Keynes’ Law and Say’s Law in the AD/AS model |...

Keynes’ Law and Say’s Law in the AD/AS model

Posted 2023-06-16 20:28:05

Key points

The short-run aggregate supply, or SRAS, curve can be divided into three zones—the horizontal Keynesian zone, the vertical neoclassical zone, and the upward sloping intermediate zone in between the Keynesian and neoclassical zones.
Keynes’ Law states that demand creates its own supply; changes in aggregate demand cause changes in real GDP and employment.
The Keynesian zone occurs at low levels of output on the SRAS curve where it is fairly flat, so movements in aggregate demand will affect output but have little effect on the price level.
Say’s Law states that supply creates its own demand; changes in aggregate demand have no effect on real gross domestic product or employment, only on the price level.
Say’s Law can be shown on the vertical neoclassical zone of the aggregate supply curve. The neoclassical zone occurs at the right of the SRAS curve where it is fairly vertical, so movements in aggregate demand will affect the price level but have little impact on output.
The intermediate zone in the middle of the SRAS curve is upward-sloping, so a rise in aggregate demand will cause higher output and price level, while a fall in aggregate demand will lead to a lower output and price level.

Keynes’ Law and Say’s Law in the AD/AS model

The aggregate demand/aggregate supply, or AD/AS, model can be used to illustrate both Say’s Law and Keynes’ Law. Say's Law states that supply creates its own demand; Keynes’ Law states that demand creates its own supply.

Take a look at the AD/AS diagram below. Notice that the short-run aggregate supply, or SRAS, curve is divided into three zones: the Keynesian zone, the neoclassical zone, and the intermediate zone.

Let's focus first on the Keynesian zone, the portion of the SRAS curve on the far left which is relatively flat. If the aggregate demand, or AD, curve crosses this portion of the SRAS curve—as it does at equilibrium point start text, E, k, end text—we can make certain assumptions about the economic situation. In the Keynesian zone, the equilibrium level of real gross domestic product, GDP, is far below potential GDP. The economy is in recession, and cyclical unemployment is high. If aggregate demand shifts to the right or left in the Keynesian zone, it will determine the resulting level of output, and thus unemployment. However, inflationary price pressure is not much of a worry in the Keynesian zone since the price level does not vary much in this zone.

Next, we'll examine the neoclassical zone of the SRAS curve, which is the near-vertical portion on the right-hand side. If the AD curve crosses this portion of the SRAS curve where output is at or near potential GDP—as it does at equilibrium point start text, E, n, end text—then the size of potential GDP pretty much determines the level of output in the economy. Since the equilibrium is near potential GDP, cyclical unemployment is low in this economy, although structural unemployment may remain an issue. In the neoclassical zone, shifts of aggregate demand to the right or left have little effect on the level of output or employment. The only way to increase the size of the real GDP in the neoclassical zone is for aggregate supply to shift to the right. Shifts in aggregate demand in the neoclassical zone will, however, create pressures to change the price level.

Finally, let's look at the intermediate zone of the SRAS curve. If the AD curve crosses this portion of the SRAS curve—as it does at equilibrium point like start text, E, i, end text—then we might expect unemployment and inflation to move in opposing directions. For instance, a shift of AD to the right will move output closer to potential GDP and thus reduce unemployment, but this shift will also lead to a higher price level and upward pressure on inflation. On the other hand, a shift of AD to the left will move output further from potential GDP and raise unemployment, but the shift will also lead to a lower price level and downward pressure on inflation.

Dividing the SRAS curve into different zones, as we did above, works as a diagnostic test that can be applied to an economy—similar to a doctor checking a patient for symptoms. First, figure out which zone the economy is in and then use that information to understand economic issues, tradeoffs, and policy choices.

Some economists believe that the economy is strongly predisposed to be in one zone or another. Hard-line Keynesian economists believe that economies are in the Keynesian zone most of the time; they view the neoclassical zone as a theoretical abstraction. On the other hand, hard-line neoclassical economists argue that economies are in the neoclassical zone most of the time and that the Keynesian zone is a distraction.

Case study: the US housing bubble

Now that you have a general idea of how an AD/AS diagram can be used as a diagnostic tool, let's take a look at a real-world example.

Economic fluctuations, whether those experienced during the Great Depression of the 1930s, the stagflation of the 1970s, or the Great Recession of 2008 to 2009, can be explained using the AD/AS diagram.

Short-run fluctuations in output occur due to shifts of the SRAS curve, the AD curve, or both. In the case of the US housing bubble, the AD curve shifted to the right as more people felt that rising home values increased their overall wealth. Many homeowners took on mortgages that exceeded their ability to pay because they thought as home values continued to go up, the increased value would pay off any outstanding debt. Increased wealth due to rising home values lead to increased home equity loans and increased spending. The shifting of the AD curve to the right also contributed to low unemployment rates and economic growth in the United States.

When the housing bubble burst, however, overall wealth dropped dramatically, wiping out the recent gains. This drop in the value of homes was a demand shock to the US economy because of its impact directly on the wealth of the household sector and its affect on the financial sector that essentially locked up new credit. The AD curve shifted to the left, as evidenced by the rising unemployment of the Great Recession.

Understanding the source of these macroeconomic fluctuations provided monetary and fiscal policy makers with insight about what policy actions to take to mitigate the impact of the housing crisis.

From a monetary policy perspective, the Federal Reserve lowered short-term interest rates to between 0% and 0.25% to loosen up credit throughout the financial system. Discretionary fiscal policy measures included the passage of the Emergency Economic Stabilization Act of 2008 that allowed for the purchase of troubled assets, such as mortgages, from financial institutions and the American Recovery and Reinvestment Act of 2009 that increased government spending on infrastructure, provided for tax cuts, and increased transfer payments. In combination, both monetary and fiscal policy measures were designed to help stimulate aggregate demand in the US economy, pushing the AD curve to the right.

While most economists agree on the usefulness of the AD/AS diagram in analyzing the sources of economic fluctuations, there is still some disagreement about the effectiveness of policy decisions meant to stabilize these fluctuations.

Summary

The short-run aggregate supply, or SRAS, curve can be divided into three zones—the Keynesian zone, the neoclassical zone, and the intermediate zone.
Keynes’ Law states that demand creates its own supply; changes in aggregate demand cause changes in real GDP and employment.
The Keynesian zone occurs at the left of the SRAS curve where it is fairly flat, so movements in aggregate demand will affect output but have little effect on the price level.
Say’s Law states that supply creates its own demand; changes in aggregate demand have no effect on real gross domestic product or employment, only on the price level.
Say’s Law can be shown on the vertical neoclassical zone of the aggregate supply curve. The neoclassical zone occurs at the right of the SRAS curve where it is fairly vertical, so movements in aggregate demand will affect the price level but have little impact on output.
The intermediate zone in the middle of the SRAS curve is upward-sloping, so a rise in aggregate demand will cause higher output and price level, while a fall in aggregate demand will lead to a lower output and price level.

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