Part 3 Economics 102 Page 5

PART 3

The Economy in the Short Run

So I am skeptical about the argument that the subprime mortgage problem will
contaminate the whole mortgage market, that housing construction will come to a halt,
and that the economy will slip into a recession. Every step in this chain is questionable
and none has been quantified. If we have learned anything from the past 20 years it is
that there is a lot of stability built into the real economy.
Robert E. Lucas

If you want a good economic ride, you must catch the wave like a champion surfer.
But, economic waves are hard to read.

• What makes the economy ebb and flow in waves around its long-run growth
trend?
• Why do the waves sometimes rise high and then crash, and sometimes rise
and roll on a long high?

We begin part 3 by explaining a model of real GDP and the price level that
summarizes the consensus view of macroeconomists on the sources of the uneven
pace of economic growth, inflation and the business cycle. The Aggregate demand
(AD) and Aggregate Supply (AS) model provides a framework for understanding the
forces that result in fluctuations in the pace of real GDP growth, that bring inflation,
cause the business cycle, and make the economy of South Africa expand and
contract.

In the second part of part 3, we discuss the trade-off between inflation and
unemployment, a relationship called the Phillips curve. Given the scale of
unemployment it would seem fair to say, with Keynes, that unemployment constitutes
an unresolved failing of the economic society in which we live today, and is arguably
the single biggest economic problem in South Africa. Furthermore, there appears to
be no end in sight, as unemployment, both strict and broad, has continued to rise
over time. We therefore need to look very carefully at what the Keynesian model of
the economy allows us to understand about the factors determining the level of
employment, the size of GDP etc. We often want to study changes in both the
expected and actual inflation rates as well as changes in the short-run trade-off
between inflation and real economic activity (real GDP and unemployment). The
Phillips curve assists us to do this, by providing a simpler tool and clearer insights
than what the AS-AD model has provided.

In the final section of part 3 we consider the forces that determine planned
expenditures, the consumption function, the equilibrium income and the multiplier.
Keynesian economists see planned expenditures or demand, as the driving force in
the economy. According to the Keynesian model, the level of output produced (and
hence the level of employment) is determined by the level of aggregate demand. The
Keynesian model recognises that the output an economy produces need not also be
demanded, i.e. that it will not always be profitable to continue hiring labour and
producing output up until the full-employment level of output. Instead there may be an
overall lack of demand (at a price which makes it profitable to produce) for the output
which could physically be produced at full employment. In that case, only the level of
output that is demanded will be produced and unemployment will prevail. Given these
arguments, Keynesian economists say that the government needs to intervene in the
economy to ensure full employment through implementing demand management
policies.
Part 3 Economics 102 Page 5

Apart from the objectives listed in the textbook at the beginning of each of the
chapters prescribed for this part, the overall objective of Part 3 is to gain a better
understanding of the models proposed by the Keynesian economists. In turn, these
models will form the basis of the economic policy discussion in Part 4. .

Reading

The reading for this part is drawn from Chapters 23 and 24 of the text by Parkin,
Economics: Global and Southern African Perspectives (Parkin GSAP), 2010,
chapters 27,28 and 29 in the 2013 edition and chapters 28, 29 and 30 in the
2020 edition – see detailed page references below. Besides working through the
problems and exercises set out on the following pages, we also strongly urge you
to make use of the tutorials and Parkin GSAP’s end of chapter problems for
Chapters 23 and 24; 2010, chapters 27,28 and 29 in the 2013 edition and
chapters 28, 29 and 30 in the 2020 edition.

