Download Aggregate Supply and Aggregate Demand

Aggregate Supply and Aggregate Demand
Day 1
Q1: During the Great Depression we saw a rise in
unemployment and deflation. In the recession of
1979-1982 a rise in unemployment but inflation.
Why?
Q2: What is stagflation?
Aggregate Supply and Aggregate Demand
• Since inflation changes from year to year, and a nations productivity
level over time is tracked in monetary terms using GDP, how can
you tell if a change in a country's level of output is due to a real
change in productivity or whether it is due to fluctuations in the
level of the prices of that output? The answer is you can't.
If you recall the concept of "holding all else constant" you will
quickly realize that without adjusting GDP to account for the effect
of inflation, you will be unable to accurately compare a country's
GDP from year to year.
To deal with this issue, a "fudge factor" called the GDP deflator is
used to convert Nominal GDP (GDP with the effects of inflation)
into Real GDP (GDP without the effects of inflation). Nominal GDP is
divided by the GDP deflator to get Real GDP. Basically, the GDP
deflator is used to "cancel out" the effects of inflation.
GDP Deflator
• Essentially, GDP Deflator is an adjustment for the impact of changes
in prices on changes in nominal GDP. GDP Deflator can be
considered the most comprehensive measure of inflation since a
wide array of goods and services are included in its construction.
But it may not reflect the full impact of inflation on consumer
welfare because it does not include imported goods and services
that constitute a significant portion of what people buy.
• GDP Deflator is the ratio of the value of aggregate final output at
current market prices (Nominal GDP) to its value at the base year
prices (Real GDP). In effect the basket of goods for the construction
of this price index includes all the final output produced within the
geographic boundaries of the country.
GDP Deflator = Nominal GDP/ Real GDP
Nominal GDP
• Nominal GDP can change from time to time because of
two reasons:
• changes in the physical volume of output or
• changes in the prices at which output is valued
• We want to use GDP to look at changes in the physical
volume of output. Since Nominal GDP can also change
due to changes in the prices at which output is valued
it is necessary to "deflate" the value recorded for
Nominal GDP (GDP with inflation) into "real" dollars so
we can make comparisons across years.
Real GDP
• When we divide GDP at current market prices
(Nominal GDP) by the corresponding GDP
deflator, we obtain what is called real GDP.
• Real GDP = Nominal GDP / GDP Deflator
• Real GDP can change only because of changes
in the physical volume of output. As a result
Real GDP is considered a better measure of
economic growth than nominal GDP.
SRAS Curve
• There is a positive relationship between the
aggregate price level and the quantity of
aggregate output supplied, other things equal.
Q3: What does this mean?
Q4: What law of economics does this reflect in
the microeconomic arena?
Q5: If you have a job what is your nominal wage?
SRAS Curve
• What is compensation?
• Direct compensation: Wage or salary
• Indirect compensation: Benefits and perquisites
Q6:
Why does Krugman say wages are an inflexible cost
(sticky) incurred by employers?
Q7:
What two types of wage agreements does
Krugman say exist between employees and
employers? Reapplying for your job every 4 years.
SRAS Curve
Q7:
Assume the aggregate price level rises.
The typical producer receives a higher price for
their final good or service.
In the SR, are most production costs fixed or
variable?
In that case, as aggregate price levels increase,
does the firm become more profitable or less
profitable?
Are wages considered a fixed cost in the SR?
Shifts in the SRAS Curve
The following can cause a shift in the SRAS Curve:
1. Changes in Commodity Prices
2. Changes in Nominal Wages
- What is a COLA?
- How is a COLA determined?
- Are COLA’s prevalent today?
3. Changes in Productivity
Day 2
Aggregate Supply (AS) Curve
•
The shape of the AS curve depends
on whether one is looking at a LRAS
or a SRAS.
•
The LRAS is a vertical line reflecting
the classical view that wages and
prices are flexible, meaning that firms
will always produce at the full
employment level of output.
•
How can this be the case?
•
Free response question
“Assume ALL prices across the U.S.
economy are cut in half at the exact
same time. What would happen to
aggregate output?” Explain your
answer.
Aggregate Supply (AS) Curve
Answer
1.
2.
3.
4.
5.
Each producer would receive a lower price for their product.
50% less
Costs of production would fall by the same proportion. 50% less
Every unit of output that was profitable to produce before the
change would still be profitable to produce after the change.
