Transcript My lecture

Mankiw: Brief Principles of
Macroeconomics, Second Edition
(Harcourt, 2001)
Ch. 14: Aggregate Demand and
Aggregate Supply
Short-run
• In the long-run the economy follows a trend
line.
• From year to year, economy diverges from
this trend.
• Recessions are when the size of the
economy shrinks for two quarters.
• Unemployment rises during recessions.
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Economic Fluctuations
1. Economic fluctuations are irregular and
unpredictable.
1. Business cycles do not follow similar periods.
2. The last recession was in 1991.
3. Before that we had recessions in 1970, 1974-75,
1980, and 1982.
2. Most macroeconomic variables move together.
1. When real GDP increases, so do consumption,
home sales, imports, etc.
3. As output falls, unemployment increases.
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Review of Long Run
• Growth of GDP depends on resources
(capital, labor) and technology.
• Productivity growth determines improved
standard of living.
• Investments increase capital and technology
and contribute to productivity growth.
• Savings in an economy has to match the
investments. The two are equated by real
interest rate.
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Review of Long Run
• Unemployment is never zero. Full employment
implies operating at the natural rate of
unemployment.
• Increases in the available money in an economic
system lead to rising price level.
• Inflation pushes up the nominal interest rate
while real interest rate is determined as savings
are matched with investments.
• Trade balance and net foreign investment
determine the real exchange rate.
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Review of Long Run
• Real variables do not get affected by
monetary policies.
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Real GDP
Real interest rates
Real savings
Real investments
Real exchange rates
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Review of Long Run
• Monetary policies affect nominal variables
in the long run.
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Price level
Inflation
Nominal interest rate
Nominal exchange rate
• This is the classical dichotomy: money is
neutral in the long run.
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Short Run
• Short run is the period when adjustment
takes place from money supply increase to
price level increase.
• Short run can be as short as immediate or as
long as a number of years.
• During the short run monetary policies do
affect real variables.
• Short run will be discussed using aggregate
demand and aggregate supply curves.
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Short Run
• Since in the short run both price level and
real GDP respond, we will concentrate on
their behavior using AD and AS.
• AD shows total spending in the economy
(C+I+G+NX) in the short run as the price
level changes.
• AS shows total output (Y) in the economy
as the price level changes.
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Aggregate Demand Curve
• As the price level falls, the aggregate demand
increases.
– As P falls, C increases because of wealth effect.
– The real value of bank accounts, loans you gave,
contractual payments due to you increase.
P
Y
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Aggregate Demand Curve
• As the price level falls, the aggregate demand
increases.
– As P falls, I increases because of interest rate effect.
– Lower P means lower demand for money.
Households use their excess money to provide
savings to the financial market. Interest rates fall.
P
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Aggregate Demand Curve
• As the price level falls, the aggregate demand
increases.
– As P falls, NX increases because of exchange rate
effect.
– As P falls in the US, real exchange rate [¥/$(P$/P¥)]
falls and stimulates exports and discourages imports.
P
Y
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Aggregate Demand Curve
P
C+I+G+NX
Y
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Shifts in AD
• Because AD is comprised of C+I+G+NX,
any increase in one of these components
will shift the AD to the right and any
decrease in one of these components will
shift the AD to the left.
• Any increase (or decrease) in C or I or G or
NX that is NOT RELATED to changes in
the price level will shift the AD.
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Changes in Consumption
• If households decide to consume more at
each and every level of prices because they
are confident of the future of social security,
the AD will shift right.
• If social security taxes increase, thus
reducing the disposable income of the
households, AD will shift left.
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Changes in Investment
• If businesses become less confident about
the future and postpone their expansion
plans, investments fall and AD shifts left.
• If the government passes an investment tax
credit law, AD shift right.
• If the Fed increases the money supply, thus
lowering the interest rates in the short run,
investments will be stimulated, shifting AD
to the right.
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Changes in Government Purchases
• If Congress decides to increase the federal
budget to pay more for the military or the
states decide to increase their education
budgets, G will increase, shifting AD to the
right.
• Reducing government spending will shift
AD to the left.
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Changes in Net Exports
• If Mexico experiences rapid growth, it will
increase its purchases of American goods
and services, shifting AD to the right.
• If war breaks out in the Middle East and
investors flock to the US as a safe haven,
the dollar appreciates and net exports fall,
shifting AD to the left.
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Aggregate Supply
• Total quantity of goods and services firms
produce at each and every price level.
• Just like aggregate demand, the price level
is measured on the vertical axis and GDP on
the horizontal axis.
• In the long run, the economy operates at full
employment.
– Regardless of the price level, an economy that
operates at full employment will produce the
constant amount.
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Aggregate Supply
P
When the economy is operating
at the full employment level, the
output produced will not be
affected by the price level. In the
long run, it is the labor, capital
and technology that determines
the GDP.
Y*
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Aggregate Supply
• Any force that shifts the Production Possibilities
Frontier outward would shift the long run
aggregate supply (LRAS) curve right.
Capital
goods
P
Consumption
goods
GDP
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Shifts in LRAS
•
•
•
•
Change in Labor
Change in Capital
Change in Natural Resources
Change in Technology
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Impact of Labor Changes
• Immigration would shift LRAS right.
• Emigration would shift LRAS left.
• Drop in the natural rate of unemployment
would shift LRAS right.
