Download Economics: Explore and Apply 1/e by Ayers and Collinge Chapter 8

ECONOMICS:
EXPLORE & APPLY
by Ayers and Collinge
CHAPTER 8
“A Framework for
Macroeconomic Analysis”
©2004 Prentice Hall Publishing
Ayers/Collinge, 1/e
1
Learning Objectives
1. Contrast the perspectives of classical
economist to those of Keynesians.
2. Describe how full-employment output
can change.
3. Explain why the price level does not
matter in the long run.
4. Interpret and apply the aggregate
demand-aggregate supply model.
©2004 Prentice Hall Publishing
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Learning Objectives
5. Relate the difference between demand-side
and supply-side inflation in the long run.
6. (E&A) Interpret how the war against
terrorism can cause both inflation and lower
output, and ways in which these effects might
be countered.
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8.1
KEYNESIAN SHORT-RUN AND
CLASSICAL LONG-RUN PERSPECTIVE
When we answer macroeconomic questions
about employment, output, and inflation we
must provide near term events with a long-run
perspective.
This context is called the long-run, which
involves underlying economic forces that make
themselves felt over time.
In contrast, the short run represents more
immediate and transitory economic
developments.
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John Maynard Keynes
British economist who wrote “The General
Theory of Employment, Interest and Money”
in 1936.
Developed the emergence of
macroeconomics as a field of analysis
separate from microeconomics.
Offered a new short-run perspective that
came to be known as Keynesian economics.
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Keynesian Short-Run and Classical
Long-Run Perspectives
Macroeconomic theory can be placed
within two broad categories..
Keynesian, which suggest that
government action is an appropriate
response to short-run macroeconomic
problems;
Classical, which suggest that a steady
policy aimed at the long-run best allows
the economy to take care of itself.
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The Phillips Curve
The Phillips curve is a graphical
representation of data that depicted a
distinct curvilinear tradeoff between low
unemployment and low inflation during
the 1960’s.
Data past the decade of the 1960’s shows
no systematic relationship between
unemployment and inflation.
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Inflation Rate
The Phillips Curve
Phillips Curve
Unemployment Rate
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Rational Expectations
In the modern world, people are more likely to
have rational expectations in which they can
predict the implications of government policy
action and thus cannot be systematically tricked.
With rational expectations, we keep up with
the news analyses and base our expectations on
the best information available to us.
The idea of rational expectations provides
support to classical arguments that the
government should step back and let the
macroeconomy take care of itself.
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8.2
MODELING THE LONG RUN
A fundamental macroeconomic goal is is to
obtain full-employment output, also termed
full-employment GDP.
The existence of a natural rate of
unemployment implies that the long-run
tendency is towards full-employment GDP.
Actual real GDP in the U.S. has generally
been close to the full-employment potential.
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Long-Run Aggregate Supply
The economy supplies full employment output in the
long run, no matter the price level.
Because the price level is irrelevant to the potential
for full-employment output, long-run aggregate
supply is always vertical.
The desire of people to receive income pushes
unemployment down toward its natural rate which
leads to full employment output in the long run.
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Long-Run Aggregate Supply
Price Level
Long-Run
Aggregate Supply
The effect of fewer
resources or poorer
technology.
Full-Employment
GDP would fall
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Starting FullEmployment GDP
Real GDP
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Long-Run Aggregate Supply
Price Level
Long-Run
Aggregate Supply
The effect of more
resources or better
technology.
Starting FullEmployment GDP
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Full-Employment
GDP would rise
Real GDP
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Aggregate Demand
Aggregate demand relates how much
real GDP consumers, businesses, and
government will purchase at each price
level.
Aggregate demand has a downward
slope.
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Aggregate Demand
Price Level
Aggregate demand slopes
downward because:
1) consumers get more goods and
services for each dollar they spend
and,
2) consumers spend more money
out of their current incomes
because the lower price level
increases the value of their
savings.
Aggregate
Demand
Real GDP
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Aggregate Demand
Price level decreases
Aggregate purchases increase
Price level increases
Aggregate purchases decrease
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Aggregate Demand
 Purchasing power effect: A lower price level
allows consumers to receive more goods and
services for any given number of dollars they
spend.
 Wealth effect: A lower price level causes
consumers to spend more money out of their
current incomes because the lower price level
increases the value of the money they have
saved.
 These two effects combined explain the inverse
relationship between the price level and the
quantity of GDP Demanded.
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Price Level
Long-Run Macro Equilibrium
Long-Run
Aggregate Supply
A
Too
high
Full-employment
price level
Aggregate
Demand
Too low
GDP with Full-Employment GDP with
Unemployment
Overheating
GDP
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Real GDP
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8.3
ROOT CAUSES OF INFALTION
Demand-pull inflation: When a rightward
shift in aggregate demand moves the
economy to both a higher output and a
higher price level.
