Download Long run equilibrium

Ch 10


Analyze the impact of unanticipated changes
in aggregate demand and short run
aggregate supply
Evaluate the economy’s self-correcting
mechanism


Anticipated change – foreseen in time to
make adjustments
Unanticipated change – not foreseen,
appropriate adjustments were not made
A change in the price level
represents a movement along
the curve
Price Level
P2
P1
AD
Y2
Y1
Output
Price Level
Changes in things besides the
price level shift the curve and
(AD1) increase or (AD2)
decrease aggregate demand
AD1
AD2
AD0
Output

1. Increases in real wealth shift AD right
◦ a. Stock market
◦ b. Housing prices
◦ Example: The 1990s “new economy”

2. When the interest rate falls, AD shifts right
because borrowing (for consumption and
investment) becomes cheaper

3. When people are optimistic about the
future, AD shifts right
◦ Consumer sentiment index
◦ “Animal Spirits” – Keynes
◦ “Irrational Exuberance” – Greenspan

4. When expected inflation is high, AD shifts
right
◦ Less incentive to save, spend now

5. If other countries’ incomes are rising, AD
shifts right
◦ Demand for U.S. exports increases as other
countries prosper
◦ The larger the trade sector, the bigger the shift

6. When the dollar depreciates, AD shifts
right
◦ Imports become more expensive
◦ Exports become cheaper
◦ So, NX will rise
Increase in AD (shift right)
Decrease in AD (shift left)
↑ in real wealth, stock mkt, housing
↓ in real wealth, stock mkt, housing
↓ in real interest rate
↑ in real interest rate
Optimism about the future
Pessimism about the future
↑ in expected inflation
↓ expected inflation
↑ real incomes abroad
↓
real incomes abroad
↓
↑
value of nation’s currency
prices
value of nation’s currency
prices

Permanent change in production conditions
◦ Shift LRAS
◦ Shift SRAS

Temporary change in production conditions
◦ Shift SRAS
Price Level
An increase in the economy’s
production capacity will shift
LRAS right
LRAS1 LRAS2
Output (real GDP)

Improvements in resource base
Ch 16 Sources
of Economic
Growth
◦ Physical capital investment
◦ Human capital investment


Improvements in technology
Institutional and government policy changes
◦ Easy to conduct business
◦ Enforce contracts fairly
◦ Protect private property rights
Increase in LRAS (shift right)
Decrease in LRAS (shift left)
↑ in supply of resources
↓ in supply of resources
Technology and productivity
improvements
Technology and productivity
deteriorations
Institutional changes that improve
efficiency of resource use
Institutional changes that reduce
efficiency of resource use
Note: Rightward shifts are much more common in the U.S.
than leftward shifts, thank goodness!
Price Level
Increase in price level will
increase quantity supplied in
the short run
SRAS
P2
P1
Output
Y1
Y2
Price Level
Changes in things besides the price
level shift the curve and (SRAS1)
increase or (SRAS2) decrease short
run aggregate supply
SRAS2
SRAS0
SRAS1
Output (real GDP)

1. When resource prices fall, SRAS shifts right
◦ If the change is long-term, LRAS will shift also

2. When expected inflation is low, SRAS
shifts right
◦ No benefit from holding onto goods to sell at a
later date

3. Favorable supply shocks shift SRAS right
◦ Supply shock – unexpected event that temporarily
increases or decreases aggregate supply
◦ Examples: OPEC increases output, favorable
growing conditions
Increase in SRAS (shift right)
Decrease in SRAS (shift left)
↓ in resource prices (production
↑
↓ in expected inflation
↑ in expected inflation
Favorable supply shocks like good
weather or lower prices of oil
Unfavorable supply shocks like bad
weather or higher prices of oil
costs)
in resource prices (production
costs)


Holding fiscal and monetary policy constant
Ceteris Paribus (one change at a time)

Do not cause equilibrium disruptions
Decision makers plan for change
No booms and busts

Graph long run, steady economic growth:


◦ Long run equilibrium is the same as short run
equilibrium (no disequilibrium)
 Higher output
 Lower price level
Price Level
LRAS1 LRAS2
SRAS1
SRAS2
P1
E1
P2
E2
AD
Output
YF1
YF2

Cause equilibrium disruptions, disequilibrium
◦
◦
◦
◦

Increase in AD
Decrease in AD
Increase in SRAS
Decrease in SRAS
No economic growth is occurring
◦ Booms and busts
◦ LRAS will not shift

Graphing
◦ What is the short run equilibrium?
◦ How do we return to long run equilibrium?

