Transcript CHAPTER 10- Real GDP and PL in Long Run

Chapter 8 – Business Cycle
AS/AD, (condensed)
Is the market economy of U.S. stable?
How do we know?
What can keep the economy stable?
Government or Private Enterprise?
GDP 2007 to 2010
Stable or Unstable?
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Prior to the 1930s, conventional wisdom was
a market-driven economy, which was
inherently stable.
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Business cycles (ups and downs in the economy)
were short-lived, and the market seemed to correct
(regulate) itself.
There was no need for government intervention –
that is, the prevailing view dictated a policy of
laissez faire..
Laissez faire: the doctrine of “leave it
alone,” of nonintervention by government in
the market mechanism.
A Self-Regulating Economy
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Classical economics: the economy “selfadjusts” to any deviations from its longterm growth trend.
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In this view, wages and prices are flexible.
If there are excess goods, the producer can
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Lower prices and sell more, eliminating excess goods.
Decrease output and lay off workers. Laid-off workers
compete for jobs by asking for lower wages. At lower
wages, firms will hire more workers.
This is the essence of Say’s Law.
A Self-Regulating Economy
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Say’s Law: supply creates its own
demand.
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Whatever was produced would be sold.
All workers who sought employment would be
hired.
This would occur because people have time to
adjust prices and wages downward.
The economy therefore is self-regulating.
Macro Failure
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The self-adjustment mechanism did not
work during the Great Depression.
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John Maynard Keynes analyzed the situation
and concluded that self-adjustment could not
occur because of “an insufficiency of
effective demand.”
He asserted that a market-driven economy
was, in fact, inherently unstable.
He concluded that the government must
intervene by increasing aggregate
demand.
Government Intervention
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For an underperforming economy, Keynes
proposed that the government intervene to
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By more output.
Employ more people.
Provide more income transfers.
Make more money available.
For an overheated economy, Keynes
proposed the opposite.
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Higher taxes.
Spending reductions.
Reduce availability of money.
Business Cycle
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The four parts of a modern
business cycle are
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The peak, where GDP
maximizes.
Recession, where GDP
declines.
The trough, where GDP
minimizes.
Recovery, where GDP
increases.
These are variations
around a growth trend
that slopes upward.
Terms Associated with the Business
Cycle
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Economic growth: real GDP grows faster
than 3%. Expansion.
Growth recession: real GDP grows, but
slower than 3%. The economy expands
too slowly.
Recession: real GDP contracts (for two or
more consecutive quarters).
Depression: an extremely deep
recession.
What is Aggregate Demand?
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A schedule or curve showing amounts of
real output that buyers collectively desire
to purchase at each possible price level.
Think: Why does AD slope downward?
Aggregate Demand
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Aggregate demand (AD): the total quantity
of output (real GDP) demanded at alternative
price levels in a given time period, ceteris
paribus.
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The collective behavior of all buyers in the
marketplace.
It comprises all goods and services.
AD slopes downward; people will buy more
goods and services at lower price levels, and
vice versa.
Aggregate Demand (AD)
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Why does AD slope downward?
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Real balances effect: the cash you hold is
worth more when the price level falls, so you
can buy more.
Foreign trade effect: lower price levels in the
United States convince customers to buy more
American goods and fewer foreign goods.
Interest rate effect: lower interest rates
promote more borrowing and more spending.
Effect on AD
Wealth
Why an Increase in Price
Level Reduces Quantity of
Real GDP Demanded
Why a Decrease in Price
Level Raises Quantity of
Real GDP Demanded
When P falls, consumers are
When P rises, consumers are
wealthier in real terms. This
poorer in real terms. This
primarily increases the
primarily decreases the demand
demand for consumption
for consumption goods.
goods.
When P rises, individuals save
less, which increases the
equilibrium interest rate. Higher
Interest Rate
interest rates reduce the
quantity demanded of
investment goods.
When P falls, individuals can
afford to save more, which
decreases the equilibrium
interest rate. Lower interest
rates increase the quantity
demanded of investment
goods.
When P rises in the United
States, all else equal, goods
International and services produced
Trade
elsewhere are less expensive.
Imports rise and exports fall so
that net exports fall.
When P falls in the United
States, all else equal, goods
and services produced
elsewhere are more
expensive. Imports fall and
exports rise so net exports fall.
ASSUMPTION for Aggregate demand IS:
If Price level is decreasing, so are
incomes.
Economy moves down its AD curve
Moves to lower price level
*remember circular flow model- (when consumers pay lower
prices for goods and services – Less nominal income flows to
resource suppliers .
Difference between Quantity of AD and
Change of AD
QAD = movement up or down as result of
price level changing (ONLY)
Change in AD =
Change in any of the component parts of
AD (C + I + G + Net Exports)
Shifts of Aggregate Demand
Curve shifts right or left according to
stimuli.
