Transcript Unit 2 Microeconomics 2.1a Markets

Section 1 Macroeconomics
2.1a The circular flow
• In the resource (or factor) market, businesses
are buyers who compete for the factors of
production to produce their goods and services.
• This generates demand for labor, capital, land
and entrepreneurial ability.
• For these resources, they will pay wages,
interest, rent and profits (WiRP).
• Each payment correlates to a factor of
production:
Factor of
production
Labor
Capital
Land
Entrepreneurial
ability
Payment
Wages
Interest
Rent
Profits
• Sellers of resources (households) will try to
maximize their income by selling their factors to
the highest bidder.
• For example, a worker with scarce skills will be
able to sell their labor for a higher wage than a
less qualified competitor.
• With their incomes, the sellers of resources will
turn to the product market to spend their
earnings on goods and services.
The circular flow
• Circular Flow Diagrams are the simplest models
for understanding how a macro-economy works.
This relatively simple example shows how
aggregate income levels are exchanged for
resources—including labor—that are bought
from households.
• Income, in turn, gets spent on goods and
services, repaying firms for the money spent on
resources.
• Sophisticated circular flow models include
leakages and injections into the macroeconomy.
The relative size of each leakage or injection
can have a large impact upon the economy’s
final output.
• Leakages and injections must equal each other
and therefore can be presented as follows:
Leakages
Injections
Taxes
Imports
Government
spending
Exports
Savings
Investment
• One implication of the model is that the
values of each flow are equal.
• Since resource expenditure is funded by
consumer spending, they must be equal,
and the total value of production must be
the same as well.
2.1b Measuring national income
• There are two distinct methods of
measuring the total output of an economy.
• Gross Domestic Product (GDP)
• Gross National Product (GNP)
• GDP is the total money value of all goods
and services produced in an economy
over a certain time, usually one year. GDP
includes the output of foreign firms in a
country, but does not include the output of
domestic firms overseas. This figure is
based on geographic boundaries.
• GNP is the total money value of all goods
and services produced by the citizens or
firms of a particular country, no matter
where they are based, but does not
include the production of foreign firms
within the country. This figure is based on
nationality/citizenship of the owner of the
property or labor.
• Net Domestic Product (NDP) is Gross Domestic
Product less depreciation, and depreciation is
the value of capital that is used-up in production
and must be replaced.
• GDP = NDP + depreciation
• Another important distinction is that of
Nominal GDP vs. REAL GDP.
• Nominal GDP can exaggerate the true
value of production because it measures
output at current prices. If there is
significant inflation, any change in GDP
will be greater than the real change in
output.
• REAL GDP measures output with a single
year’s prices, what is called a base year.
• GDP is useful in discerning a broad picture
of the relative size of economies and
making general comparisons between
countries.
• Another valuable measure is called Per
Capita GDP, which is a better measure of,
on average, how wealthy people are in
different countries.
• Per Capita GDP = GDP ÷ population
• GDP as a measurement has several
shortcomings, one of which was just noted
(income distribution).
A. GDP also does not take into account
qualitative changes in the output of goods
and services. We know that electronics
that have been developed recently have
many more features than those just 5
years old. GDP does not take into
consideration this advance in technology.
B. GDP does not take into account informal
or black market activities. Consequently,
the babysitting that you provided to your
neighbor last weekend is not counted in
the GDP. Nor are illegal activities such as
selling stolen goods counted.
C. Do it yourself activities are not counted in
the GDP. The work of stay at home
parents around their house nor is the shed
built by your dad last summer included in
GDP.
D. Used or second hand goods are not
counted as they were already calculated in
the GDP the year they were originally
manufactured.
E. Purely financial transactions such as
stock market transactions or transfer
payments between the government and
citizens or family gifting of cash (such as
at holiday or graduation time).
F. In developing countries, most citizens are
engaged in informal subsistence economic
activities, which are not in the formal
economy and therefore not counted in the
GDP figures.
• Finally, GDP does not take into account
negative externalities that are produced as
a result of economic activity.
