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Output, growth and business cycles Econ 102

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GDP Growth Countries: High savings rate have higher GDP/ cap. high population growth rates have low GDP/ cap.

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Solow model:

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GDP and Per capita GDP

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Output grows over time:

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Very long run Aggregate Supply

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SR and LR Aggregate Supply LR Aggregate SupplySR Aggregate Supply

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SR and LR Aggregate Supply There are constraints on Price changes and Output changes. Very long run: capacity is growing, shifts in the LRAS curve. Long run AS: capacity of production is constant, an increase in demand increases prices but not quantity. Short run AS : price pressures are less, there are unemployed resources and if demand increases output increase without price increase.

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Which output level is produced: Demand and Supply Aggregate Demand and Aggregate Supply

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Aggregate Demand Total of desired aggregate expenditures Which type expenditures? – Desired Consumption Expenditures: – Desired Investment Expenditures: – Government Expenditures: – Net Exports: WHY ‘DESIRED’ EXPENDITURES?

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Agents may want to purchase, may plan to buy but Are there enough goods there? If not ? What happens? What type adjustment occur will happen?

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‘Desired’ Aggregate Expenditures Buyers in the Goods and Services Market: Desired Consumption Expenditures + Desired Investment Expenditures + Desired Government Expenditures + Desired Net Exports ___________________________________________________ Desired Aggregate Expenditures (AE d )

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Closer look at the components of desired AE? AE d = C d + I d + G d + X d – M d Household: C d depends on Disposable Income, after tax income. Firms: I d depends on cost of borrowing; interest rate. External Sector: X d and M d depends on exchange rate and Income of domestic and foreign income. Government: determines its own expenditure level G d (it is a policy tool).

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When will there be an equilibrium? When aggregate desired expenditures are equal to total output produced AE d = Y (Equilibrium) If Aggregate Expenditure is less than output AE d < Y, stocks of unsold good will pile up. If Aggregate Expenditure is more than output AE d > Y stocks of unsold good will decline.

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Equilibrium in a Macroeconomy (Keynesian Model) Graphical Presentation and Equilibrium:

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Disequilibrium adjustment If the economy starts at a point where AE ≠ Y; what happens? The forces in the economy will bring the economy to the equilibrium output level. (Stable equilibrium) If for example AE<Y… then inventories will pile up, the firms will cancel orders, firms will cut back production, fire workers, employment and production will decline until AE=Y. (Reverse is also true for AE>Y )

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Equilibrium in a Macroeconomy Keynesian Model: (emphasizes the demand side, assumes constant prices and unemployed resources) If AE d > Y, then there is unplanned decline in the inventory levels of the firms, firms start to increase production. If AE d = Y, then there is no unplanned change in inventory levels, no change in production (Equilibrium). If AE d < Y, then there is unplanned increase in the inventory levels of the firms, firms start to decrease production.

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More of a closer look at the components of Aggregate Expenditures Desired Consumption Expenditures: C d – What is Disposable Income? DI – Therefore desired consumption expenditures are increasing function of DI and hence Y.

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A Model for Desired Aggregate Expenditures Desired Investment Expenditures: I d The model assumes interest rates to be constant, hence we can write: –

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A Model for Desired Aggregate Expenditures Desired Government Expenditures: G d – Therefore we can write as:

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A Model for Desired Aggregate Expenditures Desired Net Exports: NX d I n the simple model the exchange rate and foreign income are held constant, hence we can write:

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Mathematical Example Steps to find the Equilibrium Income (Output): 1.Find Desired Aggregate Expenditure Function as a function of Y. 2.Use equilibrium condition: AE d = Y 3.Solve for Y, which will be the level of output which is equal to the level of AE d. Example…

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Why does the Equilibrium Income change? If any of the autonomous spending increase then equilibrium income will increase from Y E to Y E NEW. Possible causes of autonomous income increase are: (Graphically all of these are vertical (upward) shift of the AE function)

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How does the Equilibrium Income change? Example: If Investment increases from to (where ) Then

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How does Eq. Income respond to a change in AE d ? What is the change in equilibrium income if I d increases? Multiplier: Numeric example…

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Why is there a ‘multiplier effect’? Initial increase in autonomous spending sets off a series of increase in AE and in real GDP. First increases, which means firms want to purchase more new machines, the AE in the economy increases, the factories which makes these machines will hire workers. This will increase their salary payments, the workers will increase their desired consumption and hence the economy will move to a higher Y level along the new AE function.

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