Download Price Level - cloudfront.net

Feb 20, 2015
HW Check – Recessions in U.S. History
Grades are posted. Let me know of any errors. I submit grades next
Mon.
Assembly seating: far right facing the stage, rows B-E
Tonight’s HW
1. Aggregate Supply and Demand Practice
Recessions in U.S. History


Which recession is the most severe? Why? Explain.
Similarities?
 Oil
-- 1990-1991, 1981-1982, 1973-1975
 Speculative Bubbles - 2007-2009 (housing bubble),
2001 (dot-com bubble), The Great Depression (stock
bubble)
 High interest rates/Fed's monetary policy - 2001,
1990-1991, 1981-1982, The Great Depression

Differences?
 Stagflation
- 1973-1975, 1981-1982
3
Unit 2:
Economic Fluctuations and
Fiscal Policy
Aggregate Supply and Demand Model
The AS-AD model helps us understand
economic fluctuations.
Price
Level
Aggregate = added all together;
combining all prices and all quantities.
LRAS
SRAS
Aggregate Demand – total consumption by
entire population for all goods and
services
Aggregate Supply –total output (total
production of all goods and services).
AD
0
Real GDP
Aggregate Demand
What is Aggregate Demand?
Aggregate Demand is all the goods and services (real GDP)
that buyers are willing and able to purchase at different
price levels.
The demand for everything by everyone in the US.
Inverse relationship between price level and Real GDP.
If the price level:
•Increases (Inflation), then real GDP demanded falls.
•Decreases (deflation), the real GDP demanded increases.
Aggregate Demand Curve
Price
Level
Changes in
price level
cause a
move along
the curve
AD is the demand by consumers,
businesses, government, and
foreign countries
AD = C + I + G + Xn
7
Real domestic output (GDPR)
Why is AD downward sloping?
1.
•
•
•
Wealth EffectHigher price levels reduce the purchasing power of money
This decreases the quantity of expenditures
Lower price levels increase purchasing power and increase
expenditures
Example:
• If the balance in your bank was $50,000, but inflation
erodes your purchasing power, you will likely reduce your
spending.
• So…Price Level goes up, GDP demanded goes down.
Why is AD downward sloping?
2. Interest-Rate Effect
• When the price level increases, lenders need to charge
higher interest rates to get a REAL return on their loans.
• Higher interest rates discourage consumer spending and
business investment. WHY?
• Example: An increase in prices leads to an increase in the
interest rate from 5% to 25%. You are less likely to take
out loans to expand your business.
• Result…Price Level goes up, GDP demanded goes down
(and Vice Versa).
Why is AD downward sloping?
10
3. Net Export Effect
• When U.S. price level rises, foreign buyers purchase fewer
U.S. goods and Americans buy more foreign goods
• Exports fall and imports rise causing real GDP demanded
to fall. (XN Decreases)
• Example: If prices triple in the US, Canada will no longer
buy US goods causing quantity demanded of US products
to fall.
• Again, Price Level goes up, GDP demanded goes down
(and Vice Versa).
Determinants/Shifters of
Aggregate Demand
GDP = C + I + G + Xn
Shifts in Aggregate Demand
Price
Level
An increase in spending will
shift AD right, and decrease
in spending shifts it left
AD1
AD2
AD = C + I + G + Xn
Real domestic output (GDPR)
12
Shifters of Aggregate Demand
13
1. Change in Consumer Spending
Consumer Wealth (Boom in the stock market…)
Consumer Expectations (People fear a recession…)
Interest Rate (Increase/decrease cost of borrowing…)
Taxes (Decrease in income taxes…)
2. Change in Investment Spending
Interest Rate (Increase/decrease cost of borrowing…)
Future Business Expectations (Optimistic…)
Business Taxes (Higher corporate taxes means…)
Shifters of Aggregate Demand
3. Change in Government Spending
(War…)
(Nationalized heath care…)
(Decrease in defense spending…)
4. Change in Net Exports (X-M)
Exchange Rates
(If the us dollar depreciates relative to the euro…)
National Income Compared to Abroad
(If a major importer has a recession…)
(If the US has a recession…)
AD = GDP = C + I + G + X
Aggregate Demand
Consumers respond to high
levels of debt by reducing
their purchases of
consumer goods.
Price
Level
Component of AD?
Consumption
Change in AD? Increase or
decrease?
AD
Resulting AD shift?
0
Real GDP
How does this cartoon relate to Aggregate Demand?
How does this cartoon relate to Aggregate Demand?
18
Aggregate Supply
What is Aggregate Supply?
Aggregate Supply is the amount of goods and services (real
GDP) that firms will produce in an economy at different price
levels.
The supply for everything by all firms.
AS depends on the quantity of labor and capital and the level
of technology.
Aggregate Supply differentiates between short run and longrun and has two different curves.
Short-run Aggregate Supply
• Wages and Resource Prices will not increase as price levels
increase.
Long-run Aggregate Supply
• Wages and Resource Prices will increase as price levels
increase.
Refresher…
In the short run, at least one input is fixed.
The long run is a period of time long enough for firms
to change any of their inputs, thus all costs are
variable.
Short-Run Aggregate Supply
In the short run, wages and resource prices will NOT increase
(“sticky”) as price levels increase.
Example:
• If a firm currently makes 100 units that are sold for $1 each.
The only cost is $80 of labor. How much is profit?
• Profit = $100 - $80 = $20
What happens in the SHORT-RUN if price level doubles?
• Now 100 units sell for $2, TR=$200. How much is profit?
• Profit = $120
With higher profits, the firm has the incentive to increase
production.
AS is upward sloping bc