Cost-push inflation: When firms adjust
their inflationary expectations downward,
it may cause the economy to move up the
aggregate demand curve to a point with
higher prices and lower output.
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Demand Side Inflation
Price Level
Long-Run
Aggregate Supply
New
Equilibrium
Demand side
inflation
Starting
Equilibrium
Full-Employment
GDP
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Aggregate Demand
Real GDP
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Demand Side Inflation
Price Level
Long-Run
Aggregate Supply
Starting
Equilibrium
Aggregate Demand
Demand side
inflation
New
Equilibrium
Full-Employment
GDP
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Real GDP
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Supply Side Inflation and
Deflation
Changes on the supply side can also cause
either inflation or deflation.
If long-run aggregate supply were to shift to the
left, we would see supply side inflation in which
the same amount of spending is able to buy
fewer goods at higher prices.
Full employment GDP decreases as long-run
aggregate supply shifts to the left.
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Long-run cost-push inflation
Long-Run
Aggregate Supply
Cost-push inflation
can arise from
changes in
employment practices
that lead to higher
real production costs.
Price Level
Supply Side
Inflation
Aggregate
Demand
Full-Employment
GDP
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Real GDP
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Price Level
Long-run cost-push inflation
Long-Run
Aggregate Supply
Supply Side
deflation
New equilibrium
Aggregate Demand
Full-Employment
GDP
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Real GDP
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8.4
CLASSICAL VERSUS KEYNESIAN
 Economic analysis influences people’s politics.
 Political Liberals often side with the Keynesian
perspective which supports large government.
 Political conservatives side with the Classical
analysis which supports the more laissez faire
approach.
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8.5 EXPLORE & APPLY
Fighting Terrorism
As a result of the terrorist attack of 9/11/01,
added security measures were imposed
throughout the economy.
This meant that it was more expensive to do
business.
The security industry prospered, as demand
and prices went up in that line of work.
Numerous other industries suffered as they
faced higher cost of production and slower
deliveries of raw materials.
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Price Level
Fighting Terrorism
Long-Run
Aggregate Supply
Price level
1. Higher security
cost shift LRAS left.
2. The result is a
change in the full
employment
equilibrium
rises
Aggregate Demand
Full-Employment
GDP
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Real GDP
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Fighting Terrorism
This shift can be moderated or even
offset by advances in technology.
To the extent that advances in monitoring
cameras and scanning cameras can
reduce the need for security personnel,
the effect is to increase full-employment
output, and shift AS to the right.
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Fighting Terrorism
The 2001 terrorist attacks had a
significant effect on the demand side of
the economy.
The shock and uncertainty caused business
to postpone new investment, and consumers
to postpone new purchases.
The result was a leftward shift in aggregate
demand.
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Fighting Terrorism
Price Level
Long-Run
Aggregate Supply
First output and employment drop.
Aggregate Demand
Price level
falls
Second, the price
level falls
Full-Employment
GDP
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The long run
Equilibrium
moves lower
Real GDP
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Fighting Terrorism
o The question after the attacks was how
long would it take for consumers to
resume their former spending patterns.
o The government took action by
spending additional money to combat
the terrorist.
o Government also lowered borrowing
cost, and increased the money supply
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Terms along the Way
 long run
 short run
 Keynesian
 Classical
 the Phillips Curve
 inflationary
expectations
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 adaptive expectations
 stagflation
 rational expectations
 full-employment
output
 long-run aggregate
supply
 aggregate demand
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Terms along the Way
 purchasing power
effect
 wealth effect
 full-employment
output
 demand-side
inflation
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 supply-side inflation
 supply shock
 real business cycle
 supply side deflation
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Test Yourself
1.
a.
b.
c.
d.
Full-employment GDP
must be equal to actual GDP.
must be less than actual GDP.
must be greater than actual GDP.
could be equal to, greater than, or even
less than actual GDP.
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Test Yourself
2. Because of the desire of people to have an
income, the long-run tendency of the economy is
to
a. move up and down with the business cycle.
b. produce the full employment level of output.
c. behave in unpredictable ways.
d. exhibit stable prices.
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Test Yourself
3. “In the long-run we are all dead” is a
statement that best expresses
a. Keynesian economics.
b. Classical economics.
c. both Keynesian and Classical
economics.
d. neither Keynesian nor Classical
economics
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Test Yourself
4. The Phillips curve shows an inverse
relationship between ______________
and _________.
a. inflation; unemployment
b. GDP; price level
c. supply-side inflation; demand side
inflation
d. aggregate demand; aggregate supply.
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Test Yourself
5. A graph of long-run aggregate supply
would show the curve to be
a. upward sloping to the right.
b. downward sloping to the right.
c. vertical.
d. horizontal.
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Test Yourself
6.
a.
b.
c.
d.
The aggregate demand curve is ?
upward sloping to the right.
downward sloping to the right.
vertical.
horizontal.
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The End!
Next Chapter 9
“Inflation"
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