Chapter 6: Aggregate Supply and Aggregate Demand Keynes’s Challenge John Maynard Keynes created the logic of the AS/AD framework in his 1936 book. Say’s Law- everything that is produced will be bought up as a market moves toward equilibrium. Karl Marx predicted that capitalism would fail under the weight of growing unemployment. Keynes’s Aggregate Demand Argued that to understand macro economy one needed to use aggregate (total) supply and aggregate (total) demand. Interaction between AS and AD determines the actual level of real output, or real gross domestic product (GDP), and the actual price level. AD curve has a downward slope for three main reasons: 1. Pigou’s wealth or the effect of real balance. 2. Keynes’s interest rate effect. 3. The foreign trade effect. Pigou Effect Pigou Effect- argued that lower prices would increase the purchasing power of the public’s savings and will result in higher levels of spending. Pigou’s Argument- If the price level falls, the purchasing power of people’s savings increases-they can buy more stuff-and then the total level of spending increases. The real value, or purchasing power, of assets with fixed nominal values, such as bank savings accounts or bonds, decreases as prices increase. The Pigou effect is also referred to as the real balance effect, because the real or inflation-adjusted, value of assets decreases as the price level increases. The price level increases, the real balance of savings decreases, along with total kevel of spending. Keynes’s Interest Rate Effect Keynes’s argued that with constant money supply, a higher price level results in an increase in demand for money because more money is needed to purchase the same amount of goods and services. (Increases in demand for money while supple of money remain the same means that the price money will increase).
As the price level increases, interest rate increases. As interest rate increases, the level of business spending decreases because as interest rates increase the cost of capital for firms increases. As the cost of capital increases, the overall level of business investment spending decreases. Higher interest rates also lead to a decrease in consumption spending. HIGHER PRICE LEVELS BRING ON HIGHER INTEREST RATES AND THEN A LOWER LEVEL OF TOTAL SPENDING. Foreign Trade Effect As US prices increase, the amount of Americans import increases. As the US price level increases, US exports decrease. Total output includes net exports, or exports minus imports, total output decreases as the price level in an economy increases. AS THE PRICE LEVEL INCREASES, THE LEVEL OF REAL OUTPUT DECREASES. Interest Rates Capital Budgeting- The process by which a firm determines whether to pursue a project. Projects include research and development of new products, continued production of an existing product, construction of a new facility, and continued operation of an existing facility, among others High interest rates would likely kill the project, thus reducing the overall level of investment spending, and instead buy a bond.
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