4OK… 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
5The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve 5
6Output 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)106
7Output 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 technology117
8Think: Why does AD slope downward? Vertical axis representsPrice level for ALL final goodsAnd servicesThe aggregate price levelIs measured by either GDPDeflator or CPIPrice levelThe horizontal axis representsthe real quantity of all G&Spurchased as measured by thelevel of REAL GDPADReal domestic output, GDP
9Figure 10-4 The Aggregate Demand Curve As the price level rises, real GDP declines9
10ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes.
11There are 3 Reasons that cause the Aggregate Demand Curve to be downward sloping.Real Balance Effect (Wealth effect)Interest Rate EffectInternational Trade Effect
12Real 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.
13Real Balance Effect The change in the purchasing power of dollar- Relates to assets that result from a change in the price level
14Interest 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.
15Interest Rate continued Now 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…
16International 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)2516
17Macro AD vs Micro D Aggregate Demand versus Demand for a Single Good When 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.2617
18Change in QAD and Change in AD What is the difference?PLPLABAD 2AD1GDPGDP
19Change in Consumer Spending Consumption DETERMINANTS OF AGGREGATE DEMANDChange in Consumer SpendingConsumptionConsumer WealthConsumer Expectations (expect higher prices)Interest rate (interest sensitive durables)Taxes
20Changes in Investment Spending Real Interest Rates (rates high- not much I taking place)Expected Future Sales (health of economy- confidence is big)Business Taxes (higher taxes less profit)
21Government SpendingThis will be discussed further, but anytime government spends, it has an affect on GDP.Infrastructure – Health Care Supplies for militaryEducationEtc.
22Net Export SpendingNational 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 nation’s 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 nation’s 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.
23Long-Run Equilibrium and the Price Level For 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).3723
27Can a Change in Money Supply Change AD? RealRateOfInterestD2D1Money SupplyCan 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 AD
28Long Run Aggregate Supply LRASLRPrice levelLong-runAggregateSupplyFull-EmploymentQfQReal domestic output, GDP
29Unanticipated Increase in Aggregate Demand LRASGoods & Services (real GDP)Price levelP100YFSRAS1AD1AD2Short-run effects of an unanticipated increase in ADP105Y2In 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).
30Growth in Aggregate Supply F2LRAS2LRAS1Goods & Services (real GDP)Price levelYFADP1SRAS1F1SRAS2P2YF2Here 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.A 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).
31Effects of Adverse Supply Shock LRASGoods & Services (real GDP)Price levelADYFP100SRAS1 (Pr1)ASRAS2 (Pr2)BP110Y2The 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.If 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.
32DEMAND-PULL INFLATION INCREASES IN AD:DEMAND-PULL INFLATIONPAD1AD2ASP2Price LevelP1QQfQ1Q2Real Domestic Output, GDP
33DECREASES IN AS: COST-PUSH INFLATION bPrice LevelaP1AD1QQ1QfReal Domestic Output, GDP
38CLASSICAL 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.
39Basic Macroeconomic Relationships Say’s LawHow Classical Works (or not)Interest Rate and InvestmentIncome and Consumption (or savings)Changes in spending and changes in output
40SAY’S 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.
41The Classical Model (cont'd) Classical economists—Adam Smith, J.B. Say, David Ricardo, John Stuart Mill, Thomas Malthus, A.C. Pigou, and others—wrote from the 1770s to the 1930s.They assumed wages and prices were flexible, and that competitive markets existed throughout the economy.41
42The 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.42
43The Classical Model Consequences of The Assumptions If 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.43
44Classical TheoryClassical economists believed that prices, wages and interest rates are flexible.Say’s 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.
45Classical belief on wages and prices Believed 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.
46Three States of the Economy Real 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%)
47Key: Wage rates and prices will adjust quickly to surplus or shortage In recession- unemployment rate higher than natural rate.Surplus exists in labor marketDrives down wage rate4) In inflationary gap, unemployment lower than natural rate5) Shortage exists in labor market6) Drives up the wage rate
48Effect of a Decrease in Aggregate Demand in the Classical Model 48
49BOTH THEORIES CLASSICAL AND KEYNESIAN DO AGREE…… TWO THINGS WE CAN DO WITH DISPOSABLE INCOME-SPEND OR SAVE!We all know that consumption is 2/3 (or more) of GDP
50***Classical theorists say, the funds from aggregate savings eventually borrowed and turned into investment expenditures which are a component of real GDPBUT…. 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 won’t do it by itself. Needs assistance through monetary or perhaps fiscal policy.
51The Classical View of the Credit Market 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.
52Long-run EquilibriumThe 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.
53Recessionary (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.
54Inflationary (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.
55Policy 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 interferingwith market activities in the economy.
5625% unemployment Banks closed Production ceased Drought hit Then what happened?25% unemploymentBanks closedProduction ceasedDrought hitStocks worthlessNo money for purchasesNo jobsBleak!AS 1ADASAD 1PRICELVGDP
57Bottom 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?)
58In 1939- per capital income was still 10% less than in 1929. Keynesian IdeasThe classical approach fell into disrepute during the economic decline of the 30’s. Real GDP fell by more than 30%In per capital income was still 10% less than in 1929.*U.S. began to embrace John Maynard Keynes’s 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)
60Keynes’s View of Say’s Law in 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.
61John Maynard Keynes and the Great Depression 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.Classical 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
62Keynes’ 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.
63Keynesian Economics Works only on the AD curve Assumes AS is stationaryCritics of Keynes:…But this will cause deficits!…But the government can’t spend that much!
64The Economy Gets “Stuck” in a Recessionary 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.
65Real GDP and the price level, 1934–1940 Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd)Real GDP and the price level, 1934–1940Keynes 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.65
66Keynesian 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 beginpeople would purchase with money they earned from jobs.
68A Question of How Long It Takes for Wage Rates and Prices to Fall Suppose 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 levelsThe speed at which wage rate falls is a keyTo whether Keynesian or Classical theoryIs more valid. Answers never for sure.
69Keynes rejected the classical notion of self-adjustment, ( Keynes 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” change…Worsened sales expectations causes decline in investment spending that shifts the AD curve to the left leading to pileups of unwanted inventory.
70Example: 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?70
71Keynesian Theory LRAS P R I C E L V AD 2 AD 3 *Price Goes up AD 1 AS Real GDP OutputKeynesian TheoryAD unstable, prices and wages are inflexible AD no effect on prices until LRAS
72Figure 11-9 Real GDP Determination with Fixed versus Flexible Prices 72