Download Short-Run Model Essentials

Macro Short‐Run AS & AD Model Essentials Up to this point, our discussions of unemployment, inflation, output, and income have revolved around how we measure theses indicators of economic performance. Now we want to focus on understanding how real‐world events and government policy change these measures of economic performance. Our tool for understanding how these events and policy changes affect inflation, unemployment, and output will be the aggregate supply and demand model. Aggregate – means to add up, aggregation usually implies that the things being added up are similar, but not exactly identical The Short‐Run Aggregate Supply/Aggregate Demand Model  Similar to our basic supply and demand model  Output of all goods, measured by Real GDP, is on the horizontal axis  Confusingly, we use Y on the horizontal axis as the symbol for Real GDP  The price level, often measured by the GDP Deflator, is on the vertical axis  In the short‐run model, we assume that input prices are fixed PL SRAS
Sort‐Run Equilibrium SRAS = AD
PE AD
Y
YE Short‐Run Equilibrium  Occurs where the SRAS curve intersects the AD curve Why is this model useful?  It allows us to see how real‐world events and policy changes affect output, unemployment, and the price level.  Inflation can be tracked on the vertical axis.  Real output/income and unemployment can be tracked on the horizontal axis. Example 1 – Demand‐pull inflation resulting from a tax cut PL SRAS
PE2 PE1 AD2
AD1
Y 1
2
YE YE Demand‐pull inflation  occurs when from increased overall demand for final goods and services bids up prices  silver lining: real output increases from YE1 to YE2 and unemployment likely falls Example 2 – Cost‐push inflation resulting from a higher oil prices SRAS2
PL SRAS1 PE2 PE1 AD
Y 2
1
Y
Y
E
E
Cost push inflation  occurs when rising input prices force up the cost of production and therefore the prices of final goods and services  also known as stagflation  worst of all possible worlds: prices rise, real output falls, unemployment rises  relatively uncommon occurrence, thankfully  significant stagflation during the 1970s Misery index = the unemployment rate + the rate of inflation Aggregate Demand – defined as the quantity of real domestic product that households, firms, government agencies, and foreign buyers wish to purchase at each price level, ceteris paribus AD = C + I + G + (X‐M) Components of AD  Consumption (C) – essentially all spending by households on final goods and services except new homes  Investment (I) – has 3 components: spending by households on new homes, spending by firms on new capital equipment, additions to inventories by firms  Government Purchases (G) – purchases of goods and services by the government, (this does not include transfer payments)  Net Exports (X‐M) – spending by foreign citizens on “our” final goods and services minus spending by “our” citizens on foreign final goods and services Short‐Run Aggregate Supply ‐ the quantity of real domestic product firms are willing to produce at each price level, ceteris paribus Slope of the SRAS curve  Generally speaking, SRAS has a positive slope  Higher prices of final goods and services lead to higher profits for firms if input costs are “sticky”  Input costs are often assumed to be sticky due to the fact that wages and prices of other inputs are often fixed by long‐term contracts  Slope of SRAS is a bone of contention responsible for a number of disagreements in modern macroeconomics  Important because the steepness affects the outcome of policy changes  Classical thought argues that it is very steep, even vertical  Keynesian argues that it is much flatter, even horizontal at times  Keynesian section represents a revision of thought resulting from the Great Depression Shape of the AD curve  Remember, AD = C + I+ G + (X‐M)  Generally speaking, we believe that AD has a negative slope for 3 reasons. 1) Wealth, or real balances, effect 2) Interest rate effect 3) Foreign purchases effect/net export effect Wealth effect  acts through consumer expenditures (C)  as the price level of final goods and services falls, the quantity of goods and services that your nominal wealth will purchase increases (purchasing power, or real wealth, increases)  this is true for wealth held in the form of bank deposits, etc.  real wealth increase  so, as P decreases, real wealth rises, we feel richer and spend more so consumption rises and AD increases Interest rate effect  AD curve is drawn assuming that the supply of money is fixed  as the price level falls, fewer dollars are needed to purchase goods and services  demand for dollars falls  price of dollars falls  price of the dollar is known as the interest rate  projects and home ownership become more affordable as interest rates drop  investment rises as the interest rate falls  so, as PL falls, the demand for money falls, interest rates fall, and therefore investments rise, and AD increases i S
iE1 D1
iE2 D2
Q Money Market Net export, or foreign purchases, effect  we buy foreign goods because they are cheaper than domestic goods  same holds true for foreigners  if our PL falls compared to the PL in other countries, “our” goods become more attractive residents of other countries, so our exports rise  simultaneously, “their” goods become less attractive to us, so “our” imports fall  as a result, (X‐M) rises  so, as our PL decreases compared to the PL in other countries, net exports (X‐M) rise and therefore AD rises Why are AS/AD models useful?  AS/AD models can be used to predict how real world events and economic policies might change output, unemployment, and inflation.  We need to understand what makes the curves shift in order to understand these changes. What factors would shift the AD curve?  remember AD = C+I+G+(X‐M)  anything that affects the desire of HH, firms, the government, or foreign citizens to purchase final goods and services will shift the AD curve Consumption determinants 1) Changes in real wealth ‐ stock market gains 2) Expectations ‐ regarding wealth, income, etc. 3) Indebtedness ‐ flip side of wealth 4) Taxes ‐ on wealth, income Investment determinants 1) Interest rates 2) Expectations regarding the profitability of projects 3) Business taxes ‐ esp. capital gains and ITC's 4) Technological change 5) Degree of excess capacity Government spending determinants 1) Whatever the government decides to spend Net exports determinants 1) Foreign national income 2) Exchange rates 3) Tariffs and quotas What factors shift the SRAS curve? 1) Wages and other input prices ‐ not the general price level 2) Changes in productivity ‐ new technology allows greater output at constant price 3) Changes in the legal/institutional environment – changing tax and regulatory structures affect the firms’ incentives, and ability, to produce Example 1 – China grows rapidly  Output and income are flip sides of the same coin  If Chinese output rises, Chinese incomes rise  Some of their additional income will be spent on goods and services from the U.S., so our exports rise  AD shifts out  Result: Real GDP rises, unemployment falls, the price level rises PL SRAS PE2 AD2
PE1 AD1
YE1 YE2
Example 2 – Consumer confidence takes a dive as Congress becomes more dysfunctional  Nervous consumers put off large projects and new purchases of durable goods  Consumption, and therefore AD, falls  AD shifts back  Result: Real GDP falls, unemployment rises, the price level falls PL SRAS
PE1 AD1
PE2 AD2
YE2 YE1 Example 3 – New fracking technology makes it easier to extract oil and natural gas  This reduces the cost of two major inputs  SRAS shifts out  Result: Real GDP rises, unemployment falls, the price level falls SRAS1
PL SRAS2 PE1 PE2 AD
Y 1
2
YE YE Example 4 – Congress mandates 12 months paid maternity leave for mothers and fathers from all jobs  This essentially makes employees much more expensive  SRAS shifts back  Result: Real GDP falls, unemployment rises, the price level rises SRAS2
PL SRAS1 PE2 PE1 AD
Y 2
YE 1
YE