Download AD 1

Price
Level
Long run AS curve
Long run AS curve: A
vertical line
indicating all
possible output and
price level
combinations the
economy could end
up in the long run
0
YFE
Real GDP
($Trillions)
(How does it work?)
Some economists (Mankiw
included) believe the
economy is “selfcorrecting”—that is, forces
are present that push the
economy to long-run (or
full-employment)
equilibrium.
Long Run AS Curve
AS2
Price
Level
AS1
P4
P3
P2
K
Let AD shift from
AD1 to AD2
J
H
P1
E
AD2
AD1
0
YFE Y3 Y2
Real GDP
($Trillions)
Change in short-run equilibrium
P and Y 
Positive demand shock
Y > YFE
Wage
Rate
Unit
Cost
P
Long-run adjustment process
Y
until Y
=YFE
Price
Level
Why is point E a short-run
equilibrium?
AS
B
140
E
100
F
•At point B, the price
level is 140 and AS =
$14 trillion. But
equilibrium GDP is
equal to $6 trillion
when the price level
is 140—we know
this from the AD
curve.
•At point E, the price
level is consistent
with an output level
of $10 along both
AS and AD curves
AD
0
6
10
14
Real GDP
($Trillions)
Fiscal Policy
Fiscal policy is the use of the spending and
taxing powers of government to influence
total spending and thereby to stabilize real
GDP, employment, and prices.
The Employment Act of
1946 establishes a
responsibility for the
Federal government to
“promote maximum
employment, production,
and purchasing power.
Effect of a Demand Shock
Price
Level
Increase in
government
spending
AS
130
J
H
100
Issue: Why
did the
economy
move from
point E to
point H—
instead of E
to J?
E
AD2
AD1
0
10
12
13.5
Real GDP
($Trillions)
AD curve shifts rightward
G
GDP
Multiplier Effect
Movement along new AD curve
Unit
cost 
P
Money
Demand
Interest
rate 
C and
I
Movement along AS curve
Net result: GDP increases, but by less due to the
effect of an increase in the price level
GDP 
Price
Level
100
Effect of a decrease in
taxes
AS
K
E
S
AD1
0
6.5 8
10
AD2
Real GDP
($Trillions)
AD curve shifts rightward
T↓
YD
Multiplier Effect
C
GDP
Movement along new AD curve
Unit
cost 
P
Money
Demand
Interest
rate 
C and
I
Movement along AS curve
Net result: GDP increases, but by less due to the
effect of an increase in the price level
GDP 
The use of the instruments of monetary policy to
change total spending in the economy and thereby
influence total output and employment.
Price
Level
100
Effect of a decrease in
the money supply
AS
K
E
S
AD1
0
6.5 8
10
AD2
Real GDP
($Trillions)
AD curve shifts Leftward
Interest
rate 
M
C and
I
GDP 
Movement along new AD curve
Unit
cost 
P
Money
Demand 
Interest
rate 
C and
I
GDP 
Movement along AS curve
Net result: GDP decreases, but by less due to the
effect of an decrease in the price level
20
Recessions are shaded
18
16
14
12
10
8
79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01
Federal Funds
20
Recessions are shaded
Conventional 30 year
18
16
14
12
10
8
6
80
82
www.economagic.com
84
86
88
Mortgage Interest Rates
90
92
Monthly payments on a $110,000
30 year mortgage note
Mortgage
rate
8%
Monthly
Payment1
$807.14
10%
$965.33
12%
$1,131.47
14%
$1,303.36
16%
$1,479.23
1 Does
not include prorated insurance or
property taxes.
2400
Recessions are shaded
Data in thousands of units
2000
1600
1200
800
400
80
www.economagic.gov
82
84
86
88
Monthly Housing Starts
90
92
More recently, the
Fed raised the
federal funds rate six
times between May
99 and May 2000—
from 4.75% to 6.5
%.
The Fed reversed course
at the beginning of 2001
and reduced the federal
funds rate 11 times
that year!
The following factors could shift the (short-run)
aggregate supply schedule up to the left:
•An increase in the price of a basic commodity—e.g.,
petroleum, natural gas, wheat, soybeans.
•An increase in average money wages and benefits
not restricted to just one industry or sector of the
economy.
•An increase in the average markup over unit cost
not restricted to just one industry or sector of the
economy.
Effect of an increase in
petroleum prices
Price
Level
AS2
AS1
S
130
100
E
AD1
0
6.5 8
10
AD2
Real GDP
($Trillions)
Date
Jan. 1972
Dec. 1973
Jan. 1974
April 1979
June 1979
Nov 1979
Aug. 1980
Oct. 1981
Price ($)
1.79
4.68
10.84
14.55
18.00
24.00
30.00
34.00
Price of One Barrel of 340 crude oil
Source: The Petroleum Economist
I’d call that a shock,
wouldn’t you? The story
of Joseph (see Old Testament)
suggests buffer stocks
as the remedy for
supply-shock
inflation
Productivity () means
the average output of a worker
per year, or alternatively:
 = GDP/N
where N is total employment and Y
is real GDP.
 depends on
the efficiency with
which labor is employed
in the production of
goods & services
 Let  denote average annual compensation of
employees (including benefits). Thus unit labor
cost (UCL) is defined as:
ULC =  /
Notice that compensation
can rise with no effect on ULC,
so long as productivity
keeps pace
Annual Percent Change I n Productivity, Compensation, and Unit Labor Cost
U.S., 1971-83
12
10
8
6
4
Output per hour
2
Com pensation
0
per hour
-2
-4
Unit labor c ost
71
72
73
74
75
76
77
78
79
80
81
Year
Source: Economic Report of the President, Table B-49
82
83
The Classical view of Fiscal policy
Friends, we believe that fiscal
policy is unnecessary and
ineffective. The economy is doing
just fine without meddling by
Washington.
The Federal Budget
The Federal budget is an annual statement of
expenditures, tax receipts, and surplus or deficit
of the government of the U.S.
Let:
•G denote federal spending for goods and services
in a fiscal year (Oct. 1 thru Sept. 30).
•TX is federal tax receipts.
•TR is federal transfer payments.
•T is federal net taxes (TX - TR)
If G exceeds T in a fiscal year,
then we have a federal deficit.
If, however, T exceeds G,
then we have
a federal surplus.
•Crowding out is the idea that an increase in one
component of spending will cause a decrease in other
spending components.
•An increase in G may cause a decrease in C, IP, or
both—that is, government spending may “crowd out”
private spending.
Crowding Out With an Initial Budget Deficit
Total Supply of
Funds (Saving)
Interest Rate
A
5%
•Increase in G = AH
B
7%
C
H
•Decrease in C = AC
•Decrease in IP = CH
D2 = IP +
G2 - T
D1 = IP +
G1 - T
0
1.75 2.05 2.25
Trillions of Dollars
Effects of a Reduction in the Government Surplus
S2 = Savings + T – G2
Interest Rate
S1 = Savings + T – G1
B
7%
H
5%
C
A
D = Investment
0
1.25 1.55
1.75
Trillions of Dollars
President Clinton’s
economic strategy appears
to have been effective in
reducing interest rates
2000 = 100
2000 = 100