Download Ch. 31 Notes - Solon City Schools

LRAS
Price Level
SRAS1
SRAS
AD1
AD
Yf
GDP, Income, Employment
Not to scare you…..but……
Aggregate Demand and Aggregate Supply Model (AD/AS)
Ch. 31: Aggregate Demand and Aggregate Supply
• What causes short run fluctuations?
• Can public policy prevent falling income and
rising unemployment?
• Can public policy reduce severity of recessions
or depressions?
• Key is to focus on short run fluctuations
around the long run trends.
LRAS
Price Level
SRAS1
SRAS
AD1
AD
Yf
GDP, Income, Employment
Understanding Short Run Fluctuations
1. Business Cycle – NOT regular or predictable
2. Macroeconomic Quantities Fluctuate
Together
RGDP = most commonly used to monitor short
run changes…..
…..but RGDP tends to move with Income,
corporate profits, consumer spending,
investment spending, industrial production,
retail sales, home sales, auto sales………..
……..so, there is a lot more than RGDP to look at
in the short run….
• 3. As output falls, unemployment rises
Explaining Short Run Economic
Fluctuations
• “Classical Dichotomy”, “Monetary Neutrality”
p. 705 – skip for now
• Short Run model focused on …
• Economy’s output (RGDP)
• Price Level (CPI or GDP Deflator)
Price Level
SRAS
AD
Yf
GDP, Income, Employment
The good news………acts much the same as Supply
and Demand from Micro
The bad news……this is Macro……..much more to the
curves than in Micro
I. Aggregate Demand
a. shows VARIOUS amounts of goods and services that
the entire economy desires to purchase
b.different from Micro D curve (individual choices for
one good) ;
– will NOT be able to apply income
(normal/inferior) or substitution
(substitute/compliment)effects****
c. Similar to law of Demand …..
Inverse relationship :
lower P level = larger real GDP
higher the P level = smaller real GDP
AD slopes downward: Wealth Effect
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When prices go up = real wealth goes…..
down
When prices go down = real wealth goes….
Up
As PL decreases, consumers feel …..
“wealthier” and increase quantity of …..
goods and services demanded
AD slopes downward: Interest Rate Effect
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As PL goes down = money demanded goes…
down
People will usually lend more (in form of …..
savings accts, bonds, etc.) = increase in the Supply of
Loanable Funds
= interest rates go……
down
As interest rates go down = firms will …….
borrow more to invest (consumers in new housing)
So…..Interest rates down = Investment up = increase ….
quantity of goods and services demanded
AD slopes downward: Exchange Rate Effect
• As PL goes down, interest rates go down
• US investors seek higher returns elsehwere
..meaning? …
• Want to invest where interest rates are higher to
get better returns on bonds
• As more US dollars leave, the Supply of US dollars
in “Foreign Exchange Market” increases and in
turn “DEPRECIATES” the dollar relative to value of
other currencies. *Important – DO NOT think
about inflation in this context of “appreciation”
or “depreciation”
• Each dollar now buys fewer units of foreign
currency = foreign goods become……
• More expensive …..so the US Imports will ……
• Decrease….and US Exports will …….
• Increase ……and overall US Nx will…….
• Increase …..and increases the ……..
• Quantity of goods and services demanded
• Simplify:
• As PL goes down, Interest Rates go down,
dollar depreciates, Nx go up, Qd of goods and
services go up
Why does AD Shift?
• Very similar to D shifting in micro
• Remember AD = C+I+G+Nx
• So if any component of AD increases or
decreases independently of PL, then AD shifts
• C : want to save more or less, stock market
boom increases wealth, increase or decrease
in taxes paid
• I : invest in new technology, optimism or
pessimism about future, increase or decrease
in business taxes or tax credits
AD shifiting ..cont..
• G : any increase or decrease in G spending
• Nx : foreign nations experience a economic
growth or recession…affect on AD?.....
• any outside force which makes the US dollar
“appreciate or depreciate” ….affect on AD? ….
» Remember: “At any given price level, there is now more
Aggregate Demand”
Aggregate Supply
A. How do we know that aggregate supply is upward sloping
in the short run and vertical in the long run?
B. First, recall from microeconomics that output is a function
of the inputs to production
i. Supplies of labor, capital, natural resources, and
available technology –(these are not affected by the price
level)
ii. The only way to increase output in the long run is to
increase the levels of capital and labor.
iii. This is called increasing the capital stock--the result of
investment--and increasing the labor force--the result of
more people working
iv. Therefore, in the long run, the aggregate
supply curve is affected only by the levels of
capital and labor and not by the price level.
Thus, the long run aggregate supply is vertical
with respect to the price level.
