Economics III: Trade Balances, AD/AS, the Keynesian and Neoclassical Perspectives, International Trade, Protectionism, and the Major Theorists

This is Unit Fifteen of Social Sciences and History, part one of two: economics from the trade balance to the neoclassical return. Unit fourteen closed on fiscal policy with the anchor's doubts attributed. This part carries the argument behind those doubts, and it carries one idea: the same diagram, read by two schools. Keynes's law, demand creates its own supply, holds where the aggregate supply curve is flat, far below potential; Say's law, supply creates its own demand, holds where it is steep, at potential. Many mainstream economists, the anchor says, take Keynes for the short run and Say for the long. Learn the diagram once, and both readings come with it, and the trade balances at the start enter that diagram as one of demand's four parts. By the end you will be able to say why a deficit is a capital inflow and work the identity. To say which curve an event shifts and what happens. To place an economy in its zone. To name the Keynesian prescription for a gap. And to state the neoclassical return to potential.

Five entries on trade balances: the balance and the current account, deficits as inflows, the identity worked, whether deficits are bad, and level against balance.

The trade balance.

SSH 1401 Trade Balance and Current Account

The trade balance is the gap between a country's exports and imports, and the merchandise trade balance counts goods alone. In most high-income economies goods are under half of production and services over half. The current account balance adds to goods and services the flows of investment income and unilateral transfers, one-way payments. Financial capital finances trade and investment.

Deficits as inflows.

SSH 1402 A Deficit Is a Capital Inflow

A trade deficit means a net inflow of financial capital from abroad; a surplus a net outflow. A current account deficit makes a country a net borrower from the world; a surplus a net lender. The United States has run deficits since the early eighties, larger from the late nineties. The anchor's summary says early-eighties surpluses; that is an error, and its own text says deficits.

The identity.

SSH 1403 The Saving and Investment Identity: Working It

The exam gives a country's saving, investment, budget balance and trade balance and asks which must follow, and the anchor's identity answers: the financial capital supplied from all sources equals the financial capital demanded from all sources. With S private saving, T taxes, G government spending, M imports, X exports and I investment, for an economy with a current account deficit and a budget deficit, S plus M minus X equals I plus G minus T: private saving plus the capital inflow the trade deficit brings supplies what investment and the government's borrowing demand. Rearranged, a larger budget deficit, with saving and investment unchanged, must be matched by a larger trade deficit; a recession raises the trade balance, a boom lowers it. Saving one hundred, investment one hundred twenty, a budget deficit of thirty: the trade deficit must be fifty, since one hundred plus fifty equals one hundred twenty plus thirty. The budget moves to balance with nothing else changing: the trade deficit falls to twenty. A boom: imports rise and the trade balance falls. Ask which term is missing and solve the identity for it. The trap is reading the identity as a theory; it is an accounting truth, so it says what must balance, not what caused it. The second trap is the sign of M minus X, which is positive in a deficit.

Whether deficits are bad.

SSH 1404 Neither Good Nor Bad: What the Capital Buys

Trade surpluses guarantee no economic health and trade deficits no weakness; either can work out well or poorly depending on how the capital is invested. A borrowing country that puts the money into productivity-boosting investment can improve its long-term growth: borrow to build, then repay. A deficit spent on consumption is the poor case.

Level against balance.

SSH 1405 Level of Trade Against Balance of Trade

The level of trade is exports as a percentage of GDP; the balance of trade is the dollar difference between exports and imports. Small economies with nearby partners and a trading history have high levels of trade; large economies with few neighbors trade less. A country can be open yet balanced, or closed yet in deficit. Level depends on history, geography and size.

Eight entries on the AD/AS model: two laws, the supply curves, why demand slopes down, what shifts supply, reading an event, why it is not the micro diagram, three goals on one chart, and the zones.

The two laws.

SSH 1406 Say's Law and Keynes's Law

Say's law, the neoclassical emphasis, holds that supply creates its own demand. Keynes's law holds that demand creates its own supply. Many mainstream economists take the Keynesian view for the short run and the neoclassical view for the long run: two laws, two horizons. Aggregate demand is total spending; aggregate supply, total output firms will sell. This is the lecture's idea, stated.

The supply curves.

