ad & as barnett uhs ap econ. introduction over the long run, real gdp grows about 3% per year...

AD & ASBarnett

UHS

AP ECON

Introduction

Over the long run, real GDP grows about 3% per year on average.

In the short run, GDP fluctuates around its trend. Recessions: periods of falling real incomes

and rising unemployment Depressions: severe recessions (very rare)

Short-run economic fluctuations are often called business cycles.

1965 1970 1975 1980 1985 1990 1995 2000 2005 20100

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

Three Facts About Economic Fluctuations

FACT 1: Economic fluctuations are irregular and unpredictable.

U.S. real GDP, billions of 2005 dollars

The shaded bars are

recessions


FACT 2: Most macroeconomic quantities fluctuate together.

1965 1970 1975 1980 1985 1990 1995 2000 2005 20100

500

1,000

1,500

2,000

2,500

Investment spending, billions of 2005 dollars

1965 1970 1975 1980 1985 1990 1995 2000 2005 20100

2

4

6

8

10

12


FACT 3: As output falls, unemployment rises.

Unemployment rate, percent of labor force

Classical Economics—A Recap

Most economists believe classical theory describes the world in the long run, but not the short run.

In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate).

To study the short run, we use a new model.

The Model of Aggregate Demand and Aggregate Supply

P

Y

AD

SRAS

P1

Y1

The price level

Real GDP, the quantity of output

The model determines the eq’m price level

and eq’m output (real GDP).

“Aggregate Demand”

“Short-Run Aggregate

Supply”

The Aggregate-Demand (AD) Curve

The AD curve shows the quantity of all g&s demanded in the economy at any given price level.

P

Y

AD

P1

Y1

P2

Y2

Why the AD Curve Slopes Downward

Y = C + I + G + NX

Assume G fixed by govt policy.

To understand the slope of AD, must determine how a change in P affects C, I, and NX.

P

Y

AD

P1

Y1

P2

Y2 Y1

The Wealth Effect (P and C )

Suppose P rises.

The dollars people hold (save) buy fewer g&s, so real wealth is lower.

People feel poorer.

Result: C falls.

P

Y

AD

P1

Y1

P2

Y2

The Wealth Effect (P and C )

Suppose P falls.

More goods and services can be demanded with income savings (wealth).

Purchasing power of wealth increases at a lower price level

Result: C increases.

P

Y

AD

P2

Y1

P1

Y2

The Interest-Rate Effect (P and I )

Suppose P rises.

Buying g&s requires more dollars.

Demand for money increases.

This drives up interest rates.

Result: I (investment) falls.

(Recall, I depends negatively on interest rates.)

P

Y

AD

P1

Y1

P2

Y2

The Exchange-Rate Effect (P and NX )Suppose P rises.

U.S. interest rates rise (the interest-rate effect).

Foreign investors desire more U.S. bonds & currency

Higher demand for US $ in foreign exchange market. U.S. dollar appreciates.

U.S. exports more expensive to people abroad, imports cheaper to U.S. residents.

Result: NX falls.

P

Y

AD

P1

Y1

P2

Y2

The Slope of the AD Curve: Summary

An increase in P reduces the quantity of g&s demanded because:

P

Y

AD

P1

Y1

the wealth effect (C falls)

P2

Y2

the interest-rate effect (I falls)

the exchange-rate effect (NX falls)

Why the AD Curve Might ShiftAny event that changes C, I, G, or NX—except a change in P—will shift the AD curve.

Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right.

P

Y

AD1

AD2

Y2

P1

Y1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1616

A.Features of the economy in the SRA.Sticky pricesB.Output can fluctuateC.Unemployment can deviate from natural

rateD.Output determined by demand

B.Features of the economy in the LRA.Flexible pricesB.Output is at its potentialC.Economy is at full employmentD.Output determined by potential (LRAS)

Why the AD Curve Might Shift

Changes in C Consumer Confidence Household Income Interest Rates* Household Borrowing MPC vs MPS*

Changes in I Profit Expectations New Technologies available Investment tax incentives Access to new Foreign Markets Interest Rates*

Why the AD Curve Might Shift

Changes in G Federal spending, e.g., defense State & local spending, e.g., roads, schools

Changes in NX Domestic Product Quality Foreign Household Income Domestic Price Level* Market for Domestic Suppliers Value of Domestic Currency*

A C T I V E L E A R N I N G 1

The Aggregate-Demand curve

What happens to the AD curve in each of the following scenarios?