• The green GDP, which has been
attempted by several countries, is meant
to measure the output of goods and
services while subtracting the “bads” of
environmental destruction.
• There two primary methods of calculating
GDP:
Income method = adding up all of the money
incomes generated by the owners of the
factors of production (or WiRP) of a given
economy for a given accounting period.
Expenditure method = compiling all of the
expenditures on final goods and services
within an economy for a given accounting
period.
• The income approach to GDP accounting
is demonstrated from the data for the U.S.
economy in the first quarter of 2012 shown
below:
Category
Compensation of employees
(wages)
Rents
Interest
Gross value
(billions USD)
8,451.5
445.5
709.6
Proprietor’s profits
1,130.8
Corporate profits
1,604.5
Taxes on production and
imports
Adjustments to misc.
income
National Income
Consumption of Fixed
Capital
GDP
1,113
52.6
13,507.5
2,004.1
15,511.6
Note several interesting elements of the
methodology:
• Taxes on Production and Imports: This is
basically an adjustment to take into
account indirect taxes (i.e. business
property, sales and excise taxes) that find
their way into transactions but are not
really counted in the WiRP figure.
• Consumption of Fixed Capital: Essentially
this is value of depreciated capital that has
been replaced as a cost of production,
which is not counted as income. As the
money is not available for other uses, it
does not show up in anybody’s income.
This category is an accounting method to
balance the GDP in the income method
with the expenditure method.
• The most common method of GDP
accounting though is the expenditure
method. It is broken down as follows:
• Consumption (C): Personal household
expenditures on goods and services. This
includes everything from food to utilities to
rent to clothing to cars to school supplies.
Services are things like hair styling,
doctors, auto repair and banking.
Investment (I): Gross private investment in
physical plant, machinery, construction
and inventories. This includes replacement
investment of worn out machinery or
buildings. This figure does not include
paper assets (stocks and bonds) as these
are mere changes in ownership rather
than the creation of new productive
capacity.
Government expenditures (G):
Government purchases includes
expenditures on goods and services used
in providing public services as well as
spending on schools and highways which
might not be used up in a year.
• Net exports (X-M): Exports are goods
and services, which are developed within
an economy and sold abroad to consumer
from other countries. In the expenditure
method these are an injection, yet imports
(our country’s purchases of foreign made
goods and services) are a leakage.
Therefore, we take the net effect of these
transactions and include that figure in the
final GDP figure.
• All of this can be put together as a simple
equation:
C + I + G +(X – M) = GDP
• This equation also happens to be the
equation for Aggregate Demand (AD)
which will become a useful tool for you in
future sections when discussing how
different policies impact economic output.
• Here is an example from the first quarter
of 2012 in the U.S. economy.
Category
Value (billions USD)
Personal Consumption (C)
11,009.5
Gross private investment (I)
2,046.5
Government expenditures (G)
3,108.2
Net exports (X-M)
- 620.1
GDP
15,454.0
2.1c The business cycle
• Most economies experience a long run
upward trend in economic growth partially
due to the increase in population and
improvements in productivity.
• Potential output is represented as a trend
line of growth. Potential output is the
output of the economy if all factors of
production are fully employed in their
highest and best use.
• However, the actual growth of the
economy is not always a straight line and
there are often periods of instability or
recession.
• There are four phases most commonly
referred to in business cycle theory.
• Peak – When an economy has reached its
maximum output with the performance
being at or near full employment or the
economy’s capacity. This is characterized
by a shortage of skilled labor and
materials, which puts upward pressure on
prices. Companies are making solid profits
and optimism is high.
• Recession – Indicates a period of
decreasing total output and other
measurements. A recession can be a point
at which consumers and firms have
exhausted their consumption or
investment budgets. This usually lasts at
least 6 months and is associated with
contractions in employment and business
activity. Unemployment rates usually rise
during these periods
• Trough – The bottom of a recession. This
is associated with high rates of
unemployed labor and productive
capacity. Corporate profits are low and
pessimism is high.
• Recovery – Sometimes called an
expansion. Economies cannot stay in a
trough forever as machinery wears out
and firms have to start to replace capital.
