Apr 08 2011

The battle of ideas: Hayek versus Keynes on Aggregate Supply

Introduction: The two models below represent two very different views of a nation’s aggregate supply curve. The theories behind the two models represent the ideas about the macroeconomy of two economists, John Maynard Keynes and Friedrich von Hayek.
 

Instructions: The videos introducing Keynes’ and Hayek’s theories can be found here: “Commanding Heights: the Battle for Ideas”. We will watch them in class, but if you need to review them you may watch them again from home. Once you’ve watched the videos and read chapter 17 from your Course Companion, answer the questions that follow each of the two models below.
Figure 1: the Classical AD/AS model

  1. Why does Hayek’s “classical” aggregate supply curve always lead to an equilibrium level of national output equal to the full-employment level of

    real GDP?

  2. The vertical AS curve above is sometimes referred to as the “flexible-wage and flexible-price” model of the macroeconomy. Why must wages and prices be perfectly flexible for this model to be an accurate representation of a nation’s economy.
  3. Hayek was an advocate for free markets, he felt that government intervention in a nation’s economy would only interfere and disrupt the efficient allocation of resources. How does the model above reflect his belief that governments cannot improve a nation’s level of output beyond what the free market is able to achieve?
  4. Do you believe that the classical model of aggregate supply is representative of the real world? Why or why not? What evidence is there from recent history that the model is or is not accurate?

Figure 2: The Keynesian AD/AS model

  1. Based on the model above, which level of aggregate demand corresponds with the macroeconomic goals of “full-employment and stable

    prices”?

  2. Changes in which factors could cause aggregate demand to shift from AD2 to AD3? If AD falls to AD3, what happens to the price level in the economy? What happens to the level of output of goods and services? What happens to employment and unemployment?
  3. Sometimes the Keynesian AS model is known as the “sticky-wage and sticky-price model”. How does the model reflect the idea that wages are downwardly inflexible, in other words, will not fall even if demand for goods and services fall? For what reasons might wages in an economy be downwardly inflexible (in other words, not fall even as total demand in the economy falls)?
  4. How realistic is the Keynsian model of aggregate supply in the real world?
    1. Can you point to any evidence from the last few years that it might be correct (in other words, that a fall in AD will lead to decrease in national output?) Find data on the GDP’s of two Western European countries from 2008 and 2009 to support your findings.
    2. Can you point to any evidence from the last few years that the model might be flawed (in other words, that a fall in AD actually does lead to a fall in the price level)? Find data on inflation in the same two Western European countries to examine whether or not wages and prices are completely inflexible downwards as the model suggests.

 

Figure 3: Our IB Economics AD/AS model

The diagram above represents a compromise between the classical AD/AS model and the Keynesian AD/AS model. This graph is the one we will use throughout the IB and AP Economics course when illustrating a nation’s macroeconomy. Answer the questions that follow about the diagram.
  1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
  2. Why are there two aggregate supply curves? What is the difference between the two?
  3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
  4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
  5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

260 responses so far

260 Responses to “The battle of ideas: Hayek versus Keynes on Aggregate Supply”

  1. hkimon 02 Apr 2013 at 11:11 pm

    #akim

    Good usage of terminology there! Especially in Question 3 where you mentioned “fixed-wage period” and “flexible-wage period” would be great examples of how to use them tests or IAs! 🙂 Good job!

  2. rkangon 03 Apr 2013 at 1:14 am

    1.How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
    – The two graphs of LRAS and SRAS are different models of two different economists. Keynes developed the short run aggregate supply curve while Hayek developed the long run aggregate supply curve. Hayek’s LRAS model also known as the neo classical model, represents the potential output that could be produced if the economy were operating at full capacity. Keynes’s SRAS model represents three different stages of the LRAS curve. They have conflicting representations of the LRAS curve.

    2.Why are there two aggregate supply curves? What is the difference between the two?
    – There are two different curve because each of the curves represent the different theories of LRAS. The difference is that Keyne’s curve is of the short run while Hayek’s curve is of the long run.

    3.What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
    – In the SRAS curve, when the aggregate demand falls from AD2 to AD3 there will be a decrease in price and output. This is because of the fixed wages during the short run. So when the aggregate demand falls, firms are looking to not lose their output by not lowering wages too much.

    4.What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
    – In the short run when aggregate deamnd increases from AD2 to AD1, the output and the price level will increase. In the long run, because it is assumed be perfectly inelastic, there will be a constant level of output.

    5.What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?
    – Minimum wages is a way the government protects workers from receiving very low wages. The government does a good job of making sure workers get enough money to support themselves and their family.

