Question

Use an AD-AS graph to demonstrate and explain the pricelevel and real-output outcome of an anticipated decline in aggregate demand, as viewed by RET economists. (Assume that the economy initially is operating at its full- employment level of output.) Then demonstrate and explain on the same graph the outcome as viewed by mainstream economists.

Short answer

RET economists see instant price adjustments, keeping output steady; mainstream predict temporary lower output.

Step-by-step solution

Understand the Initial Condition

The economy starts at full employment, which means the Aggregate Demand (AD) curve intersects the Aggregate Supply (AS) curve at the natural rate of output, denoted as Y*. The price level is at P*.

Analyze the AD Decline - RET Economists View

Rational Expectations Theory (RET) economists believe that people expect changes and thus adjust quickly. When AD declines, RET economists argue that wages and prices adjust instantly. As a result, the AS curve shifts to the right to AS' almost immediately, keeping output at Y* but lowering the price level to P'.

Analyze the AD Decline - Mainstream Economists View

Mainstream economists believe that prices are sticky in the short run. When AD decreases, the economy moves down the original AS curve, causing both the price level and output to fall; output drops to Y1 and the price level to P1. Over time, adjustments may bring the economy back to full employment.

Graphical Representation

Draw a graph with the vertical axis representing the price level and the horizontal axis the real GDP. Plot the initial AD, AS, and LRAS (Long Run Aggregate Supply) curves intersecting at (Y*, P*). For RET, show AS shifting right; for mainstream, show movement along AS.

Key concepts

Rational Expectations Theory

Rational Expectations Theory (RET) is an influential economic idea that suggests people, firms, and institutions can accurately predict future economic conditions. They use all available information efficiently and quickly, adjusting their expectations accordingly. This means that if individuals expect a change in economic policy or conditions, they will adjust their behavior to lessen the impact of such changes.

In the context of aggregate demand and supply, RET economists argue that when there is an anticipated decline in aggregate demand, individuals and businesses will swiftly adjust wages and prices. This adjustment happens so quickly that the economy remains at full employment, with only the price level being affected.

Key aspects of RET include:

• Instantaneous adjustment to economic changes.
• Minimal impact on employment levels as expectations mitigate economic shocks.
• Emphasis on the power of foresight and adaptation.

As a result, according to RET, the aggregate supply curve shifts right instantly, maintaining full output levels while only the price level changes.

Full Employment

Full employment is a critical concept in economics, referring to a situation where all available labor resources are being used in the most economically efficient way. It is important to note that full employment does not mean zero unemployment. Instead, it means that the only unemployment present is frictional or structural, not cyclical or due to a lack of demand.

Economically, full employment is represented where the aggregate demand and aggregate supply curves intersect at the natural rate of output, labeled as Y*. At this point, the amount of real GDP produced aligns with the economy's capacity, without causing inflation.

Key factors defining full employment are:

• All workers seeking jobs can find one at prevailing wage rates.
• Employment levels match natural qualifications and skills of the workforce.
• Cyclical unemployment is absent, although some unemployment due to job transitions remains.

This concept is crucial as it establishes a benchmark, helping policymakers decide how to stimulate the economy.

Price Level

Price level is a measurement of the average change in prices over time in a particular market basket of goods and services. It is a critical tool as it indicates the cost of living and purchasing power of consumers. In the context of aggregate demand and supply, the price level gives insights into inflationary or deflationary trends and helps economists understand economic conditions.

In an AD-AS model, the price level is plotted on the vertical axis and real GDP on the horizontal axis. A shift in aggregate demand or supply can affect the price level significantly.

Key points about price levels include:

• They help assess inflationary pressures in an economy.
• A falling price level during a demand decline might trigger deflation.
• Price levels affect consumer confidence and purchasing power.

Understanding the price level is essential for comprehending how different economic theories, like RET and mainstream economics, view adjustments to shifts in aggregate demand.

Mainstream Economists

Mainstream economists believe that economic systems do not adjust instantaneously to changes in aggregate demand. They argue that prices and wages are sticky in the short term, meaning that they do not adjust immediately. This stickiness can lead to temporary disequilibria in the economy, causing fluctuations in output and employment.

During an anticipated decline in aggregate demand, mainstream economists suggest that rather than shifting the aggregate supply, the economy moves down along the supply curve. This leads to a decrease in both the price level and real GDP in the short run, moving the economy below full employment levels.

Essential considerations for mainstream views are:

• Short-term price and wage rigidity affects economic adjustments.
• There is a slower response to policy changes compared to RET.
• Temporary cycles of decreased output and increased unemployment might occur.

The mainstream perspective enriches economic analysis by acknowledging the potential delays in returning to full employment due to market frictions.