A. A ten-year-old investment tax credit expires.

B. The U.S. exchange rate falls.

C. A fall in prices increases the real value of consumers’ wealth.

D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains.



Answers

A. A ten-year-old investment tax credit expires. I falls, AD curve shifts left.

B. The U.S. exchange rate falls. NX rises, AD curve shifts right.

C. A fall in prices increases the real value of consumers’ wealth. Move down along AD curve (wealth-effect).

D. State governments replace sales taxes with new taxes on interest, dividends, and capital gains. C rises, AD shifts right.


The Aggregate-Supply (AS ) Curves

The AS curve shows the total quantity of g&s firms produce and sell at any given price level.

P

Y

SRAS

LRAS

AS is:

upward-sloping in short run

vertical in long run

The Long-Run Aggregate-Supply Curve (LRAS)

Amount of output the economy produces when unemployment is at its natural rate (around 5% unemployment)

YF is called

full-employment output.

P

Y

LRAS

YF

Why LRAS Is Vertical

YF determined by the

economy’s stocks of labor, capital, and natural resources, and on the level of technology.

An increase in P

P

Y

LRAS

P1

does not affect any of these, so it does not affect YF.

(Classical dichotomy)

P2

YF

Why the LRAS Curve Might Shift

Any event that changes any of the determinants of YF

will shift LRAS.

Example: Immigration increases L, causing YF to rise.

P

Y

LRAS1

YF

LRAS2

YF1


Changes in L or natural rate of unemployment Immigration Baby-boomers retire Govt policies reduce natural u-rate

Changes in K or H Investment in factories, equipment More people get college degrees Factories destroyed by a hurricane


Changes in natural resources Discovery of new mineral deposits Reduction in supply of imported oil Changing weather patterns that affect

agricultural production

Changes in technology Productivity improvements from technological

progress

LRAS1990

Using AD & AS to Depict Long-Run Growth and Inflation

Over the long run, tech. progress shifts LRAS to the right

P

Y

AD2000

LRAS2000

AD1990

Y2000

and growth in the money supply shifts AD to the right.

Y1990

AD2010

LRAS2010

Y2010

P1990Result: ongoing inflation and growth in output.

P2000

P2010

Short Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping:

Over the period of 1–2 years, an increase in P

P

Y

SRAS

causes an increase in the quantity of g & s supplied.

Y2

P1

Y1

P2

Why the Slope of SRAS Matters

If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment.

P

Y

AD1

SRAS

LRAS

ADhi

ADlo

Y1

If AS slopes up, then shifts in AD do affect output and employment.

Plo

Ylo

Phi

Yhi

Phi

Plo

Three Theories of SRASIn each,

some type of market imperfection

result: Output deviates from its natural rate when the actual price level deviates from the price level people expected.

1. The Sticky-Wage Theory

Imperfection: Nominal wages are sticky in the short run,they adjust sluggishly. Due to labor contracts, social norms

Firms and workers set the nominal wage in advance based on PE, the price level they

expect to prevail.

1. The Sticky-Wage Theory

If P > PE,

revenue is higher, but labor cost is not.

Production is more profitable, so firms increase output and employment.

Hence, higher P causes higher Y, so the SRAS curve slopes upward.

2. The Sticky-Price Theory

Imperfection: Many prices are sticky in the short run. Due to menu costs, the costs of adjusting

prices. Examples: cost of printing new menus,

the time required to change price tags

Firms set sticky prices in advance based on PE.

2. The Sticky-Price Theory

Suppose the Fed increases the money supply unexpectedly. In the long run, P will rise.

In the short run, firms without menu costs can raise their prices immediately.

Firms with menu costs wait to raise prices. Meanwhile, their prices are relatively low, which increases demand for their products,so they increase output and employment.

Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.

3. The Misperceptions Theory

Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell.

If P rises above PE, a firm sees its price rise before

realizing all prices are rising.

The firm may believe its relative price is rising, and may increase output and employment.

So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.