  3. rkangon 03 Apr 2013 at 1:19 am

    #hkim
    The government established a minimum wage to make sure workers get a fair amount of pay for their labour. But as of now, I think that the unemployment rate is so high that firms are looking for ways to get rid of their workers because the economy is doing so poorly. I think the minimum wage promotes bosses to fire their workers because they cannot afford to may them their certain paycheck. It definately cuts into their output levels but if the firm wants to maintain profits, they must fire their workers. I think this is why the unemployment rate is so high.

  4. rparsonon 03 Apr 2013 at 1:25 am

    1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?

    This model represents a compromise between the two views by using a hybrid of the two theories, with an elbow shaped SRAS curve derived from Keynes’ theories and a vertical LRAS line derived from Hayek’s to the left. This takes into account both views of aggregate supply.

    2. Why are there two aggregate supply curves? What is the difference between the two?

    There are two AS curves because one shows the AS in the short term and the other in the long term, when the market reaches long term equilibrium.

    3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?

    In the short run, price falls slightly and real GDP by a large amount, while in the long term the real GDP will return to normal, but with a greater fall in price. In the long run spare capacity will be used up and factors of production fully employed.

    4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?

    In the short run, both price and real GDP will increase, but in the long term only price will remain higher. Output returns to its full employment because factors of production become fully employed with wages being changed to fit the new equilibrium.

    5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?

    This model suggests that government intervention can be used to stimulate an economy in the short run, growing it and increasing employment, though this will not work in the long run.

  5. rparsonon 03 Apr 2013 at 1:32 am

    # m2keo,
    I quite liked your answer to the first question, it is clear and well laid out.

  6. ykim3on 03 Apr 2013 at 1:39 am

    1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
    – The model compromises by including both curves.
    2. Why are there two aggregate supply curves? What is the difference between the two?
    – They have different theories and one can change the wage by short-run and other one cannot do so because it is a long-run
    3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
    – If AD falls from 2 to 3, the price will also decrease as much as it drops. According to this, the output will also decrease. On the other hand, in the long run, people can recover so it will return to the full employments.
    4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
    – When AD increases from AD1 to AD2, the output will also increase and the average price level increases as well. In the long run, the output would not change that much.
    5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?
    – The government must have a right to interfere the economy when its help is needed.

  7. ykim3on 03 Apr 2013 at 1:41 am

    # rparson
    I like your comments that the government can intervene the economy.

  8. xhuanfon 03 Apr 2013 at 7:03 am

    1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
    In Hayek’s model the AS curve is a vertical straight line, completely inelastic. In Keynes’s model, although the first two ranges of the curve are quite elastic, the third range of the curve is exactly the same as Hayek’s model, the output is perfectly inelastic. This represents a compromise because this showed that when the economy reach full employment level, Keynes’s theory agrees with Hayek’s theory that the LRAS will be independent from price level.
    2. Why are there two aggregate supply curves? What is the difference between the two?
    Because they are models of two contradicting theories. Hayek’s theory believes that in the long run the aggregate supply will always be the full employment level, independent from AD and price level. Keynes’s theory believes that the LRAS might not be at full employment level, and when it isn’t, the LRAS curve might be very elastic. Hayek’s curve will always be inelastic; Keynes’s curve is divided into 3 ranges, gradually becomes inelastic.
    3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
    In the short run, in both models, the price level and output will fall. In the long run in Hayek’s model, the output will not be changed but the price level goes down, known as deflation. In Keynes’s model, the price level and output will both decrease.
    This helps explain why in Hayek’s model the economy will move toward its long run equilibrium at the full employment model. When in short run output decrease, the price level also decrease which means the average cost also decrease as firms don’t need to pay as much wages. Since the cost of production decrease, the SRAS will shift rightward and the output level goes back to full employment level, with only price level decreasing.

    4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
    In the short run both price level and output will increase. In the long run the price level goes up, and output just increase a little, if any.
    In order to increase output and meet the demand, in the long run the firms need to increase the wage rate instead of simply paying overtime wages. The cost of production will go up as result, and shift the SRAS curve to the left. Therefore the output goes back to full employment level again with price going up.
    5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?
    The Keynes’ model suggest that a country might not be producing at full employment level of output, which is not good. So government might use expansionary policies to increase aggregate demand to increase aggregate supply. For example, decrease interest rate or income tax. Government might also need to decrease aggregate demand to avoid inflation. In that case, government might increase the income tax.