• ***see example on bottom of pg. 712 to 713
Why LRAS will Shift
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Think of what would shift PPF out
pg. 713-714
LABOR
CAPITAL
NATURAL RESOURCES
TECHNOLOGICAL KNOWLEDGE
A New Way to Depict Long-Run Growth and Inflation
PL
1. There are many
forces that govern
the economy in
the long run…but
most imprt. are
technology and
monetary policy
PL2
PL1
Yf1
Yf2
3. Fed increases money
supply over time =
increase spending and
shifting AD right
2. Tech progress
increases production of
goods/services ; shifting
LRAS right
4. Shows the Long Run
trends in growth and inflation
PL
PL2
PL1
The purpose of AD/AS
model is to provide a
framework for short run
analysis.
Yf1
Yf2
As we develop short run
analysis, we will not
necessarily show the
continuing growth of
GDP.
PL
The Short Run fluctuations in
output and the price level should
be viewed as deviations from the
continuing long run trends
PL2
PL1
Yf1
• Stated another way……
1. LRAS is vertical and represents full employment
and full output (natural rate of unemployment)
Real GDP is maximized.
2. Any changes in AD will affect only the price level.
3. In the long run, prices and wages are flexible.
4. This means that if products don’t sell and
employees become unemployed, the market will
self correct
We will look at HOW the economy will self correct
later…but first lets analyze the SRAS
Why AS slopes upward in short run
• As PL rises, Q of goods and services supplied rises
(similar to Law of Supply in Micro)
• Three theories help explain why AS is upward sloping
in short run
• 3 theories but 1 common theme: Q of output
supplied deviates from its long run or natural level
when the PL deviates from the PL that people
expected.
• When PL is higher than expected, Output rises above
its natural rate
• When PL is lower than expected, Output falls below
its natural rate.
Misperceptions Theory
• Example
• PL falls below expectations
• Firms may feel the reward for production has
been lowered and reduce output
• “Lower than expected PL causes
misperceptions about relative prices and these
misperceptions induce suppliers to respond by
decreasing Q of goods and services supplied”
• If PL rises above expectations……
Stick-Wage Theory
• Nominal wages are sticky in the short run
• Think long term contract at given wage
• As PL falls below expectations, nominal wages are
fixed, but real wages rise.
• Because real wages are major input cost, firms real
costs rise and begin to hire less and produce less
• “As PL falls below expectations, nominal wages are
sticky, makes real wages and costs rise, production is
less profitable and firms decrease quantity of goods
and services supplied”
• If PL rises above expectations……
Sticky Price Theory
• As PL falls below expectations, not all firms will react
immediately and so some Prices are sticky
• The firms that do not lower Prices right away will
have relatively higher prices which will reduce sales
……
• This induces firms to reduce production and
employment
• As PL falls unexpectedly, some firms leave prices
higher than desired which results in lower sales.
Firms begin to decrease the quantity of goods and
services supplied.
• If PL rises above expectations……
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Shifting SRAS
If it shifted LRAS, then it must also shift SRAS
Labor, Capital, Natural Resources, Technology
One new variable…..
Expected Price Level
• If the Expected Price Level falls….(notice
difference from the three theories) ….
• Firms expect wages and all input costs to fall
and begin to increase the Quantity of goods
and services supplied
• If the Expected Price Level rises……
AD/AS: Self Correcting in the Long Run
• The Effects of a Shift in AD
• The economy self corrects; P and W change
but it is nominal (not real) and these changes
offset eachother and purchasing power
remains the same.
• = Classical view
• …but how long do we wait for self correcting?
• This was the question being asked during the
Great Depression and one in which the Bush
and Obama administrations definitively
answered. …….discuss
• Lets look at how this model self corrects when
AD increases
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Yf
Event increases (C, I, G, or Xn) = shift AD right
Evaluate = P and GDP (output is beyond full employment levels)…..how do we
know this is short run ? ….
Long run RGDP growth is only possible when LRAS shifts right
The current condition = Inflationary Gap ……why?
Nominal Wages don’t respond in short run = so Real Wages ….
decrease …explain?
Yf
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As “Long Run” nears and PL remain high, Nominal Wages begin to respond
and increase….Explain?
All input P have increased and now W increase = Shift Short Run AS left
Result= higher P but back at Yf and increase in Nominal W are offset by
increase in P level
• Now lets see how it self corrects when AD
decreases
Yf
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Event decreases (C, I, G, or Xn) = shift AD left
Evaluate= P decrease, GDP decrease (below full employment levels)
= Recessionary Gap ….why?
As GDP and PL fall , Nominal Wages don’t respond in short run, so = Real Wages…..
increase
With lower Prices and output and Nominal wages “stuck” higher = decrease profits for firms
As the Long Run nears, Nominal W begin to decrease
All input P have decreased and now W decrease = shift Short Run AS right
Result = lower P level but back at Yf, and decrease in Nominal W are offset by lower P levels