Price levels may have fallen low enough to
induce new investment in inventories or
new consumption as consumers may be
tired of not buying. GDP growth and
employment increase off the bottom of the
trough as the economy expands.
• Some of these periods are also associated
with what are called output gaps.
• If the gap is negative (Y < Yfe), then it is
referred to as a recessionary gap
• If the gap is positive (Y>Yfe), then it is
referred to as an inflationary gap as we
have gone beyond full employment.
• Let’s look at a diagram.
• As the diagram makes clear, the
inflationary gaps occur when the economy
is peaking or growing faster than the trend
line of growth.
• The recessionary gaps are apparent when
economic growth dips below the trend line
or potential output of the economy.
2.2a Aggregate Demand
• Aggregate demand (AD) is comprised of
all the spending that comes to a domestic
market. Aggregate demand, is a schedule,
which shows the amounts of real GDP that
buyers will collectively buy at given
average price levels in the economy.
• Therefore we categorize the different
types of demand like this:
•
•
•
•
Consumer spending (C)
Investment (I)
Government spending (G)
Net Exports (X – M)
• The aggregate demand curve has a
negative slope. Essentially the AD curve is
the visual representation of the
expenditure method of GDP accounting.
• The price level is measured as the
average price level of final goods and
services (product) in the economy and is
considered a measurement of inflation.
• Why is the AD curve negatively sloped?
• The first reason is called the real balances
effect. As the price level rises, the
purchasing power of the public’s income or
savings decreases so they can buy less as
the price level rises. This factor is most
closely associated with consumption (C).
• Secondly, the interest rate effect
influences the slope. As prices rise, there
is an increase in demand for money and
the cost of borrowing money (the interest
rate) will rise as well. Lenders will charge a
higher rate of interest for the public to
borrow money to finance household
consumption or for firms to invest in
productive capacity. This effect is usually
most visible in investment (I).
• Finally there is the foreign purchases
effect. When the price level rises, it
makes the country’s exports more
expensive to foreign buyers. This leads to
a decrease in foreign purchases of the
country’s exports. Moreover, rising
domestic prices may make imported
goods cheaper and result in citizens
substituting imports for exports at higher
price levels. This is effect is seen in net
exports (X – M).
• In the diagram above, the economy is
producing output Y at the price level P.
• Shifts in the AD curve are the result of
changes in the components of AD or
changes in the factors of the following
equation:
C + I +G + (X – M) = AD
Consumption – The elements that affect
consumer spending would be changes in
the following:
Consumer wealth – While changes in
income will clearly change consumption,
so will the wealth of households. If there is
a change in the value of physical (real
estate) or paper (stocks and bonds)
assets, then consumers will feel more or
less wealthy and adjust their spending
accordingly.
• Consumer expectations – If consumers
believe that their real income will change
in the future, they will increase or reduce
expenditures based upon their
expectations.
• Personal income taxes – A direct tax will
affect disposable income which will have
an impact upon households ability to
consume.
• Household indebtedness – When
households borrow to consume (or invest),
the purchases bought with borrowed
money will increase AD. However, when
consumers pay back that debt, they will
have to reduce current expenditures to
pay back for previous consumption which
will decrease AD.
• Interest rates – The cost of borrowing
money will impact the purchase of “big
ticket” items or consumer durable goods.
These are goods that last longer than a
year and are difficult for households to buy
without borrowing moneyIf interest rates
are low, then households would be willing
to borrow money to buy the goods they
desire, thereby increasing AD as noted
above.
Investment spending – Investment is the
most volatile variable in AD because it
relies upon future expectations of
businesses and individuals of economic
activity. The elements that affect business
investment would be changes in the
following:
Real interest rates – Again, the cost of
borrowing money can induce businesses
to take or put off investing. If the real
interest rate increases, then businesses
will hold off borrowing to buy new plant
and equipment. If real interest rates
decrease, then firms would increase
investment with a corresponding increase
in AD.
Expected returns – If companies believe that
they will be able to make a good return on
investment, then they will increase their
purchases and shift the AD curve to the
right. If businesses believe that business
conditions will improve, then they will
invest in new projects.
