ae equilibrium at full employment, real gdp equals potential gdp and the unemployment rate equals...

AE equilibrium At full employment, real GDP equals potential GDP and the unemployment rate

equals the natural unemployment.

Y = YFE uc = 0 g ≈ 3% ≈ 2% u ≈ 5%

Potential GDP and the natural unemployment rate are determined by real factors and are independent of the PL.

Changes in the quantity of money change nominal GDP and the PL but have no effect on potential GDP.

Aggregate Demand (AD) is derived from Snarrian aggregate expenditure by imposing the AE equilibrium (Y = AE ) and then solving for PL.

AE = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }Y

AD is the relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same

AD and Aggregate Supply (AS) determine equilibrium real GDP and the PL

AD-AS-FE Model

“Snarrian” Aggregate Demand is found by substituting

AE = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }Y

Y = [W + Ye – PL – r – mpc ∙ T + I + G + X ] + { mpc – mpm }Y

PL = [W + Ye – r – mpc ∙ T + I + G + X ] + { mpc – mpm }Y – 1 Y

PL = [W + Ye – r – mpc ∙ T + I + G + X ] + { mpc – mpm – 1 }Y

PL = [W + Ye – r – mpc ∙ T + I + G + X ] – {– mpc + mpm + 1 }Y

PL = [W + Ye – r – mpc ∙ T + I + G + X ] – {1 – mpc + mpm }Y

PL = [W + Ye – r – mpc ∙ T + I + G + X ] – {mps + mpm }Y

Aggregate Demand

Marginal propensity to

save

Marginal propensity to

save

Snarrian Aggregate Demand

Example: In our continuing numerical example of the economy, W = 5, Ye = 7, PL = 8, r = 2, T = 3, I = 1, G = 3.5, X = 0.5 with mpc = 0.75, and mpm = 0.25. Derive the AD equation.

First, ignore the fact that PL = 8 because AD isthe relationship between real GDP and PL.


PL = [5 + 7 – 2 – 0.75 ∙ 3 + 1 + 3.5 + 0.5] – {0.25 + 0.25}∙ Y

PL = 12.75 – 0.5 Y

When Y = 0

PL = 12.75 – 0.5 (0) = 12.75

When Y = 9.5

PL = 12.75 – 0.5 (9.5) = 8

Aggregate Demand

Snarrian AD

Example (continued ):

Point 1

Y = 0

PL = 12.75

Point 2

Y = 9.5

PL = 8

By assumption, aggregate planned expenditure equals real GDP (Y = AE ).

In the AE model, Y = 9.5 when PL = 8 at the equilibrium point.

0

12.75

Y

PL

9.5

8

AD

Aggregate Demand

Snarrian AD

Example: What happens if government spending is increased to $4 trillion (G = 4)?

PL = [5 + 7 – 2 – 0.75 ∙ 3 + 1 + 3.5 + 0.5] – {0.25 + 0.25}∙ Y

PL = 13.25 – 0.5 Y

4

Increased government

spending increases AD.

This increases real GDP

provided the price level

remains at $8 thousand.

PL = 13.25 – 0.5 Y

8 = 13.25 – 0.5 Y

0.5 Y= 5.25

Y= 10.5

0

12.75

Y

PL

10.5

8

AD

9.5

13.25

AD’ Note: Increasing G

raises the $500 billion budget

deficit to $1 trillion

Aggregate Demand

Snarrian Aggregate Demand

Example: What happens if taxes are lowered to $2.5 trillion (T = 2.5) instead?

PL = [5 + 7 – 2 – 0.75 ∙ 3 + 1 + 3.5 + 0.5] – {0.25 + 0.25}∙ Y

PL = 13.125 – 0.5 Y

2.5

The tax cut increases AD.



remains at $8 thousand.