These shifts come from any or all
components of GDP (C, I, G, X-M)
DETERMINANTS OF AGGREGATE DEMAND
Change in Consumer Spending
•Consumer Wealth (people’s
houses fell in value)
•Consumer Expectations
(expect higher prices)
• Interest rate (interest
sensitive durables)
• Taxes
Think in aggregate terms
Changes in Investment Spending
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Real Interest Rates (rates high- not much I
taking place)
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Expected Future Sales (health of economy-
confidence is big)
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Business Taxes (higher taxes less profit)
Government Spending
This will be discussed further, but anytime
government spends, it has an affect on
GDP.
Infrastructure –
Health Care
Supplies for military
Education
Etc.
Net Export Spending
National Income Abroad-(when foreign
nations do well, their incomes are higher- can buy
more U.S. goods and services. – U.S. exports rise)
Exchange Rates- Price of one nation’s currency
in terms of another. Dollar vs Euro
Our currency appreciates if it takes more foreign $
to buy it.. (depreciates if it takes more of ours to buy
theirs.) $1.00 to $1.25 Euro.
Depreciation of nation’s currency makes foreign
goods more expensive (but attracts foreigners to buy
our goods.) Our exports rise. *this is why the Fed
has not worried about our low dollar valuation.
Factors That Change Aggregate Demand &
Consumption/Interest Rates
Interest Rate ↑ → C↓ → AD↓
Interest Rate ↓ → C ↑ → AD↑
Factors That Change Aggregate Demand &
Investment/ Interest Rates
Interest rates ↑ → I↓ → AD↓
Interest rates ↓ → I ↑ → AD↑
Factors That Change Aggregate Demand &
Investment/ Business Taxes
Business taxes↓ → I↑ → AD↑
Business taxes↑ → I↓ → AD↓
Long-Run Equilibrium and the Price
Level
For the economy as a whole, long-run
equilibrium occurs at the price level where
the aggregate demand curve (AD) crosses
the long-run aggregate supply curve
(LRAS).
Figure 10-5 Long-Run
Economywide Equilibrium
OK… One more time…..
Component parts of GDP?
C + I + G + (X-M) = GDP
Long-Run Aggregate Supply Curve (LRAS)

A vertical line representing the real output of goods and
services after full adjustment has occurred
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It represents the real GDP of the economy under
conditions of full employment; the economy is on its
production possibilities curve
The Production Possibilities and the
Economy’s Long-Run Aggregate Supply
Curve
Output Growth and the Long-Run
Aggregate Supply Curve (cont'd)
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LRAS is vertical
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Input prices fully adjust to changes in output
prices
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Suppliers have no incentive to increase output
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Unemployment is at the natural rate
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Determined by endowments and technology
(or existing resources)
Output Growth and the Long-Run
Aggregate Supply Curve (cont'd)
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Growth is shown by outward shifts of
either the production possibilities curve or
the LRAS curve caused by
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Growth of population and the labor-force
participation rate
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Capital accumulation
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Improvements in technology
What does Long Run Equilibrium
Mean?
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Economy is a full employment
Any additional production would be
difficult to achieve.
Economy operating at natural rate of
unemployment (anyone wanting job=have
it.)
Equate the LRAS curve with bowed line on
PPC.
To extend either would be to discover new
resources – R&D
Full Employment
The condition that
exists when the
unemployment rate
is equal to the
natural
unemployment rate.
 Full productive
capacity has been
 Reached.
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Image Cylinder= Economy…
Businesses, factories, economy
not working at full capacity
Full Employment
AD
AS
LRAS
SRAS (short run aggregate supply)
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Period where adjustment occurs.
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Direct relationship
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As the output increases that puts upward
pressure on price.
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Movement on the curve denotes the
relationship between price level and real
output.
SRAS………….Shift
Shift in the curve denotes determinates
that affect more or less real output
production at various price levels.
 Determinants:
Change in input prices (steel, plastic, wool
change in resource availability )
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Change in productivity (+ = Shift right; - =
Shift left) (more for less is the object)
Change in legal environment (contracts,
taxes, subsidies)
AD and SRAS
Long Run Aggregate Supply
Price level
P
LRASLR
Long-run
Aggregate
Supply
Full-Employment
Qf
Real domestic output, GDP
Q
Real
Rate
Of
Interest
D1
Money Supply
Can a Change in Money Supply Change AD?
Probably… but it is a chain of events.
MS changes, then Interest Rates, then change in
consumption
Aggregate Demand and Supply
Macro Equilibrium
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AS and AD summarize the
market activity of the
macro economy.
Macro equilibrium: the
combination of price level
and real output that is
compatible with both AD
and AS.
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Where AD and AS intersect.
… at PE and QE.
Macro Failures
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Let QF be the goal of
full-employment GDP.
The equilibrium
output QE is
undesirable; it does
not reach our macro
goal.
Also, AD and AS can
shift, meaning that any
equilibrium can be
unstable.
