Price
Q
Supply
Demand
Q e
P e
Supply and Demand graphs- The Basics
The purpose of this graph is to look at markets. Free Market Price and Quantity
Price Level
Measure of
Inflation
G.D.P real
employment
Aggregate Supply (AS)
Aggregate Demand (AD)
Q e
P e
Aggregate- all together (total)
The Aggregate Market- The Basics
Long Run Aggregate Supply (LRAS)
Qy
Qy= Quantity at full employment
The purpose of this graph is to look at countries. Total supply and demand at full employment
You may find it amazing how a fairly simple graph can be interpreted in so many different ways.
Learning the basics of the graph will provide you an opportunity to learn fiscal and monetary policy in different ways.
The law of demand is the same.
There is an inverse relationship- PL up, AD down, PL down AD up
The law of supply is the same
There is a direct relationship- PL up, AS up, PL down AS down
AD= Aggregate Demand
AD= GDP= C + I G + NX
Conflicting Views
Classical Views Keynesian Views
1. Prices and Wages are flexible – markets quickly and efficiently achieve equilibrium. When applied to the resource market full employment is maintained- unemployment is not a long term problem
2. Say’s Law- supply creates it own demand- aggregate product of goods and service produces enough income to exactly purchase all output
3. Savings-investment equality-any decrease in output because of savings is offset an increase in the demand for investment
This creates a different market – the money market
Investment is demandSavings is Supply
Interest rates create equilibrium- Monetarist
1. Prices and Wages are Sticky- Prices and wages respond slowly to changes in supply and demand and this results in shortages and surplus- especially with labor.
2. Increase Aggregate Demand to increase GDP- is influenced by a host of economic decisions both public and private.- savings hurt The paradox of thrift 3. “In the Long Run we are all dead”- care more about Short run and not so much about the long run. Changes in AD have greater short run effect on real GDP and employment but not as much on price. What is true in the short run isn’t always true in the long run
4. The multiplier- increases in spending will increase consumption and increase output- which will lead to more spending
5. Steer the Market- advocated stabilization policies such as tax, government spending, laws, and regulation in order to defend against the sudden and unpredictable changes in the business cycle
Less Government
Equilibrium of market
Increase consumer or InvestmentsSAVINGS!!!!!
F.A. Hayek
Neo-ClassicalAustrianMonetaristSupply-siders
John M. Keynes More GovernmentMicro not Macro
KeynesiansNeo-Keynesians Increase Gov’tDemand-siders spending!!!!!!!!
Fiscal Policy
4. Individualism
Keynesian’s Paradox of thriftA Prisoner’s Dilemma for Savings
A Prisoners Dilemma between individuals in a society who want to save.
It is smart to save during the good times , but if everybody saves than Aggregate demand drops and GDP drops now we are in a recession.
How does the government attempt to avoid this?
Wages
Employment
(AS)
(AD)
Q
W e
AS/AD/LRAS graphs- Classical vs Keynesian models Labor Market
(AD) 1
Classical (Monetarist)- believe that when demand for employment decreases- wages will fall and the market will clear (return to equilibrium). Some people will choose not to work but most will eventually lower their wages.
W 1
Q 1
Keynesians- say- no when demand for employment falls- wages and prices are sticky. We simply get a new quantity at the same wage. This creates a surplus of supply of workers which will remain until demand increases.
Quantity demanded is less than the quantity supplied.
Q 2
P.L.
G.D.P real
(AS) much like the LRAS
(AD)
Q y
P e
The whole purpose of these graphs is to find the Price level, GDP, and unemployment
AS is vertical and at the same point of full employment
Classical economist believe that resources prices and wages are flexible
This model says that the government doesn’t need to get involved because the market will fix itself.
Aggregate Supply (The classical model)
What will happen to price as AD falls?
(AD) 1
P 1The classical model suggest that the economy fixes itself and that prices and resources price will fall to create a new equilibrium.
When Aggregate demand falls what happens to. . .
Price?
Employment?
Wage (remember wages are price)?
GDP real?
P.L.
G.D.P real
LRAS
(AD)
Q y
P e
Aggregate Supply (The classical model)
SRAS
(AD) 1
If there is a decrease in ADThere will be a reduction in price level and higher unemployment
P 1
Q 1
SRAS 1
Q 2
According to classical economist the SRAS will eventually increase as wages decrease and the price of resources decrease
This will give you a new quantity demanded back at full employment
This will occur as long as wages can adjust. What can keep wages artificially elevated? Or in other words what can keep the market from clearing?
Unions
Min. Wage laws
Unemployment benefits
Whether or not the market will clear will also depend on the worker’s wage expectations.
Rational Expectations
Workers will revise their expectations instantaneously
Adapted Expectations
It may take workers weeks, months, or years but eventually they will adapt their wage expectations.
P.L.
