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Ch.10 Commentary

Ch.10 Commentary - 1 INSTRUCTOR COMMENTARY Textbook...

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INSTRUCTOR COMMENTARY Textbook Reference: Chapter 10 (Please Note: The Appendix to Chapter 10 will be covered In conjunction with Chapter 17 and will not be covered at this time) Survey of Macroeconomic Theory Since 1975 1. Chapter 10 focuses on the following important concepts: A. The fundamental weakness of the Keynesian model. The Keynesian model was unable to account for the simultaneous existence of both unemployment and inflation. The existence of both problems (at the same time) characterized the decade of the 1970s in the U.S. economy. In a recessionary gap situation (text, p. 214), the unemployment rate was higher than that consistent with “full” employment but there was no inflation. In an inflationary gap situation (text, p. 216), demand-pull inflation was occurring but the economy’s unemployment rate was consistent with “full” employment. Hence, in the Keynesian model, the economy could experience unemployment (without inflation), or inflation (without cyclical unemployment). Essentially, the Keynesian model allowed only demand-pull inflation (the type that occurs at full employment GDP), but not cost-push inflation. (text, Chapter 7, p. 184) B. Determinants of the aggregate demand (AD) schedule. The aggregate demand (AD) schedule demonstrates how aggregate expenditures (C + I + G + X – M) change as the overall price level changes, all other things equal. A rise in the price level is expected to reduce consumption expenditures (wealth effect, also called the “real balances” effect), reduce investment expenditures (interest rate effect) and reduce net exports (net exports effect). As a result, the total of aggregate expenditures is predicted to be inversely related to the domestic price level, all other things equal. It is important for you to distinguish between two terms that sound similar but have very different meanings. The term “aggregate expenditures” refers to the level of total expenditures on GDP by households, business, government and the rest of the world (C + I + G + X – M) at each level of GDP. It was the total of aggregate expenditures that determined the 1
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equilibrium level of GDP in the Keynesian model. The term “aggregate demand” refers to the total of aggregate expenditures on real GDP at each possible domestic price level. In this sense, aggregate demand is a “schedule” that shows the total of C + I + G + X – M at different possible domestic price levels. The concept of “aggregate demand” for goods and services has replaced the Keynesian concept of “aggregate expenditures” as a fundamental determinant of the equilibrium level of production in the economy. (text, pp. 243-247) C. Determinants of the aggregate supply (AS) schedule. The aggregate supply (AS) schedule measures the amount of real GDP supplied by profit-maximizing firms at different possible price levels, all other things equal. The Keynesian AS schedule was horizontal up to the point of full employment. The Classical AS schedule was vertical at the point of full employment. The intermediate range of the AS schedule depicts AS rising as the price level rises.
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