Causes: unanticipated
◦
◦
◦
◦
◦
increase in real wealth
fall of the interest rate
optimism about the future
rising incomes abroad, or
depreciation of domestic currency
Bull Market

Short run
◦
◦
◦
◦

Output higher than potential
Price level rises unexpectedly
Resource prices and interest rates fixed
Producer profits are higher than normal
Long run
◦
◦
◦
◦
Resource prices, interest rates rise
SRAS shifts left
Return to full employment, normal profits
Price level permanently higher
Too Fast
Price Level
LRAS
SRAS1
e2
P105
P100
E1
AD2
AD1
Output (real GDP)
YF
Y2
Price Level
LRAS
SRAS2
P110
P105
P100
E2
E1
SRAS1
e2
AD2
AD1
Output (real GDP)
YF
Y2

Causes: unanticipated
◦
◦
◦
◦
◦
decrease in real wealth
rise of the interest rate
pessimism about the future
falling incomes abroad, or
appreciation of domestic currency
Bear Market

Short run
◦
◦
◦
◦

Output lower than potential
Price level falls unexpectedly
Resource prices and interest rates fixed
Producer profits are lower than normal
Long run
◦
◦
◦
◦
Resource prices, interest rates fall
SRAS shifts right
Return to full employment, normal profits
Price level permanently lower

Resource prices are “downward sticky”
◦ Long term contracts
◦ Workers hesitant to accept lower wages
◦ Unions

Can make adjustment process slow
Too Slow
Price Level
LRAS
SRAS1
P100
P95
E1
e2
Y2 YF
AD1
AD2
Output (real GDP)
Price Level
LRAS
SRAS1
SRAS2
P100
P95
P90
E1
e2
E2
Y2 YF
AD1
AD2
Output (real GDP)

Causes: unanticipated, temporary
◦ Favorable supply shock
 Good weather
 Cheap oil
Best Party Ever!
Price Level
LRAS
SRAS1
P100
SRAS2
E1
P95
e2
AD1
Output (real GDP)
YF
Y2
Well, all good things
must come to an
end. We had fun!
Price Level
LRAS
SRAS1
P100
SRAS2
E1
P95
e2
AD1
Output (real GDP)
YF
Y2

Short run
◦
◦
◦
◦

Output higher than potential
Price level falls unexpectedly
Resource prices and interest rates fixed
Producer profits are higher than normal
Long run
◦
◦
◦
◦
Favorable conditions come to an end
SRAS shifts left and returns to original position
Return to full employment, normal profits
No changes in prices or output in the long run

Causes: unanticipated, temporary
unfavorable supply shock

Short run
◦
◦
◦
◦

Output lower than potential
Price level rises unexpectedly
Resource prices and interest rates fixed
Producer profits are lower than normal
Long run
◦
◦
◦
◦
Unfavorable conditions come to an end
SRAS shifts right and returns to original position
Return to full employment, normal profits
No changes in prices or output in the long run
Ugh, this
sucks!
Price Level
LRAS
SRAS2
SRAS1
P105
e2
P100
E1
AD1
Output (real GDP)
Y2
YF
Whew! Glad that’s
over. Back to
normal
Price Level
LRAS
SRAS2
SRAS1
P105
e2
P100
E1
AD1
Output (real GDP)
Y2
YF



When AD shifts unexpectedly, the long run
impacts are seen only in the price level
When SRAS shifts unexpectedly, there are no
long run impacts because the change was
temporary
When markets are allowed to adjust, we will
always return to full employment and output


Unanticipated changes in AD or SRAS can
disrupt the economy
But changes in
◦ Resource prices
◦ Interest rates

Return the economy to long run equilibrium

Recession (GDP less than YF)
◦ Weak demand for resources causes unemployment
◦ Resource prices then fall
◦ Return to full output

Boom (GDP greater than YF)
◦ Strong demand for resources causes greater than
normal profits
◦ Resource price then rise
◦ Return to full output

Recession (GDP less than YF)
◦ Weak demand for borrowing
◦ Interest rates then fall
◦ Return to full output

Boom (GDP more than YF)
◦ Strong demand for borrowing
◦ Drives up interest rates
◦ Return to full output


Keynesian Economists: too long!
New Classical Economists: not too long at all!
Period of Expansion
Length
(in Months) Period of Recession
Length
(in Months)
Oct ‘49 to Jul ’53
44
Jul ‘53 to May ’54
10
May ‘54 to Aug ’57
39
Aug ‘57 to Apr ’58
9
Apr ‘58 to Apr ’60
24
Apr ‘60 to Feb ’61
10
Feb ‘61 to Dec ’69
105
Dec ‘69 to Nov ’70
10
Nov ‘70 to Nov ‘73
36
Nov ‘73 to Mar ’75
16
Mar ‘75 to Jan ’80
58
Jan ‘80 to Jul ’80
6
Jul ‘80 to Jul ’81
12
Jul ‘81 to Nov ’82
16
Nov ‘82 to Jul ’90
92
Jul ‘90 Mar ’91
9
Mar ‘91 to Mar ’01
120
Mar ‘01 to Nov ’01
8
Nov ‘01 to Nov ’07
73
Dec ‘07 to June ‘09
18


Analyze the impact of unanticipated changes
in aggregate demand and short run
aggregate supply
Evaluate the economy’s self-correcting
mechanism