Week 8 Flashcards
Business cycle
Fluctuations in the economy are often called the business cycle
Three key facts about economic fluctuations
Economic fluctuations are irregular and unpredictable.
Most macroeconomic variables (that measure some types of income or production) fluctuate together
Do they do so by the same amounts?
As output falls, unemployment rises
Why?
Explaining short-run economic fluctuations
Most economists believe that classical theory describes the world in the long run but not in the short run
The basic model of economic fluctuations
Two main macroeconomic variables, output and prices, are used to develop a model to analyze the short-run fluctuations.
The economy’s output of goods and services measured by …?
The overall price level measured by…?
The model looks at the aggregated behaviour of households and firms, how it is affected by Y and P and how these in turn affect the behaviour
AD
The aggregate-demand curve (AD) shows the quantity of goods and services that households, firms, and the government want to buy at each price level
An important note AD
it is also possible to present the model in terms of inflation rather than the price level, with the intuition slightly changed (inflation rate used in a textbook)
Components of AD
The aggregate demand for goods and services has four components:
Aggregate Demand = C + I + G + NX
Aggregate Supply = Y
In equilibrium, supply = demand
Therefore, in equilibrium Y = C + I + G + NX
The aggregate-demand curve illustrated
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The demand curve for an individual commodity is downward sloping because of two effects:
Substitution effect: when ice cream becomes cheaper people buy more ice cream because they are switching from frozen yogurt (a substitute)
Income effect: when price of ice cream falls and income is unchanged, people feel richer and, therefore, buy more ice cream
The demand curve for an individual commodity is downward sloping because of two effects:
EXTRA NOTES
But the AD curve can consider only changes in the overall price level. If all prices decrease, there can be no substitution effect
It is inconsistent to talk about changes in aggregate demand while assuming unchanged income, because aggregate income must be equal to aggregate demand. Therefore, the income effect can’t be applied to the aggregate economy.
Shifts in the Aggregate Demand Curve
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Why the Aggregate-Demand Curve Might Shift
Shifts arising from
Consumption: consumer optimism, tax rates, prices of assets (stocks, bonds, real estate)
Investment: technological progress, business confidence, tax rates, money supply
Government Purchases
Net Exports: foreign GDP, expectations about exchange rates
The aggregate-supply curve
The aggregate-supply curve (AS) shows the quantity of goods and services that firms choose to produce and sell at each price level.
In the long run (LR), is Y affected by P?
What is then the slope of LRAS?
The long-run aggregate-supply curve
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Why the Long-Run Aggregate-Supply Curve Might Shift
Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.
Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.
Labor: population growth, immigration, natural rate of unemployment
Capital, physical or human
Natural Resources: price of imported oil
Technology
Laws, government policies
The short-run aggregate-supply curve
We empirically observe that in the SR, unlike the LR, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.
A decrease does the opposite
Put differently, P has temporary but not permanent positive effect on Y
The short-run aggregate-supply curve
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WHY does a nominal variable like M or P have effect on a real variable like Y???
There are 3 main theories
All have something to do with some imperfections in the adjustment process
All lead to an upward sloping SRAS
There are 3 main theories
All have something to do with some imperfections in the adjustment process
All lead to an upward sloping SRAS
(1) the misperceptions theory
(2) the sticky-wage theory
(3) the sticky-price theory
How the SRAS curve shifts
SRAS1 shows the aggregate supply curve for 2010
the expected price level and the natural rate of output, must be on the SRAS curve
If either Pe↓ or YN↑, the green dot moves down or to the right
When the green dot shifts, so must the AS curve
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The long-run equilibrium
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Two causes of recession
In some LR equilibrium (called the steady state) all the main variables are either constant or change by a certain (unchanging) percentage
For example: inflation is 2% each year, output growth is 3% each year etc.
New economic developments (shocks) however may shift the three curves further and this leads to SR fluctuations
The economy then has a tendency to go back to some LR equilibrium (either the original one or a new one).
