Sessions 6 and 7

8/3/2019 Sessions 6 and 7

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Session - 6

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AA CC TT II V V E LE L EE AA RR NN II NN GG 11::

ExerciseExercise

What happens to theAD curve in each of the

following scenarios?

A. A ten-year-old investment tax credit expires.

B. The U.S. exchange rate falls.

C. A fall in prices increases the real value ofconsumers wealth.

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AnswersAnswers

A. A ten-year-old investment tax credit expires.

I falls,AD curve shifts left.

B. The U.S. exchange rate falls.

NXrises,AD curve shifts right.

C. A fall in prices increases the real value ofconsumers wealth.

Move down alongAD curve (wealth-effect).

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The Aggregate-Supply (AS) Curves

The AS curve shows

the total quantity of

g&s firms produce andsell at any given price

level.

P

SRAS

LRAS

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Y

ASis:

upward-sloping

in short run

vertical in

long run


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The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of

output (YN) is the

amount of outputthe economy produces

when unemployment

P LRAS

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.

YN is also called

potential output

or

full-employment

output.

YYN


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Why LRAS Is Vertical

YN determined by the

economys stocks of

labor, capital, and

natural resources, and

on the level of

technology.

P LRAS

P2

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An increase in P

Y

P1

does not affect

any of these,

so it does not

affect YN.YN


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Why the LRAS Curve Might Shift

Any event that changes

any of the

determinants ofYNwill shift LRAS.

Exam le: Immi ration

P LRAS1 LRAS2

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increases L,causing YN to rise.

YYN YN


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Why the LRAS Curve Might Shift

Changes in L or natural rate of unemployment

Immigration

Govt policies reduce natural u-rate Changes in Kor H

Investment in factories, equipment

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More people get college degrees Factories destroyed by a hurricane


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Why the LRASCurve Might Shift

Changes in natural resources

discovery of new mineral deposits

reduction in supply of imported oil changing weather patterns that affect

agricultural production

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Changes in technology

productivity improvements from technologicalprogress


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LRAS1980

Using AD &AS to Depict LR Growth and

Inflation

Over the long run,

tech. progress shifts

LRASto the right

P LRAS1990

and growth in the

LRAS2000

P2000

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YAD1990AD1980

Y1990

money supp y s sAD to the right.

Y1980

AD2000

Y2000

P1980Result:

ongoing inflationand growth in

output.

P1990


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Short Run Aggregate Supply (SRAS)

The SRAScurve

is upward sloping:

Over the periodof 1-2 years,

an increase in P

P

SRAS

P2

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Y

causes anincrease in the

quantity of g & s

supplied. Y2

P1

Y1


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Why the Slope ofSRASMatters

IfASis vertical,fluctuations inADdo not causefluctuations in outputor employment.

P

SRAS

LRAS

Phi

Phi

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Y

AD1

ADhi

ADlo

Y1

IfASslopes up,

then shifts inAD

do affect outputand employment.

Plo

Ylo Yhi

Plo


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Three Theories ofSRAS

In each,

some type of market imperfection

result:Output deviates from its natural rate

when the actual price level deviates

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from the price level people expected.


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1. The Sticky-Wage Theory

Imperfection:

Nominal wages are sticky in the short run,

they adjust sluggishly. Due to labor contracts, social norms.

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advance based on PE, the price level theyexpect to prevail.


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1. The Sticky-Wage Theory

IfP> PE,

revenue is higher, but labor cost is not.

Production is more profitable,so firms increase output and employment.

Hence hi herPcauses hi herY

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so the SRAS curve slopes upward.


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2. The Sticky-Price Theory

Imperfection:

Many prices are sticky in the short run.

Due to menu costs, the costs of adjustingprices. Examples: cost of printing new menus,

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the time required to change price tags. Firms set sticky prices in advance based

on PE.


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2. The Sticky-Price Theory

Suppose the Fed increases the money supplyunexpectedly. In the long run, Pwill rise.

In the short run, firms without menu costs canraise their prices immediately.

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Meantime, their prices are relatively low,which increases demand for their products,so they increase output and employment.

Hence, higherPis associated with higherY,so the SRAS curve slopes upward.


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3. The Misperceptions Theory

Imperfection:

Firms may confuse changes in Pwith changes

in the relative price of the products they sell.

IfPrises above PE, a firm sees its price rise

before realizing all prices are rising.

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The firm may believe its relative price is rising,and may increase output and employment.

So, an increase in Pcan cause an increase inY,

making the SRAS curve upward-sloping.


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What the 3 Theories Have in Common:

In all 3 theories, Ydeviates from YN whenPdeviates from PE.