PL = 13.125 – 0.5 Y

8 = 13.125 – 0.5 Y

0.5 Y= 5.125

Y= 10.25

0

12.75

Y

PL

10.25

8

AD

9.5

13.125

AD’ Note: Cutting T raises the $500 billion budget

deficit to $1 trillion

Aggregate Demand

Excel Simulation Assignment 4

Aggregate Demand

PL = [W + Ye – r – mpc ∙ T + I + G + X ] – { mps + mpm }∙ Y

AD increases if W, Ye, I, G or X increase OR if r or T decrease

AD decreases if W, Ye, I, G or X decrease OR if r or T increase

The Congress and President are in charge of fiscal policy. Expansionary fiscal policy involves a cut in T and/or increase in G Restrictive fiscal policy involves a raising T and/or cutting G

The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy involves lowering the federal funds interest rate Restrictive monetary policy involves raising the federal funds interest rate

Aggregate Demand

Potential GDP is determined by the quantities of Labor employed Capital, human capital, and the state of technology Land and natural resources Entrepreneurial talent

At full employment (Y = YFE, g ≈ 3%, ≈ 2%, uc = 0, u ≈ 5%),

The real wage rate makes the quantity of labor demanded equal to the quantity of labor supplied.

Along the potential GDP line, when the price level changes the money wage rate changes to keep the real wage rate at the full-employment level.

Since u equals the natural rate of unemployment there is no pressure on inflation to change

Over the business cycle The quantity of labor employed fluctuates around its full employment level. Real GDP fluctuates around potential GDP

Potential GDP

Full-employment

Example: Suppose the economy’s production function shows the volume of output that can be produced by its labor force of size L given levels of K units of capital, R units of resources and z percent of the knowledge/talent that is contained in the universe.

Suppose there are a total of L = 144 (million) workers in the economy with resources, capital, and technology/talent currently at R = 400 (million acres of land and barrels of oil), K = 100 (million machines/roads/networks) and z = 1 (percent).

1. What is the economy’s short-run production function? Graph it.

0.005 1 100 400Y L

0.005Y z K R L

Potential GDP

0.005 40,000Y L

0.005 200Y L

Y L

Short-run production function

0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P

Full-employment

Example (continued):

2. Graph the economy’s short-run production function:

Y L

Potential GDP

L Y

0 0.00

50 7.07

100 10.00

150 12.25


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P

er


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P

Full-employment


3. Compute potential GDP.

Y L

YFE = 12 (trillion $)

Potential GDP

144Y

12

144er

Full-employment


4. Compute the output of the economy if only 121 million of the 144 million in the labor force are working.

23 million workers

are (cyclically)

unemployed, resulting

in Y < YFE

Potential GDP

Y L

Y = 11 (trillion $)

121Y


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P

144121

11

er

Full-employment


5. Compute the output of the economy if all 144 million workers in the labor force are full time (40 hours per week) and 50 million of them are working 20 hours of overtime per week.

Potential GDP


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P

144

Since Y > YFE the unemployment rate is

‘low’

Since 50 million are working an extra 20

hours/wk, the effective size of the (fulltime)

work force is

L = 144 + 50/2 = 169

169 13Y

13

er


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P


0

2

4

6

8

10

12

14

0 25 50 75 100 125 150 175

labor

real

GD

P

Full-employment


6. Compute potential GDP if capital increases to K = 121 (million machines/roads/networks). What is the new level of potential GDP?

Potential GDP

144

0.005 1 400 100Y L

0.005 48,400Y L

0.005 220Y L

1.1Y = L

121

YFE = 13.2 (trillion $)

1.1 144Y

13.2

er

Potential GDP

Full-employment


7. Increases in an economy’s resources and knowledge/talent have the same effect as an increase in capital.

8. Graph the potential GDP you computed in part (3) with AD below.

Y

PL YFE

0

12.75

12

AD

Together, AS and AD determine equilibrium real GDP and the PL

The goal of policy makers is to keep

equilibrium real GDP “close” to potential

GDP with

g ≈ 3% ≈ 2%u ≈ 5%

Aggregate Supply is the relationship between the quantity of real GDP supplied and PLwhen all other influences on production plans remain the same The AS curve is positively sloped (AS slope = )

Firms maximize profits. If prices increase while all other costs are constant, production rises because it is more profitable. Firm supply, industry supply and AS slope up.

Alternatively, when PL rises with constant wages, real wages falls, employment rises, and quantity of real GDP supplied rises.

Shifters of AS are contained in its intercept: The money wage rate changes (w). The money prices of other resources change (p). Government changes supply-side taxes () Potential GDP changes:

Advances in technology (z) Increases in the size of the Labor Force (L) Increased public or private investment in capital (K) Increased Land and natural resources (R)

The general form of AS:

PL = [w + p + – z – K – R – L ] + ∙ YAS

Along the AS curve, the only influence on production plans that changes is PL. That is, the quantity of real GDP supplied increases (decreases) when the PL rises (falls).