This works through the supply side and is called the self-correcting mechanism
Case (1): A Contraction in Aggregate Demand
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Case (1): ECONOMIC FLUCTUATIONS: AD
Contraction (leftward shift) in Aggregate Demand (AD)
Case (1): ECONOMIC FLUCTUATIONS: AD
In the short run
output decreases,
the overall price level decreases, and
the unemployment rate increases
Case (1): ECONOMIC FLUCTUATIONS: AD
In the long run
the overall price level decreases,
but output and the unemployment rate remain unchanged at their long-run levels
Case (2): ECONOMIC FLUCTUATIONS: AS
A leftward shift in Short-Run Aggregate Supply
Output falls below the natural rate of employment
Unemployment rises
The price level rises
If the government does nothing, the SRAS will shift back to where it was.
The price level, total production and unemployment will be unaffected in the long run.
Case (2): An Adverse Shift in Aggregate Supply
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Stagflation
Adverse shifts in aggregate supply cause stagflation — a period of recession and inflation
Output falls and prices rise.
The effects of a shift in aggregate supply
Policy responses to recession
Do nothing and wait for prices and wages to adjust (the economy to self correct)
Take action
Accommodating an Adverse Shift in Aggregate Supply
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Why is the aggregate demand curve downward sloping
Inflation rate and investments (Interest rate effect)
Inflation rate and wealth (Pigou’s wealth effect)
Inflation rate and net exports (Mundell-Flemings exchange rate effect)
(Mundell-Flemings exchange rate effect)
A lower inflation rate lowers the interest rate. Investors will seek higher returns by investing abroad. The increase in net foreign investment raises the dollar supply, lowering the real exchange rate. Domestic goods become relatively cheaper compared to foreign goods. Net exports rise thereby increasing the quantity of goods and services demanded.
(Interest rate effect)
A lower inflation rate induces the RBA to reduce the interest rate which encourages greater spending on investment goofs. It therefore increases the quantity of goods and services.
(Pigou’s wealth effect)
A decrease in the inflation rate (overall price level decreases) makes consumers feel wealthy. In turn it encourages them to spend more.
Why the aggregate supply curve is vertical in the long run
In the long run an economy’s supply of goods and services depends on its supplies of resources along with the available production technology. Because the inflation rate does not affect the determinants of output in the long run, the LRAS curve is vertical at the natural rate of output.
The new classical mispercetions theory
Changes in the inflation rate (overall price level) can temporarily mislead suppliers about what is happening in the markets in which they sell their output. Suppliers respond to changes in the level of prices and thus the SRAS curve is upward sloping.
The Keynesian sticky wage theory
Wages do not adjust to changes in prices in short run therefore real wages change and suppliers adjust their output levels. A lower rate of inflation makes employment and production less profitable leading firms to lower the quantity of goods and services supplied.
The new Keynesian sticky price theory
The prices of some goods and services are also sometimes slow to respond to changes in the economy (menu costs). An unexpected fall in inflation rate leaves some firms with higher than desired prices which depresses sales and induces the firms to lower the quantity of goods and services supplied.
Why the short run supply curve might shift
Events that shift long run
Inflation rate expectations
Events that shift long run
Events that shift the LRAS will shift the SRAS as well e.g. production costs, technology, minimum wages.
Inflation rate expectations
People’s expectations of the inflation rate will affect the position of the SRAS curve even though it has no effect on the LRAS curve. A higher expected inflation rate will decrease the quantity of goods and services supplied and shift the SRAS curve to the left whereas a lower expected inflation rate increases the goods and services supplied and shifts the SRAS curve to the right.
If the world oil price increases
If the world oil prices rise, then short-run AS would decrease
Keynes attempted to explain:
short-run economic fluctuations and advocated policies to increase aggregate demand
The Keynesian school of thought argues that due to the multiplier effect, a relatively small increase in aggregate expenditures will have a larger final effect on total expenditures over time and therefore only a proportionally small boost to national spending is required to close a relatively large gap in GDP (being the gap between the actual level of GDP and the full employment level of GDP). Thus, Keynes advocated aggregate demand focused policies.
- When an increase in the minimum wage raises the natural rate of unemployment:
both short-run and long-run aggregate-supply curves shift to the left
