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 occurred – It 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 Economy’s Long-Run Aggregate Supply Curve
Output Growth and the Long-Run Aggregate Supply Curve (cont'd) LRAS is vertical – Input prices fully adjust to changes in output prices – Suppliers have no incentive to increase output – Unemployment is at the natural rate – Determined by endowments and technology (or existing resources)
Output 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 by – Growth of population and the labor-force participation rate – Capital accumulation – Improvements in technology
Think: Why does AD slope downward? Real domestic output, GDP AD Price level Vertical axis represents Price level for ALL final goods And services The aggregate price level Is measured by either GDP Deflator or CPI The horizontal axis represents the real quantity of all G&S purchased as measured by the level of REAL GDP
Figure 10-4 The Aggregate Demand Curve As the price level rises, real GDP declines
ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes.
There are 3 Reasons that cause the Aggregate Demand Curve to be downward sloping. Real Balance Effect (Wealth effect) Interest Rate Effect International Trade Effect
Real Balance Effect Price level falls- causes purchasing power to rise… translates into more money to spend or monetary wealth improves. 1)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 level
Interest Rate Effect Inverse 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 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 rate As 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 Effect – Higher 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)
Macro 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.
Change in QAD and Change in AD What is the difference? PL GDP A B PL GDP AD1 AD 2
Changes 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)
Government Spending This will be discussed further, but anytime government spends, it has an affect on GDP. Infrastructure – Health Care Supplies for military Education Etc.
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 nation’s currency in terms of another. Dollar vs Euro Our 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.
Long-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).
Figure 10-5 Long-Run Economywide Equilibrium
SRAS Period where adjustment occurs.
AD and SRAS
Real Rate Of Interest Money Supply D1 D2D2 Can a Change in Money Supply Change AD? Probably… but it is a chain of events. MS changes, then Interest Rates, then chance in consumption and investment. Then Change in AD
Long Run Aggregate Supply Price level Real domestic output, GDP Q P LRAS LR Long-run Aggregate Supply QfQf Full-Employment
LRAS G oods & S ervices (real GDP) P rice level P 100 Y F SRAS 1 AD 1 Unanticipated Increase in Aggregate Demand In response to an unanticipated increase in AD for goods & services (shift from AD 1 to AD 2 ), prices will rise to P 105 and output will temporarily exceed full-employment capacity (increases to Y 2 ). P 105 Y 2 AD 2 Short-run effects of an unanticipated increase in AD
LRAS 1 G oods & S ervices (real GDP) P rice level Y F AD P 1 SRAS 1 Y F1 SRAS 2 Y F2 LRAS 2 Y F2 Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example. Both LRAS and SRAS increase (to LRAS 2 and SRAS 2 ); the full employment output of the economy expands from Y F1 to Y F2. P 2 Growth in Aggregate Supply 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 (Y F2 ) and lower price level (P 2 ).
LRAS G oods & S ervices (real GDP) P rice level AD Y F P 100 SRAS 1 (P r 1 ) A P 110 Y 2 The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P 110 and output falls to Y 2. What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. Effects of Adverse Supply Shock 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. SRAS 2 (P r 2 ) B
Price Level Real Domestic Output, GDP Q P AS AD 1 INCREASES IN AD: DEMAND-PULL INFLATION P2P2 P1P1 AD 2 QfQf Q1Q1 Q2Q2
Price Level Real Domestic Output, GDP Q P AS 1 AD 1 DECREASES IN AS: COST-PUSH INFLATION P2P2 QfQf Q1Q1 a b AS 2 P1P1
Non-governmental actions that shift AS Shift AS left: – Raw materials cost rise – Wages rise faster than productivity – Worker productivity decreases – Obsolescence – Wars – Natural disasters
Fiscal Policy Governmental actions that shift AD Shift AD right: – Govt spending increases – Taxes decreases – Money Supply increases Shift AD left: – G decreases – T increases – MS 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 Say’s Law How Classical Works (or not) Interest Rate and Investment Income and Consumption (or savings) Changes in spending and changes in output
SAY’S LAW Economists 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 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.
The Classical Model (cont'd) Assumptions of the classical model – Pure competition exists. – Wages and prices are flexible. – People are motivated by self-interest. – People cannot be fooled by money illusion.
The 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.
Classical Theory Classical 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.
Classical 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 shortages Equilibrium established again.
Three States of the Economy 1.Real GDP is less than Natural Real GDP (recessionary gap) 2.Real GDP is more than Natural Real GDP (inflationary gap) 3.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 shortage 1)In recession- unemployment rate higher than natural rate. 2)Surplus exists in labor market 3)Drives down wage rate ) In inflationary gap, unemployment lower than natural rate 5) Shortage exists in labor market 6) Drives up the wage rate
Effect of a Decrease in Aggregate Demand in the Classical Model
BOTH 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
***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 won’t do it by itself. Needs assistance through monetary or perhaps fiscal policy.
The 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.
Long-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.
Recessionary (Contractionary) Gap The economy is currently in short-run equilibrium at a Real GDP level of Q 1. Q N is Natural Real GDP or the potential output of the economy. Notice that Q 1 < Q N. When this condition (Q 1 < Q N ) exists, the economy is said to be in a recessionary gap.
Inflationary (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.
Policy 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-faire A public policy of not interfering with market activities in the economy.
Then what happened? 25% unemployment Banks closed Production ceased Drought hit Stocks worthless No money for purchases No jobs Bleak! AS AD AD 1 AS 1 GDP PRICELEVELPRICELEVEL
Bottom Line Classical 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 Ideas The 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 *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)
Keynesian in a Nutshell
Keynes’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.
John Maynard Keynes and the Great Depression Classical Economics: In a recession, – Wages will fall (more will be hired) – Prices will fall (more will be bought) – The economy self- regulates, and – Moves 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’ Prescription For 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 Economics Works only on the AD curve Assumes AS is stationary Critics of Keynes: – …But this will cause deficits! – …But the government can’t spend that much!
The 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.
Keynesian Economics and the Keynesian Short-Run Aggregate Supply Curve (cont'd) Real GDP and the price level, 1934–1940 – Keynes 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.
Keynesian 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
A 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 P 1. 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 key To whether Keynesian or Classical theory Is more valid. Answers never for sure.
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.
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?
Keynesian Theory AS LRAS PRICELEVELPRICELEVEL Real GDP Output Keynesian Theory AD unstable, prices and wages are inflexible AD no effect on prices until LRAS AD 1 AD 2AD 3 *Price Goes up
Figure 11-9 Real GDP Determination with Fixed versus Flexible Prices