Combined Chapters

Combined Chapters Aggregate Supply/Aggregate DemandFiscalClassical/KeynesianMultiplierCHAPTER 10-Real GDP and PL in Long Run

GDP 2007 to 2010

OK One more time..Component parts of GDP?C + I + G + (X-M) = GDP

Long-Run Aggregate Supply Curve (LRAS)A vertical line representing the real output of goods and services after full adjustment has occurredIt represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

The Production Possibilities and the Economys Long-Run Aggregate Supply Curve

55Output Growth and the Long-Run Aggregate Supply Curve (cont'd)LRAS is verticalInput prices fully adjust to changes in output pricesSuppliers have no incentive to increase outputUnemployment is at the natural rateDetermined by endowments and technology (or existing resources) 6610Output Growth and the Long-Run Aggregate Supply Curve (cont'd)Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused byGrowth of population and the labor-force participation rateCapital accumulationImprovements in technology7711Think: Why does AD slope downward?Real domestic output, GDPADPrice levelVertical axis representsPrice level for ALL final goodsAnd servicesThe aggregate price levelIs measured by either GDPDeflator or CPIThe horizontal axis representsthe real quantity of all G&Spurchased as measured by thelevel of REAL GDPFigure 10-4 The Aggregate Demand CurveAs the price level rises, real GDP declines

99ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes.

There are 3 Reasons that cause the AggregateDemand Curve to be downward sloping.

Real Balance Effect (Wealth effect)Interest Rate EffectInternational Trade EffectReal Balance EffectPrice level falls- causes purchasing power to rise translates into more money to spend or monetary wealth improves.Real Balance Effect (or wealth effect) Higher price level means less consumption spending.

Real Balance Effect

The change in the purchasing power of dollar-

Relates to assets that result from a change in the price level13Interest Rate EffectInverse relationship between price level and quantity demanded of GDP because households and businesses adjust to interest rates for those interest-sensitive purchases.Price level falls (bundle of goods costs less) rest of money into savings, more money available for borrowing interest rate down.Think of money as stationary demand drives up price of money. Interest Rate continuedNow if bundle of goods increases want to purchase interest sensitive good, cost to borrow is up.An increase in money demand will drive up the price paid for its use use of money = interest rateAs price level rises, houses and firms require more money to handle transactions

International Trade Effect (Open Economy Effect) FYI: An open economy is global, a closed economy is domestic.The Open Economy EffectHigher price levels result in foreigners desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e., net exports fall).Equivalent to a reduction in the amount of real goods and services purchased in the U.S. When Demand for exports decreases, this is an unfavorable balance of trade (imports exceed exports)

161625Macro AD vs Micro DAggregate Demand versus Demand for a Single GoodWhen the aggregate demand curve is derived, we are looking at the entire circular flow of income and product.When a market demand curve is derived, we are looking at a single product in one market only.171726Change in QAD and Change in ADWhat is the difference?PLGDPABPLGDPAD1AD 2DETERMINANTS OF AGGREGATE DEMANDChange in Consumer SpendingConsumptionConsumer WealthConsumer Expectations (expect higher prices) Interest rate (interest sensitive durables) TaxesChanges in Investment SpendingReal Interest Rates (rates high- not much I taking place) Expected Future Sales (health of economy- confidence is big)Business Taxes (higher taxes less profit)

Government SpendingThis will be discussed further, but anytime government spends, it has an affect on GDP.Infrastructure Health CareSupplies for militaryEducationEtc.Net Export Spending

National Income Abroad-(when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. U.S. exports rise)

Exchange Rates- Price of one nations currency in terms of another. Dollar vs EuroOur currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro.Depreciation of nations currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.Long-Run Equilibrium and the Price LevelFor the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).232337Figure 10-5 Long-Run Economywide Equilibrium

2424SRASPeriod where adjustment occurs.AD and SRAS

26RealRateOfInterestMoney SupplyD1D2Can a Change in Money Supply Change AD?Probably but it is a chain of events.MS changes, then Interest Rates, then chance in consumptionand investment. Then Change in ADLong Run Aggregate SupplyPrice levelReal domestic output, GDPQPLRASLRLong-runAggregateSupplyQfFull-EmploymentLRAS Goods & Services(real GDP)Price levelP 100YFSRAS1AD1Unanticipated Increase in Aggregate DemandIn response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2).P 105Y2AD2Short-run effects of an unanticipated increase in ADLRAS1 Goods & Services(real GDP)Price levelYFADP 1SRAS1YF1SRAS2YF2LRAS2YF2Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example.Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2.P 2Growth in Aggregate SupplyA sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2).LRAS Goods & Services(real GDP)Price levelADYFP 100SRAS1 (Pr1)AP 110Y2The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P110 and output falls to Y2.What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. Effects of Adverse Supply ShockIf temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A).If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium.SRAS2 (Pr2)BPrice LevelReal Domestic Output, GDPQPASAD1INCREASES IN AD: DEMAND-PULL INFLATIONP2P1AD2QfQ1Q2Price LevelReal Domestic Output, GDPQPAS1AD1DECREASES IN AS: COST-PUSH INFLATIONP2QfQ1abAS2P1