Aggregate Supply

Snarrian Aggregate Supply

Example: Suppose money wage rate is $400 per week (w = 400) and money prices of other resources of $230 per week (p = 230) given a supply-side tax rate of 15.75 percent (), technological advancement of 1 percent (z = 1), accumulated capital of 100 million machines/roads/networks (K = 100), 400 million acres of land and barrels of oil (R = 400), and a labor force of 144 million workers (L = 144). 1. Derive the AS equation which has a slope of = 0.5.

PL = [w + p + – z – K – R – L ] + ∙ YAS

PL = [400 + 230 + 15.75 – 1 – 100 – 400 – 144] + 0.5 YAS

PL = 0.75 + 0.5 Y

When Y = 0

PL = 0.75 + 0.5 (0) = 0.75

When Y = 12

PL = 0.75 + 0.5 (12) = 6.75

Aggregate Supply

Snarrian AS

Example (continued )

2. Graph AS

Point 1

Y = 0

PL = 0.75

Point 2

Y = 12

PL = 6.75

0

0.75

Y

PL

12

6.75

AS

Aggregate Supply

Snarrian AS

Example (continued )

3. What happens if government cuts supply-side taxes to 15 percent ()?

PL = [400 + 230 + 15.75 – 1 – 100 – 400 – 144] + 0.5 YAS

PL = 0.5 Y

15

Supply-side tax cuts increase AS.



remains at 6.75 (thousand $).

PL = 0.5 Y

6.75 = 0.5 Y

Y= 13.5

Aggregate Supply

0

0.75

Y

PL

12

6.75

AS

AS’

13.5

Aggregate Supply

Snarrian AS


4. Graph potential GDP (YFE = 12) with AS equation found in part (1).

PL = 0.75 + 0.5 Y

If real GDP equals YFE, the PL = 6.75

If the PL is greater than 6.75, real GDP

exceeds potential GDP.

If the PL < 6.75, real GDP is less than potential GDP

YFE

12

0.75

Y

PL

6.75

AS

ASAS

YFE

13.5

YFE

Snarrian AS


5. Show what happens to AS and YFE when technology increases.

PL = [w + p + – z – K – R – L ] + ∙ YAS

Potential GDP immediately shifts to

the right

The increases in z decrease the value of

the AS intercept.

AS increases(shifts to the right)

12 Y

PL

6.75

Aggregate Supply

Snarrian AS


6. Graph AS with potential GDP and AD below.

AD

PL = 0.75 + 0.5 Y

PL = 0.75 + 0.5 (12) = 6.75

Together, AS and AD determine equilibrium real

GDP and the PL

The goal of policy makers is to keep equilibrium real

GDP “close” to potential GDP with

g ≈ 3% ≈ 2%u ≈ 5%

Aggregate Supply

YFE

12 Y

PL

6.75

AS

0.75

Aggregate Supply

PL = [w + p + – z – K – R – L ] + ∙ YAS

AS decreases if w, p, or increase OR if z, K, R or L decrease

AS increases if w, p, or decrease OR if z, K , R or L increase

The Congress and President are in charge of fiscal policy. Expansionary supply-side fiscal policy involves cutting Restrictive supply-side fiscal policy involves raising

The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy lowers the federal funds interest rate Restrictive monetary policy raises the federal funds interest rate

Aggregate Supply

Inflationary gaps

Example: Suppose potential GDP is $11 trillion and AS and AD are given by

PL = –0.25 + 0.75 YAS PL = 15.25 – 0.5 Y AD

1. Graph AD, AS and YFE.

AS graph

PL = –0.25 + 0.75(11) = 8

AD-AS-YFE Equilibrium

YFE

11 Y

PL

9.75

AS

-0.25

AD graph

PL = 15.25 – 0.5(11) = 9.75

8AD

15.25

Inflationary gaps

Example:

2. Compute equilibrium real GDP and PL.

Real GDP

–0.25 + 0.75Y = 15.25 – 0.5Y

0.75Y = 15.5 – 0.5Y

1.25Y = 15.5

Y = 12.4

PL and check

PL = –0.25 + 0.75(12.4) = 9.05PL = 15.25 – 0.5(12.4) = 9.05


Y

PL

12.4

AS

-0.25

9.05

AD

15.25

YFE

11

9.75

8

AS

-0.25

Inflationary gaps

Example:

3. Is the economy in a recessionary or inflationary gap?


Y

PL

12.4

9.05

AD

15.25

Since real GDP exceeds potential GDP, the economy is in an inflationary gap.

