Transcript Economics: Explore and Apply 1/e by Ayers and Collinge Chapter 9

ECONOMICS:
EXPLORE & APPLY
by Ayers and Collinge
Chapter 9
“Short-Run Instability”
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
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Learning Objectives
1. Explain why wages and prices might be slow to
adjust downward, and what significance this
can have.
2. Discuss how fiscal policy to stabilize the
economy is subject to lags, and how the lags
can be overcome automatically.
3. Explain how balancing the full-employment
budget is consistent with a budget deficit.
4. Identify the characteristics, and significance of
short-run aggregate supply.
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Learning Objectives
5. Describe demand –pull and cost-push
inflation, and how they can be part of
an inflationary spiral.
6. Detail the differences between classical
and Keynesian analysis.
7. (E&A) Analyze the rationale and
limitations of deficit spending.
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9.1
SHORT RUN STICKINES ALONG AD
Whenever there is an economic downturn,
members of the press and the public call on
government to do something about it.
The economic downturn of March 2001 led
President Bush and Congress to to authorize the
refunding of some tax payments back to the
taxpayer in August that year.
There had been budget surpluses for the
previous four years.
Taxpayers received up to $300 per person or
$600 per couple.
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Short Run Instabilities
Because of the shock of 9/11/01, instead of being
energized, there was no discernable increase in
consumer spending.
To bring the economy out of what appeared to
be a deepening recession the President and
Congress enacted $100 billion worth of new
spending and tax cuts.
To correct short-run instabilities, Keynesians
argue for government action, while classical
economist emphasize that markets are capable
of self-adjustment.
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The Macro Policy debate
Classicalist
Keynesians
Wait for a
movement along
aggregate
demand.
Take action to
manage aggregate
demand.
The economy can
self-adjust.
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Meaning to shift
the aggregate
demand curve
itself..
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The Classical Analysis
When a market is
not in equilibrium,
the forces of supply
and demand will
cause price to
change until the
equilibrium comes
about.
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1. Wage and price
adjustments will lead
to a long-run macro
equilibrium.
2. The new long-run
equilibrium is
characterized by both
full employment, and
an associated full
employment output.
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The Keynesian Analysis
 Keynesians dismiss
the classicalist
analysis as irrelevant
in the short run.
 Their rationale is the
existence of
downwardly sticky
wages and sticky
prices.
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1. Sticky refers to an
inflexibility that makes
it difficult for wages
and prices to fall
2. The stickiness can be
due to labor contracts
or human psychology.
3. Rigidities exist in both
labor markets and
output markets.
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Price Level
Long-Run Macro Equilibrium
Long-Run
Aggregate Supply
A
Actual
price level
Full-employment
price level
Wages and prices may be
downwardly sticky preventing
the economy from rapidly
moving to a full-employment
equilibrium.
Aggregate
Demand
Actual Output Full-Employment
GDP
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Real GDP
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Price Level
Long-Run Macro Equilibrium
Long-Run
Aggregate Supply
A
Actual
price level
Full-employment
price level
In the long-run prices
will fall from point A to
the full-employment
output, but wage and
price rigidity might
prevent it from doing so
in the short-run.
Aggregate
Demand
Actual Output Full-Employment
GDP
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Real GDP
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9.2
FISCAL POLICY TO STABILIZE
THE BUSINESS CYCLE
 Fiscal policy refers to the government’s policy
toward taxing and spending.
 Keynesians commonly advocate using
expansionary fiscal policy (increased
government spending or reduced taxation) to
stimulate (shift) aggregate demand.
 Shifting aggregate demand can also be
accomplished through monetary policy
 Monetary policy involves varying the quantity of
money available to spend.
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Price Level
Aggregate demand
Long-Run
Aggregate Supply
Current
sticky
price level.
The economy starts
at an unemployment
equilibrium
Fiscal Stimulus
increases aggregate
Demand.
Expansionary fiscal
policy is increased
government spending
or reduced taxes
Aggregate
toStarting
stimulate
AD.
Demand
Real GDP
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Keynesians and Fiscal Policy
 When the economy overheats – growing
so fast that inflation threatens –
government can use contractionary fiscal
policy.
 Both expansionary and contractionary
fiscal policy are examples of discretionary
policy.