Y = YN + a (P PE)Output Expected

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Natural rateof output(long-run)

a > 0,

measureshow much Y

responds tounexpected

changes in P

Actualprice level

pr ce eve


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What the 3 Theories Have in Common:

P

SRASWhen P> PE

Y = YN + a(P PE)Y = YN + a(P PE)

YYN

Y> YN

When P< PE

Y< YN

PEe expec eprice level


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SRASand LRAS

The imperfections in these theories are

temporary. Over time,

sticky wages and prices become flexible misperceptions are corrected

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,

PE = P AScurve is vertical


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LRAS

SRASand LRAS

P

SRASIn the long run,

Y = YN + a(P PE)Y = YN + a(P PE)

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Y

PE

YN

PE = Pand

Y= YN.


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Why the SRASCurve Might Shift

Everything that shifts

LRASshifts SRAS, too.

Also, PE shifts SRAS:IfPE rises,

workers & firms set

LRASP

SRASSRAS

P

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higher wages.

At each P,

production is less

profitable, Yfalls,SRASshifts left. Y

PE

YN


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The Long-Run Equilibrium

In the long-run

equilibrium,

PE = P,

Y= YN ,

P

SRAS

P

LRAS

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and unemploymentis at its natural rate.

Y

AD

YN


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Changes in Short-Run Aggregate Supply

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Short-Run Equilibrium

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Changes in Short-Run Equilibrium in

the Economy

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How a Factor Affects the Price Level, Real GDP,and the Unemployment Rate in the Short Run

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Supply Shocks

Supply shocks are

external events that shiftthe aggregate supply

curve.

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verse supp y s oc s can

cause a recession (a fall in

output) with increasing

prices. This phenomenon

is known as stagflation.


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A Summary Exhibit ofADand SRAS

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Session-7

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Learning Objectives

Derive the aggregate supply curve under classical

assumption.

Derive the aggregate supply curve under Keynesian

Assumption.

How does the generalised aggregate supply curve looks

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e em o y ng c ass ca , eynes an an ew

Keynesian assumptions).

Distinguishing between Demand pull and cost-push

Inflation

How to Study the Impact of Economic Fluctuations on

output and Inflation


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Why did Keynes assume fixed product prices and wages?

During a deep recession or depression, there are many

idle resources in the economyWhy do idle resources mean fixed prices?Producers are willing to sell additional output at currentrices because there is lent of resources to o around

What is the Aggregate supply curve?

Shows the level of real GDP produced at different pricelevels during a time period, ceteris paribus

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for everyone who wants themWhy do idle resources mean fixed wages?

Unemployed workers willing to work for the prevailingwage diminishes the power of workers to increase theirwages

What kind of supply curve would explain fixed prices andwages?

A horizontal supply curve


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200

150

vel(CP

I)

The Keynesian Horizontal

Aggregate Supply Curve

full employment

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100

50

2 4 6 8

1

Real GDP

PriceL

1210

AD2

AD1


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Price level remainsconstant, while real GDP

and employment rise

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Governmentspending (G)

increases

increases and theeconomy moves from E1to E2


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According to Keynes, what will a shift in aggregatedemand do?

It will restore a depressed economy to full employment

What is the Classical view of the aggregate supplycurve?

It is a vertical line at the full employment output

Accordin to the Classical economists where does the

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economy normally operate?The economy normally operates at its fullemployment level

How do the Classical economists view prices andcosts?

The price level of products and production costs changeby the same percentage in order to maintain fullemployment


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200

150

Full em lo ment

The Classical Aggregate Supply Curve

AS

vel(CPI)

Surplus

71

100

50

2 4 6 8 10 12 14 16

Real GDP

PriceL

17

AD1

AD2


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The economy moves to alevel of full employment

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Aggregate demanddecreases at full

employment

Unemployment causes adecrease in prices


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Three Ranges of the Aggregate Supply Curve

AS

ceLevel

Classical

Ran

ge

FullEmployment

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YKReal GDP

KeynesianRange

Pri

YF


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AS

$150

$200 Full Employment

Increasing Demand

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2 4 6 8 10 120

$50

$100

AD1AD2 AD3

AD4

AD5


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200

150

full em lo ment

A Rightward Shift in the Aggregate Supply Curve

AS1

Level

E1

E2

AS2

75

100

50

2 4 6 8 10 12 14 16

Price

17

AD

Real GDP


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What is cost push inflation?

A rise in the general price level resulting from an

Cost push

Demand pull

What are the two types of inflation?

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What is demand pull inflation?

A rise in the general price level resulting from anexcess of total spending


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200

150full

Cost Push Inflation

iceLe

vel

E2

AS1AS2

77Session 13 and 14 Biswa Swarup

100

50

2 4 6 8 10 12 14 16

P

17

AD

E1

Real GDP


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200

150 fullemployment

Demand Pull Inflation

eLevel

E2

AS

78

100

50

2 4 6 8 10 12 14 16

Pric

17

AD1

E1

Real GDP

AD2

What is stagflation?


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What determines the business cycle?

Shifts in the aggregate demand and aggregate supplycurves

What is stagflation?