  9. xhuanfon 03 Apr 2013 at 7:11 am

    to # Francisco_Jose_Caril:
    I really like your answer for first two questions. But for question 4, you answered:
    It helps explain it because it because if the wages are really high it means that maybe the total profits for the organization are also really high. When the wages fall, AD also falls because people now have less money to buy, which means a fall in something will make other things fall, which balances things out.
    What you are saying is true, but that’s not the point of the question. The key point is that when short run output increase, the average cost of production increase, and as the consequence the SRAS curve will be shifted leftward, bringing output back to full employment level.

  10. amcpikeon 04 Apr 2013 at 7:29 am

    How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?

    The model is a compromise as it is immediately apparent that the Neo-Classical or Hayek’s model is being used for LRAS and Keynes model for SRAS allowing both concepts to exist on the same graph. If we observe Hayek’s graph —which is also a Neo-Classical view— which is being used to represent long run aggregate supply we can see that it is illustrating the maximum employment level of output and resource use. A point where he believed the economy would stay at all points. This was challenged by the Keynes model
    —SRAS— because it also takes into account the governments ability to influence short run production levels, and employment levels through changes in fiscal policy.

    Why are there two aggregate supply curves? What is the difference between the two?

    We have two aggregate supply curves because we are studying two different theories. One from John Maynard Keynes an American economist, and another from the Austrian economist Friedrich Hayek. Keynes believed that supply and therefore employment levels and the overall economy could and should be influenced by government spending. Hayek on the other hand believed that in a free market prices will always shift to ensure the economy is operating at full capacity —hence the inelastic rGDP—. This can be seen on a graph as any change in aggregate demand leading to a change in price level but not the rGDP. However we also have to consider that rGDP is adjusted for inflation and therefore is based on production, the price for each good is inconsequential.

    What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?

    The effect of the drop will depend entirely on whether we focus on the short run or “fixed wage period” or the long run or “flexible wage period”. In the short run a drop from AD2 to AD3 will signify both a drop in rGDP and Price Levels from Y1 to Y3 and from P2 to P3 respectively. In the long run however we would see a drop in price level from P2 to P3lr however as the rGDP curve Yfe is inelastic the drop in price level would not be terribly important.

    What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?

    In the short run or “fixed wage period” and increase in AD from AD2 to AD1 would result in an increase in both rGDP and Price level. However as we are nearing the bend in the curve the more drastic change would be in Price level. Flexibility of wages is a major contributor to the long run full employment levels as it allows for the flexibility needed to withstand economy pitfalls such as recessions where wages would need to drop to ensure everyone has a job and the economy is operating at full capacity.

    What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?

    Any Keynesian economist would likely tell you that government intervention in the economy is a necessity. In the sense that it would take an active role in ensuring that the economy was always operating at full capacity, especially during periods where this is made difficult by political or social changes, etc. The model in question indicates that in the short run the rGDP of the country and its employment levels are in fact malleable, and therefore need to be shaped by the government who would presumably have the economies best interests at heart. During times of economic success the government would likely spend little, and during times of economic hardship the government would be able to spend more developing public goods and therefore jobs to support the economy.

    #dtumanavarro

    Hey David,

    I thoroughly enjoyed your responses, however I have one small question about part of your answer to question two; “Keynes’ theory states that in an economy with low levels of output or employment there is little to no capacity for a firm to increase their output without raising their costs of production per unit. This leads to a horizontal LRAS curve.” I was wondering whether you would mind quickly explaining why that would lead to a horizontal LRAS curve.

  11. msurninon 04 Apr 2013 at 12:02 pm

    1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
    This model could be considered “middle ground” between Keynes’ and Hayek’s views of aggregate supply, as it takes into account both of them and represent both of them to some extent on the diagram.

    2. Why are there two aggregate supply curves? What is the difference between the two?
    Keynes believed that government intervention is beneficial to a country’s economy, and therefore his model is in the form of a hyperbole (half of a hyperbole). On the other hand, Hayek’s view was that government interference is detrimental to a country’s economy, and this is why his model is a vertical line at full employment. At any price level real GDP will stay the same, unless the quantity or quality of resources changes.

    3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
    In the short run the aggregate demand (AD) falls, followed by the output and the price level that also decrease, because the wages are fixed (short-run!). In the long run, wages are a variable factor, and therefore, can be changed. The price level will be decreased, while the output will stay the same.

    4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
    When AD increases in the short run, both the output and the price level also increase. In the long run, the graph is basically a vertical line, which means that the employment is already at its full capacity and therefore output cannot be changed.

    5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?
    Government intervention is absolutely necessary to some extent – for example, they should control the minimum wage rate, which will have a great effect on the whole economy.

  12. msurninon 04 Apr 2013 at 12:08 pm

    #ykim3

    What do you mean by your answer to question #2? The difference is not only in the ability of changing the wage rate or not, it is also about the effectiveness of government intervention in an economy and whether it would be beneficial to it or not.