In the short run, many costs that producers face are
fixed. The largest fixed cost tends to be wages
paid to workers. Wages are often determined by
contracts and even when they are not, employers
are slow to increase or decrease them in response
to economic conditions. When the price level rises,
the production costs do not rise by the same
proportion as the rise in the price of the unit so
profits tend to rise in the short run. Higher profits
incentivize producers to increase output.
Aggregate Supply Curve
Price
Level
AS
AS is the production
of all the firms in
the economy
Real domestic output (GDPR)
23
Long-Run Aggregate Supply
(potential Real GDP)
In the long run, wages and resource prices WILL increase as price
levels increase.
Same Example:
• The firm has TR of $100 an uses $80 of labor.
• Profit = $20.
What happens in the LONG-RUN if price level doubles?
• Now TR=$200
• In the LONG RUN workers demand higher wages to match
prices. So labor costs double to $160
• Profit = $40, but REAL profit is unchanged.
If REAL profit doesn’t change
the firm has no incentive to increase output.
Output is determined by the resources that exist in the economy
 full employment
Long run Aggregate Supply
In Long Run, price level increases but GDP doesn’t
Price level
LRAS
Long-run
Aggregate
Supply
Full-Employment
(Trend Line)
QY
GDPR
In the long run the economy will be producing at full employment.
Natural level of real GDP
25
Shifts in Aggregate Supply
An increase or decrease in national production can shift
the curve right or left
AS2 AS
Price
AS1
Level
Real domestic output (GDPR)
26
Determinants/ Shifters
Aggregate Supply
R. A. P.
1. Change in Resource (labor, capital) Prices
Prices of Domestic and Imported Resources
(Increase in price of Canadian lumber…)
(Decrease in price of Chinese steel…)
Supply Shocks
(Negative Supply shock…)
(Positive Supply shock…)
27
Shifters of Aggregate Supply
2. Change in Actions of the Government
(NOT Government Spending)
Taxes on Producers
(Lower corporate taxes…)
Subsidies for Domestic Producers
(Lower subsidies for domestic farmers…)
Government Regulations
(EPA inspections required to operate a farm…)
3. Change in Productivity
Technology
(Computer virus that destroy half the computers…)
Human Capital
Aggregate Supply
Unions are more effective so
that wage rates increase.
Price
Level
AS
Determinant of AS?
Input costs or productivity?
Change in AS? Increase or
decrease?
Resulting AS curve?
0
Real GDP
What causes Business Cycles?
Partner Discussion
Using the info from the Recession in U.S History handout, answer the
following:
1. What factors might cause spending (AD) in the economy to
change?
2. What factors would increase or decrease production (AS)?
31
Putting AD and AS together to get
Equilibrium Price Level and Output
Aggregate Supply and Demand Model
Business investment
increases
AS
Real GDP
Price
Level
Price Level
AD
Unemployment
0
Real GDP
Shifters of Aggregate Demand
AD = C + I + G + X
Change in Consumer Spending
Change in Government Spending
Change in Investment Spending
Net EXport Spending
Shifters of Aggregate Supply
AS = R + A + P
Change in
Change in
33
Change in
Resource Prices
Actions of the Government
Productivity (Investment)
Inflationary and
Recessionary Gaps
34
Example: Assume the government increases
spending. What happens to PL and Output?
Price
Level
LRAS
AS
PL and Q will
Increase
PL1
PLe
AD
QY Q1
GDPR
AD1
35
Inflationary
Gap
Output is high and unemployment is less than NRU
Price
Level
LRAS
AS
Actual GDP
above
potential GDP
PL1
AD1
QY Q1
GDPR
36
Example: Assume the price of oil increases
drastically. What happens to PL and Output?
Price
Level
LRAS
AS1
AS
PL1
Stagflation
PLe
Stagnate
Economy +
Inflation
AD
Q1 QY
GDPR
37
Recessionary Gap
Output low and unemployment is more than NRU
Price
Level
LRAS
AS1
Actual GDP
below
potential GDP
PL1
AD
Q1 QY
GDPR
38
Short Run and
Long Run
39
Shifts in AD or AS change the price level and output
in the short run
Price
Level
LRAS
AS
PLe
AD
QY
GDPR
40
Example: Assume consumers increase
spending. What happens to PL and
Output?
Price
Level
LRAS
AS
PL1
PLe
AD
QY Q1
GDPR
AD1
41
Now, what will happen in the LONG RUN?
Inflation means workers seek higher wages and
production costs increase
Price
Level
LRAS
AS1
AS
PL2
Back to full
employment with
higher price level
PL1
PLe
AD
QY Q1
GDPR
AD1
42
Example: Consumer expectations fall and consumer
spending plummets. What happens to PL and
Output in the Short Run and Long Run?
Price
Level
LRAS
AS
AS1
AS increases as workers
accept lower wages and
production costs fall
PLe
PL1
PL2
AD1
Q1 QY
AD
GDPR
43
Positive economic growth results from an
increase in productive resources, such as
labor and capital. With more resources, it is
possible to produce more final goods and
services, and hence, the natural level of
real GDP increases. Positive economic
growth is therefore represented by a shift
to the right of the LAS curve.
Similarly,negative economic growth
decreases the natural level of real GDP,
causing the LAScurve to shift to the left.
Homework
2008 Recession reading packet. You need to answer the
questions at the end of each reading.
1. Taking Out a Mortgage – Prime vs. Subprime
2. Nicole Bradury, Robo-Signer Victim
3. Rise and Fall of Bubbles
Federal Funds Rates
May 17, 2013 rate: 0.15%
Discussion Qs
What should the government do to address the 2008
financial crisis?
Should the US government bail out the
banking/financial/insurance industry?
Bailout Spending (as of 5/23/13)





