Transcript Macroeconomics - Econproph on Macro

MACRO
Economics
Unit 7: The Real Sector:
ADAS & Classical Theory
Economist: Someone who sees something in practice and
wonders if it would work in theory.
-- Senator Ernest “Fritz” Hollings
Created: 2007-2013 by Jim Luke.
This work is licensed under the Creative Commons
Attribution-NonCommercial License
MACRO
Economics
Why Theory Matters
“The ideas of economists and political
philosophers, both when they are right
and when they are wrong, are more
powerful than is commonly understood.
Indeed, the world is ruled by little else.”
-- John Maynard Keynes
Slide 2
MACRO
Economics
AD-AS Model illustrates & analyzes theory
using shifts in 3 curves:
AD – Aggregate Demand
 SRAS –Short-Run Aggregate Supply
 LRAS – Long Run Aggregate Supply

MACRO
Economics
AD-AS Model is NOT same as micro
supply-and-demand.
Aggregates behave differently.
Remember the fallacy of composition?
MACRO
Use AD-AS Model to show:
Economics



Level & changes in:
 real output (real GDP)
 price index
 How people respond to price level changes
Capacity of the economy (PPF)
Economic Conditions
 Inflation
 Recession & Unemployment
 Stagflation
 Deflation and depression
MACRO
Economics
Understanding the AD-AS Model:
Aggregate Demand-Aggregate Supply
(actually it’s AD-SRAS-LRAS)
MACRO
Graphic Space is
Real Output vs. Price Level
Economics
P
Price Level
(price index)
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Economy at some starting point.
P
Price Level
(price index)
Price Index
@start
Start
Real
GDP
@start
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Economy Grows  shifts right
P
Price Level
(price index)
after real growth
in GDP, but no
inflation or deflation
Price Index
@start
start
(now)
after
Real
GDP
Real
GDPaft
@start
er
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Economy shrinks  moves left (recession)
P
Price Level
(price index)
after decline in real GDP
unemployment has increased
because fewer resources
are employed
Price Index
after
Start
Real
GDPafter
Real
GDP
@start
@start
Q
Real Output
(amount of real goods & services produced)
MACRO
Inflation  shift upward
Economics
P
Price Level
(price index)
Price Index
after inflation
after
Inflation
Price Index
Start
@start
Created:
Jan 2008
by Jim
Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
Real
GDP
@start
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Deflation  shift downward
P
Price Level
(price index)
Price Index
Start
@start
deflation
Price Index
after
after deflation
Real
GDP
@start
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Real Life: both prices & real GDP change
“Stagflation” shift up & left
“stagflation”
P
Price Level
(price index)
Price Index
after inflation
after
Inflation
Start
Price Index
@start
Real
GDPafter
Real
GDP
Q
@start
Real Output
(amount of real goods & services produced)
MACRO
Economics
Inflationary Growth  up & right
P
Price Level
(price index)
Price Index
after
after inflation
Inflation
Price Index
Start
@start
Real
GDP
Real
GDPafter
Q
@start
Real Output
(amount of real goods & services produced)
MACRO
Economics
2 Other Possibilities

Prices decline & real GDP increase
  down and to the right

Prices decline & real GDP decrease
  down and to left
MACRO
Economics
Reactions to Changes in Prices
Two relationships (curves) show how
people react to inflation/deflation:
 Aggregate Demand (AD)

Willingness to spend.
 Short-Run Aggregate Supply
(SRAS).

Willingness to sell.
MACRO
AD is downward sloping because
of 3 effects:
Economics
Wealth & Fixed Incomes
Interest Rate & Debt Payments
International Trade
MACRO
AD curve shows
changes in willingness to buy real Q
in response to changes in price level.
Economics
P
Price Level
(price index)
Price Index
@start
Start
AD
Real
GDP
Q (or Y)
Real Output
@start
(amount of real goods & services produced)
MACRO
Economics
AD: Inflation reduces ability to buy
P
Price Level
(price index)
Price Index
Start
@start
Real
GDP
@start
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Deflation increases ability to buy.
P
Price Level
(price index)
Price Index
Start
@start
Real
GDP
@start
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
AD:
buyer reactions to inflation / deflation
P
Price Level
(price index)
Price Index
Start
@start
Real
GDP
@start
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Now: producers & sellers
Inflation: all prices increase

But, inflation is not highly visible.

Single-product price changes are.
Producers/sellers see price change of their product.

perceive a real price increase when it is really
inflation

willing to produce & sell more goods

Temporary reaction

SRAS, or Short-Run Aggregate Supply.
Eventually costs increase & qty returns to original
MACRO
Economics
SRAS curve shows
changes in desire to sell real Q
in response to changes in price level.
P
Price Level
(price index)
Price Index
@start
Start
Real
GDP
@start
Q (or Y)
Real Output
(amount of real goods & services produced)
MACRO
Economics
SRAS: Price change “fools” producer
P
Price Level
(price index)
Price Index
Start
@start
Real
GDP
@start
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Deflation “fools” into reduced output.
P
Price Level
(price index)
Price Index
Start
@start
Real
GDP
@start
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
SRAS curve
P
Price Level
(price index)
Price Index
@start
Start
Real
GDP
@start
Q (or Y)
Real Output
(amount of real goods & services produced)
MACRO
Economics
Short-Run Equilibrium:
Purchases = Sales 
where AD intersects SRAS.
P
Price Level
(price index)
Price Index
@start
SR-AS
start
AD
Real
GDP
Q (or Y)
@start
Real Output
In a short-run equilibrium, the economy is always where
SRAS=AD because the quantity of Real GDP we buy
must equal the amount we sell.
MACRO
Economics
AD and SRAS curves only show
Real GDP vs Price Level changes.
Other changes shift the curves.
MACRO
AD curves shift (move) when
changes such as…
Economics
 Expectations about future


