No Such Thing as a Free Lunch: Principles of Economics (Part 138)

That's the world we live in: when it comes to economics, people have emotions; it's not like chemistry or physics.

Robert J. Shiller

Aggregate Demand, Aggregate Supply, and Inflation

(Part G)

by

Charles Lamson

Aggregate Demand, Aggregate Supply, and Monetary and Fiscal Policy

FIGURE 11

Figures 11 and 12 show that it is important to know where the economy is before a policy change is put into effect. The economy is producing on the nearly flat part of the AS curve if most firms are producing well below capacity. When this is the case, firms will respond to an increase in demand by increasing output much more than they increase prices. If the economy is producing on the steep part of the AS curve, firms are close to capacity and will respond to an increase in demand by increasing prices much more then they increase output.

To see what happens when the economy is on the steep part of the AS curve, consider the effects of an increase in G with no change in the money supply. What will happen is that when G is increased, there will be virtually no increase in Y. In other words, the expansionary fiscal policy will fail to stimulate the economy.

The first thing that happens when G increases is an unanticipated decline in the firm's inventories. Because firms are very close to capacity output when the economy is on the steep part of the AS curve, they cannot increase their output very much. The result, as Figure 12 shows, is a substantial increase in the price level. The increase in the price level increases the demand for money, which (with a fixed money supply) leads to an increase in the interest rate, decreasing planned investment. There is nearly complete crowding out (phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the demand or supply side of the market) of investment. If firms are producing at capacity, prices and interest rates will continue to rise until the increase in G is completely matched by a decrease in planned investment and there is complete crowding out.

Long-Run Aggregate Supply and Policy Effects

We have so far been considering monetary policy and fiscal policy effects in the short run. Concerning the long run, it is important to realize:

The AS curve is vertical in the long run, neither monetary policy nor fiscal policy has any effect on aggregate output in the long run.

The conclusion that policy has no effect on aggregate output in the long run is perhaps startling. Do most economists agree that the aggregate supply curve is vertical in the long run? 

Most economists agree that input prices tend to lag behind output prices in the short run, giving the AS curve some positive slope. Most also agree that the AS curve is likely to be steeper in the long run, but how long is the long run? The lower the lag time, the greater the potential impact of monetary and fiscal policy on aggregate output. If the long run is only three to six months, policy has little chance to affect output; if the long run is 3 or 4 years, policy can have significant effects. A good deal of research in macroeconomics focuses on the length of time lags between input and output prices. In a sense, the length of the long run is one of the most important open questions in macroeconomics.

The "new classical" economics assumes prices and wages are fully flexible and adjust very quickly to changing conditions. New classical economists believe, for example, that wage rate changes do not lag behind price changes. The new classical view is consistent with the existence of a vertical AS curve, even in the short run. At the other end of the spectrum is what is sometimes called the simple "Keynesian" view of aggregate supply. Those who hold this view believe there is a kink in the AS curve at capacity output.

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 546-549*

end