SSH 1407 Why SRAS Slopes Up and LRAS Stands Vertical

The short-run aggregate supply curve slopes up: higher output prices against fixed input prices invite production. It is near-horizontal on the left and near-vertical on the right. The long-run curve is vertical at potential GDP, the most the economy can produce, also called full-employment GDP. The axes are price level and real GDP.

Why demand slopes down.

SSH 1408 Three Reasons AD Slopes Down

Three reasons AD slopes down. The wealth effect: a higher price level cuts real wealth, so consumption. The interest rate effect: a higher price level raises money demand, interest rates up, investment down. The foreign price effect: a higher price level makes domestic goods dearer, so fewer exports, more imports. Three effects, and not the micro law of demand.

What shifts supply.

SSH 1409 What Shifts AS; Stagflation

Aggregate supply shifts right as productivity rises, and left as the price of key inputs rises, an oil shock the classic leftward push. A leftward AS shift brings lower output, higher unemployment and higher inflation together: stagflation, stagnation and inflation at once. A rightward shift can bring lower inflation, higher output and lower unemployment.

Reading an event.

SSH 1410 Which Curve Shifts, and What Happens

The exam describes a macroeconomic event and asks what happens to output and the price level, and the anchor's model answers in three steps. First, which curve: aggregate demand shifts when its components move, consumption, investment, government spending, exports minus imports, through confidence or policy; aggregate supply shifts when productivity changes or the price of key inputs changes. Second, which way: more spending, higher productivity or cheaper inputs shift right; less spending or costlier inputs shift left. Third, the result: AD right raises output and the price level, AD left lowers both; AS right raises output and lowers the price level, AS left lowers output and raises the price level, stagflation. How much output moves against price depends on where AD meets AS, flat or steep. Consumer confidence collapses: AD left, output down, prices down, recession. A new technology raises productivity: AS right, output up, prices down. Oil prices double: AS left, output down, prices up. Government spending rises: AD right, output up, prices up. Ask whether the event touches spending or the cost of producing. The trap is the diagram's resemblance to micro supply and demand; the axes are price level and real GDP and the reasons for the slopes differ. The second trap is the trade balance, which enters indirectly, exports and imports through AD and imported inputs through AS.

Not the micro diagram.

SSH 1411 Not the Micro Diagram

The AD/AS diagram superficially resembles the microeconomic supply and demand diagram, but its axes and its curves' reasons differ. Long-term growth appears as a gradual rightward drift of aggregate supply; a recession as an intersection substantially below potential GDP; expansion as one near potential. Unit thirteen's curves are one market; these, the economy.

Three goals on one chart.

SSH 1412 Growth, Unemployment, Inflation on One Chart

In the model cyclical unemployment is large when equilibrium sits well below potential GDP and small near it, and the natural rate is built into potential GDP. Inflation pressure appears when a move between equilibria raises the price level. Trade enters through exports in AD and imported inputs in AS. Three macro goals, one diagram, the anchor's key model.

The zones.

SSH 1413 Keynesian, Intermediate, Neoclassical: Which Zone?

The exam describes where an economy sits and asks which economist's law applies, and the anchor divides the short-run aggregate supply curve into three zones. The Keynesian zone, on the left where GDP is far below potential, is flat: movements in aggregate demand change output and employment with little effect on the price level, so Keynes's law, demand creates its own supply, holds. The neoclassical zone, on the right at or near potential, is steep to vertical: movements in aggregate demand change the price level with little effect on output, so Say's law, supply creates its own demand, holds. The intermediate zone between them slopes upward: a rise in aggregate demand raises both output and the price level, a fall lowers both. Deep recession, idle factories, a stimulus raising output without inflation: the Keynesian zone. Full employment, a stimulus raising only prices: the neoclassical zone. Recovery under way, more demand bringing some growth and some inflation: intermediate. Ask how far output is from potential, then whether the curve there is flat, sloped, or steep. The trap is treating the zones as schools; they are regions of one curve, and the anchor says mainstream economists use both laws at different horizons. The second trap is the natural rate, which sits inside potential GDP at the zone boundary. Which law applies is where the economy sits: the lecture's idea, on the curve.

Six entries on the Keynesian perspective: demand's four components, sticky prices, menu costs and coordination, the multiplier, the Phillips curve, and the two gaps with their fiscal answer.

The four components.