What the 3 Theories Have in Common:

All three imply that Y (output) deviates from its long-run level YF (the “natural rate

of output”) when the price level (P) deviates from the level people had expected (PE)

Y = YF + a (P – PE)Output

Natural rate of output (long-run)

a > 0, measures

how much Y responds to unexpected

changes in P

Actual price level

Expected price level

What the 3 Theories Have in Common:

P

Y

SRAS

YF

When P > PE

Y > YF

When P < PE

Y < YF

PE

the expected price level

Y = YF + a (P – PE)

SRAS and LRAS

The imperfections in these theories are temporary. Over time, sticky wages and prices become flexible misperceptions are corrected

In the LR, PE = P AS curve is vertical

LRAS

SRAS and LRAS

P

Y

SRAS

PE

YF

In the long run,

PE = P

and

Y = YF.

Y = YF + a (P – PE)

Why the SRAS Curve Might Shift

Everything that shifts LRAS shifts SRAS, too.

Also, PE shifts SRAS:

If PE rises,

workers & firms set higher wages.

At each P, production is less profitable, Y falls, SRAS shifts left.

LRASP

Y

SRAS

PE

YF

SRAS

PE

The Long-Run Equilibrium

In the long-run equilibrium,

PE = P,

Y = YF ,

and unemployment is at its natural rate.

P

Y

AD

SRAS

PE

LRAS

YF

Economic Fluctuations

Caused by events that shift the AD and/or AS curves.

Four steps to analyzing economic fluctuations:

1. Determine whether the event shifts AD or AS.

2. Determine whether curve shifts left or right.

3. Use AD–AS diagram to see how the shift changes Y and P in the short run.

4. Use AD–AS diagram to see how economy moves from new SR eq’m to new LR eq’m.

LRAS

YF

The Effects of a Shift in ADEvent: Stock market crash

1. Affects C, AD curve

2. C falls, so AD shifts left

3. SR eq’m at B. P and Y lower,unemp higher

4. Over time, PE falls,

SRAS shifts right,until LR eq’m at C.Y and unemp back at initial levels.

5. What if policymakers do not want to wait for self-correction?

P

Y

AD1

SRAS1

AD2

SRAS2P1 A

P2

Y2

B

P3 C

Two Big AD Shifts: 1. The Great Depression

From 1929–1933, money supply fell

28% due to problems in banking system

stock prices fell 90%, reducing C and I

Y fell 27% P fell 22% u-rate rose

from 3% to 25%

550

600

650

700

750

800

850

900

19

29

19

30

19

31

19

32

19

33

19

34

U.S. Real GDP, billions of 2000 dollars

Two Big AD Shifts: 2. The World War II Boom

From 1939–1944,

Gov’t outlays rose from $9.1 billion to $91.3 billion

Y rose 90%

P rose 20%

Unempoyment fell from 17% to 1% 800

1,000

1,200

1,400

1,600

1,800

2,000

19

39

19

40

19

41

19

42

19

43

19

44

U.S. Real GDP, billions of 2000 dollars


Working with the model

Draw the AD-SRAS-LRAS diagram for the U.S. economy starting in a long-run equilibrium.

A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment.



Answers


LRAS

YF

P

Y

AD2

SRAS2

AD1

SRAS1

P1

P3 C

P2

Y2

B

A

Event: Boom in Canada

1. Affects NX, AD curve

2. Shifts AD right

3. SR eq’m at point B. P and Y higher,unemp lower

4. Over time, PE rises,

SRAS shifts left,until LR eq’m at C.Y and unemp back at initial levels.

LRAS

YF

The Effects of a Shift in SRASEvent: Oil prices rise

1. Increases costs, shifts SRAS(assume LRAS constant)

2. SRAS shifts left

3. SR eq’m at point B. P higher, Y lower,unemp higher

From A to B, stagflation, a period of falling output and rising prices.

P

YAD1

SRAS1

SRAS2

P1A

P2

Y2

B

LRAS

YF

Accommodating an Adverse Shift in SRAS

If policymakers do nothing,

4. Low employment causes wages to fall, SRAS shifts right,until LR eq’m at A.

P

YAD1

SRAS1

SRAS2

P1A

P2

Y2

B

AD2

P3 C

Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift: Y back to YF, but

P permanently higher.

