price level real gdp ($trillions) 0 long run as curve: a vertical line indicating all possible...
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PriceLevel
Real GDP($Trillions)
0
Long run AS curve: A vertical line indicating all possible output and price level combinations the economy could end up in the long run
Long run AS curve
YFE
Some economists (Mankiw included) believe the
economy is “self-correcting”—that is,
forces are present that push the economy to long-run (or full-employment)
equilibrium.
(How does it work?)
PriceLevel
Real GDP($Trillions)
0
AD1
AS1
Long Run AS Curve
YFE Y3 Y2
AD2
AS2
P1
P3
P2
P4
E
HJ
KLet AD shift from AD1 to AD2
Positive demand shock P and Y
Change in short-run equilibrium
Y > YFEWage
RateUnit Cost
PY until Y =YFE
Long-run adjustment process
PriceLevel
Real GDP($Trillions)
0
AD
AS
E
B
F
6 10 14
100
140
Why is point E a short-run equilibrium?
•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 $10 along both AS and AD curves
Fiscal Policy
The Employment Act of 1946 establishes a
responsibility for the Federal government to
“promote maximum employment, production, and purchasing power.
Fiscal policy is the use of the spending and taxing powers of government to influence total spending and thereby to stabilize real GDP, employment, and prices.
PriceLevel
Real GDP($Trillions)
0
AD1
AS
Effect of a Demand Shock
AD2
10 12 13.5
E
H J
100
130
Increase in government spending
Issue: Why did the economy move from point E to point H—instead of E to J?
G GDPMultiplier Effect
AD curve shifts rightward
Unit cost P
Money Demand
Interest rate
C and I GDP
Movement along new AD curve
Movement along AS curve
Net result: GDP increases, but by less due to the effect of an increase in the price level
PriceLevel
Real GDP($Trillions)
0
AD2
AS
Effect of a decrease in taxes
AD1
1086.5
EK
S
100
T↓ GDPMultiplier Effect
AD curve shifts rightward
Unit cost P
Money Demand
Interest rate
C and I GDP
Movement along new AD curve
Movement along AS curve
Net result: GDP increases, but by less due to the effect of an increase in the price level
YD C
The use of the instruments of monetary policy to change total spending in the economy and thereby influence total output and employment.
PriceLevel
Real GDP($Trillions)
0
AD2
AS
Effect of a decrease in the money supply
AD1
1086.5
EK
S
100
M GDP
AD curve shifts Leftward
Unit cost P
Money Demand
Interest rate
C and
I GDP
Movement along new AD curve
Movement along AS curve
Net result: GDP decreases, but by less due to the effect of an decrease in the price level
Interest
rate
C and I
8
10
12
14
16
18
20
79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01
Federal Funds
Recessions are shaded
6
8
10
12
14
16
18
20
80 82 84 86 88 90 92
Mortgage Interest Rates
Recessions are shadedConventional 30 year
www.economagic.com
Mortgage rate
Monthly Payment1
8% $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.
Monthly payments on a $110,000 30 year mortgage note
400
800
1200
1600
2000
2400
80 82 84 86 88 90 92
Monthly Housing Starts
Recessions are shadedData in thousands of units
www.economagic.gov
More recently, the Fed raised the
federal funds rate six times between May 99 and May 2000—from 4.75% to 6.5
%.
The Fed reversed course at the beginning of 2001 and reduced the
federal funds rate 11 times that year!
The following factors could shift the (short-run) aggregate supply schedule up to the left:
•An increase in the price of a basic commodity—e.g., petroleum, natural gas, wheat, soybeans.
•An increase in average money wages and benefits not restricted to just one industry or sector of the economy.
•An increase in the average markup over unit cost not restricted to just one industry or sector of the economy.
PriceLevel
Real GDP($Trillions)
0
AD2
AS1
Effect of an increase in petroleum prices
AD1
1086.5
E
S
100
AS2
130
Date Price ($)Jan. 1972 1.79Dec. 1973 4.68Jan. 1974 10.84
April 1979 14.55June 1979 18.00
Nov 1979 24.00
Aug. 1980 30.00Oct. 1981 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 forsupply-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 onthe efficiency with
which labor is employedin 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 compensationcan rise with no effect on ULC,
so long as productivitykeeps pace
Annual Percent Change In Productivity, Compensation, and Unit Labor Cost
U.S., 1971-83
Source: Economic Report of the President, Table B-49
Year
83828180797877767574737271
12
10
8
6
4
2
0
-2
-4
Output per hour
Compensation
per hour
Unit labor cost
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
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)
The Federal budget is an annual statement of expenditures, tax receipts, and surplus or deficit of the government of the U.S.
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.
Inte
rest
Rat
e
Trillions of Dollars
Crowding Out With an Initial Budget Deficit
Total Supply of Funds (Saving)
D1 = IP + G1 - T
H5%
0 1.75
D2 = IP + G2 - T
7%
2.05 2.25
A C
B •Increase in G = AH•Decrease in C = AC•Decrease in IP = CH
Inte
rest
Rat
e
Trillions of Dollars
Effects of a Reduction in the Government Surplus
S1 = Savings + T – G1
D = Investment
B
5%
0 1.75
S2 = Savings + T – G2
AH
7%
C
1.25 1.55
President Clinton’s economic strategy appears to have been effective in reducing interest rates
2000 = 100
2000 = 100