Download AD-AS analysis to show external demand and supply

AD-AS analysis to show external demand and supply-side shocks to an economy
Supply-sideshocksareunexpectedeventsaffectingcosts
andpricesindifferentcountries.Anaggregatesupply
shockiseitheraninflationshockorashocktoacountry’s
potentialnationaloutput.
Adverseaggregatesupplyshocksofbothtypesreduce
outputandincreaseinflationandcanincreasetheriskof
stagflationforaneconomy.Forexampleariseinthe
worldpriceofcrudeoilornaturalgas.Orperhapsan
unexpectedandsizeablechangeinworldpricesof
foodstuffsusedbothfordirectconsumptionandalsoas
aninputintotheproductionofmanufacturedfoods.
Theeffectsofsupply-sideshocksarenormallytocausea
shiftintheshortrunaggregatesupplycurve.
Ademandshockisasuddensurpriseeventthattemporarilyincreasesordecreasesdemandforgoodsor
services.Apositivedemandshockincreasesdemand,whileanegativedemandshockdecreasesdemand.
Bothpositiveandnegativedemandshockhaveaneffectonthepricesofgoodsandservices.
Negative Output Gap
This occurs when actual output is less than potential output gap. This is also called a deflationary
(or recessionary) gap. In this situation the economy is producing less than potential. There will be
unemployment, low growth and / or a fall in output. A negative output gap will typically cause low
inflation or even deflation.
Lost Output During 2008-12 Recession
Positive Output Gap
This occurs when actual output is greater than potential output. This will occur when economic
growth is above the long run trend rate (e.g. during an economic boom). It will involve firms asking
workers to overtime.
With a positive output gap, there will be inflationary pressures. It will also tend to cause a bigger
current account deficit as consumers buy more imports due to domestic supply constraints.
Trade / business cycle diagrams
Crowding out / loanable funds markets
Crowding out theory in general applies to all markets in which the government operates (including labour markets) but
the most important version, particularly in the current climate when a shortage of labour clearly isn’t a problem, is
crowding out in money markets which are intrinsically linked to the budget deficit. The argument can be seen on the
diagram below and is as follows:
The assumptions of the diagram is that the governments
demand is perfectly inelastic (that is it isn’t affected by interest
rates) since they have to borrow the money in order the meet
their spending commitments.
Without any public sector borrowing the market is in
equilibrium with a quantity of money lent of D at an interest
rate of A since this is where the private sector demand
schedule (green) meets the (total) supply schedule (grey).
Then consider what happens when the government requires
money to maintain the public sector, it needs to borrow an
amount, B, from the markets, its demand is drawn as vertical
line upwards from B (in blue). This causes an increase in total
demand for money represented by a rightward shift in demand
for money by B (this means that at any given interest rate the
total amount of money people are seeking to borrow (both the
public and private sectors) is increased by B) to the (grey) line
marked total demand.
As a result of this interest rates increase from A to F since the
equilibrium point moves along the supply curve. Since interest rates are higher an increased amount of money in total
is borrowed of which B is government borrowing and E-B is private sector borrowing. However, we can see the affect
of the higher interest rates on private sector borrowing by looking at private sector demand curve (green). This shows
that at an interest rate of F only C is borrowed by the private sector which means there is a fall in private sector
borrowing of D-C. This is the “crowded out” private sector borrowing.
Phillips Curve
ThePhillipscurvesuggeststhatchangesinthe
levelofunemploymenthaveadirectand
predictableeffectonthelevelofprice
inflation.Theacceptedexplanationduringthe
1960’swasthatafiscalstimulus,andincrease
inAD,wouldtriggerthefollowingsequenceof
responses:
1. Anincreaseinthedemandforlabouras
governmentspendinggenerates
growth.
2. Thepoolofunemployedwillfall.
3. Firmsmustcompeteforfewerworkers
byraisingnominalwages.
4. Workershavegreaterbargainingpower
toseekoutincreasesinnominalwages.
5. Wagecostswillrise.
6. Facedwithrisingwagecosts,firmspass
onthesecostincreasesinhigherprices.
Using AD/AS to demonstrate the Phillips Curve effect
Assumetheeconomyisatastableequilibrium,
atY.Anincreaseingovernmentspendingwill
shiftADfromADtoAD1,leadingtoarisein
incometoY1,andafallinunemployment,inthe
shortterm.
However,householdswillsuccessfullypredictthe
higherpricelevel,andbuildtheseexpectations
intotheirwagebargaining.
Asaresult,wagecostsriseandtheASshiftsup
toAS1andtheeconomynowmovesbacktoY,
butwithahigherpricelevelofP2.
New Keynesian interpretation of the Phillips curve
NewKeynesiansexplainthebreakdownof
thesimplePhillipscurveintermsoftheNonAcceleratingInflationRateof
Unemployment(NAIRU).NAIRU,whichexists
attheLongRunPhillipsCurve,istherateof
unemploymentatwhichinflationwill
stabilise-inotherwords,atthisrateof
unemployment,priceswillriseatthesame
rateeachyear.
Labour markets at work
Gini Coefficient / Lorenz Curve for showing relative poverty / inequality
TheLorenzCurveisagraphicalmethodusedto
displaytheconcentrationofactivitieswithinan
area(e.g.thedegreeofindustrial
specializationwithinanurbanarea).Fieldwork
datamaybeusedbutitismorecommonto
usesecondarysources(e.g.censusdata,etc).
Thistechniqueisparticularlyusefulasit
providesagoodvisualcomparisonofany
observeddifferencesandfromitaprecise
index(GiniCoefficient)canbecalculated.
