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AE equilibrium At full employment, real GDP equals potential GDP and the unemployment rate equals the natural unemployment. Y = Y FE u c = 0 g 3% 2% u 5% Potential GDP and the natural unemployment rate are determined by real factors and are independent of the PL. Changes in the quantity of money change nominal GDP and the PL but have no effect on potential GDP. Aggregate Demand (AD) is derived from Snarrian aggregate expenditure by imposing the AE equilibrium (Y = AE ) and then solving for PL. AE = [ W + Y e – PL – r – mpc T + I + G + X ] + { mpc – mpm } Y AD is the relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same AD and Aggregate Supply (AS) determine equilibrium real GDP and the PL AD-AS-FE Model

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Snarrian Aggregate Demand is found by substituting AE = [ W + Y e – PL – r – mpc T + I + G + X ] + { mpc – mpm } Y Y = [ W + Y e – PL – r – mpc T + I + G + X ] + { mpc – mpm } Y PL = [ W + Y e – r – mpc T + I + G + X ] + { mpc – mpm } Y – 1 Y PL = [ W + Y e – r – mpc T + I + G + X ] + { mpc – mpm – 1 } Y PL = [ W + Y e – r – mpc T + I + G + X ] – { – mpc + mpm + 1 } Y PL = [ W + Y e – r – mpc T + I + G + X ] – {1 – mpc + mpm } Y PL = [ W + Y e – r – mpc T + I + G + X ] – { mps + mpm } Y Aggregate Demand Marginal propensity to save

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Snarrian Aggregate Demand Example: In our continuing numerical example of the economy, W = 5, Y e = 7, PL = 8, r = 2, T = 3, I = 1, G = 3.5, X = 0.5 with mpc = 0.75, and mpm = Derive the AD equation. First, ignore the fact that PL = 8 because AD is the relationship between real GDP and PL. PL = [ W + Y e – r – mpc T + I + G + X ] – { mps + mpm } Y PL = [ – 2 – ] – { } Y PL = – 0.5 Y When Y = 0 PL = – 0.5 (0) = When Y = 9.5 PL = – 0.5 (9.5) = 8 Aggregate Demand

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Snarrian AD Example (continued ): Point 1 Y = 0 PL = Point 2 Y = 9.5 PL = 8 By assumption, aggregate planned expenditure equals real GDP (Y = AE ). In the AE model, Y = 9.5 when PL = 8 at the equilibrium point Y PL AD Aggregate Demand

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Snarrian AD Example: What happens if government spending is increased to $4 trillion (G = 4)? PL = [ – 2 – ] – { } Y PL = – 0.5 Y 4 Increased government spending increases AD. This increases real GDP provided the price level remains at $8 thousand. PL = – 0.5 Y 8 = – 0.5 Y 0.5 Y= 5.25 Y= Y PL AD AD Note: Increasing G raises the $500 billion budget deficit to $1 trillion Aggregate Demand

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Snarrian Aggregate Demand Example: What happens if taxes are lowered to $2.5 trillion (T = 2.5) instead? PL = [ – 2 – ] – { } Y PL = – 0.5 Y 2.5 The tax cut increases AD. This increases real GDP provided the price level remains at $8 thousand. PL = – 0.5 Y 8 = – 0.5 Y 0.5 Y= Y= Y PL AD AD Note: Cutting T raises the $500 billion budget deficit to $1 trillion Aggregate Demand

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Excel Simulation Assignment 4 Aggregate Demand PL = [W + Y e – r – mpc T + I + G + X ] – { mps + mpm } Y AD increases if W, Y e, I, G or X increase OR if r or T decrease AD decreases if W, Y e, I, G or X decrease OR if r or T increase The Congress and President are in charge of fiscal policy. Expansionary fiscal policy involves a cut in T and/or increase in G Restrictive fiscal policy involves a raising T and/or cutting G The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy involves lowering the federal funds interest rate Restrictive monetary policy involves raising the federal funds interest rate Aggregate Demand

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Potential GDP is determined by the quantities of Labor employed Capital, human capital, and the state of technology Land and natural resources Entrepreneurial talent At full employment (Y = Y FE, g 3%, 2%, u c = 0, u 5%), The real wage rate makes the quantity of labor demanded equal to the quantity of labor supplied. Along the potential GDP line, when the price level changes the money wage rate changes to keep the real wage rate at the full-employment level. Since u equals the natural rate of unemployment there is no pressure on inflation to change Over the business cycle The quantity of labor employed fluctuates around its full employment level. Real GDP fluctuates around potential GDP Potential GDP

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Full-employment Example: Suppose the economys production function shows the volume of output that can be produced by its labor force of size L given levels of K units of capital, R units of resources and z percent of the knowledge/talent that is contained in the universe. Suppose there are a total of L = 144 (million) workers in the economy with resources, capital, and technology/talent currently at R = 400 (million acres of land and barrels of oil), K = 100 (million machines/roads/networks) and z = 1 (percent). 1.What is the economys short-run production function? Graph it. Potential GDP