Business taxes – Taxes will have a direct
effect upon the profits that a firm expects
to make from an investment.
Consequently, a reduction in business
taxes will increase investment and AD. An
increase in such taxes will have the
opposite effect.
Technology – Improvements in technology,
which bring with them a corresponding
increase in productivity, will increase
returns to an investment. Technological
change incentivizes firms to increase their
investment, which then leads to an
increase in AD.
Government spending – The elements that
affect government spending would be
changes in the following:
Changes in political priorities – If a
government decides to change spending
due to a perceived threat or crisis then the
G variable will impact AD. An example
might be a change in defense
expenditures.
Changes in economic priorities – In the case
of a recessionary environment, the
government may increase expenditures to
make up for the loss of AD or employment
that occurs in a downturn. An example of
this might be increasing expenditures on
infrastructure such as roads.
Net Export spending would be affected by
the following:
National income abroad – When trade
partners incomes rise, they have a
tendency to buy more imports, which could
mean an increase in purchases of our
exports. The opposite is true if their
incomes decrease.
Exchange rates – When our country’s
currency depreciates, it makes our exports
cheaper to foreign buyers as it takes fewer
units of their currency to pay for the goods
or services we sell them. This will
increase AD. Conversely, we may see the
opposite effect if our currency appreciates
against that of our trade partners.
Levels of protectionism – If there is
increased protectionism (import tariffs or
quotas) practiced by trade partners, this
can reduce exports and thereby AD.
2.2b Aggregate supply
• Aggregate supply (AS) is a schedule of
real domestic output that is produced at
each possible price level.
• Unlike aggregate demand, aggregate
supply is more complex in its
measurement. This is due to the fact that
producers cannot adjust quickly to
changes in the average price level.
• The short run is defined as the timeframe
in which wages and input prices cannot
adjust to changes in the average price
level.
• The long run is considered to be the time
in which wages and input prices can adjust
to changes in the average price level.
Movements along the SRAS curve –
• Due to what we call a recognition lag,
wages and factor input costs do not
respond immediately to changes in the
price level so it takes time for these prices
to adjust.
• While an increase in the price level might
allow a firm to increase its product prices,
the factor input costs will respond much
more slowly.
• Remember that the largest cost for most
firms is labor and so the nominal wage
rate plays a dominant role in firms’
operations.
• Wage rate changes often lag changes in
the price level in an economy as it takes
time for workers to realize that their
purchasing power has declined.
• When the price level rises, firms are able
to increase their final goods prices and
make larger profits as their wage bill
remains unchanged.
• Subsequently, a firm will increase its
output when the price level is rising to
capture more profits.
• Consequently, the firms increase output
and can push the economy beyond full
employment as they hire unemployed
workers and encourage employees to
work overtime or to move to full time work.
• The situation is illustrated in the diagram
below at point b in which the Y’ level of
RGDP at the P’ price level demonstrates a
rise up along the SRAS curve.
• Firms respond to falls in the price level by
lowering their final goods prices as they
attempt to clear inventory.
• This reduction in sales revenues will
reduce profits and put firms in a position to
decrease production or even lay off
workers. The increase in unemployment
will correspond to a decrease in SRAS.
• This condition corresponds to the Y” level
of RGDP at the P” price level or at point c
on the diagram below.
• The movements along the SRAS curve
described above originate at point a.
• Production costs are the primary factor in
changes in AS. However, there are
several determinants of AS:
• Resource costs – All factor input prices
will play a role in the final product price,
consequently any change in resource
costs will shift the curve. If for example,
there is a decrease in the price of oil, then
the AS curve will shift out to the right as
we can produce more output with the
same expenditure as before the price
change. Conversely, a rise in wages will
push the curve up and to the left.
• Resource costs are not just domestic in
nature. While labor is a domestic expense,
some raw materials are imported. As a
result, exchange rates and control over the
supply of the needed resource can
complicate prices firms.
• If one particular trade partner has
inordinate market power over a
commodity, then it can increase the price
and thereby impact our AS due to our use
of the input in our production.