929 Recipients
Total disbursement = $606 billion
Total returned = $364 billion
Total revenues from dividends, interest, and other
fees = $116 billion
Total net to date = $-126 billion
http://projects.propublica.org/bailout/list
Bailout Tracker
http://money.cnn.com/news/storysupplement/economy/bailout
tracker/
http://projects.propublica.org/bailout/list
http://money.cnn.com/news/storysupplement/economy/aig/in
dex.html
Recovery Act Spending
http://www.recovery.gov/Pages/default.aspx
Table 3-1.1, Changes in AD
Change
Component of AD
Direction of AD
Resulting
Curve
A – “reducing purchases”
C
Decrease, left
AD2
B – “reduction in investment”
I
Decrease, left
AD2
C – “Gov’t spending
increases”
G
Increase, right
AD1
D – “Consumer confidence
jumps”
C
Increase, right
AD1
E – “investors lose billions”
I, C
Decrease, left
AD2
F – “productivity rises”
N/A
NC, it affects AS
AD
Xn
Decrease, left
AD2
G – “trade war that reduces
exports by more than it
reduces imports”
Table 3-1.1, Changes in AS
Change
Determinant of AS
Change in AS
Resulting
Curve
A – “wage rates increase”
Input Costs
Decrease, left
AS1
B – “increase oil prices”
Input Costs
Decrease, left
AS1
C – “labor productivity
increases”
Productivity
Increase, right
AS2
D – “gas discovery
decreases energy prices”
Input Costs
Increase, right
AS2
E – “new efficiency”
Productivity
Increase, right
AS2
F – “Gov’t spending
increases”
N/A
NC (affects AD)
AS
G – “save and invest”
N/A
NC
AS
H - “Low birth rate
decrease the LF”
Input Costs
NC (until the
future)
AS
I – “increased skills”
Productivity
Increase, right
AS2
Shift in
AD/AS
Shift
Effect on
Price Level
Effect on
Real GDP
1. Business investment increases
AD
right
increase
increase
2. Gov’t increases spending
AD
Right
Increase
Increase
3. Oil discovery causes decrease in price
AS
Right
Decrease
Increase
4. Consumer spending increases
AD
Right
Increase
Increase
5. Production costs increase
AS
Left
Increase
Decrease
6. New tech and better education increase
productivity.
AS
Right
Decrease
Increase
7. Consumer confidence increases
AD
Right
Increase
Increase
8. Net exports decrease
AD
Left
Decrease
Decrease
9. “Economic boom in Japan and Europe”
AD
Right
Increase
Increase
10. “reduce taxes and increase transfer
payments”
AD
Right
Increase
Increase
11. “highest corn and wheat yields”
AS
Right
Decrease
Increase
12. “defense spending was increased”
AD
Right
Increase
Increase
13. “cuts SS by 10% and fin-aid by 20%”
AD
Left
Decrease
Decrease
14. “Begin to buy…to replace failing models’
AD
Right
Increase
Increase
Changes in SRAS and AD
Recessions in U.S. History
Draw AD-AS models
for each of the
recessions.
AS
Price
Level
AD
0
Real GDP
Causes of the 2008 Financial Crisis
2001 Recession
1996-2006, average home
prices more than doubles
Fed lowers interest rates
Low interest rates make it cheaper to buy a home
INCREASES DEMAND FOR HOMES
ubprime loans made home buying more accessible to more individuals
INCREASES DEMAND FOR HOMES
Investment banks  SECURIZATION  Mortgage-backed Securities (CDOs)
2008 Financial Crisis
The Crisis of Credit Visualized
http://crisisofcredit.com/
1. Why did America experience a housing boom?
2. How did investment bankers make so much money?
3. How would you assign blame (mortgage lenders, mortgage
borrowers, the Federal Reserve?) for the housing market
collapse and financial crisis that followed? Why?
Any questions?
NBER: Effects of the Financial Crisis and Great
Recession on American Households