 Public Policy which is adjusted at the
discretion of lawmakers.
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Fiscal Policy Lags
Recognition Lag: It takes time to know
that a recession is at hand.
Action Lag: Tax and spending bills are
not passed overnight.
Implementation Lag: Planning
government spending takes time. It also
takes time before tax changes can take
effect.
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Keynesians and Fiscal Policy
o Instead of discretionary policy, lawmakers can
rely on automatic stabilizers.
o Automatic stabilizers are components of
existing fiscal policies that stimulate the
economy when it is sluggish, and act as a drag
when it overheats.
o The U.S. has automatic stabilizers embedded
within its system of of taxation and spending.
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Automatic Stabilizers
 On the tax side..
 Personal and corporate
incomes fall during
recession and so do U.S.
personal and corporate
income taxes.
 Alternatively, if the
economy is booming,
income taxes collect
more revenue.
 No policy action is
necessary.
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 On the spending side..
 Payments for welfare,
unemployment, and
other social programs
rise when the economy
slows, and provides a
safety net for people.
 Conversely, this spending
falls when the economy
heats up.
 Again no policy action is
necessary.
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Balancing the Budget
If the economy is at full employment, fiscal
policy should be neutral.
The neutral fiscal policy could generate a
balanced budget (federal).
When the economy is overheating the
government would run a budget surplus.
When economic health is poor, the government
would choose a budget deficit.
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9.3
THE SHORT-RUN ADKUSTMENT
PROCESS
 In the long-run aggregate supply is unaffected by
the price causing it to be vertical.
 Short-run aggregate supply, the amount of output
the economy has to offer in the short-run will slope
upward.
In the short-run the amount of output can exceed full
employment GDP as workers offer to work overtime, or
seek out extra jobs.
Conversely, if workers expect more inflation than
actually occurs the work they would offer at the actual
price level would be less than the full employment GDP.`
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Price Level
The Short-Run Aggregate Supply
Long-Run
Aggregate Supply
Short-Run Aggregate
Supply slopes upward
intersecting LRAS at the
expected price level.
Expected
and Actual
Price Level
Aggregate
Demand
Full-employment
GDP
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Real GDP
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The Short-Run Aggregate Supply
Structural rigidities are
one reason for the
upward sloping SRAS
curve.
As new spending power
is added to the economy,
it tends to raise wages
and prices where it first
hits, before eventually
diffusing throughout the
economy.
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The production effect is
the second reason for
the upward sloping
SRAS curve.
When the price level
rises and labor supply
curves remain
unchanged, firms can
profit by increasing
output and employment
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The Short-Run Aggregate Supply
Price Level
Long-Run
Aggregate Supply
Short-Run Aggregate
Supply slopes upward
Expected
Price Level
Long-Run equilibrium
Actual
Price Level
Short_run
unemployment
equilibrium
Aggregate Demand
Actual GDP Full-employment
GDP
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Real GDP
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Types of Inflation
Demand-pull inflation: When a rightward
shift in aggregate demand moves the
economy to both a higher output and a
higher price level.
Cost-push inflation: When firms adjust
their inflationary expectations downward,
it may cause the economy to move up the
aggregate demand curve to a point with
higher prices and lower output.
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Price Level
Stimulative Fiscal Policy
Short-Run Aggregate
Supply
The result is an increase
in output along with
demand-pull inflation.
Inflation
Output Increases
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Aggregate Demand
Real GDP
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Fiscal or Monetary Stimulus
Price Level
Long-Run
Aggregate Supply
2. Moving to full-employment
equilibrium without causing
inflation.
3. Stimulus in spending
causes demand-pull
inflation.
Starting Aggregate
Demand
1. Output increases,
but by less than
was intended.
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Full-Employment
Output
Aggregate Demand after
Stimulus
Real GDP
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Cost–Push Inflation
 Inflation could also arise from an upward shift in
the short-run supply curve.
 Because the short-run aggregate supply curve
intersects long-run aggregate supply at the
expected price level, a change in the expected price
level will shift the short-run aggregate supply
upward.
 If the expected price level increases, short-run
supply shifts vertically upward.
 Likewise if the expected price level decreases ,
short-run supply shifts downward.