In addition to the above you are encouraged to read more widely in two main
areas. First, there are many introductory texts in the library of which Economics
by PA Samuelson and An Introduction to Positive Economics by RG Lipsey are
probably the most famous in the world. Should you not be sure whether or not the
text you have found in the library is any good, consult your lecturer. Secondly, pay
attention to the financial and business news contained in the daily newspapers and
TV programmes, as well as the weekly financial magazines. There are also a
host of internet sites devoted to South African economic issues which you may
wish to consult. A few useful sites are listed below:

• South African Reserve Bank (www.resbank.co.za)

• Financial Mail (www.fm.co.za)
• South African Financial Sector Forum (www.finforum.co.za)

Outline of Part 3

Please note that the page numbers given below refer to the Reading only for each
lecture session. To ensure you cover all the materials for the syllabus you should
make sure that you read the pages immediately surrounding these pages concerning
study plan problems and applications and, of course, attempt the Review Quiz
questions.

In addition please note that the number of sessions per session topic is meant as a
guide only: your lecturer may spend less time on some topics and more time on
others.

Session 1 AD-AS model: aggregate demand and aggregate supply

Reading Parkin 2010 GSAP pp 604-615

Parkin 2013 GSAP pp 631-639
Parkin 2020 GSAP pp 682-689
Key concepts

• Long-run aggregate supply and short-run aggregate supply

• Movements along the curves
• Changes in aggregate supply
• The aggregate demand curve
• Changes in aggregate demand
Part 3 Economics 102 Page 5

Session 2 AD-AS model: macroeconomic equilibrium

Reading Parkin 2010 GSAP pp 616-622

Parkin 2013 GSAP pp 639-645
Parkin 2020 GSAP pp 690-697
Key concepts

• Long-run and short-run macroeconomic equilibrium

• Economic growth and inflation
• The business cycle
• Fluctuations in aggregate demand and supply.

Session 3 AD-AS model: demand-pull and cost-push inflation

Reading Parkin 2010 GSAP pp 622-629

Parkin 2013 GSAP pp 653-659
Parkin 2020 GSAP pp 705-710
Key concepts

• Demand-pull and cost-push inflation

• Expected inflation.

Session 4 AD-AS model: inflation, unemployment and the Phillips curve

Reading Parkin 2010 GSAP pp 629-638

Parkin 2013 GSAP pp 660-662
Parkin 2020 GSAP pp 712-719
Key concepts

• Long-run Phillips curve

• The natural rate of unemployment
• Macroeconomic schools of thought
• Monetary policy review
• Inflation outlook.

Sessions 5 & 6 The Keynesian model: planned expenditure and the

consumption function

Reading Parkin 2010 GSAP pp 643-651

Parkin 2013 GSAP pp 600-605
Parkin 2020 GSAP pp 642-646

Key concepts

• Expenditure plans and GDP

• Consumption function
• 45-degree line
• Savings function
• Marginal propensities to consume and save
• Import function.
Part 3 Economics 102 Page 5

Session 7 The Keynesian model: determination of equilibrium income

Parkin 2010 GSAP pp 651-656; 671-672
Reading
Parkin 2013 GSAP pp 605-609; 621-622
Parkin 2020 GSAP pp 646-650; 662-665
Key concepts

• Equilibrium expenditure at a fixed price level

• Aggregate planned expenditure and real GDP
• Actual expenditure
• Planned expenditure and real GDP
• Equilibrium expenditure
• Convergence to equilibrium.
Sessions 8 & 9 The Keynesian model: the multiplier Reading

Parkin 2010 GSAP pp 656-662; 673-676

Parkin 2013 GSAP pp 609-614; 623-627

Parkin 2020 GSAP pp 650-655; 662-668

Key concepts

• The basic idea of the multiplier effect

• The multiplier effect
• Why the multiplier is greater than one
• The size of the multiplier
• The multiplier and the slope of the aggregate expenditure curve
• Imports and income taxes
• Business cycle turning points
•

Sessions 10 & 11 The multiplier and the price level

Reading
Parkin 2010 GSAP pp. 663-668
Parkin 2013 GSAP pp. 614-619
Parkin 2020 GSAP pp 655-660

Key concepts

• The aggregate demand curve

• Movements along versus shifts of the demand curve