Non-governmental actions that shift AS Shift AS left:Raw materials cost riseWages rise faster than productivityWorker productivity decreasesObsolescenceWars Natural disasters

Fiscal PolicyGovernmental actions that shift ADShift AD right:Govt spending increasesTaxes decreasesMoney Supply increasesShift AD left:G decreasesT increasesMS decreases

Chapter 11 Classical vs. Keynesian

CLASSICAL BELIEVES:Markets will behave according to S&D.

In other words. S&D will respond accordingly to Inflationary Gap, Recessionary Gap, and long run stability when all curves intersect.Basic Macroeconomic Relationships Says LawHow Classical Works (or not)Interest Rate and InvestmentIncome and Consumption (or savings)Changes in spending and changes in output

SAYS LAWEconomists agree Says law works in Barter economy and disagree about if it works in a money economy.Supply creates its own demand baker bakes enough bread to trade for what he wants.That works.Classical economics believes it works in money economy and here is why.The Classical Model (cont'd)Classical economistsAdam Smith, J.B. Say, David Ricardo, John Stuart Mill, Thomas Malthus, A.C. Pigou, and otherswrote from the 1770s to the 1930s.They assumed wages and prices were flexible, and that competitive markets existed throughout the economy.41The Classical Model (cont'd)Assumptions of the classical modelPure competition exists.Wages and prices are flexible.People are motivated by self-interest.People cannot be fooled by money illusion.42The Classical Model Consequences of The AssumptionsIf the role of government in the economy is minimal,If pure competition prevails, and all prices and wages are flexible,If people are self-interested, and do not experience money illusion,Then problems in the macroeconomy will be temporary and the market will correct itself.43Classical TheoryClassical economists believed that prices, wages and interest rates are flexible. Says law says when economy produces a certain level of real GDP, it also generates the income needed to purchase that level of real GDP.) hence, always capable of achieving the natural level of GDP. Fallacy here: no guarantee that the income received will be used to purchase g & s.----some will be saved. But theory would be redeemed, if the savings goes into equal needed amounts of investment.

Classical belief on wages and pricesBelieved all markets competitive- (S&D * Key) adjust to surplus and shortage.If oversupply of labor, wage rates drop and S&D of labor will be in sinc.What holds for wages also applies to prices.Prices adjust quickly to surplus or shortagesEquilibrium established again.Three States of the EconomyReal GDP is less than Natural Real GDP (recessionary gap)Real GDP is more than Natural Real GDP (inflationary gap)Real GDP is equal to Natural Real GDP.What is Natural Real GDP? Real GDP that is produced at the natural unemployment rate. (which we agree around 5%)Key: Wage rates and prices will adjust quickly to surplus or shortageIn recession- unemployment rate higher than natural rate.Surplus exists in labor marketDrives down wage rate++++++++++++++4) In inflationary gap, unemployment lower than natural rate5) Shortage exists in labor market 6) Drives up the wage rate Effect of a Decrease in Aggregate Demand in the Classical Model

48 BOTH THEORIES CLASSICAL AND KEYNESIAN DO AGREETWO THINGS WE CAN DO WITH DISPOSABLE INCOME- SPEND OR SAVE!We all know that consumption is 2/3 (or more) of GDP***Classical theorists say, the funds from aggregate savings eventually borrowed and turned into investment expenditures which are a component of real GDP BUT. What if no or low savings?Theory breaks down here have to have equal amounts of investment for savings. (the idea here is that savings leads to investment) This is true but it probably wont do it by itself. Needs assistance through monetary or perhaps fiscal policy.

The Classical View of the CreditMarket

In classical theory, the interest rate is flexible and adjusts so that saving equals investment.If saving increases and the saving curve shifts rightward the increase in saving eventually puts pressure on the interest rate and moves it downward. A new equilibrium is established where once again the amount households save equals the amount firms invest.51Long-run Equilibrium

The condition where the Real GDP the economy is producing is equal to the Natural Real GDP and the unemployment rate is equal to the natural unemployment rate.52Recessionary (Contractionary) Gap

The economy is currently in short-run equilibrium at a Real GDP level of Q1.

QN is Natural Real GDP or the potential output of the economy.