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Full-employment Example (continued): 2.Graph the economys short-run production function: Potential GDP LY er

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Full-employment Example (continued): 3.Compute potential GDP. Y FE = 12 (trillion $) Potential GDP er

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Full-employment Example (continued): 4.Compute the output of the economy if only 121 million of the 144 million in the labor force are working. 23 million workers are (cyclically) unemployed, resulting in Y < Y FE Potential GDP Y = 11 (trillion $) er

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Full-employment Example (continued): 5.Compute the output of the economy if all 144 million workers in the labor force are full time (40 hours per week) and 50 million of them are working 20 hours of overtime per week. Potential GDP 144 Since Y > Y FE the unemployment rate is low Since 50 million are working an extra 20 hours/wk, the effective size of the (fulltime) work force is L = /2 = er

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Full-employment Example (continued): 6.Compute potential GDP if capital increases to K = 121 (million machines/roads/networks). What is the new level of potential GDP? Potential GDP Y FE = 13.2 (trillion $) 13.2 er

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Potential GDP Full-employment Example (continued): 7.Increases in an economys resources and knowledge/talent have the same effect as an increase in capital. 8.Graph the potential GDP you computed in part (3) with AD below. Y PL Y FE AD Together, AS and AD determine equilibrium real GDP and the PL The goal of policy makers is to keep equilibrium real GDP close to potential GDP with g 3% 2% u 5%

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Aggregate Supply is the relationship between the quantity of real GDP supplied and PL when all other influences on production plans remain the same The AS curve is positively sloped (AS slope = ) Firms maximize profits. If prices increase while all other costs are constant, production rises because it is more profitable. Firm supply, industry supply and AS slope up. Alternatively, when PL rises with constant wages, real wages falls, employment rises, and quantity of real GDP supplied rises. Shifters of AS are contained in its intercept: The money wage rate changes (w). The money prices of other resources change (p). Government changes supply-side taxes ( ) Potential GDP changes: Advances in technology (z) Increases in the size of the Labor Force (L) Increased public or private investment in capital (K) Increased Land and natural resources (R) The general form of AS: PL = [w + p + – z – K – R – L ] + Y AS Along the AS curve, the only influence on production plans that changes is PL. That is, the quantity of real GDP supplied increases (decreases) when the PL rises (falls). Aggregate Supply

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Snarrian Aggregate Supply Example: Suppose money wage rate is $400 per week (w = 400) and money prices of other resources of $230 per week (p = 230) given a supply-side tax rate of percent ( ), technological advancement of 1 percent (z = 1), accumulated capital of 100 million machines/roads/networks (K = 100), 400 million acres of land and barrels of oil (R = 400), and a labor force of 144 million workers (L = 144). 1.Derive the AS equation which has a slope of = 0.5. PL = [w + p + – z – K – R – L ] + Y AS PL = [ – 1 – 100 – 400 – 144] Y AS PL = Y When Y = 0 PL = (0) = 0.75 When Y = 12 PL = (12) = 6.75 Aggregate Supply

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Snarrian AS Example (continued ) 2.Graph AS Point 1 Y = 0 PL = 0.75 Point 2 Y = 12 PL = Y PL AS Aggregate Supply

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Snarrian AS Example (continued ) 3.What happens if government cuts supply-side taxes to 15 percent ( )? PL = [ – 1 – 100 – 400 – 144] Y AS PL = 0.5 Y 15 Supply-side tax cuts increase AS. This increases real GDP provided the price level remains at 6.75 (thousand $). PL = 0.5 Y 6.75 = 0.5 Y Y= 13.5 Aggregate Supply Y PL AS 13.5

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Aggregate Supply Snarrian AS Example (continued): 4.Graph potential GDP (Y FE = 12) with AS equation found in part (1). PL = Y If real GDP equals Y FE, the PL = 6.75 If the PL is greater than 6.75, real GDP exceeds potential GDP. If the PL < 6.75, real GDP is less than potential GDP Y FE Y PL 6.75 AS

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Y FE 13.5 Y FE Snarrian AS Example (continued): 5.Show what happens to AS and Y FE when technology increases. PL = [w + p + – z – K – R – L ] + Y AS Potential GDP immediately shifts to the right The increases in z decrease the value of the AS intercept. AS increases (shifts to the right) 12 Y PL 6.75 Aggregate Supply

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Snarrian AS Example (continued): 6.Graph AS with potential GDP and AD below. AD PL = Y PL = (12) = 6.75 Together, AS and AD determine equilibrium real GDP and the PL The goal of policy makers is to keep equilibrium real GDP close to potential GDP with g 3% 2% u 5% Aggregate Supply Y FE 12 Y PL 6.75 AS 0.75

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Aggregate Supply PL = [w + p + – z – K – R – L ] + Y AS AS decreases if w, p, or increase OR if z, K, R or L decrease AS increases if w, p, or decrease OR if z, K, R or L increase The Congress and President are in charge of fiscal policy. Expansionary supply-side fiscal policy involves cutting Restrictive supply-side fiscal policy involves raising The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy lowers the federal funds interest rate Restrictive monetary policy raises the federal funds interest rate Aggregate Supply