There would be no impact on the nation’s aggregate output
supplied.
When all prices are fully flexible, inflation and deflation have
the same effect as a price increase or decrease.
Rule: Changes in the aggregate price level do not change the
aggregate output supplied in the LR.
Aggregate Supply
Q. What is the intersection of
LRAS and the Real GDP axis
called? Define it.
B
C
Q. What is the Y axis called in
addition to GDP Deflator?
D
Q. What happens to the
aggregate output level
supplied when there is a
price change from C to D?
A
Aggregate Supply
Q. What is the intersection of LRAS
and the Real GDP axis called?
Define it. Potential output, Yp:
the level of real GDP the
economy would produce if all
prices, including nominal wages,
were fully flexible.
Q.
What is the Y axis called in
addition to GDP Deflator?
Aggregate Price Level
Q.
What happens to the aggregate
output level supplied when
there is a price change from C
to D? Nothing
B
C
D
A
Free Response: Analyze this graph. Identify the key national and
international events that influenced changes in U.S.
GDP.
Answer
• Arab Spring
• Japan Tsunami
• Eurozone – Especially Spain,
Greece, Portugal, Ireland, and
Italy
• Most of the money from the $800
billion stimulus package was
spent before the end of 2010.
• Housing in the U.S. will remain
weak as the overhang of unsold
homes, inventory in waiting
(people waiting for better times
to sell their homes), and
foreclosures provide a ready
supply of homes.
• Unemployment
• Oil Prices
SRAS Curve Basics
•
•
The vertical axis on the AS measure
the price level not the price. Think of
the price level as the average level of
prices for all goods.
•
Remember that expenditures on
output (GDP) ultimately become
income (NI), so the horizontal axis
can be considered a measure of
national output and income.
•
Aggregate Supply
Do not confuse the AS and the firm
supply curve.
Because it is the real value of GDP, it
changes not only when the price
level changes but also when the
quantity of goods and services
produced changes.
AS
Price
Level
C
B
A
E
D
A = Depression or Keynesian Stage
B = Intermediate Stage
C = Classical Stage
D = Physical Limit
Real GDP
SRAS Curve Basics
• A: During a depression, firms
have large inventories and
excess capacity and would be
glad to sell more output at the
existing price level.
• Workers and factors of
production are plentiful and
the economy can increase its
output without placing
upward pressure on prices or
wages.
• This results in a horizontal
segment of the aggregate
supply curve.
• In other words, during a
depression, changes in
aggregate demand affect real
GDP but not the price level.
Aggregate Supply
AS
Price
Level
C
B
A
E
D
A = Depression or Keynesian Stage
B = Intermediate Stage
C = Classical Stage
D = Physical Limit
Real GDP
SRAS Curve Basics
• B: The economy normally
operates in the intermediate
range of the AS curve, which is
why many diagrams illustrate
this positively sloped segment
of the curve.
• At these intermediate levels of
output there are no excessive
inventories, and firms are
closer to their productive
capacities.
• Expansions in output require
firms to hire additional
workers and work their plants
and equipment at a faster
pace, actions which require a
profit incentive for higher
output.
Aggregate Supply
AS
Price
Level
C
B
A
E
D
A = Depression or Keynesian Stage
B = Intermediate Stage
C = Classical Stage
D = Physical Limit
Real GDP
SRAS Curve Basics
Aggregate Supply
• C: As the economy reaches
full employment, it
becomes more difficult for
firms to find additional
labor and they must
increase the wage rate.
• The price level escalates
until the economy reaches
its physical limit for output.
In this case increases in
aggregate demand result
simply in increases in the
price level.
AS
Price
Level
C
B
A
E
D
A = Depression or Keynesian Stage
B = Intermediate Stage
C = Classical Stage
D = Physical Limit
Real GDP
Classical Analysis
Wages, prices, and interest rates fluctuate
quickly bringing to equilibrium labor and
capital markets and allowing input and
output prices to stay in line with each other.
Classical economists also believe in Say’s
Law - the idea that supply creates its own
demand.
Aggregate Supply
Day 3
Aggregate Supply
AS
Price
Level
C
In other words, when supplying goods,
workers earn money to spend or save, and
savings end up being borrowed and spent
on business investments.
There should be no problem finding
demand for goods and services produced
because the income from making them will
be spent purchasing them.