The 1970s Oil Shocks and Their Effects

# of unemployed persons

Real GDP

CPI

+ 1.4 million

+ 2.9%

+ 26%

+ 99%

+ 3.5 million

– 0.7%

+ 21%

+ 138%Real oil prices

1978–801973–75

John Maynard Keynes, 1883–1946

The General Theory of Employment, Interest, and Money, 1936

Argued recessions and depressions can result from inadequate demand; policymakers should shift AD.

Famous critique of classical theory:

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.

The long run is a misleading guide to current affairs. In the long run, we are all dead.

Monetary Policy and Aggregate Demand

To achieve macroeconomic goals, the Fed can use monetary policy to shift the AD curve.

The Fed’s policy instrument is MS.

The news often reports that the Fed targets the interest rate. More precisely, the federal funds rate, which

banks charge each other on short-term loans

To change the interest rate and shift the AD curve,

the Fed conducts open market operations to change MS.

The Effects of Reducing the Money Supply

Y

P

M

Interest rate

AD1

MS1

MD

P1

Y1

r1

MS2

r2

AD2

Y2

The Fed can raise r by reducing the money supply.

An increase in r reduces the quantity of g&s demanded.


Monetary policy

For each of the events below, - determine the short-run effects on output - determine how the Fed should adjust the money

supply and interest rates to stabilize output

A. Congress tries to balance the budget by cutting govt spending.

B. A stock market boom increases household wealth.

C. War breaks out in the Middle East, causing oil prices to soar.



Answers

A. Congress tries to balance the budget by cutting govt spending.

This event would reduce agg demand and output.

To stabilize output, the Fed should increase MS and reduce r to increase agg demand.



Answers

B. A stock market boom increases household wealth.

This event would increase agg demand, raising output above its natural rate.

To stabilize output, the Fed should reduce MS and increase r to reduce agg demand.



Answers

C. War breaks out in the Middle East, causing oil prices to soar.

This event would reduce agg supply, causing output to fall.

To stabilize output, the Fed should increase MS and reduce r to increase agg demand.


Liquidity traps Monetary policy stimulates aggregate demand by

reducing the interest rate.

Liquidity trap: when the interest rate is zero

In a liquidity trap, mon. policy may not work, since nominal interest rates cannot be reduced further.

However, central bank can make real interest rates negative by raising inflation expectations.

Also, central bank can conduct open-market ops using other assets—like mortgages and corporate debt—thereby lowering rates on these kinds of loans. The Fed pursued this option in 2008–2009.

Fiscal Policy and Aggregate Demand

Fiscal policy: the setting of the level of govt spending and taxation by govt policymakers

Expansionary fiscal policy an increase in G and/or decrease in T shifts AD right

Contractionary fiscal policy a decrease in G and/or increase in T shifts AD left

Fiscal policy has two effects on AD...

1. The Keynesian Spending Multiplier If the gov’t buys $20b of planes from Boeing, Boeing’s

revenue increases by $20b.

This is distributed to resource suppliers (households) - Boeing’s workers (as wages) and owners (as profits or stock dividends).

These people are also consumers and will spend a portion of the extra income – becomes income for other households

This extra consumption causes further increases in aggregate demand.Multiplier effect: the additional shifts in AD

that result when fiscal policy increases income and thereby increases consumer spending

1. The Keynesian Spending Multiplier

A $20B increase in G initially shifts AD to the right by $20B.

The increase in Y causes C to rise, which shifts AD further to the right.

Y

P

AD1

P1

AD2AD3

Y1 Y3Y2

$20 billion

Marginal Propensity to Consume/Save

How big is the multiplier effect? It depends on how much consumers respond to increases in income.

Marginal propensity to Consume (MPC): the fraction of extra income that households consume rather than save

Marginal Propensity to Save (MPS): the fraction of extra income that households save rather than consume

Example:

if income rises $100 and C rises $80

MPC = 0.8

MPS = 1-MPC…..thus MPS = 0.2

Other Applications of the Multiplier Effect The multiplier effect: Each $1 increase in G can generate more than a $1

increase in AD.

Also true for the other components of GDP (C,I,Nx)

Example: Suppose a recession overseas reduces demand for U.S. net exports by $10B.

Initially, AD falls by $10B.

The fall in Y causes C to fall, which further reduces AD and income.

* Multiplier = 1/MPS or 1/(1-MPC)

2. The Crowding-Out Effect

Fiscal policy has another effect on AD that works in the opposite direction.