We find that the effects of the recession are
widespread: between November 2008 and April
2010 about 39 percent of households had either
been unemployed, had negative equity in their
house or had been in arrears in their house
payments. Reductions in spending were common
especially following unemployment. On average
expectations about stock market prices and housing
prices are pessimistic, particularly long-run
expectations. Among workers, expectations about
becoming unemployed have recovered somewhat from
their low point in May 2009 but still remain high.
Overall the data suggest that households are not
optimistic about their economic futures.
- Sept, 2010

2008 Financial Crisis


https://www.youtube.com/watch?v=LHHVcIlHGc&list=UUOBwTuxW6hWHiR0Bw9pppIQ
https://www.youtube.com/watch?v=zaYCsn3QoQM
Circular Flow and GDP Practice KEY
b. $800 million (C+I+G+X-M or wages+dividends+interest+rent)
c. Disposable income = $670
d. Household savings = $270
e. no, gov’t had to borrow $70 million
f. $290m (borrowing) = $290 (household savings & foreign lending)
g. $800m (goes into product market) = $800m (goes into factor market)
h. $800m (goes into factor market) = $800 (household income)
#2
a.
Included - investment spending
b.
Not included – house was built in 2001 – used
and no realtor = no income.
c.
Included – gov’t spending
d.
Included – exports
e.
Not included – non-market transaction
f.
Included - investment
#3
Calculating Nominal and
Real GDP
a. 2010 = $8,000
2011 = $8,866
2012 = $9,650
b. 10.8%
((88668000)/8000)*100
c. 8.8%
((96508866)/8866)*100
d. 2010 = 8,000
2011 = 8,650
2012 = 9,070
e. 8.1%
((86508000)/8000)*100
f. 4.9%
((90708650)/8650)*100
g. 2010 = 100
2011 = 102.5
2012 = 106.4