Notice that Q1< QN. When this condition (Q1< QN) exists, the economy is said to be in a recessionary gap.53Inflationary (Expansionary) Gap

The condition where the Real GDP the economy is producing is greater than the Natural Real GDP and the unemployment rate is less than the natural unemployment rate.54Policy Implication Laissez-faire Classical, new classical, and monetarist economists believe that the economy is self-regulating. For these economists, full employment is the norm: The economy always moves back to Natural Real GDP.

Laissez-faireA public policy of not interfering with market activities in the economy.55Then what happened?

25% unemploymentBanks closedProduction ceasedDrought hitStocks worthlessNo money for purchasesNo jobsBleak!ASADAD 1AS 1GDPPRICE

LEVEL

Bottom LineClassical viewpoint- not possible to overproduce goods because the production of those goods would always generate a demand that was sufficient to purchase the goods. (what would they say about the recent inventories of our auto industry?)

Keynesian IdeasThe classical approach fell into disrepute during the economic decline of the 30s. Real GDP fell by more than 30% 1930-33In 1939- per capital income was still 10% less than in 1929.*U.S. began to embrace John Maynard Keyness theory of stimulating the economy through aggregate demand (Lord Keynes) had studied classical economics and wrote his famous General Theory of Employment, Interest and Money. (which was a complete rebuttal of the classical theory)

Keynesian in a Nutshell

Keyness View of Says Lawin a Money Economy

According to Keynes, a decrease in consumption and subsequent increase in saving may not be matched by an equal increase in investment. Thus, a decrease in total expenditures may occur.To learn more about John Maynard Keynes, click his photo above.60John Maynard Keynes and the Great DepressionClassical Economics: In a recession,Wages will fall (more will be hired)Prices will fall (more will be bought)The economy self-regulates, andMoves back to full-employment GDP

Keynes criticism: In a recession, Wages would not fall.Prices would not fall.Self-regulation could not occur.The economy could get stuck with high unemployment.

Keynes PrescriptionFor an economy stuck at a high unemployment equilibrium,Self-regulation was not working.A jumpstart was needed:An injection of new spending to get the economy moving again.The only spender who could do this was Government.Keynesian EconomicsWorks only on the AD curveAssumes AS is stationaryCritics of Keynes:But this will cause deficits!But the government cant spend that much!The Economy Gets Stuck in aRecessionary Gap

If the economy is in a recessionary gap at point 1, Keynes held that wage rates may not fall. The economy may be stuck in the recessionary gap.64Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd)Real GDP and the price level, 19341940Keynes argued that in a depressed economy, increased aggregate spending can increase output without raising prices.Data showing the U.S. recovery from the Great Depression seem to bear this out.In such circumstances, real GDP is demand driven.65Keynesian Economics was the answer to Classical economic theories and the suggested way to jump-start the economy again pull out of the depression.

Idea: Government enters the economy.Stimulates the economy through Aggregate Demand.Fiscal policy would move the production engine by stimulating spending. increased employment, jobs would be filled, production would begin people would purchase with money they earned from jobs.

Classical vs. Keynes I

67A Question of How Long It Takes forWage Rates and Prices to FallSuppose the economy is in a recessionary gap at point 1. Wage rates are $10 per hour, and the price level is P1.The issue may not be whether wage rates and the price level fall, but how long they take to reach long-run levels

The speed at which wage rate falls is a keyTo whether Keynesian or Classical theory Is more valid. Answers never for sure.68Keynes rejected the classical notion of self-adjustment, (????) and he predicted things would get worse once a spending shortfall emerged.Example:Business expectations of future sales worsens.Business investment is cut back.Unsold capital goods begins to pile up (includes office equip. machinery, airplanes, etc.)*this is an undesired changeWorsened sales expectations causes decline in investment spending that shifts the AD curve to the left leading to pileups of unwanted inventory.Example: Are the U.S. and European SRAS Curves Horizontal? Keynesians contend that the SRAS is essentially flat.Based on research, they contend SRAS is horizontal because firms adjust their prices about once a year.If the SRAS schedule were really horizontal, how could the price level ever increase?70Keynesian TheoryASLRASPRICE

LEVEL

Real GDP OutputKeynesian TheoryAD unstable, prices and wages are inflexible AD no effect on prices until LRASAD 1AD 2AD 3 *PriceGoes upFigure 11-9 Real GDP Determination with Fixed versus Flexible Prices

72Table 11-2 Determinants of Aggregate Supply

QUESTIONS?

Long run growth
P
Y
x
P1
Yf1
AD1
Yf2
LRAS1
AS1
AS2
AD2
LRAS2
P2
Consumergoods
Capitalgoods
PPC shifts out andLRAS shifts right.