A fiscal expansion raises r,which reduces investment, which reduces the net increase in agg demand.

So, the size of the AD shift may be smaller than the initial fiscal expansion.

This is called the crowding-out effect.

How the Crowding-Out Effect Works

Y

P

M

Interest rate

AD1

MS

MD2

MD1

P1r1

r2

A $20b increase in G initially shifts AD right by $20b

But higher Y increases MD and r, which reduces AD.

AD3AD2

Y1 Y2

$20 billion

Y3

Changes in Taxes

A tax cut increases households’ take-home pay.

Households respond by spending a portion of this extra income, shifting AD to the right.

The size of the shift is affected by the multiplier and crowding-out effects.

Another factor: whether households perceive the tax cut to be temporary or permanent. A permanent tax cut causes a bigger increase

in C—and a bigger shift in the AD curve—than a temporary tax cut.


Fiscal policy effects

The economy is in recession. Shifting the AD curve rightward by $200B would end the recession.

A. If MPC = .8 and there is no crowding out, how much should Congress increase G to end the recession?

B. If there is crowding out, will Congress need to increase G more or less than this amount?



Answers


A. If MPC = .8 and there is no crowding out, how much should Congress increase G to end the recession?

Multiplier = 1/(1 – .8) = 5

Increase G by $40b to shift AD by 5 x $40b = $200b.



Answers


B. If there is crowding out, will Congress need to increase G more or less than this amount?

Crowding out reduces the impact of G on AD.

To offset this, Congress should increase G by a larger amount.


Tax Multiplier How much RGDP inc. or dec. b/c of Δ in autonomous T

Mtax = -MPC/MPS

Mtax * Change in taxes

Ex: tax rates reduced 5% Tax Revenue dec. 300B MPC = 0.8 Multiplier = ? Change in RGDP = ?

Balanced Budget Multiplier

How much RGDP inc. or dec. b/c of equal Δ in G & T Combines Mexpenditure & Mtax

Equal to 1 b/c multiplier effects offset all but initial Δ in autonomous G

Using Policy to Stabilize the Economy

Since the Employment Act of 1946, economic stabilization has been a goal of U.S. policy.

Economists debate how active a role the govt should take to stabilize the economy.

The Case for Active Stabilization Policy

Keynes: “Animal spirits” cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment.

Also, other factors cause fluctuations, e.g., booms and recessions abroad stock market booms and crashes

If policymakers do nothing, these fluctuations are destabilizing to businesses, workers, consumers.

The Case for Active Stabilization Policy

Proponents of active stabilization policy believe the gov’t should use policy to reduce these fluctuations:

Recessionary Gap: When GDP falls below its natural rate, use expansionary monetary or fiscal policy to prevent or reduce a recession.

Inflationary Gap: When GDP rises above its natural rate, use contractionary policy to prevent or reduce an inflationary boom.

Keynesians in the White House

1961: John F Kennedy pushed for a tax cut to stimulate AD. Several of his economic advisors were followers of Keynes

2009: Barack Obama pushed for spending increases and tax cuts to increase AD in the face of a deep recession.

The Case Against Active Stabilization Policy

Monetary policy affects economy with a long lag: Firms make investment plans in advance,

so I takes time to respond to changes in interest rate

~ 6 months for monetary policy to affect output and employment

Fiscal policy also works with a long lag: Changes in G and T require acts of Congress The legislative process can take months or years

The Case Against Active Stabilization Policy

Due to these long lags, critics of active policy argue that such policies may destabilize the economy rather than help it:

By the time the policies affect AD, the economy’s condition may have changed.

These critics contend that policymakers should focus on long-run goals like economic growth and low inflation.

Automatic Stabilizers

Automatic stabilizers: Auto changes in fiscal policy that stimulate AD when economy goes into recession

The tax system In recession, taxes fall automatically (pay less)

which stimulates AD.

Gov’t spending In recession, more people apply for public assistance

(welfare, unemployment insurance). Gov’t spending on these programs automatically rises,

which stimulates agg demand.

ad & as barnett uhs ap econ. introduction over the long run, real gdp grows about 3% per year...

Documents

classroom use

short run

passwordprotected website

certain product

cengage learning

long run

economic fluctuationsfact

real variables