G.D.P real
LRAS
(AD)
Q yfull
P e
Aggregate Supply (The Keynesian Model)
Y1
According to Keynes, it is possible for the economy to be in a recession permanently. Prices/wages won’t change and output will remain low.
When output is below full employment, the price level doesn’t fall because wages/resource prices don’t fall (wages are sticky)
(AD) 1
P.L.
G.D.P real
LRAS
Q yfull
P e
Aggregate Supply (The Keynesian Model)
Y1
According to Keynes, only with the help of the help of the government can Aggregate demand increase.
Demand side economics- focus on demand
Fiscal approach- government spending and taxationMonetarist approach is to increase investments
(AD) 1
(AD) 2 (AD) 3
Any aid past Qy- is purely inflationary
(AD) 4
(AD) 5
P.L.
G.D.P real
LRAS
Q yfull
P e
Aggregate Supply – So what Model is correct?
They Both have some valid points
Keynesian Phase
AD
When in the Keynesian Phase
Output can increase with no change in price.No increase in price level, no inflationary pressure, spare room to grow.
Intermediate Phase
AD
When in the Intermediate Phase
As AD approaches the curve
An increase in AD and decrease in unemployment
Result in a gradual increase of price and some inflationary pressure
ClassicalPhase
AD
When in the Classical Phase
The economy is operating at full employment
Any and all increase in AD will result in an increase in price and in increase in inflation
P.L.
G.D.P real
(AS)
(AD)
Q e
P e
If Aggregate Demand increases
AS/AD/LRAS graphs- how it works during Expansion
(LRAS)
Qy
(AD) 1
P 1
Q 1
Both Prices and GDP will increase.
In the long run – an increase in price will not lead to an increase in output.
Why?
Because as prices increase so does the price of resources including labor, wages, and materials.
(AS) 1
As a result the Aggregate supply will shift to the left (decrease) and we will find ourselves back at full employment.
A
B
CP 2
P.L.
G.D.P real
(AS)
(AD)
Q e
P e
If Aggregate Demand decreases.
AS/AD/LRAS graphs- how it works during Recession
(LRAS)
Qy
(AD) 1
Q 1
P 1
Both Price Level and output will decrease.
In the long-run a decrease in price will not lead to a decrease in output.
Why?
Because as prices decrease so does the price of resources including labor, wages, and materials.
As a result the Aggregate supply will shift to the right (increase) and we will find ourselves back at full employment.
(AS 1)
P 2
A
B
C
Inflationary and Recessionary Gaps- Steering the Market
Economic Activity
Time (years)
Potential GDP
Inflationary Gap
Recessionary Gap
The Government can steer the economy in different ways1. Laws and Regulations- stabilizers2. Fiscal Policy- changes in government spending or taxation to influence the economy3. Monetary policy- changes in monetary supply to influence the economy
AS/AD/LRAS graphs- Inflationary Gap
AS
AD 1
GDP real
Price Level
Q1
Fiscal Policy:
Monetary Policy:
LRAS
Q yFE
Actual GDP > Potential GDPOutput is beyond full employment
Unemployment very lowPrices very high
P1Government wants to limit inflation by reducing demand
AD 2
P2 How do they do it?
Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE
Federal Reserve can decrease money supply or increase interest rates. AD = C + I + G + NE
AS/AD/LRAS graphs- Recessionary Gap
AS
AD 1
GDP real
Price Level
Q1
Fiscal Policy:
Monetary Policy:
LRAS
Q yFE
Actual GDP < Potential GDPOutput is below full employment
High unemployment
P1
Government wants to limit unemployment by increasing demand
AD 2
P2
How do they do it?
Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE
Federal Reserve can increase money supply or decrease interest rates. AD = C + I + G + NE
Fiscal Policy (Demand side)
Keynesians and Democrats
Keynesian economics
President sets the budget, Congress develops programs- they can tax and borrowCommerce clause – etc.
Raising Revenue- Tax or Borrow
Spending- increase of Decrease
Monetary Policy (Demand side)
Leading advocates- Monetarist
Milton Friedman showed that people’s annual consumption is a function of their “permanent income,” a term he introduced as a measure of the average income people expect over a few years.
Monetarist believe that price level depends on money supply
Friedman stated that in the long run, increased monetary growth increases prices but has little or no effect on output. In the short run, he argued, increases in money supply growth cause employment and output to increase, and decreases in money supply growth have the opposite effect.
Friedman’s solution to the problems of INFLATION and short-run fluctuations in employment and real GDP was a so-called money-supply rule. If the Federal Reserve Board were required to increase the money supply at the same rate as real GDP increased, he argued, inflation would disappear.
He argued that the Great Depression was caused by the Federal Reserves poor management of money.