This supports the contention that the
government does not need to concern itself
with policies that maintain demand at a
desirable level.
B
A
E
D
A = Depression or Keynesian Stage
B = Intermediate Stage
C = Classical Stage
D = Physical Limit
Real GDP
Critics of Say’s Law
argue that that savings
might not equal
investment, because
interest rates do not
fluctuate freely enough
to clear the capital
market.
Aggregate Supply
Day 3
Aggregate Supply
AS
Price
Level
C
The Capital Market
Real
% Rate
B
S
A
ie
E
I
Se = Ie
Savings (S)
Investments (I)
D
A = Depression or Keynesian Stage
B = Intermediate Stage
C = Classical Stage
D = Physical Limit
Real GDP
•
John Maynard Keynes argued that
investment depends more on expectations
about the prosperity of the economy than
on interest rates.
•
If savings exceed investment, some of the
nation’s real GDP will not be purchased and
firm inventories will expand, resulting in
layoffs and subsequent production below
full employment output.
•
•
Aggregate Supply
Day 3
Aggregate Supply
AS
Price
Level
C
Likewise if savings are less than
investment, expenditures will exceed GDP
and firm inventories will deplete, resulting
in inflation and production beyond full
employment output.
B
Keynes said the AS curve would remain
horizontal until the full-employment level
of output ,, where it becomes vertical. He
called this the “depression range.” He
blamed the existence of unemployment
and the inability of the economy to selfadjust to full employment output largely
on “sticky” wages.
A
E
D
A = Depression or Keynesian Stage
B = Intermediate Stage
C = Classical Stage
D = Physical Limit
Real GDP
•
The Theory of Rational Expectations
suggests that people learn to anticipate
government policies designed to influence
the economy, thereby making the policies
ineffectual.
•
With an understanding of inflation, and
using all available information, workers and
consumers respond quickly to policies unless
they are somehow caught off guard or
fooled.
•
Aggregate Supply
Day 3
Rational Expectations
Price
Level
AS2
AS1
For example, if the government predictably
attempts to boost real GDP by increasing the
money supply or government spending (and
thus aggregate demand – AD1 to AD2),
people will anticipate the resulting inflation
and build it into their wage and price
demands.
•
The increased wages will shift the AS back
from AS1 to AS2 and the government policy
will have no real effect on output or income.
•
Bottom line for this theory, government
intervention is not necessary or useful for
stabilizing the economy.
AD2
AD1
0
Y
Real
GDP
Unemployment Types
Frictional Unemployment
Occurs as unemployed
workers and firms search
for the best available
worker-job matches.
Includes new labor force
entrants looking for their
first jobs and workers who
are temporarily between
jobs because they are
moving to new locations or
an occupation in which they
will be more productive.
Unemployment Types
Structural Unemployment
The results of a mismatch.
As voice recognition
software is perfected, skilled
typists may find themselves
out of work. Poorly
educated people may find
themselves structurally
unemployed because they lack
the necessary marketable
skills.
Unemployment Types
Cyclical Unemployment
Results from a downturn in
the business cycle. During
recession and depressions,
firms are likely to hire fewer
workers or let existing
workers go. When the
economy recovers, many of
these cyclical workers will
again find work.
Unemployment Types
Seasonal Unemployment
Changes in hiring patterns due to the
time of the year, e.g. ski instructors and
life guards.
Discouraged Workers
Those who are willing and able to
work, but who have become so
frustrated in their attempts to find
work that they stop trying. Because
they are not making an effort to find
a job at least once each 4 weeks,
they are not counted in the
unemployment official statistics.
Unemployment
Natural Rate of Unemployment
About 5% in the U.S. in a
normally functioning economy
and is often thought of as the
sum of frictional and structural
unemployment.
Full employment is not 100%
employment but the level of
employment that corresponds
with the natural rate of
unemployment.
With full employment there is
no cyclical unemployment.
Okun’s Law
•
Some unemployment can be a good
things
•
Frictional unemployment allows
workers to move into new jobs that are
more satisfying for both the worker and
the employer.
•
High rates of unemployment can be
devastating, leading to personal loss of
self-confidence, crime, the break-up of
families, and suicide.
•
There are also losses to output and
income.
•
Okun estimated that for every one
percentage point increase in the
unemployment rate above the natural
rate, output falls by 2 to 3 percentage
points. This is called Okun’s Law.