AS Shifts
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AS will shift left if
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AS will shift right if
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Business costs rise.
Business taxes rise.
Natural disaster occurs.
Business costs fall.
Business taxes fall.
Bounteous harvests occur.
On the graph, AS shifts
left away from fullemployment GDP.
AD Shifts
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AD will shift left if
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AD will shift right if
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Sending decreases.
Expectations get worse.
Taxes increase.
Spending increases.
Expectations improve.
Taxes decrease.
On the graph, AD shifts left
away from fullemployment GDP.
Short-Run Instability:
Competing Theories
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Classical economists believe the economy
will self-regulate and gravitate toward full
employment.
Keynes and his followers do not believe
this. They believe the economy might get
worse without government intervention.
In addition, there are controversies about
the shape of AS and AD and the potential
to shift these curves.
Equilibrium States of the Economy
During the time an economy moves from one
equilibrium to another, it is said to be in disequilibrium.
Short-Run Instability:
Competing Theories
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Classical economists believe the economy
will self-regulate and gravitate toward full
employment.
Keynes and his followers do not believe
this. They believe the economy might get
worse without government intervention.
In addition, there are controversies about
the shape of AS and AD and the potential
to shift these curves.
Keynesian Theory
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This is a demand-side theory.
A recession originates with a deficiency of
spending.
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AD is too far to the left.
Policy: increase government spending to shift
AD back to the right.
Inflation originates with an excess in
spending.
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AD is too far to the right.
Policy: increase taxes to shift AD back to the
left.
Monetary Theory
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This is also a demand-side theory.
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“Tight” money might cause AD to shift too far
to the left.
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Emphasizes the role of money in financing AD.
Policy: increase money supply and lower interest
rates to shift AD back to the right.
“Easy” money might cause AD to shift too far
to the right.
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Policy: decrease money supply and raise interest
rates to shift AD back to the left.
Supply-Side Theory
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A shift in AS to the left causes output and
employment to decrease and inflation to
increase.
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This problem cannot be corrected by shifting
AD.
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Shift AD right and unemployment falls but inflation
worsens.
Shift AD left and inflation is reduced but
unemployment rises.
Policy: devise ways to shift AS back to the
right.
Supply-Side Theories
Unanticipated Increase
in Aggregate Demand
Price
level
LRAS
SRAS1
Short-run effects of an
unanticipated increase in AD
P105
P100
AD1
YF Y2

AD2
Goods & Services
(real GDP)
In response to an unanticipated increase in AD for
goods & services (shift from AD1 to AD2), prices will
rise to P105 and output will temporarily exceed fullemployment capacity (increases to Y2).
Growth in Aggregate
Supply
LRAS2
Price
level
LRAS1
SRAS1
SRAS2
P1
P2
AD
YFF1
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
Goods & Services
(real GDP)
YF2
YF2
Here we illustrate the impact of economic growth due to
capital formation or a technological advancement, for
example.
Both LRAS and SRAS increase (to LRAS2 and SRAS2); the
full employment output of the economy expands from YF1
to YF2.
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A sustainable, higher level of real output and real income is the
result. ***If the money supply is held constant, a new long-run
equilibrium will emerge at a larger output rate (YF2) and lower
price level (P2).
Effects of Adverse Supply Shock
Price
LRAS
level
SRAS2 (Pr2)
SRAS1 (Pr1)
P110
P100
B
A
AD
YF
Goods & Services
(real GDP)
Y2

The higher resource prices shift the SRAS curve to the left; in
the short-run, the price level rises to P110 and output falls to
Y
2.
What
happens in the long-run depends on whether the
reduction in the supply of resources is temporary or
permanent.
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If temporary, resource prices fall in the future, permitting the economy
to return to its original equilibrium (A).
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If permanent, the productive potential of the economy
will shrink (LRAS shifts to the left) and (B) will become
the long-run equilibrium.
INCREASES IN AD:
DEMAND-PULL INFLATION
Price Level
P
AD1
AD2
AS
P2
P1
Qf
Q 1 Q2
Real Domestic Output, GDP
Q
DECREASES IN AS:
COST-PUSH INFLATION
AS2
Price Level
P
P2
P1
AS1
b
a
AD1
Q1 Qf
Real Domestic Output, GDP
Q
Long run growth
Capital
goods
PPC shifts out and
LRAS shifts right.
P
AD2
AD1
P1
P2 AS1
LRAS1 LRAS2
x
AS2
Consumer
goods
Yf1
Yf2 Y
Non-governmental actions that shift AS
 Shift AS left:
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Raw materials cost rise
Wages rise faster than productivity
Worker productivity decreases
Obsolescence
Wars
Natural disasters
Fiscal Policy
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Governmental actions that shift AD
Shift AD right:
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Govt spending increases
Taxes decreases
Money Supply increases
Shift AD left:
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G decreases
T increases
MS decreases