McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Demand, Aggregate Supply, and Modern Macroeconomics Chapter 9 – Part two

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Equilibrium in the Aggregate Economy n Changes in the SAS, AD, and LAS curves affect short-run and long-run equilibrium.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Short-Run Equilibrium n Short-run equilibrium is where the AS and AD curves intersect. n Increases (decreases) in AD lead to higher (lower) real output and higher (lower) price level. n Upward (downward) shift the SAS curve lead to lower (higher) real output and higher (lower) price level.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real output Price level Short-Run Equilibrium: Shift in Aggregate Demand Y0Y0 Y1Y1 P1P1 P0P0 E F AD 0 AD 1 SAS

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real output Price level Short-Run Equilibrium: Shift in Aggregate Supply Y1Y1 Y0Y0 P1P1 P0P0 E G AD SAS 1 SAS 0

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Equilibrium n Long-run equilibrium is where AD and LAS intersect. n In the long run, output is fixed and the price level is variable.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Equilibrium n AD determines the price level. n Increases (decreases) in AD lead to higher (lower) prices.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Equilibrium: Shift in Aggregate Demand LAS AD 0 AD 1 Real output Price level P0P0 Y0Y0 E H P1P1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Integrating the Short-Run and Long-Run Frameworks n The economy is in both short-run and long- run equilibrium when all three curves intersect in the same location.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Integrating the Short-Run and Long-Run Frameworks n The ideal situation is for AD to grow at the same rate as AS and potential output. n Unemployment and growth are at their target rates with no inflation.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Run Equilibrium AD SAS YPYP Real output LAS P0P0 E Price level

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Recessionary Gap n A recessionary gap is the amount by which equilibrium output is below potential output.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Recessionary Gap n If the economy remains at this level for a long time, there would be an excess supply of factors of production. n Costs and wages would tend to fall. n As factor prices fall, the SAS curve will shift down to eliminate the recessionary gap.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real output Price level The Recessionary Gap YPYP Y1Y1 LAS AD SAS 0 SAS 1 P0P0 A P1P1 B Recessionary gap

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Inflationary Gap n An inflationary gap occurs when the economy is above potential at the current price level. n Factor prices rise causing the SAS curve to shift up. n The price level rises, and the inflationary gap is eliminated.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. (c) The Inflationary Gap Y2Y2 YPYP Real output LAS SAS 0 AD SAS 2 P0P0 C P2P2 D Inflationary gap Price level

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Economy Beyond Potential n When the economy operates below its potential, firms can hire additional factors of production without increasing production costs. n Once the economy reaches its potential output, that is no longer possible.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. The Economy Beyond Potential n As firms compete for resources, costs rise beyond productivity increases. n The short-run AS curve shifts up and the price level rises. n The economy will slow down by itself or government adopt a policy to contract output and eliminate the inflationary gap.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Demand Policy n Fiscal policy – the deliberate change in either government spending or taxes to stimulate or slow down the economy.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Demand Policy n Expansionary fiscal policy is appropriate if aggregate income is too low. n The deficit should be increased by decreasing taxes or increasing government spending. n The AD curve shifts to the right.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Aggregate Demand Policy n Contractionary fiscal policy is appropriate if aggregate income is too high. n The deficit should be decreased by increasing taxes or decreasing government spending. n The AD curve shifts to the left.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real output Price level Expansionary Fiscal Policy YPYP Y0Y0 LAS P1P1 P0P0 AD 0 AD 1 AS A

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Contractionary Fiscal Policy Real output Price level YPYP Y2Y2 LAS AS P2P2 AD 2 AD 0 B

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Additional Policy Examples n Unemployment is 12 percent and there is no inflation. n What policy would you recommend? n Use expansionary fiscal policy to shift the AD curve out to its potential income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real output Price level Expansionary Fiscal Policy P1P1 P0P0 SAS AD 0 Y0Y0 YPYP AD 1 B LAS A

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Additional Policy Examples n Unemployment is at its target rate and it is likely that consumer expenditures will rise. n What policy would you recommend? n Use contractionary fiscal policy to shift the AD curve inward to counteract the expected increase in AD.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real output Price level Contractionary Fiscal Policy YPYP LAS AD 0 SAS P1P1 Y1Y1 AD 2 B

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Additional Policy Examples n What would have happened if the government didnt institute a contractionary fiscal policy? n There would be an inflationary gap which would increase factor prices. n The SAS curve would shift up until it intersects the AD curve at Y P.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real output Price level Economy Above Potential YPYP LAS AD 1 SAS 0 P0P0 Y1Y1 AD 0 D SAS 1 C E P1P1

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fiscal Policy in World War II n The deficit increased greatly during World War II. n Real GDP grew by even more than the increase in the deficit. n Wartime wage and price controls prevented the SAS curve from shifting up.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fiscal Policy in World War II n Although World War II expanded the economy, that doesnt mean wars are good for the economy. l The production of military goods increased, but the production of consumer goods decreased. l Many people were killed or permanently disabled.

War Finance: Expansionary Fiscal Policy Year GDP (billions of 1958 dollars) $ Deficit (billions of Dollars) $ Unemployment rate 14.3% McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Real output (in billions of dollars) LAS $90$208 AD 1 AD 0 SAS

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. U.S. Economic Expansion n The economy boomed during the late 1990s and early 2000s. n The budget went from a large deficit to a large surplus.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. U.S. Economic Expansion n Significant increases in consumer and investment spending offset the contractionary effect of the surplus. n The surplus was more due to a booming economy than due to contractionary policy.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. U.S. Economic Expansion n During , political pressures increased government spending and cut taxes which led to a shrinking surplus. n The tax cut came just at the right time because the economy moved into a recession in mid-2001.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Macro Policy Is More Complicated Than It Looks n Using the AS/AD model to analyze the economy is more complicated than it looks. l Implementing fiscal policy. l Estimating potential output. l Effectiveness of fiscal policy.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 1. The Problem of Implementing Fiscal Policy n There is no guarantee that government will do what the economy needs to be done. l Implementing government spending and tax changes is a slow legislative process. l Government spending and tax decisions are made for political rather than for economic reasons.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 2. The Problem of Estimating Potential Output n Increasing AD when the economy is operating at its potential will accelerate inflation by shifting up the SAS curve.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 2. The Problem of Estimating Potential Output n One way of estimating potential output is to estimate the target rate of unemployment. n Target rate of unemployment – the rate below which inflation began to accelerate in the past.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 2. The Problem of Estimating Potential Output n Unfortunately, the target rate of unemployment fluctuates and is difficult to predict. n For example, there is structural but no cyclical unemployment at potential output – it is difficult to differentiate between the two.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 2. The Problem of Estimating Potential Output n Another way to determine potential output is to add the normal growth factor (3%) the economys previous level. n Estimating the economys potential from past growth rates is complicated by potentially dramatic changes in regulations, technology, and expectations.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 3. The Questionable Effectiveness of Fiscal Policy n The effectiveness of fiscal policy depends on the governments ability to perceive a problem and react appropriately to it.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 3. The Questionable Effectiveness of Fiscal Policy n Countercyclical fiscal policy – fiscal policy in which the government offsets any change in aggregate expenditures that would create a business cycle.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 3. The Questionable Effectiveness of Fiscal Policy n Most economists agree that the government is unable to fine tune the economy. n Fine tuning – fiscal policy designed to keep the economy always at its target or potential level of income.

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. End of Chapter 9 Aggregate Demand, Aggregate Supply, and Modern Macroeconomics