is the Classical schedule. With an initial aggregate demand curve
AD0 the economy is in equilibrium at point A with price level P 0 and
output Y0.
Suppose that the government expands the level of demand, such that
the aggregate demand curve shifts to AD1. Using the three supply
curves the impact of the higher demand on the price level and output
can be charted over different time periods. In the immediate time
period after the disturbance the initial effect is shown by reference to
the ASEK curve. At first the higher demand pulls up the actual price
level to P1; workers suffer complete money illusion; and as the real
wage falls there is a significant increase in output up to Y1 - point B.
In the medium term, however, workers begin to adjust to the new
circumstances and start to partially anticipate a higher future price
level. The economy moves onto curve ASGK. The workforce push for
higher money wages which firms accommodate because the
conditions of aggregate demand allow prices to rise even higher (i.e.
to P2). Output falls back a little to Y2 - point C, but it is still higher
than Y0.
In the long run the workforce have fully adjusted their price
expectations, and push for increases in wages which firms grant as
they move prices up to a level consistent with P 3. The real wage rate
returns to the level before the increase in aggregate demand, and
output returns to Y0 - point D. The long run effect of an expansion of
aggregate demand is to increase the price level with no impact on the
real level of output and employment.

Activity 4
Using an appropriate diagram, carefully explain the impact in the
short, medium and long term of a contractionary fiscal and
monetary policy. Be sure to make clear what is happening to the
actual and expected real wage rate in each time period.

Aggregate Demand & Supply II 128


Importance of Price Expectations
Two points are worth making from the preceding analysis. First, the
position of an aggregate supply curve depends on the price
expectations of the workforce. In turn the actual price level is
determined by the intersection of the aggregate demand and
aggregate supply curves. Therefore the workforce's expected price
PE
level in the next time period ( t  1 ) helps to determine the actual
price level in the next time period (Pt+1). In equational terms this can
be expressed as:


Pt  1  f Pt E 1 
PE
Yet, as noted, earlier the value of t  1 is itself a function of the
actual price level in the present time period (Pt). It follows that there
is an inter-relationship between the actual and expected price levels
which is illustrated below.

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Pt Pt  1 Pt  2

Pt E 1 Pt E 2 Pt E 3

The causal relationship between the expected and actual price levels
is a subject taken up by the Rational Expectations School.
Second, the preceding analysis allows a more precise definition of a
full employment equilibrium to be described. Essentially it has a
twofold character. Namely:
1. a position where in the labour market the demand for labour
equals the ‘real world’ supply of labour
2. for every economic agent (especially those in the workforce) the
actual and expected price levels are equal; i.e. price expectations
are correct and there is no money illusion.
The above is a more accurate definition of full employment than that
contained in Economic Principles notes on the ‘Natural Rate of
Unemployment’ because it explicitly deals with price expectations.
In terms of Figure 10-7 this means that only points A and D meet the
criterion of a full employment equilibrium. Points B and C are
actually positions where the economy is operating at an above full
employment level.

Activity 5
Why is the economy not in a stationary equilibrium when the
expected and actual price levels differ?

Aggregate Demand & Supply II 130


Summary
r The Extreme Keynesian AS curve is derived under the assumption of complete
money illusion. It is relatively flat (elastic) as a rise in the price level
leads to a relatively large fall in the real wage rate (as money wages do
not rise). Hence there is a relatively large rise in employment and output
r When aggregate demand changes in the extreme Keynesian case, most of the
impact is on output (and employment) rather than the general price
level.
r The General Keynesian AS curve is derived under the assumption of imperfect
foresight. It is not as elastic as the extreme Keynesian curve because a
rise in the price level does lead to some rise in the money wage rate.
However, real wages still fall and employment and out put still rise.
r When aggregate demand changes in the general Keynesian case, both the level
of output and the price level are effected. Compared to the extreme
Keynesian case, more of the impact is on the price level.
r The Classical AS curve is derived under the assumption of perfect foresight. It
is perfectly inelastic at the full employment level of output because any
rise in the price level generates an equal percentage rise in money wages
- hence the real wage rate remains constant and thus so do employment
and output.
r When aggregate demand changes in the Classical case, all of the impact is on
the general price level.
r A synthesis of the three cases is possible where the extreme Keynesian AS
curve applies in the short-run, the general Keynesian in the medium
term, and the classical in the long-run. Long-run full employment
equilibrium only occurs when the expected and actual price levels are
equal.

Further Reading
Dornbusch & Fischer: Chapter 7
Branson: Chapter 8

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