Furthermore, if our exchange rate
depreciates, we will have to pay more for
imports of a critical factor input.
• Productivity – Improvements in
productivity will increase output at all price
levels and push the AS out and to the
right.
• By improving the quality of factor inputs,
either in the case of new machines or
increasing the skill level of workers, we
can produce more output at current prices
and shift out the AS curve.
Business Environment – This addresses
many variables such as:
• Business taxes – Higher direct and indirect
taxes increase costs in the short run and
can lead to a reduction in output at every
price level with a corresponding leftward
shift in the AS curve.
• Subsidies – Payments by the government
to firms to encourage the production of
specific goods can lower production costs
and encourage companies to expand their
output.
• Regulation - The costs associated with
complying with government regulations
can divert funds from production and
decrease output for firms. An increase in
government regulation may shift the AS
curve to the left.
2.2c Controversy over aggregate supply
Aggregate supply is a source of debate
among different schools of economic
thought. Most economists agree that the
long run AS (LRAS) curve is vertical and
that it represents the full
employment/potential level of output.
• Neo- Classical economists (Friedrich
Hayek and Milton Friedman) argue that
production levels are determined through
the efficient operation of markets.
Therefore, there is no SRAS as the
economy is always just at full employment
operating on or near the LRAS curve.
• If there is a temporary downturn, then laid
off workers will quickly adjust their wage
demands or change their location and be
reemployed very soon. There is no need
for the government to intervene
• Neo-classical economists believe that any
policy to address instability in the economy
will interfere with the self-correcting
mechanism of markets and result in price
distortions (inflation).
• In essence, the neo-classical perspective
believes that AS in the long run is
independent of prices as markets will act
to push the economy back towards
equilibrium.
• The neo-classical school is often
associated with non-interventionist and
market based policies. By reducing the
role of government in the economy and
regulating the rate of growth in the money
supply (more on this later), markets will
self-correct and the economy will grow
more effectively.
• Consequently, neo-classical economists
focus on the long run and as a result they
will push for supply-side policies which
reduce impediments to competition as well
as reduce government intervention in the
economy.
• Neo-classical attitudes are connected to
mostly right leaning political parties.
Policies promoted in Ireland in the period
after the 2009 financial crisis which
reduced government spending and
encouraged austerity in general, could be
considered to be neo-classical in nature.
• However, Keynesian economists believe
that markets are imperfect and that
macroeconomic instability is the result of
different forms of market failure.
• Consequently, the Keynesians believe in
the AS curve which has three regions.
• They believe that output can fall at such as
rate that it falls into the horizontal range of
the AS curve. This means that there could
be a decrease in output with no change in
the price level.
• This is due to the belief that resource
costs and final product prices are “sticky
downwards”. This perspective is rooted in
the belief that workers do not adjust their
wage demands as rapidly as they will
attempt to find employment at their
previous income.
• Moreover, from this perspective,
producers do not adjust their product
prices until absolutely necessary to clear
inventory.
• When both of these scenarios are in play,
there is plenty of spare capacity for the
economy to put back to work without
putting upward pressure on the price level.
• Horizontal range – this is substantially
below full employment implies that the
economy is in recession or worse, a
depression. There are plenty of
unemployed resources and there is
upward pressure on prices. This is
characterized by a flat portion of the AS
curve.
• Intermediate range – as the economy
starts to grow, there is increased demand
for labor and other resources. This results
in upward pressure on factor input prices
and requires firms to increase their
product prices to maintain profitability.
There will begin to be shortages of
resources, which will further drive up
prices. This region is where most of the
short run analysis is done and is upward
sloping.
• Vertical range – when the economy
reaches its potential output or full
employment, the curve becomes vertical.
This is because the economy is at full
capacity. Any efforts by firms to increase
output will only bid resources away from
other firms and drive up prices in the
process. This is due to the finite resources
in the economy.
• Keynesian economists believe that
markets are imperfect and that
macroeconomic instability is the result of
different forms of market failure.