To keep unemployment permanently lower, he said, would require not just a higher, but a permanently accelerating inflation rate
AD
Q
PriceInterest Rate
Supply and Demand of Money
Interest rate at supply
Q1
I1
Decreasing the supply of money will increase the interest rate
Increasing the supply of money will decrease the interest rate
I2
Q2
I3
Q3
Open Market Operations:
The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.
$$ and Treasury Securities $$ and Treasury Securities
If the Federal Reserve buys Treasury Securities from banks or market
The banks will have more in their reserves
and they will be able to lead at a lower interest rate
$$
Results:
Reserves increase
Excesses reserves increase
Loans increase
Money Supply increases
Interest rates decrease
More consumer and investment spending
If the Fed. Easy money policy
Open Market Operations:
The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.
$$ and Treasury Securities $$ and Treasury Securities
If the Federal Reserve sell Treasury Securities to banks or market
The banks will have less in their reserves
and they will have to lead at a higher interest rate
$$
Results:
Reserves decrease
Excesses reserves decrease
Loans decrease
Money Supply decreases
Interest rates increase
Less inflation
If the Fed. Tight money policy
Discount Rate:
The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.
Easy money policy
Fed Reserve lowers discount rate (interest rate it charges banks)
Banks Borrow more reserves
There is an increase in the money supply
There is a lower interest rates because banks can compete with other banks
There is an increase in spending by consumers and investors
3.0%
3.0%3.0%3.0%
3.0%
Discount Rate:
The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.
Tight money policy
Fed Reserve increases discount rate (interest rate it charges banks)
Banks Borrow less reserves
There is an decrease in the money supply
There is a higher interest rate
There is an decrease in spending which will slow down inflation
11.0%
11.0%11.0%11.0%
11.0%
Reserve Requirements:
The Fed can further adjust the proportion of reserves that banks must keep to back outstanding deposits (the reserve ratio). Higher and lower rates affect the deposit multiplier and the amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve requirements, then banks can use existing reserves to make more loans and thus increase the money supply. If the Fed raises reserve requirements, then banks can use existing reserves to fewer more loans and thus decrease the money supply. This tool is seldom used as a means of controlling the money supply.
A depository institution's reserve requirements vary by the dollar amount of net transaction accounts held at that institution. Effective December 30, 2010, institutions with net transactions accounts:
Of less than $10.7 million have no minimum reserve requirement;Between $10.7 million and $58.8 million must have a liquidity ratio of 3%;Exceeding $58.8 million must have a liquidity ratio of 10%.
Monetary Policy (Demand side)
Who- the Federal ReserveWhat- increasing or decreasing the amount of money in circulationGoal- full employment, stability, and growth
Easy Money Supply- increasing money supply and decreasing interest rates
Open Market Operations- buy securitiesDiscount Rates- lower discount rateReserve Requirements- lessen requirements
Decrease interest rates
Tight Money Supply – decreasing the money supply and increasing interest rates
Open Market operations- sell securitiesDiscount Rates- increase discount ratesReserve Requirements- increase requirements
Prisoner’s Dilemma between Monetary and Fiscal Policy.
Normally, high expenditures and is a dominate strategy for Congress and tight money for the Fed. When each selects its preferred strategy will be deficit spending with tight money.
It is important that both the Fed and Congress aligned their ideas, but they are independent of each other and have different goals. The goal’s of the Fed can vary but the goals representatives in Congress is the same- get reelected.
If the Fed and Congress oppose follow their dominate strategies they will find themselves in a prisoner’s dilemma- this happen a lot in the 1980’s
Congress
The Fed.
Payoffs (Utility) 1-10
1 being least desirable10 being most desirable
High Expenditures
Low Expenditures
Easy Money
Tight Money 10, 0
0, 10
4, 4
6, 6
Supply-side theory in AS/AD/LRAS
v v v
LRAS 1 LRAS 2 LRAS 3
Supply side economics
1. Supports any action by the government that enables business to lower cost, boost efficiency, and competitiveness.
2. This increases potential output
3. There are a number of methodsa. Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment
benefitsb. Invest in educationc. Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)d. Lower corporate tax ratese. Invest in infrastructure
4. Eliminate safety nets and allow for profit and loss
How to fix the economy? According to . . .
Fiscal Policy Monetary Policy Supply Side Policy
During aRecession
With high unemployment
During Expansion
With high inflation
Increase Government Spending
Decrease Taxes
Buy Securities from banks or dealers
Decrease Discount Rate
Reduce Reserve requirements
All ideas intended to lower interest rate
Cut tax on Business
Reduce Regulation
Give business a chance to expand and hire
Decrease Government Spending
Increase Tax
Sell securities to banks
Increase Discount Rate
Increase Reserve Requirements
All ideas intended to increase interest rates
Eliminate tax cuts
No capital gains tax or marginal (progressive income tax)
Increase regulation and oversight
Expand minimum wage and unemployment benefits
Capital gain tax
The Problem with Lag.
Knowledge lag- knowledge and recognition lag, it takes time to recognize and correctly understand the problem.
Procedure or Action Lag- In the United States our legislative process can take long and there can be many hold ups.
Change or impact Lag- By the time change has taken place or the impacts are felt we may have been past the initial phase of the business cycle
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