SSH 1414 The Four Components and Their Movers

Aggregate demand sums consumption, investment, government spending and net exports. Consumption moves with income, disposable income being income after taxes, taxes, expectations and wealth. Investment moves with expected profitability: expected growth, technology, input prices, tax incentives and interest rates. Politics sets G; net exports follow relative growth and prices. This chapter's glossary defines real GDP as actually sold, and unit fourteen's definition governs.

Sticky prices.

SSH 1415 Sticky Prices as a Macroeconomic Externality

Keynesian economics rests on two ideas: aggregate demand usually causes short-run events like recessions, and sticky wages and prices, prices not falling when demand falls, turn a downturn into unemployment. Stickiness is a macroeconomic externality: micro surpluses lower prices; macro adjustment comes through lower quantities. The externality is the micro-macro gap.

Menu costs and coordination.

SSH 1416 Menu Costs and the Coordination Argument

Menu costs are what firms face in changing prices: relabeling, records, and telling customers. The coordination argument holds that downward wage and price flexibility would require perfect information about what lower pay others would accept, which no one has, so nobody cuts first, and firms' upward-sloping supply curves become a flat aggregate supply curve. Both explain stickiness; neither requires irrationality.

The multiplier.

SSH 1417 The Expenditure Multiplier

Keynesians hold that an expenditure multiplier exists: a change in autonomous spending causes a more than proportionate change in real GDP, since spending becomes income and is spent again. So a purchase or tax cut moves AD by more than itself, and the witness's marginal propensity to consume sets its size. The anchor states the idea, not the arithmetic.

The Phillips curve.

SSH 1418 The Phillips Curve, Short Run

A Phillips curve shows the tradeoff between unemployment and inflation. In the Keynesian view it slopes down: higher unemployment means lower inflation and lower unemployment higher inflation, lower unemployment bought with inflation for a while. But a downward-sloping Phillips curve is a short-term relationship that may shift after a few years. The word tradeoff is the exam's hook.

The gaps.

SSH 1419 Recessionary Gap, Inflationary Gap, and the Fiscal Response

The exam describes an economy's position against potential GDP and asks the Keynesian prescription, and the anchor's two gaps decide it. A recessionary gap is equilibrium at output below potential GDP: unemployment above the natural rate, idle capacity. The response is expansionary fiscal policy, tax cuts to stimulate consumption and investment or direct increases in government spending, shifting aggregate demand right. An inflationary gap is equilibrium above potential GDP: unemployment low, the price level rising. The response is contractionary fiscal policy, tax increases or spending cuts, shifting aggregate demand left. The prescription is intervention at the macro level, raising demand when private demand falls and lowering it when private demand rises; it does not mean government setting prices and quantities in individual markets. Output ten percent below potential, unemployment high: recessionary gap, expansionary policy, AD right. Output above potential, prices accelerating: inflationary gap, contractionary policy, AD left. The government fixes the price of bread: not Keynesian policy at all. Ask where equilibrium sits relative to potential, then push demand the other way. The trap is confusing fiscal with monetary: the Keynesian chapter's tools are taxes and spending; unit fourteen's monetary tools move the same curve by another route. The second trap is reading intervention as price control; the anchor separates macro stabilization from micro markets.

One entry to close: the neoclassical return, flexible prices and the vertical long-run curve, the other reading of the same diagram.

The neoclassical return.

SSH 1420 Flexible Prices Return the Economy to Potential

The neoclassical perspective holds that in the long run the economy adjusts back to potential GDP through flexible prices, so the long-run aggregate supply curve is vertical: the cycle fluctuates around full employment, and a recession is a detour, not a destination. Long-term productivity growth, not demand, determines potential GDP. Long run is the operative phrase, and the horizon is the whole dispute.

Look at what you can now do. You can say a trade deficit is a capital inflow, that the anchor's summary misstates the eighties, and you can solve the identity for a missing term. You can say which curve an event shifts by asking whether it touches spending or the cost of producing, and what happens to output and the price level. You can place an economy in its zone by how far output is from potential, and you know the zones are regions of one curve, not schools. You can name expansionary fiscal policy for a recessionary gap and contractionary for an inflationary one, and say prices are sticky because nobody cuts first. And you can state that the neoclassicals see the economy return to potential in the long run. Two readings of one diagram, sorted by horizon: that was the idea. Part two opens on expectations, then carries the neoclassical case, international trade, protectionism, and the theorists to one recession read by both schools.