• They believe that output can fall at such as
rate that it falls into the horizontal range of
the AS curve. This means that there could
be a decrease in output with no change in
the price level.
• This is due to the belief that resource
costs and final product prices are “sticky
downwards”. This perspective is rooted in
the belief that workers do not adjust their
wage demands as rapidly as they will
attempt to find employment at their
previous income.
• Moreover, producers do not adjust their
product prices until absolutely necessary
to clear inventory.
• When both of these scenarios are in play,
there is plenty of spare capacity for the
economy to put back to work without
putting upward pressure on the price level.
• Keynesian policies to address economic
instability are often a mix of fiscal
(government driven) and monetary (central
bank directed) policies. These policies
often affect the economy through the
demand or AD side.
• These tactics can be interventionist as in
increasing government spending to make
up for a decrease in AD or cutting taxes to
increase investment. Or the central bank
could increase the money supply to lower
interest rates to promote investment.
• Unfortunately, both of these policies often
result in inflation, which we will discuss in
more detail in the future.
• An example of such Keynesian
government driven policies was the $819
billion stimulus package of increased
spending and continuation of tax cuts
passed by Congress in the U.S. in 2009.
2.2d Long run aggregate supply
• Despite their differences, both Keynesians
and neo-classical economists agree on the
LRAS being vertical at the potential output
of the economy and the goal of shifting the
LRAS to the right.
• The LRAS corresponds to the fullemployment output (Yfe) of the economy.
This is basically when the economy is
operating at its potential.
• Another way of saying this is that the
economy is operating at the natural rate of
unemployment (NRU). This point occurs
when the number of job applicants is equal
to the number of vacancies.
• The economy can operate below the NRU
or at time beyond the NRU. How the
economy adjusts to these two conditions is
the subject of much controversy and we
will discuss this dispute in more detail in
section 2.3.
• Shifting the LRAS is another way of
demonstrating economic growth through
expanding the potential or full employment
output of the economy.
• In this case it is very similar to the how the
PPC operates.
Notice how the PPC is pushed out demonstrating
economic growth and how this matches the
increase from Yfe to Yfe’ in the LRAS on the AD/AS
model on the right.
• Two sources of expansion of the LRAS
are increasing the quantity and quality of
factor inputs.
• If there is an increase in the factors of
production we can shift the potential of full
employment output.
• For example, we can add more to our
labor force via population growth or
increase labor force participation. By
having formerly unemployed workers or
more women enter the labor force, we
have increased our potential output.
• If we increase our stock of physical capital
through investment, we have pushed out
our potential. When firms put in place
more machinery, it will increase the
productivity of labor and consequently
potential output.
• A new natural resources discovery will
push the LRAS to the right reflecting an
increase in land as a factor of production.
An example of this might be Brazil’s oil
discovery in 2006, which added to its
potential GDP.
• By improving the quality of inputs, we can
push the LRAS outward as well. This is
usually associated with improvements in
training and education for labor to increase
productivity. Highly trained labor can be
more capable of suggesting cost saving
ideas to increase output.
• Technological advances associated with
capital equipment will make labor more
productive and thereby push the LRAS out
as well. For example, new machines in a
metal fabrication plant, which use raw
materials more efficiently, will increase
potential output.
• Finally, we can improve our allocative
efficiency by more effectively organizing
our productive resources. Companies
endeavor to do this by continually
examining production processes to
decrease wasted movements or
procedures.
2.2e SRAS/AD equilibrium
• Similar to equilibrium in microeconomics,
macroeconomic equilibrium occurs when
AD and the SRAS behave in a manner to
move towards equilibrium in which:
P level = AD = SRAS
Real Output Demanded
(AD)
Price level (Index
Number)
Real Output Supplied
(AS)
440
110
453
443
105
450
447
100
447
450
95
444
453
90
441
The table makes evident that macroeconomic
equilibrium will occur at a price level of 100 with a
real output of $447 billion. Let’s look at a diagram.
As the diagram makes clear, the equilibrium
level of output is at $447 billion at the price
index of 100.
• Arriving at a new equilibrium in the short
run can be achieved through the demand
side or the supply side. Let’s examine the
demand side first.
