Transcript Working with our basic Aggregate Demand / Supply Model

1. What will be the GDP?
2. Will it be long-run equilibrium?
3. What will be the relationship between the actual and
natural rates of unemployment?
AD105
6,900
6,600
6,300
6,000
5,700
5,400
Price Level
90
95
100
105
110
115
SRAS105
4,500
4,800
5,100
5,400
5,700
6,000
1. What will be the GDP?
2. Will it be long-run equilibrium?
3. What will be the relationship between the actual and
natural rates of unemployment?
AD105
6,300
6,000
5,700
5,400
5,100
4,800
Price Level
90
95
100
105
110
115
SRAS105
4,500
4,800
5,100
5,400
5,700
6,000
4. Will this GDP be sustainable?
Price
Level
P1
P2
A reduction in the price
level will increase the
quantity of goods &
services demanded.
AD Goods & Services
(real GDP)
Y1 Y2
• A lower price level will
1. increase the wealth of people holding the fixed quantity of money,
2. lead to lower interest rates, and
3. make domestic goods cheaper relative to foreign goods.
• Each of these factors tends to increase the quantity of goods
& services purchased at the lower price level.
Price
Level
AD1
AD0
AD2
Goods & Services
(real GDP)
a. Increases shift the curve right
b. Decreases shift the curve left
c. Stock prices, real estate values affect
real wealth
a. Lower rates shift the curve right
b. Higher rates shift the curve left
a. Optimism shifts the curve right
b. Pessimism shifts the curve left
c. Stock prices, world events affect
expectations
a. Higher future rates shift the curve right
b. Lower future rates shift the curve left
c. In the present
a. Increased income shifts the curve right
b. Decreased income shifts the curve left
c. The large the trade sector, the larger the effect
a. Appreciation shifts the curve right
b. Depreciation shifts the curve left
1. How will each of the following factors influence
aggregate demand in the United States:
(a) An increased fear of recession.
(b) An increased fear of inflation.
(c) The rapid growth of real income in Canada
and Western Europe.
(d) A reduction in the real interest rate.
(e) A higher price level (be careful).
(f) A stock market decline.
Vote a for an increase in Aggregate Demand
Vote b for a decrease in Aggregate Demand
Price
Level
LRAS1 LRAS2
YF,1
a. Minimum wage
b. Public policy
Goods & Services
YF,2
(real GDP)
Price
Level
SRAS1 SRAS2
Goods & Services
(real GDP)
a. Expected higher reduces supply
b. Expected lower increases supply
2. How will each of the following factors influence
aggregate supply in the Short Run:
(a) An increase in real wages.
(b) 4 hurricanes that destroy half of the orange
crop in Florida.
(c) An increase in the expected rate of inflation.
(d) An increase in the world price of oil.
(e) Abundant rainfall during the growing season.
Vote a for an increase in Aggregate Supply
Vote b for a decrease in Aggregate Supply
Price
Level
LRAS1
LRAS2
SRAS1
SRAS2
P100
P95
AD
YF1 YF2
Goods & Services
(real GDP)
• Start with Equilibrium, then increase LRAS (How?).
• Both LRAS and SRAS increase
full employment output expands from YF1 to YF2.
• A sustainable, higher level of real output is the result.
• Prices are high relative to production costs
• Unanticipated increase in AD.
• Supply shock
• Increased output is unsustainable
Price
Level
P105
LRAS
SRAS1
Short-run effects of
an unanticipated
increase in AD
P100
• Improves
profits.
AD2
AD1
• Output
Goods & Services
(real GDP)
increases
YF Y2
• Unemployment drops below the natural rate,
Price
Level
SRAS2
LRAS
SRAS1
P110
Long-run effects of
an unanticipated
increase in AD
P105
P105
AD2
AD1
YF Y 2
Goods & Services
(real GDP)
• Resource prices will rise. (SRAS shifts)
• Output will recede to the long-run potential.
• Prices are low relative to production costs
• Unanticipated decrease in AD.
• Supply shock
• Causes losses, so production decreases
Price
Level
LRAS
SRAS1
Short-run effects of
an unanticipated
reduction in AD
P100
P95
AD2 AD1
Y2 YF
• Profits fall.
• Output decreases
• Unemployment rises,
Goods & Services
(real GDP)
Price
Level
LRAS
SRAS1
SRAS2
Long-run effects of
an unanticipated
reduction in AD
P100
P95
P90
AD2 AD1
Y 2 YF
Goods & Services
(real GDP)
• Resource prices adjust down. (SRAS shifts)
• Output will recede to the long-run potential.
Price
Level
LRAS
SRAS1
SRAS2
Due to some
favorable supply
shock
P100
P95
AD
YF Y2
Goods & Services
(real GDP)
• Prices fall
• Output increases
• But conditions return to normal SRAS shifts back
Decrease in SRAS
Resource
Market
S2
Price
Level
S1
Pr2
Pr1
D
Q2
Q1
Quantity of
resources
• An adverse supply shock, (crop failure or oil price increase)
• prices rise from Pr1 to Pr2.