Workers work overtime and/or more than one job, and firms compete for scarce labor.

The unemployment is sayu = 4%, which is lower than the natural rate of 5%.

For these reasons, there are upward pressures on wages. This raises AS until the gap is closed.

AS’

YFE

11

9.75

PL = [w + p + – z – K – R – L ] + ∙Y

Inflationary gaps

Example:



Y

PL

AD

15.25

Allowing gaps to close on their own via changes in wages is a laissez faire policy.

Today, inflationary gaps tend to close faster.

The inflation redistributes income from those on fixed incomes (pensioners) to those with variable income (wages adjusted for inflation)

Governments have also used inflation as a tax to avoid cutting G or increasing T.

AS’

YFE

11

9.75

Recessionary gap

Example: Suppose potential GDP is $13 trillion and AS and AD are given by

PL = –0.25 + 0.75 YAS PL = 15.25 – 0.5 Y AD


AS graph

PL = –0.25 + 0.75(13) = 9.5


YFE

13 Y

PL

9.5

AS

-0.25

AD graph

PL = 15.25 – 0.5(13) = 8.758.75

AD

15.25

Recessionary gap

Example:

2. Compute equilibrium real GDP and PL.

Real GDP

–0.25 + 0.75Y = 15.25 – 0.5Y

0.75Y = 15.5 – 0.5Y

1.25Y = 15.5

Y = 12.4

PL and check

PL = –0.25 + 0.75(12.4) = 9.05PL = 15.25 – 0.5(12.4) = 9.05


YFE

13 Y

PL

12.4

AS

-0.25

9.05

AD

15.25

9.5

8.75

AS

-0.25

Recessionary gap

Example:



YFE

13 Y

PL

12.4

9.05

AD

15.25

Since real GDP is less than potential GDP, the economy is in a recessionary gap.

Factories, resources, and workers are not being fully utilized.

The unemployment is sayu = 8.5%, which is higher than the natural rate of 5%.

The surplus of workers bids down wages, which lowers AS until the gap is closed.

AS’

8.75

PL = [w + p + – z – K – R – L ] + ∙Y

Recessionary gap

Example:



YFE

13 Y

PL

AD

15.25

If the government does nothing (laissez faire) when unemployment is high, prices in general fall (negative relationship).

Today, recessionary gaps close relatively slower than inflationary gaps.

The federal minimum wage was enacted in 1938.

John L. Lewis (UMW, CIO, USWA) organized millions of workers in the 1930s.

AS’

8.75

Recessionary gap

Example:



YFE

13 Y

PL

AD

15.25

Deflation sounds good because lower prices raise purchasing power.

However, deflation causes hardships for those whose net worth is mostly held in illiquid assets (homes).

Deflation amplifies debt since it was incurred when wages were higher. The same payment with a lower wage reduces purchasing power.

Deflation amplifies a loan's interest rate.

AS’

8.75

Induced inflationary gaps

Example: Suppose potential GDP is $12.4 trillion and AS and AD are given by

PL = –0.25 + 0.75 YAS PL = 15.25 – 0.5 Y AD


AS graph

PL = –0.25 + 0.75(12.4) = 9.05


YFE

12.4 Y

PL

9.05

AS

-0.25

AD graph

PL = 15.25 – 0.5(12.4) = 9.05

AD

15.25

AS

Induced inflationary gaps

Example:

2. Show what happens if policy makers cut T or increase G.


Y

PL

AD

Increasing G and cutting T when the economy is at full-employment induces an inflationary gap.

The policy boosts real GDP but at a cost (higher prices)

If nothing is done to combat this stimulus, wages will rise as labor markets tighten. This shifts AS up.

Hence, the increase in GDP was only temporary.

Prices soar even more.

AS’YFE

AD’


PL = [w + p + – z – K – R – L ] + ∙Y

ae equilibrium at full employment, real gdp equals potential gdp and the unemployment rate equals...

Documents

employment y

real gdp y

y e pl r mpc t

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y e r mpc t

ae equilibrium y

aggregate demand pl

y fe u c