    Also, regarding question #4: the output will stay the same as an economy’s employment is already in its full capacity. This is why the diagram is a vertical line.

  13. edubison 05 Apr 2013 at 2:00 pm

    1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
    Keynes’ aggregate supply model has the AS curve as a horizontal then vertical line that do not change, it is totally elastic at low levels of economic activity and inelastic, or at capacity, when vertical. Hayek viewed aggregate supply as a completely inelastic, vertical line. The model is a compromise because it is both vertical and horizontal and curves between the angle to show growth.
    2. Why are there two aggregate supply curves? What is the difference between the two?
    The two aggregate supply curves represent two different ways of thinking and looking at a nation’s economy. One of the curves, Keynes’, shows that wages won’t fall even if prices fall and goes with the thinking that full employment means stable prices. Hayek’s aggregate supply curve reflects the free-market thinking that wages and prices will change in relationship to the other and has the national output equal the national output if the nation had full employment.
    3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
    When AD falls, the price level and output both decrease, but the price decreases less. In the long-run, the price will decrease and supply will increase to reach equilibrium. When the wages become flexible, this is the adjustment between short-run and long-run equilibrium. This helps explain the curve when wages slowly increase or decrease.
    4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
    The AD will shift right so the output will increase in the short-run, but in the long-run the prices and wages will increase. The flexibility of wages is the best option for the economy and is the macroeconomic goal.
    5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?
    Government intervention is only necessary in the short-run and not the long-run.

  14. edubison 05 Apr 2013 at 2:02 pm

    #hkim
    Your answer to number five, stating that in the long-run the government may have to interfere to protect the workers makes sense and wasn’t obvious. However, in the long-run I thought the economy would work itself out where everyone is getting payed the proper amount for what they produce.

  15. ahmadson 05 Apr 2013 at 3:37 pm

    1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
    According to Keynes’s model, in all low price levels, the supply curve will be perfectly elastic and AS curve horizontal. But according to Hayek’s model, the AS curve will be inelastic and vertical. The compromise is that we can see both models on the same graph, which shows the long run AS and short AS and help us understand the both concepts better.

    2. Why are there two aggregate supply curves? What is the difference between the two?
    Because they come from different economists who held different believes in how to approach the economy models. Hayek believed that if there was no government intervention there would be full employment and that the market would balance itself out but Keynes believed that it was governments who could only control and bring a stable situation in the country’s economy not the free market.

    3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
    When AD falls, in the short-run, both price level and quantity demanded will decrease and this could be due to many factors such as a decrease in consumption or a decrease in government expenditure. In the long-run, there would be a potential but not big change in the price level.

    4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
    The price levels and the output will increase as AD increases from AD2 to AD1 in the short run. In the long run prices and wages will increase. Wage flexibility is something that has to be considered because based on different situations; the wage could drop and increase.

    5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?
    Depending on what school of thought you are following, Keynes’ or Hayek’s, you would justify the best possible answer. But since government intervention is only seen plausible with regards to Keynes’s theories, it is very important for the government to address different economical needs of the society based on different social and political situation. Especially in the short-run because if the government is not conscious about the way it spends its expenditure then it wont be able to help itself during a recession or economic downturn.

    #Edubis, Hey Ellen, I just wanted to say that you had provided some good responses to this activity and I do agree with most of your responses!

  16. jduplessison 05 Apr 2013 at 6:39 pm

    1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?
    What this compromise does is that it takes attributes from both models of aggregate supply and puts them together to form a new model.
    2. Why are there two aggregate supply curves? What is the difference between the two?
    There are two different supply curves because they are both concepts and the difference is that one deals with long run and the other with short run.
    3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?
    If the price level were to fall in the short run the output would increase however in the long run it may change because of the fact that a persons income can change. Which would leave them with less money to buy the goods.
    4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?
    The price level increase would mean a decrease in short run demand.
    5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?
    It is very important for the government to address the different needs of a society based upon the current state of the economy. The above graph suggests that the government may sometines need to help the economy to readjust to its optimal level

  17. jduplessison 05 Apr 2013 at 6:40 pm

    # ahmads
    Does demand not decrease as price increases??

  18. jduplessison 05 Apr 2013 at 6:41 pm

    # akraut
    I agree of the fact that the graphs differentiate due to the wages being constant or able to change.

  19. sminarovicon 06 Apr 2013 at 1:24 am

    1) How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?

    It uses the Keynes’ view of AS as the SRAS while Hayek’s view of AS as the LRAS.

    2) Why are there two aggregate supply curves? What is the difference between the two?

