Eco 1 Principles of Economics Chapter 23 PDF

Eco 1: Principles Eco 1 of Economics Review of Aggregate Expenditure and Chapter 23:Analysis Chapterof Aggregate 3 WhereDemand and Aggregate Prices Come From: Supply...

Eco 1: Principles Eco 1 of Economics Review of Aggregate Expenditure and Chapter 23:Analysis Chapterof Aggregate 3 WhereDemand and Aggregate Prices Come From: Supply The Interaction of Demand and Supply  Aggregate Demand and Aggregate Supply Model Aggregate demand and aggregate supply model: A model that explains short-run fluctuations in real GDP and the price level. It will help us to understand why real GDP, the level of employment, and the price level fluctuate. In the short run, real GDP and the price level are determined by the intersection of the aggregate demand (AD) curve and the short-run aggregate supply (AS) curve. Aggregate demand (AD) curve: A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government. Short-run aggregate supply (AS) curve: A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.  Aggregate Demand Aggregate Expenditure Relationship between output and the price level Relationship between spending and​ income Downward sloping because it reflects the inverse Upward sloping because, there is positive relationship between relationship between the price level and the level of real GDP and aggregate expenditure planned aggregate expenditure Change in Price level Change in Price level:  The Four Components of Real GDP Real GDP has four components: consumption (C), investment (I), government purchases (G), and net exports (NX): Y = C + I + G + NX Government purchases are generally determined by the decisions of policymakers; but each of the others changes, depends on the price level. The wealth effect: how a change in the price level affects consumption (C) Household consumption is most strongly determine by income, but it is also affected by wealth. Some household wealth is held in nominal assets; so as price levels rise, the real value of household wealth declines. This results in less consumption. GDP has four components; a decrease in any of the four could cause a recession. Does it make any difference which component causes the recession? Most post-WWII recessions in the U.S. have been preceded by falls in residential construction. Recent research suggests that recessions caused by financial crises tend to be larger and more long-lasting than declines due to other factors.  Why is the AD Curve Downward Sloping? The interest-rate effect: how a change in the price level affects investment (I) When prices rise, households and firms need more money to finance buying and selling. This increase in demand for money causes the “price” of holding money (the interest rate) to rise, discouraging firm investment. The international-trade effect: how a change in the price level affects net exports (NX) When U.S. price levels rise, U.S. exports become more expensive and imports become relatively cheaper. Fewer exports and more imports means net exports falls. Each effect moves in the same direction: an increase in the price level decreases real GDP.  Shifts of the AD Curve vs. Movements along It The aggregate demand curve shows the relationship between the price level and real GDP demanded, holding everything else constant. A change in the price level not caused by a component of real GDP changing results in a movement along the AD curve. A change in some component of aggregate demand, on the other hand, will shift the AD curve.  AD shifts: Changes in Monetary Policy A government policy change could shift aggregate demand. There are two categories of government policies here: 1. Monetary policy: The actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives. If the Federal Reserve causes interest rates to rise, investment spending will fall; if it causes interest rates to fall, investment spending will rise. shifts the aggregate An increase in… demand curve… because…  AD shifts: Changes in Fiscal Policy 2. Fiscal policy: Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives. Increasing or decreasing taxes affects disposable income, and hence consumption. The government can also alter its level of government purchases. shifts the aggregate An increase in… demand curve… because…  AD Shifts: Changes in Expectations Households or firms could become more optimistic about the future, increasing consumption or investment respectively. Of course, the opposite could also occur. shifts the aggregate An increase in… demand curve… because…  AD Shifts: Changes in Foreign Variables If foreign incomes rise more slowly than ours, their imports of our goods fall; if ours rise more slowly, our imports fall. If our exchange rate (the value of the $US) rises, our exports become more expensive, so foreigners buy less of them (and we buy more imports, also). Three elements affect net exports: the price level in the U.S. relative to other countries, real GDP growth in the U.S. relative to other countries, and the $US exchange rate. The second and third can shift AD; but the first causes movements along AD. shifts the aggregate An increase in… demand curve… because…  Recessions and the Components of AD Example of 2007-2009 recession Consumption spending fell, relative to potential GDP during the recession. This was unusual: consumption usually stays steady during a recession. Consumption also stayed low in the four post-recession years Residential investment had been falling before the recession, and continued to fall during it. Spending on residential investment has continued to be below the pre-recession boom levels. Net exports increased (became less negative) just before and during the recession. This was in part due to the falling value of the $US. After the recession, net exports started to decrease once more, but then have stayed relatively steady. Loose monetary policy has kept the value of the $US down.  Aggregate Supply and Time Frame Aggregate supply refers to the quantity of goods and services that firms are willing and able to supply. The relationship between this quantity and the price level is different in the long and short run. So we will develop both a short-run and long-run aggregate supply curve. Long-run aggregate supply curve: A curve that shows the relationship in the long run between the price level and the quantity of real GDP supplied.  Long-Run Aggregate Supply Curve Aggregate supply refers to the quantity of goods and services that firms are willing and able to supply. Long-run aggregate supply curve shows the relationship in the long run between the price level and the quantity of real GDP supplied. In the long run, the level of real GDP is determined by the number of workers, the level of technology, and the capital stock (factories, machinery, etc.). None of these elements are affected by the price level. So the long-run aggregate supply curve does not depend on the price level; it is a vertical line, at the level of potential or full- employment GDP.  