• Whenever one of the determinants of
aggregate demand (C+I+G+(X-M))
changes, the result will be a shift in the AD
curve.
• The increase in investment described
above will lead to an increase in aggregate
demand from AD to AD’. This results in a
new equilibrium level of output Y’ at a
higher price level of P’.
• While the economy experiences higher
output, the challenge here is that there is a
rise in the price level, which is associated
with demand pull inflation.
• Suffice it to say, if we see a decline in any
of the AD variables, the new equilibrium
would be at a lower output and a lower
price level (all things being equal).
• Drops in various components of AD may
be the result of higher interest rates
resulting in businesses reducing
Investment or Consumers income
stagnating so they buy fewer goods and
services.
• One final note here is that a natural or
man-made event can reduce Consumption
(as well as Investment) due to the
disruption in people’s lives. An example of
this might be the terrorist attacks in Spain
in 2004 and in England in 2005 leading to
less train travel by citizens or a decline in
consumption due to the earthquake in
Haiti in 2010.
• Do you think that you can draw the correct
diagram for a decline in AD?
• Decreases in SRAS are usually
associated with supply shocks. These
events are often the result of the disruption
of a segment in the supply chain due to a
natural or man-made disaster.
• The 2011 earthquake and tsunami in
Japan lead to a decrease in the SRAS in
Japan as well as impacting the supply
chain of firms in other countries.
• The classic explanation of a supply shock
is an increase in oil prices that is so
dramatic as to make every unit of output
that much more expensive to produce that
the economy creates less output at a
higher price.
• In the 1970’s when oil prices tripled in a
very short period of time, the U.S.
economy in particular, production costs
soared and the result was what is called
cost push inflation.
The lower output was at a higher price and the
diagram below illustrates the conundrum.
• With an increase in factor input costs
(such as oil in this case), producers can
make fewer goods and services for a
given budget.
• The scenario leads to a shift in the SRAS
curve to SRAS’.
• This results in a decrease in output form Y
to Y’, yet with prices increasing from P to
P’ accounting for the corresponding
increase of resource costs.
•
• There are occasions when the both AD
increases and the SRAS curve shifts out
as well. This results in low inflation and
strong economic growth.
• Unfortunately, this sort of benign
environment is not always seen in the real
economy…the U.S. experienced this
scenario between 1996 and 2000.
• The diagram below will illustrate this
favorable environment.
• As the diagram makes evident, the
growing economy shows a shift in the AD
curve from AD to AD’. The new
equilibrium shows a corresponding output
of Y’ at the price level P’.
• However, as a result of increased worker
productivity, the SRAS curve shifts out to
SRAS’. The shift in the SRAS curve
increases output even further to Y” at a
lower price level of P”.
2.2f LRAS-SRAS-AD equilibrium
• Short run and long run equilibrium can
come together at full employment.
• Remember that the full employment level
of output corresponds to the LRAS. This
is because nominal wages adjust in
response to changes in the price level
over time.
• In the long run, the SRAS goes through a
series of adjustments to changes in the
price level.
• As we will see shortly, these adjustments
can lead to a recessionary or inflationary
gap in the short run.
• Corrections can result in AD-SRAS-LRAS
equilibrium, as demonstrated by the
diagram below.
• In the scenario above, the economy starts
in a recessionary environment at Y output
at the P price level. Now suppose that
prices have fallen far enough to induce
firms to invest in new machinery and hire
workers to operate the machinery.
• The increase in I, leads to a shift in the AD
curve to AD’ at the P’ price level and Yfe
level of output. This happened to be in
long run equilibrium for the economy.
•
• The neo-classical school believes that the
economy always self-corrects, so
therefore we only need to worry about
policies that push out the LRAS.
• The neo-classical analysis shown below
starts at full employment output (Yfe) at
the price level Y or point a.
• If there is an unanticipated increase in
aggregate demand shown by the shift in
the AD curve from AD to AD’, then this will
push equilibrium beyond the full
employment level of output corresponding
to Y’ at point b.