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Inflationary gaps Example: Suppose potential GDP is $11 trillion and AS and AD are given by PL = – Y AS PL = – 0.5 Y AD 1.Graph AD, AS and Y FE. AS graph PL = – (11) = 8 AD-AS-Y FE Equilibrium Y FE 11 Y PL 9.75 AS AD graph PL = – 0.5(11) = AD 15.25

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Inflationary gaps Example: 2.Compute equilibrium real GDP and PL. Real GDP – Y = – 0.5Y 0.75Y = 15.5 – 0.5Y 1.25Y = 15.5 Y = 12.4 PL and check PL = – (12.4) = 9.05 PL = – 0.5(12.4) = 9.05 AD-AS-Y FE Equilibrium Y PL 12.4 AS AD Y FE

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AS Inflationary gaps Example: 3.Is the economy in a recessionary or inflationary gap? AD-AS-Y FE Equilibrium Y PL AD Since real GDP exceeds potential GDP, the economy is in an inflationary gap. Workers work overtime and/or more than one job, and firms compete for scarce labor. The unemployment is say u = 4%, which is lower than the natural rate of 5%. For these reasons, there are upward pressures on wages. This raises AS until the gap is closed. AS Y FE PL = [w + p + – z – K – R – L ] +Y

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Inflationary gaps Example: 3.Is the economy in a recessionary or inflationary gap? AD-AS-Y FE Equilibrium Y PL AD Allowing gaps to close on their own via changes in wages is a laissez faire policy. Today, inflationary gaps tend to close faster. The inflation redistributes income from those on fixed incomes (pensioners) to those with variable income (wages adjusted for inflation) Governments have also used inflation as a tax to avoid cutting G or increasing T. AS Y FE

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Recessionary gap Example: Suppose potential GDP is $13 trillion and AS and AD are given by PL = – Y AS PL = – 0.5 Y AD 1.Graph AD, AS and Y FE. AS graph PL = – (13) = 9.5 AD-AS-Y FE Equilibrium Y FE 13 Y PL 9.5 AS AD graph PL = – 0.5(13) = AD 15.25

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Recessionary gap Example: 2.Compute equilibrium real GDP and PL. Real GDP – Y = – 0.5Y 0.75Y = 15.5 – 0.5Y 1.25Y = 15.5 Y = 12.4 PL and check PL = – (12.4) = 9.05 PL = – 0.5(12.4) = 9.05 AD-AS-Y FE Equilibrium Y FE 13 Y PL 12.4 AS AD

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AS Recessionary gap Example: 3.Is the economy in a recessionary or inflationary gap? AD-AS-Y FE Equilibrium Y FE 13 Y PL AD Since real GDP is less than potential GDP, the economy is in a recessionary gap. Factories, resources, and workers are not being fully utilized. The unemployment is say u = 8.5%, which is higher than the natural rate of 5%. The surplus of workers bids down wages, which lowers AS until the gap is closed. AS 8.75 PL = [w + p + – z – K – R – L ] +Y

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Recessionary gap Example: 3.Is the economy in a recessionary or inflationary gap? AD-AS-Y FE Equilibrium Y FE 13 Y PL AD If the government does nothing (laissez faire) when unemployment is high, prices in general fall (negative relationship). Today, recessionary gaps close relatively slower than inflationary gaps. The federal minimum wage was enacted in John L. Lewis (UMW, CIO, USWA) organized millions of workers in the 1930s. AS 8.75

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Recessionary gap Example: 3.Is the economy in a recessionary or inflationary gap? AD-AS-Y FE Equilibrium Y FE 13 Y PL AD Deflation sounds good because lower prices raise purchasing power. However, deflation causes hardships for those whose net worth is mostly held in illiquid assets (homes). Deflation amplifies debt since it was incurred when wages were higher. The same payment with a lower wage reduces purchasing power. Deflation amplifies a loan's interest rate. AS 8.75

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Induced inflationary gaps Example: Suppose potential GDP is $12.4 trillion and AS and AD are given by PL = – Y AS PL = – 0.5 Y AD 1.Graph AD, AS and Y FE. AS graph PL = – (12.4) = 9.05 AD-AS-Y FE Equilibrium Y FE 12.4 Y PL 9.05 AS AD graph PL = – 0.5(12.4) = 9.05 AD 15.25

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AS Induced inflationary gaps Example: 2.Show what happens if policy makers cut T or increase G. AD-AS-Y FE Equilibrium Y PL AD Increasing G and cutting T when the economy is at full- employment induces an inflationary gap. The policy boosts real GDP but at a cost (higher prices) If nothing is done to combat this stimulus, wages will rise as labor markets tighten. This shifts AS up. Hence, the increase in GDP was only temporary. Prices soar even more. AS Y FE AD PL = [W + Ye – r – mpc T + I + G + X ] – {mps + mpm }Y PL = [w + p + – z – K – R – L ] +Y

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