Week 8 Flashcards
What is the first controversy regarding the AS-AD model?
Flexibility of prices and wages.
What is the second controversy regarding the AS-AD model?
Flexibility of aggregate supply (responsiveness of AS to changes in AD).
the right: aggregate supply determined independently of aggregate
demand
the left: aggregate supply responsive to changes in aggregate demand
some consensus on nature of short-run AS curve
investment and the effect on the LRAS
What factor affects the long-run aggregate supply (LRAS)?
Investment
Increased potential output in the long run from higher investment
What is hysteresis in the context of macroeconomics?
The phenomenon where economic shocks have long-lasting effects on the economy.
What is the third controversy in macroeconomic discussions?
Role of expectations in the working of the market
the right: expectations adjust rapidly to changes in prices
the left: expectations of prices depend on expectations of output and employment
What do proponents on the right believe about aggregate supply?
Aggregate supply is determined independently of aggregate demand.
- Straight long run supply curve
What do proponents on the left believe about aggregate supply?
Aggregate supply is responsive to changes in aggregate demand.
What is the nature of the short-run AS curve according to some consensus?
What happens to potential output in the long run from higher investment?
Increased potential output.
What is the assumption about wage rates in Keynesian analysis of the aggregate labor market?
Wage rates are sticky downwards.
What is the relationship between inflation and unemployment as per the Phillips Curve?
Inverse relationship between wage inflation and unemployment.
UK from 1861 to 1957.
What does the Expectations-Augmented Phillips Curve (EAPC) incorporate?
Inflationary expectations into a Phillips equation.
Phillips Equation
π = f(1/U) + π ^e + K
What happens when aggregate demand rises but expected inflation remains constant?
There is a movement up along the EAPC.
What is adaptive expectations in the context of inflation?
People form their expectations based on past inflation trends.
π^e t= π t-1
Simplest form of adaptive inflation expectations:
* Expected inflation this year = actual inflation last year.
rational expectations
Inflation expectations based on the current state of the economy.
Imperfect information: errors in prediction are random (and average to zero)
Short-run and long-run perspectives
natural rate hypothesis
fluctuations in aggregate demand and movements along EAPCs
market clearing
What is the natural rate hypothesis?
In the long-run, there is no real increase in AD & U=Un (vertical).
Assume that actual and expected inflation is zero and unemployment is at the natural rate Un (point a on EAPC0)
what is market clearing
Flexible prices
No long-run deficiency of labour demand
More rapid market clearing → faster adjustment to vertical AD.
Neoclassical economists: continuous market clearing
What do neoclassical economists believe about market clearing?
Continuous market clearing.
What is the short-run trade-off in the Monetarist perspective?
Assumptions ;
-market clearing
- adaptive expectation
increase in aggregate demand
What is the accelerationist theory in relation to unemployment and inflation?
Unemployment can be reduced below the natural level only under accelerating inflation.
attempting to reduce unemployment below the ‘natural’ level :
Government needs to rise AD faster than inflation.
People form higher inflation expectations though the same time.
Unemployment can be reduced below Un only under accelerating inflation.
What are the two routes to eliminate inflation discussed?
The ‘short, sharp shock’ and the slow route.
Stagflation and Phillips loops
clockwise Phillips loops
rightward shifts in the long-run Phillips curve
Phillips loops and the political business cycle
political business cycle
Policy implications of the Monetarist perspective
monetary and fiscal policies have no long-run effect on unemployment, moving the economy up and down the long-run Phillips curve
need for supply-side policies to shift LRPC to the left
What is the political business cycle?
The cyclical nature of economic policy influenced by political factors.
What does the New Classical Position assert about inflation and unemployment?
No trade-off between inflation & unemployment in the short-run unless there is an unexpected event
flexible wages and prices, thus markets clear rapidly
- continuous market clearing (“voluntary unemployment”)
rational expectations, but imperfect information – the ‘surprise model’
Anticipated fluctuations in aggregate demand
real aggregate demand and employment levels unchanged.
What is the assumption about wages and prices in the New Classical Position?
Wages and prices are flexible, allowing for rapid market clearing.
What is the impact of unanticipated changes in aggregate demand in the New Classical Position?
Can lead to fluctuations in output and employment levels.
What is the expected inflation based on in rational expectations?
The current state of the economy.
What is the simplest form of adaptive inflation expectations?
Expected inflation this year = actual inflation last year.
What could a rise in aggregate demand potentially cause?
A fall in national Output
What is the real wage rate represented by ?
W / P
What does the New Classical position imply about surprise fluctuations in aggregate demand?
They affect the goods market and the labour market
What happens in the labour market due to underprediction of inflation?
Real wage rate is overestimated
What are the implications of the New Classical version of the short-run Phillips curves?
Problems of inflation and unemployment are totally separate
Policy implications of the new classical ‘surprise model’
problems of inflation and unemployment are totally separate
rejection of Keynesian demand management
role for monetary policy rules and clear central bank remits
Modern (New) Keynesian Position
More recently, Keynesian analysis has incorporated three major modifications:
- An increased importance attached to equilibrium unemployment.
- A rationale for the persistence of demand-deficient unemployment.
- The incorporation of the theory of expectations: adaptive or rational.
What does the Modern Keynesian position attach increased importance to?
Equilibrium unemployment
Changes in equilibrium unemployment
changes in structural unemployment
non-accelerating inflation rate of unemployment (NAIRU)
Technological changes
Competition from abroad
High-tech capital-intensive products
hysteresis (e.g. following Covid-19 pandemic)
Skills mismatch
Firms restrain
Name one modification incorporated in Modern Keynesian analysis.
Persistence of demand-deficient unemployment
payment of efficiency wages
“Efficiency wages”
insider power
Insiders unionised – Outsiders non-unionised
What is NAIRU?
Non-accelerating inflation rate of unemployment
What factors contribute to changes in structural unemployment?
Technological changes, competition from abroad, skills mismatch
What is meant by ‘efficiency wages’?
Wages that are higher than the market equilibrium to increase productivity
What distinguishes insiders from outsiders in the labour market?
Insiders are unionised, while outsiders are non-unionised
What do expectations affect in the Modern Keynesian model?
Output, employment, and prices
What happens to the Phillips curve during an expansion of aggregate demand?
It shifts upwards as expectations adjust
What is the impact of higher investment on the Phillips curve?
Limits the upward shift in the short-run Phillips curve
What does downward stickiness of real wages imply during deflationary policies?
Only a slight fall in inflation occurs
What is a concern regarding the supply-side effects during economic downturns?
Weak growth following a recession
True or False: The Modern Keynesian analysis rejects the importance of equilibrium unemployment.
False
What is one key aspect of the Keynesian analysis of expansionary policies?
Effects on investment
What does hysteresis refer to in an economic context?
Long-term effects of economic shocks
e.g. Covid-19 pandemic
What is the relationship between inflation and unemployment according to the Phillips curve?
Inverse relationship
Incorporation of expectations
supply-side effects arising from changes in aggregate demand
Prices-wages are not perfectly flexible.
Expectations also affect output and employment besides prices.
expansion of aggregate demand
effects on investment
effects on long-term unemployed
contraction of aggregate demand
Keynesian criticisms of non-intervention
Keynesian approach to the recessions of 2008–9 and 2020 and debate over austerity measures of 2010s
concerns about supply-side effects of downturn and subsequent period of weak growth