More optimism shifts AD right
More pessimism shifts AD left.
 Growth in other countries boosts
exports.
 Government decisions change T or G
MACRO
AD shift: more optimism or more
G or lower T or more X
Economics
P
Price Level
(price index)
Price Index
Start
@start
AD after
Real
GDP
@start
AD before
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Next: Shifts in SRAS curve
Factors that shift SRAS:
 Changes in expectations about
future economic conditions.
 Technology improves.
 Cost increases: Firms realize that
resource prices have risen but they
cannot pass the increase on to
customers.
MACRO
Input cost increases shift SRAS
left/up – but there is a lag.
Economics
SRAS: short-run reaction only

“fooled” by price change
Once inflation is perceived, then
SRAS curve shifts upward/left.
MACRO
Economics
Sellers react to inflation
SR-AS
after
P
Price Level
(price index)
Price Index
after inflation
Price Index
@start
SR-AS
Final
reaction
start
Real
GDP
@start
Initial
reaction
start
MACRO
Economics
Improved technology can shift
SRAS also.
P
Price Level
(price index)
SR-AS
start
SR-AS
Price Index
@start
start
Real
GDP
@start
after
MACRO
External input cost increases also
shift SRAS - example: oil.
Economics
P
Price Level
(price index)
SR-AS
after
SR-AS
Price Index
@start
start
Real
GDP
@start
start
MACRO
Economics
Both AD & SRAS are short-run
reactions to price changes – ignoring
physical capacity.
MACRO
Economics
LRAS is missing piece representing
capacity and resources.
MACRO
Production Possibilities determined by
available resources / technology, not prices
Economics
P
Price Level
(price index)
LRAS:
long-run aggregate supply
(“capacity of economy” or
“sustainable production
rate” when all resources
are employed)
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Economy left of LRAS 
unemployment exists
P
Price Level
(price index)
LRAS:
long-run aggregate supply
any point in this region indicates
the economy is not using all
resources --- unemployment
exists
Q
Real Output
(amount of real goods & services produced)
MACRO
Economics
Unemployment.
P
Price Level
(price index)
LRAS:
long-run aggregate supply
Amount of unemployment
Q
Real Output
(amount of real goods & services produced)
MACRO
What if we sell more than we can
produce (SRAS > LRAS)?
 reduce inventories
Economics
P
Price Level
(price index)
LRAS:
long-run aggregate supply
attempting to produce more
than capacity, only possible for
short run, actually draws down
inventory
Q
Real Output
(amount of real goods & services produced)
MACRO
Long run growth is a shift in LRAS.
Economics
P
Price Level
(price index)
LRAS1
LRAS2
Q
Real Output
(amount of real goods & services produced)
MACRO
Putting them altogether.
Economics
We’re now ready to put all three
curves together.
Short-run equilibrium is where
SRAS = AD, but…
Where is that relative to LRAS?
Three possibilities…….
MACRO
Long-Run Full-Employment
Equilibrium -- the goal
Economics
LRAS
P
Price Level
(price index)
SR-AS
Price Index
start
@start
AD
Real
GDP
@start
MACRO
Economics
Recessionary Gap
(also known as “contractionary gap”)
LRAS
P
Price Level
(price index)
SR-AS
Gap
represents
amount of
unemployment
Price Index
start
@start
AD
Real
GDP
Real
GDP
@start
if we had full
employment
MACRO
Inflationary Gap
(also known as Expansionary Gap)
Economics
P
Price Level
(price index)
Price Index
LRAS
SR-AS
start
@start
AD
Real
GDP
@start
MACRO
Economics
LRAS: Beneficial Supply Shocks




Abundant harvests
Discovery of natural resources
Technology breakthroughs
Population growth & immigration
MACRO
Shocks cause a gaps.
Economics
“Supply shocks”
 New technology
 More people/resources
 Destruction of people/resources


War
Natural Disaster
MACRO
Economics
LRAS: Adverse Supply Shocks
Examples
 Drought
 Natural Disasters
 Suddenly reduced supply of any
critical resource
 Government instability
 Terrorist attacks
 War
 Any permanent reduction of
economy’s ability to produce real
goods and services
MACRO
Economics
Aggregate Demand Shocks
Changes in:
 confidence/optimism
 perceived wealth
 foreign economic events
 fiscal policy (G or T)
 monetary policy (interest rates)
MACRO
Economics
Short-Run Aggregate Supply Shocks
Changes in:
 external input cost
 short-run supply restrictions
 uncertainty re: profits?
MACRO
Economics
That’s it.
Our AD-AS model is now complete.