Decrease in SRAS
Price
Level
SRAS2 (Pr2 )
LRAS
SRAS1 (Pr1 )
P110
P100
AD
Y2 YF
Goods & Services
(real GDP)
• The higher resource prices shift SRAS to the left
• the price level rises to P110 and output falls to Y2.
• What happens in the long-run depends on whether the supply
shock is temporary or permanent.
Decrease
in SRAS
Price
Level
LRAS
SRAS2 (Pr2 )
SRAS1 (Pr1 )
B
P110
P100
A
AD
Y 2 YF
Goods & Services
(real GDP)
• If temporary, resource prices fall in the future, shifting
SRAS2 back to SRAS1, returning equilibrium to (A).
• If permanent, the productive potential of the economy
will shrink (LRAS shifts left and Y2 becomes YF2) and
(B) will become the long-run equilibrium.
Which way will the AS or AD curves move after:
A. A widespread fear of depression on the part of
consumers.
B. A large purchase of American wheat by Russia.
C.
A cut in Federal spending for health care.
D. The complete disintegration of OPEC, causing oil
prices to fall by one-half.
E. A 10 percent reduction in personal income taxes.
F. An increase in labor productivity.
G. Depreciation in the international value of the dollar.
H. A decline in the percentage of the American labor
force which is unionized.
H.
D. A
AA
The
decline
complete
in
the
disintegration
percentage
of
ofwheat
the
OPEC,
causing
labor
oil
A.
widespread
fear
of American
depression
on American
the
part
of
B.
large
purchase
of
by
Russia.
C.
A
cut
in
Federal
spending
for
health
care.
G.
Depreciation
in the
international
valueincome
of thetaxes.
dollar.
labor
productivity.
E.F.
AAn
10increase
percent
inone-half.
personal
prices
forceinreduction
to
which
fall is
byunionized.
consumers.
Price
level
LRAS
SRAS
Price level
P
Employment
GDP
AD
YF
Goods & Services
(real GDP)
Real GDP (billions of 1996 $)
9,000
• Expansion and
8,000
contraction in the
U.S. economy since
1960.
6,000
Recessions:
2001
1990
1982
1980
1974-75
1970
1960
4,000
• Reductions in real
GDP in the top
graph relate with
increases in the rate
of unemployment
above the natural
rate (bottom graph).
2,000
1960 1965 1970 1975 1980 1985 1990 1995 2000
% Labor force unemployed
10 %
8%
6%
4%
2%
Actual rate of
unemployment
Natural rate of
unemployment
1960 1965 1970 1975 1980 1985 1990 1995 2000
Source: Derived from computerized data supplied by FAME Economics.
Graphically
speaking…
Price
Level
LRAS
SRAS2
Higher resource
prices reduce SRAS
SRAS1
P100
In the short-run,
output may exceed
or fall short of
the economy’s
full-employment
capacity (YF).
AD1
AD2 Higher real interest
rates reduce AD
YF
Y1
Goods & Services
(real GDP)
• Output is becomes greater than long-run potential YF …
-Interest rates increase, reducing AD (from AD1 to AD2) …
-higher resource prices reduce SRAS (from SRAS1 to SRAS2) …
-Output falls back toward its full-employment potential (YF).
Case 2
Price
Level
LRAS
SRAS1
Lower resource
prices increase SRAS
SRAS2
P100
In the short-run,
output may exceed
or fall short of
the economy’s
full-employment
capacity (YF).
AD2
AD1 Lower real interest
rates increase AD
Y1
YF
Goods & Services
(real GDP)
• Output falls below long-run potential YF …
-interest rates decrease, shifting AD out (from AD1 to AD2) …
-resource prices decrease which increases SRAS (from SRAS1
to SRAS2) …
-Output increases toward full-employment potential (YF).
LRAS
Price
Level
r
Pr
Real interest rates fall
(because of weak
demand for investment)
This
stimulates
spending
Real resource prices fall
(because of weak demand
and high unemployment)
Goods & Services
Unemployment greater
than Natural Rate
YF
(real GDP)
• If aggregate output is less than full employment potential YF :
• weak demand for investment lowers real interest rates.
• slack employment in resource markets places downward
pressure on wages and other resource prices (Pr).
LRAS
Price
Level
r
Pr
Real interest rates fall
(because of weak
demand for investment)
r
Real resource prices fall
(because of weak demand
and high unemployment)
Pr
This slows
spending
Real interest rates rise
(because of strong
demand for investment)
Real resource prices rise
(because of strong demand
and low unemployment)
Goods & Services
Unemployment greater
than Natural Rate
YF
(real GDP)
Unemployment less
than Natural Rate
• Conversely, when output exceeds YF:
• strong demand for capital goods and tight labor market
conditions will result in both rising real interest rates
and resource prices (Pr).