• However, owners of resources/factor
inputs are quick to realize that the price
level has increased and they will demand
higher prices or wages to restore lost
purchasing power.
• As per unit production costs increase,
aggregate supply will decrease leading to
a shift in the curve from AS to AS’. Hence
the economy self-corrects to point c back
at the full employment output (Yfe) but at a
higher price level (P”).
• Neo-classical economists believe that
people behave rationally and therefore
take action rapidly to protect their selfinterest.
• Even though the economy will slip out of
long run equilibrium, individuals and firms
interacting in the market place will
automatically push it back to Yfe.
• For these reasons, there is no need for the
government to invoke any changes in
fiscal policy or for the central bank to take
monetary action…let the markets work.
• Keynesian economists have a different
perspective on how an economy falls into,
and for how long the economy can be in,
disequilibrium.
• The basic belief here is that the economy
is in equilibrium wherever AS =
AD…whether at full employment or not.
• The Keynesian school of thought focuses
on the role that aggregate demand plays
in economic instability.
• Rapid changes in any of the variables of
AD will lead to the economy reaching a
new equilibrium often above or below full
employment.
• Remember that another key to the Keynes
perspective is that individuals and firms
take a longer time to recognize and adjust
their wage and price demands.
• For example, a dramatic drop in
Consumption in an economy where
consumption plays a large role can push
the economy into recession.
• However, the most destabilizing variable is
wide swings in Investment.
• Due to investment relying upon real
interest rates and expected rates of return,
optimism (or pessimism) can lead to big
booms (or busts) in investment.
2.2g Keynesian perspective on equilibrium.
• A recessionary gap is defined as a level of
macroeconomic equilibrium below the full
employment level of output as show in the
diagram of the Malaysian economy below.
• This gap corresponds to the point when
actual economic growth falls below
potential economic growth in the business
cycle.
• The result of this decline is unemployed
resources whether it be labor or capital in
the form of plant and machinery being idle.
• In the Keynesian system, the economy
can experience long periods of recession
due to the downward rigidity in wages and
prices. In this view, individuals do not
adjust their wage demands as rapidly as
they will attempt to find employment at
their previous income.
• As noted earlier, from this perspective,
producers do not adjust their product
prices until absolutely necessary to clear
inventory.
• An equation for this might be:
AD = AS < LRAS/Yfe
• This diagram of the Malaysian economy
shows a recessionary gap where
equilibrium is reached at a price level of
100 equaling a RGDP of $447 billion.
• However, this point is below the full
employment level of potential output at
$450 billion.
• This model also allows for an inflationary
gap to occur in which the economy
reaches equilibrium beyond full
employment.
• In this case, we might be able to write this
as an equation:
AD = SRAS > LRAS/Yfe
• If an economy starts to grow rapidly and
overheat, there can be a reduction in
spare manufacturing capacity and very
tight labor markets.
• Wage rates will be bid up as firms try to
secure scarce labor to meet the growing
demand for their output.
• Natural resource and other factor input
prices will increase as firms continue to
compete for scarce resources as most
producers of natural resources cannot
quickly increase supply to meet growing
demand.
• These input price increases will lead to
higher final goods and services prices as
shown below.
• In this scenario it is evident that the
Malaysian economy is overheating
reaching equilibrium at a price level of 105
with RGDP beyond full employment at
$453 billion.
• Finally, unlike neo-classical economists,
Keynes did not believe that increases in
AD had to be inflationary.
• It is a core belief of the Keynesians that
the economy can operate for long periods
of time in the horizontal range of the
Keynesian AS curve.
• Because of the large amount of unused
resources (labor, capital or natural
resources), there are plenty of factor
inputs available for production.
• These unemployed resources can be
engaged without worry for bottlenecks or
shortages leading to wage and price
increases.
• Therefore, increases in AD can result in
growth and output can be increased with
little or no upward pressure on the overall
price level.
• In the economy above, equilibrium is deep
in the horizontal zone of the AS curve and
there is enough excess capacity and
surplus labor that AD can increase to AD’
with no impact upon the overall price level
as RGDP moves from Y to Y’.