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Price Level
Cost Push Inflation
Long-Run Aggregate
Supply
Short-Run Aggregate
Supply
Alternative
expected
price levels
Whatever the expected
price level may be that is
where the short-run
aggregate supply and LRAS
intersect and long-run
equilibrium occur.
Full-employment
GDP
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Real GDP
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Cost Push Inflation
o When aggregate supply shifts up, the
economy moves up the aggregate demand
curve to a point of higher prices and
lower output.
o Inflation that is caused this way is called
cost-push inflation.
o Cost push inflation reduces output and
increases the price level.
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9.4
SHORT-RUN PATHS TO LONG-RUN
STABILITY
 When stimulative government policy
increases aggregate demand, the result
can be an inflationary spiral.
 An inflationary spiral is an ongoing
sequence of demand-pull inflation,
followed by cost-push inflation, as shortrun aggregate supply shifts to reflect
higher expectations of inflation.
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Price Level
Inflationary Spiral
Long-Run Aggregate
Supply
The Inflationary Spiral
Inflation
Expanding Aggregate
Demand
Fluctuating
Output
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Real GDP
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SUMMARY OF CLASSICAL
AND KEYNESIAN VIEWS
CLASSICAL
KEYNESIAN
The focus is on the
long run.
The focus is on the
short run.
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SUMMARY OF CLASSICAL
AND KEYNESIAN VIEWS
CLASSICAL
KEYNESIAN
Prices and wages will
adjust upward
or downward as needed
to reach
a full employment
equilibrium.
Prices and wages adjust
upward without difficulty,
but are downwardly sticky
and thus unable to lead the
economy from an
unemployment equilibrium
to full employment.
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SUMMARY OF CLASSICAL
AND KEYNESIAN VIEWS
CLASSICAL
KEYNESIAN
Government should not
attempt to
manage aggregate
demand.
Government should actively
adjust taxes
and spending in order to
manage
aggregate demand.
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SUMMARY OF CLASSICAL
AND KEYNESIAN VIEWS
CLASSICAL
KEYNESIAN
Shortcoming:
Remedying
unemployment
requires patience.
Shortcoming: Remedying
unemployment
can lead to demand-pull
inflation and
possibly an inflationary
spiral.
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9.5 EXPLORE & APPLY
Deficits and Debt
Per capita debt for each U.S. citizen is
over $21,000.
In 2002 the budget deficit was $106 billion,
and the gross national debt stood at $6.14
trillion.
The national debt can be thought of as the
stock or inventory of past accumulated
debt, while deficit can be thought of as a
flow that adds to that debt.
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Terms along the Way
 sticky wages
 sticky wages and
prices
 unemployment
equilibrium
 fiscal policy
 expansionary fiscal
policy (fiscal
stimulus)
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 contractionary fiscal
policy (fiscal drag)
 discretionary policy
 recognition lag
 action lag
 implementation lag
 automatic stabilizers
 balanced budget
Ayers/Collinge, 1/e
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Terms along the Way
 budget deficit
 budget surplus
 full-employment
budget
 national debt
 short-run aggregate
supply
 structural rigidities
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 the production effect
 short-run
macroeconomic
equilibrium
 demand-pull inflation
 cost-push inflation
 inflationary spiral
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Test Yourself
1. When wages and prices are described as
being sticky it is meant that they
a. adjust quickly.
b. adjust slowly.
c. never adjust.
d. do not need to be adjusted.
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Test Yourself
2.
a.
b.
c.
d.
An example of an automatic stabilizer is
the U.S. income tax system.
the Internet.
sticky wages.
the full-employment equilibrium.
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Test Yourself
3.
a.
b.
c.
The federal budget deficit
has not existed since 1997.
is the accumulation of all federal debts.
equals the national debt minus the
budget surplus.
d. is the amount by which government
spending exceeds its revenue over the
course of a year.
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Test Yourself
4. Short-run aggregate supply always
intersects long-run aggregate supply at
a. the expected price level.
b. the actual price level.
c. the long-run equilibrium price level.
d. an unemployment equilibrium.
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Test Yourself
5.
a.
b.
c.
d.
In an inflationary spiral, output
always rises.
always falls.
alternatively rises and falls..
remains constant.
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The End!
Next Chapter 10
“Aggregate
Expenditures"
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