Short-Run Aggregate Supply Curve While the LRAS is vertical, the SRAS is upward sloping. Why? As prices of final goods and services rise, prices of inputs—such as the wages of workers or the price of natural resources—rise more slowly. A secondary reason is that some firms are slow to adjust their prices when the price level rises or falls. Economists tend to believe that some firms and workers fail to accurately predict changes in the price level. Based on this, there are three potential explanations for why the SRAS curve is upward-sloping: Contracts make some wages and prices “sticky”. Prices and wages are said to be “sticky” when they do not respond quickly to changes in demand or supply. Some firms and workers fail to predict price level changes, and hence do not correctly build them into long-term contracts. Firms are often slow to adjust wages. Annual salary reviews are “normal”, for example. Also, firms dislike cutting wages—it’s bad for morale. Menu costs make some prices sticky. Altering prices is sometimes costly in itself. Firms have menu costs when it costs them money to change prices, for example by having to print new catalogs. A small “optimal” change in price may not be worth the hassle for a firm to perform.  How Sticky Are Wages? There is disagreement among economists about how sticky wages and prices actually are. To examine this, it is best to look at individual worker-level data. Some recent studies have done this, finding firms are reluctant to cut workers (nominal) wages. Instead, they: Offer lower salaries to new hires Fire current workers Decreases raises or freeze pay The graph shows the percentage of workers with no wage change in a given year.  SRAS Shifts: Factors of Production and Technology An increase in the availability of the factors of production, like labor and capital, allows more production at any price level. A decrease in the availability of these factors decreases SRAS. Improvements in technology allow productivity to improve, and hence the level of production at any given price level. shifts the short-run An increase aggregate in… supply curve… because…  SRAS Shifts: Expected Future Prices If workers and firms believe the price level will rise by a certain amount, they will try to adjust their wages and prices accordingly. Widely-held expectations of future price-level increases are self-fulfilling. How expectations of the future price shifts the short-run level affect the short-run aggregate An increase aggregate supply curve in… supply curve… because…  SRAS Shifts: Adjustments to Errors in Past Expectations Workers and firms sometimes make incorrect predictions about the price level. As time passes, they will attempt to compensate for these errors. Suppose everyone failed to predict an increase in the price level. Prices rise, therefore so does output. Then once firms and workers notice the rising prices, they update their expectations and increase their price demands, decreasing short-run aggregate supply. shifts the short-run An increase aggregate in… supply curve… because…  SRAS Shifts: Unexpected Changes in Prices of Resources A supply shock is an unexpected event that causes the short-run aggregate supply curve to shift. Example: Oil prices increase suddenly. Firms immediately anticipate rising input prices, and as a consequence will only produce the same amount of output if their own prices rise. Unexpected input price increases decrease SRAS; unexpected input price decreases would shift SRAS to the right instead. shifts the short-run An increase aggregate in… supply curve… because…  Long-Run Macroeconomic Equilibrium In the long run, we expect the economy to produce at the level of potential GDP—i.e., the LRAS level. So the long-run macroeconomic equilibrium occurs when the AD and SRAS curves intersect at the LRAS level. Our next task is to explain why long-run macroeconomic equilibrium cannot occur at any other level of output. For simplicity, assume: 1. No inflation; the current and expected-future price level is 100. 2. No long-run growth; i.e. the LRAS curve is not moving.  Long-Run Macroeconomic Equilibrium Suppose that interest rates rise. AD moves left because: Firms and households reduce their planned investments, decreasing aggregate demand. Workers lose their jobs, and firms experience decreases in sales. Workers become willing to accept lower wages, and firms expect lower prices for their output. So the SRAS curve moves to the right, with goods and services sold for lower prices, until we return to full-employment. Suppose that firms become more Expansion optimistic about the future. They increase their investment, shifting AD to the right. Unemployment falls below its natural rate, forcing employers to pay more; the increased demand for goods raises prices. Firms and workers raise their expectations about the price level, shifting SRAS to the left—restoring long run equilibrium.  Supply Shock In the previous analyses, AD moved suddenly. What if instead SRAS moved suddenly? We call this a supply shock. For example, suppose a sudden increase in oil prices shifts SRAS to the left. This causes stagflation, a combination of inflation and recession, usually resulting from a supply shock.  Adjustment back to Potential GDP from a Supply Shock With the lower level of output, people are unemployed and products go unsold. Workers accept a lower wage, and firms decrease prices in order to clear inventories. With the decrease in expectations about prices, SRAS moves to the right, restoring long-run equilibrium.  How Long Does Adjustment to Long-Run Equilibrium Take? How long does it take to restore full employment? It depends on the severity of the supply shock, but it is likely to take several years. An alternative to waiting this long is to use fiscal or monetary policy to increase aggregate demand. This will result in permanently higher prices but may be worth the cost.  Dynamic AD and AS Model Before, we did not allow change in price levels(no inflation) and there was no long-run growth. Therefore, our LRAS did not move. Continually-increasing real GDP, shifts LRAS to the right (economic growth) AD also ordinarily shifts to the right SRAS shifting to the right except when workers and firms expect high rates of inflation  What Is the Usual Cause of Inflation? The usual cause of inflation is total spending increasing faster than production. AD moves further right than does LRAS. SRAS moves to the right; but the anticipated rise in the price level causes it to move less far than LRAS. Long run equilibrium is restored but with a higher price level.