    The SRAS is aggregate supply in the short run while LRAS is the aggregate supply in the long-run. The SRAS is represented by the Keynesian model. Keynes believed that the government was a crucial part of a country’s economy while Hayek believed that it was the free market that was more important. Keynes’ model is has three sections that consist of perfectly elastic, then an increasingly more inelastic section and lastly a perfectly inelastic section. Hayek’s model (neo-classical model) was perfectly inelastic.

    3) What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?

    In the short run, the price level and output decrease while in the long run only price has decreased. In the short-run wages (and thus costs of production) are fixed and will stay the same. In the long-run however, firms will decrease their costs of production to go back to the equilibrium.

    4) What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?

    In the short run, price and output have increased while in the long-run only prices will decrease. Firms will change the wages of their employees to decrease their factors of production in the long-run and the output goes back to the full employment level of output.

    5) What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?

    The government can increase or decrease minimum wage, for example, so that the SRAS meets the respective AD curve at the full employment level of output.

    #rkang

    I agree with most of your responses however sometimes the government has to decrease minimum wage for example if the value of money becomes too strong, firms may be overpaying their workers.

  20. mchastanet2on 25 Apr 2013 at 8:35 am

    How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?

    Because Keynes model is used in the short run but the neoclassical model is used for the long run. This shows that both theories are applicable to the model. They both represents the two models view.

    Why are there two aggregate supply curves? What is the difference between the two?

    There are two different curves to show the different reactions of the two theories due to the change of AD. One curve shows the short run and the other one the long run. Thus we need the two graphs to represent the changes with time. The classical model the price level will change but output will remain the same. Instead in the Keynesian model the price is and output both increase.

    What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run?
    How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?

    In the short run when AD falls due maybe to a decrease in income, output and price level will also fall. In the long run you could change the price of wages in order to decrease price level while the output will stay the same.

    What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?

    It means that price level will increase from P2 to P1 and real output will increase from Y to Y1.
    In the long run price level will increase because wages can be changed but the output will remain the same because factors of production are fully employed so cant produce more output.

    What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?

    It shows that government intervention can be helpful sometimes to reach their macroeconomics goals. They can raise or lower the minimum wage. They can also subsidize some factor of production to increase supply and output. They can also increase government spending to make more employment.

  21. mchastanet2on 25 Apr 2013 at 8:42 am

    Hey # ahmads

    I agree with your answers. You showed that you understood well the article.

    I liked your last answer. You gave both a way on how the governement could help acheive macroeconoics goals by (reducing/increasing minimum wage). But you also gave problems that the governement could encounter if they didn’t moderate their spending ( they wouldn’t be able to help themselves in case of a recession).

    Max Chastanet

  22. jaimejaime8on 30 Apr 2013 at 11:44 am

    1. How does the above model represent a compromise between Keynes’ and Hayek’s view of aggregate supply?

    In this particular case Keynes model is used for the short run while Hayek’s model is used for the long run, making both theories adapt to represent the model.

    2. Why are there two aggregate supply curves? What is the difference between the two?

    The two curves make it possible to easily compare the two theories’ reactions (in long and short run) when AD changes. We can see how both price and output change in Keynes model while, in the other hand, only price changes in Hayek’s model, leaving output unvaried.

    3. What happens in the SHORT-RUN when AD falls from AD2 to AD3 to the price level and output? What will happen in the long-run? In macroeconomics, the short-run is known as the “fixed-wage period” and the long-run the “flexible-wage period”. The main factor that can shift the SRAS curve is the level of wages in the economy (in other words, a change in wages will shift the SRAS). How does this help explain the adjustment from the short-run equilibrium and the long-run equilibrium following a fall in AD?

    In the short run, once AD has fallen output and price level will fall with it. In the long run instead, there-s only a change in price level. In the other hand, costs of production are fixed in the short run and thus will not vary while in the long run these costs will purposely be decreased in order to achieve equilibrium (no change in output, decrease in price level).

    4. What happens in the SHORT-RUN when AD increases from AD2 to AD1? What will happen in the long-run? How does the long-run flexibility of wages explain why output always seems to return to its full employment level of output in the long-run?

    When AD increases from AD2 to AD1 in the short run, both price level and output will increase respectively. In the long run however, only prices will have a change. Wages will be changed by firms in the long run in order to have a change in price levels without such change affecting output.

    5. What does the model above indicate about the possible need for government intervention to help an economy achieve its macroeconomic goals of full-employment and price level stability in the short-run?

    It shows that government intervention can help the economy achieve its macroeconomic goals of full employment and price level stability in the short run by changing the minimum wage and thus make the short run AD meet the AD curve at a full employment level of output.