• A large jump in minimum wage would raise
the natural rate of unemployment and shift
LRAS left.
• If job searches become more efficient or if
the unemployed search harder, the natural
rate of unemployment would fall.
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Impact of Capital Changes
• An increase in the capital stock will shift
the LRAS right.
• An increase in the education levels of the
population is an increase in human capital;
it would shift the LRAS right.
• Destruction or loss or obsoleteness of
capital would shift LRAS left.
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Impact of Natural Resources
• Discovery of new resources would shift
LRAS right.
• Increase in the relative prices of raw
materials would shift the LRAS left.
• Climate change may shift the LRAS, too.
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Impact of Technology
• New machines, new ways of doing things,
expanding international trade all improve
technology.
• Improvements in technology shift LRAS
right.
• Regulations that increase the cost of
production shift the LRAS left.
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Long Run Shifts in AD and AS
AS1980
AS1990 AS2000
P2000
P1990
AD2000
P1980
AD1990
Aggregate supply shifts to the
right through time because of
increases in capital, labor and
technology. In the meantime,
the growth of money supply
shifts the AD to the right. As
long as the growth rate of
money supply exceeds the
growth rate of the GDP, the
price level will rise.
AD1980
Y1980
Y1990
Y2000
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Short Run Aggregate Supply
• Contrary to LRAS, the short run aggregate
supply curve is upward sloping.
• During the short run, changes in the price
level will affect the total output of the
economy because the firms will respond to
price level changes.
• Remember that relative prices are not
changing; it is the price level that is
changing.
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Explanations for SRAS Slope
• The misperceptions theory.
– Firms are more aware of their own markets than the
general economy. A rise in the general price level
may be interpreted as a favorable change for their
industry.
– Workers may view an increase in their nominal
wages as a relative improvement and supply more
labor even though their real wages haven’t changed.
– Misperception arise from the difference between
expected price level and the actual price level.
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Explanations for SRAS Slope
• The sticky-wage theory.
– Firms negotiate nominal wages with their workers.
– When firms negotiate nominal wages, they have
designed the wage according to expected price level.
– If the general price level rises, the real wage paid to
the workers have fallen.
– Firms’ cost of production falls and they produce
more.
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Explanations for SRAS Slope
• The sticky-price theory.
– Firms establish and announce their prices in
accordance with an expected price level in the
future.
– Firms do not change their prices immediately to
respond to changing conditions.
– If the general price level has increased but some
firms have kept their announced prices constant for
a while, demand for their products will increase
and production will increase as well.
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Short Run Aggregate Supply
Until the misperceptions
are eliminated, or real
wages adjust, or prices
adjust the SRAS will be
upward sloping. As soon
as the adjustment is
complete, the SRAS will
become LRAS. In other
words, once expected price
level matches the actual price
level, SRAS=LRAS.
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Shifts in SRAS
• Any force that shifts the LRAS curve will
shift the SRAS in the same direction, as
well.
• The expected price level determines how
the firms will set nominal wages or their
own prices.
• Any change in the expected price level will
shift the SRAS.
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Misperceptions and Expected
Price Level
• Firms expect price level to rise.
• Firms observe their prices lagging behind
the expected price level.
• Their profits fall and firms cut down on
production.
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Sticky Wage and Expected Price Level
• Firms expect price level to rise.
• They raise the nominal wage.
• At the moment the actual price level is lower than
the expected price level.
• The real wage the firm is paying is now higher.
• Cost of production is higher.
• Firms cut back on production at the same price
level.
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Sticky Price and Expected Price
Level
• Firms expect higher price level in the
future.
• They raise their own prices.
• They lose customers.
• They cut down on production.
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Expected Price Level
P
Rise in expected
price level
Fall in expected
price level
Y
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Long Run Equilibrium
P
LRAS
SRAS
AD
Y
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How the Economy Adjusts
LRAS
SRAS
SRAS
P1
P2
P3
AD
AD
Y2
C or I or G
or NX drops.
AD shifts left.
Y and P both
drop.
Expected
price level
falls. SRAS
shifts right
until long run
equilibrium
is reached.
Y1
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Policy Dilemmas
• How long will the recession last?
• Should the government wait for the
economy to reach full employment on its
own?
• Should the government respond to the drop
of the AD by stimulating AD?
• If the government decides to interfere,
should it be through monetary policy or
fiscal policy?
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Examples
• During the Great Depression GDP fell by 27
percent and unemployment rose to 25 percent
because of AD shift to the left.
– Money supply decreased.
– Wealth evaporated with the stock market crash and
consumption fell.
– Bank failures created a credit crunch and a fall in
investments.
– Increased protection brought international trade to a
standstill: a technological calamity and a shift of
LRAS to the left.
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Examples
• During WWII the government purchases
increased five fold shifting AD to the right.
– Unemployment fell.
– Price level rose.
• JFK engineered a shift of AD to the right to
drag the economy out of recession.
– Tax cuts increased consumption expenditures.
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AS Shift
LRAS
SRAS
P3
P2
P1
AD
Y2
When the costs of production
increase for the economy, SRAS
shifts to the left. Price level
increases and GDP falls. The
slack in the economy forces
expected price level to fall and
shifts the AS back.
If the society complains too much
about the stagflation, the
government might stimulate the
AD to bring the economy back to
the long run equilibrium.
Y1
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