High unemployment and rapid inflation existsimultaneously

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That depends on how much each increases


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200

150

AS1AS2

Rightward Shift in Demand and Supply

Leve

l

80

100

50

2 4 6 8 10 12 14 16 17

AD1Real GDP

AD2Pric


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Increase in pricelevel

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Increase in aggregatedemand and supply

Increase in real GDP

Q & A: Identify what will happen to the price level


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Q & A: Identify what will happen to the price leveland Real GDP when each of the following occurs:

Short-Run Aggregate

Supply rises

Short-Run Aggregate

Supply falls

Aggregate Demand rises

by more than the Short-

Run Aggregate Supply

rises

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Aggregate Demand rises Aggregate Demand falls

ggrega e eman a s

by less than the Short-Run Aggregate Supply

falls

How to Study the Impact of


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How to Study the Impact of

Economic Fluctuations Caused by events that shift theAD and/or

AScurves.

Four steps to analyzing economic fluctuations:

1. Determine whether the event shiftsAD orAS.

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2. Determine whether curve shifts left or right.3. UseAD-ASdiagram to see how the shift

changes Yand P in the short run.

4. UseAD-ASdiagram to see how economymoves from new SR eqm to new LR eqm.

The Effects of a Shift in AD


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LRAS

The Effects of a Shift in AD

Event: stock market crash

1. affects C,AD curve

2. Cfalls, soAD shifts left

3. SR eqm at B.

Pand Y lower,

P

SRAS1

P1 A

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YN

unemp higher

4. Over time, PE falls,

SRASshifts right,

until LR eqm at C.

Y and unemp back

at initial levels.

Y

AD1

AD2

P2

Y2

B

P3 C

Two Big ADShifts:


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o g

1. The Great Depression

From 1929-1933,

money supply fell28% due to problemsin banking system

800

850

900

U.S. Real GDP,billions of 2000 dollars

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s oc pr ces e ,

reducing Cand I

Y fell 27% P fell 22% u-rate rose

from 3% to 25%

550

600

650

700

1929

1930

1931

1932

1933

1934

Two Big ADShifts:


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g

2. The World War II Boom

From 1939-1944,

govt outlays rosefrom $9.1 billionto $91.3 billion 1,600

1,800

2,000

U.S. Real GDP,billions of 2000 dollars

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Y rose 90% P rose 20%

unemp fell

from 17% to 1% 800

1,000

1,200

1,400

1939

1940

1941

1942

1943

1944

AA CC TT II VV E LE L EE AA RR NN II NN GG 22::


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ExerciseExercise Draw theAD-SRAS-LRASdiagram

for the U.S. economy,

starting in a long-run equilibrium.

A boom occurs in Canada.

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se your agram o e erm ne

the SR and LR effects on U.S. GDP,

the price level, and unemployment.

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AA CC TT II VV E LE L EE AA RR NN II NN GG 22::


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AnswersAnswers

LRASPSRAS2

SRAS1P3 C

Event: boom in Canada

1. affects NX,AD curve

2. shiftsAD right

3. SR eqm at point B.

8888

YNY

AD2

AD1

P1

P2

Y2

B

A

Pand Y higher,

unemp lower

4. Over time, PE rises,

SRASshifts left,

until LR eqm at C.

Y and unemp back

at initial levels.

The Effects of a Shift in SRAS


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LRAS

The Effects of a Shift in SRAS

Event: oil prices rise1. increases costs,

shifts SRAS

(assume LRAS constant)2. SRASshifts left

3. SR eqm at point B.

P

SRAS1

SRAS2

B

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YN

Phigher, Y lower,unemp higher

From A to B,stagflation,

a period offalling outputand rising prices.

Y

AD1

P1 A

Y2

Accommodating an Adverse Shift in SRAS


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LRAS

Accommodating an Adverse Shift in SRAS

If policymakers do nothing,4. Low employment

causes wages to fall,

SRASshifts right,until LR eqm at A.

P

SRAS1

SRAS2

BP3 C

90

YNY

AD1

P1 A

Y2

AD2

,

use fiscal or monetarypolicy to increaseAD

and accommodate the

ASshift:Yback to YN, but

Ppermanently higher.

The 1970s Oil Shocks and Their Effects


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The 1970s Oil Shocks and Their Effects

+ 99%

+ 138%Real oil prices

1978-801973-75

91

# of unemployed

persons

Real GDP

+ 1.4million

+ 2.9%

+ 3.5million

0.7%

John Maynard Keynes, 1883-1946


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John Maynard Keynes, 1883 1946

The General Theory of Employment,Interest, and Money, 1936

Argued recessions and depressionscan result from inadequate demand;policymakers should shiftAD.

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amous cr que o c ass ca eory:

Economists set themselves

too easy, too useless a task if in tempestuous seasonsthey can only tell us when the storm is long past,

the ocean will be flat.

The long run is a misleading guide

to current affairs. In the long run,

we are all dead.

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