ThefurtherawaytheLorenzCurveisfromthe
"lineofperfectequality"(diagonal),themore
diverseisthesampleandthemoreunevenly
thevaluesarespreadout.Thisisveryusefulto
estimatehowwealthisdistributedamonga
population:ifacountry'sLorenzCurveis
distantfromthelineofperfectequality,it
meansasmall%ofthepopulationcontrolsmostofthewealthandthatthecountry'sincomedistribution
isuneven.
Inaperfectlyequalcountry,60%ofthepopulationshouldearn60%ofthecountry'swealth,butinthis
example:
60%ofthepopulationofcountryXearns20%ofthecountry'swealth
60%ofthepopulationofcountryYearns15ofthecountry'swealth
ThismeansthattheincomedistributionincountryYismoreunequalthanincountryX
Comparative advantage and gains from trade (PPF diagrams and supply-demand
analysis)
Supposeittakes2hoursoflabourtoproduce1keg
ofbeerinGermanywhile,usinganequivalent
amountofotherresources,ittakes4hoursof
labourtoproduceakegofbeerinPoland.Also
supposethatittakes3hoursoflabourtoproducea
bushelofwheatinGermanywhileitrequires4
hoursoflabourtoproduceabushelofwheatin
Poland.
Germanyhastheabsoluteadvantageinproducing
beer:ittakesfewerresourcestoproduceakegof
beerinGermanythanitdoesinPoland.Germany
alsohastheabsoluteadvantageintheproduction
ofwheat.
Whatmattersfortradeiscomparativeadvantage.A
countryhasacomparativeadvantageinproducing
agoodifitproducesthegoodataloweropportunitycostcomparedtoanothercountry.Germanyhasaloweropportunitycost
ofproducingbeersoGermanyhasacomparativeadvantageinbeerproduction.Polandhasthecomparativeadvantagein
wheatproduction.
SupposeofPolishfarmertakes10bushelsofwheattoGermany.Germansareusedtoexchanging15kegsofbeerfor10bushels
ofwheatwhilethePolishfarmerisusedtogetting10kegsofbeerfor10bushelsofwheat.Anyexchangeof10to15kegsof
beerforthe10bushelsofwheatleaveseveryonebetteroff.
Ifbothcountriesspecializeproducingthegoodinwhichtheyhavethecomparativeadvantageandthentrade,theycanendup
consumingatpointsthatlieabovetheirproductionpossibilitiesfrontier.
Protectionism and welfare diagrams e.g. tariffs / quotas / export subsidies
Tariffs,orcustomsduties,aretaxesonimportedproducts,usually
inanadvaloremform,leviedasapercentageincreaseonthe
priceoftheimportedproduct.Tariffsareoneoftheoldestand
mostpervasiveformsofprotectionandbarriertotrade.Domestic
consumersfacehigherprices,whichalsomeansthatthereisaloss
ofconsumersurplus.However,thereisagainindomestic
producersurplusasproducersareprotectedfromcheapimports,
andreceiveahigherpricethantheywouldhavewithoutthetariff.
However,itislikelythatthereisanoverallnetwelfareloss.
Withouttrade,thedomesticpriceandquantityareP&Q.Ifa
countryopensuptoworldsupply,pricefallstoP1,andoutput
increasesfromQtoQ2.Asaresult,domesticproducers’sharefalls
toQ1andimportsnowdominate,withthequantityimportedQ1
toQ2.Theimpositionofatariffshiftsuptheworldsupplycurveto
WorldSupply+Tariff.
ThepricerisestoP2,andthenewoutputisatQ3.Domestic
producersshareofthemarketrisetoQ4,andimportsfalltoQ4to
Q3.TheresultisthatdomesticproducershavebeenprotectedfromcheaperimportsfromtherestoftheWorld.
Giventhatdomesticconsumersfacehigherprices,theyalsosufferalossofconsumersurplus.Incontrast,domesticproducers
increasetheirproducersurplusastheyreceiveahigherpricethantheywouldhavewithoutthetariff.
Increasedmarketsharealsomeansthatjobswillbeprotectedinthedomesticeconomy.
Protectionism and welfare diagrams e.g. tariffs / quotas / export subsidies
Aquotaisalimittothequantitycomingintoacountry.
Withnotrade,equilibriummarketpriceinthecountry
willexistatthepricewhichequatesdomesticdemand
anddomesticsupply,atP,andwithoutputatQ.
However,theworldpriceislikelytobelower,atP1,
thanthepriceinacountrythatdoesnottrade.Ifthe
countryisopeneduptofreetradefromtherestofthe
world,theworldsupplycurvewillbeperfectlyelasticat
theworldprice,P1.
ThenewequilibriumpriceisP1andoutputisQ1.The
domesticshareofoutputisnowQ2,comparedwithQ,
theself-sufficientquantity.Theamountimportedisthe
distanceQ2toQ1.
Inanattempttoprotectdomesticproducers,aquota
ofQ2toQ3maybeimposedonimports.
Thisenablesthedomesticshareofoutputtorise
to0toQ2,plusQ3toQ4.
Thequotacreatesarelativeshortageanddrivesthe
priceuptoP2,withtotaloutputfallingtoQ4.The
amountimportedfallstothequotalevel.Itisthis
pricerisethatprovidesanincentiveforlessefficient
domesticfirmstoincreasetheiroutput.
Oneofthekeydifferencesbetweenatariffanda
quotaisthatthewelfarelossassociatedwithaquota
maybegreaterbecausethereisnotaxrevenueearned
byagovernment.Becauseofthis,quotasareless
frequentlyusedthantariffs.
Trade creation arising from a customs union
Trade diversion arising from a customs union
Currency intervention to manage the exchange rate
J Curve effect following a depreciation/devaluation of the exchange rate
FDI and economic growth effects (e.g. shifting AD and LRAS effects)