National Income and Price Determination

Unit Goals: The student will be able to . . . Understand three keys facts about economic fluctuations Identify the determinants of aggregate demand and aggregate supply. Use the aggregate expenditure and the AD/AS models to analyze the economy and determine real output and price level. Use the concept of the multiplier effect. Explain the shortcomings of the AD/AS model including sticky wages and prices.

Unit Three: National Income + Price Determination Aggregate demand Determinants of aggregate demand Multiplier and crowding-out effects Aggregate supply Short-run and long-run analyses Sticky versus flexible wages and prices Determinants of aggregate supply Macroeconomic equilibrium Real output and price level Short and long run Actual versus full-employment output Business cycle and economic fluctuations

Three Keys Facts about Economic Fluctuations 1 ECONOMIC FLUCTUATIONS ARE IRREGULAR AND UNPREDICTABLE Fluctuations often called business cycle (periods of expansions and contractions)

Three Keys Facts about Economic Fluctuations 2 MOST MACROECONOMIC QUANTITIES FLUCTUATE TOGETHER Real GDP monitors short-run changes in the economy When real GDP falls in a recession, so do Personal income Corporate profits Consumer spending Investment spending Industrial production Retail sales Home sales Auto sales

Three Keys Facts about Economic Fluctuations 3 AS OUTPUT FALLS, UNEMPLOYMENT RISES Changes in an economy’s output of goods and services are correlated with changes in the economy’s utilization of its labor force Decrease in production = decrease in workers needed

The Basic Model of Economic Fluctuations Focuses on the behavior of TWO variables 1. Economy’s output of goods and services as measured by real GDP 2. The overall price level as measured by the CPI Model of aggregate demand and aggregate supply: Used to explain short-run fluctuations in economic activity around its long-run trend Vertical axis – overall price level in the economy Horizontal axis – overall quantity of goods and services

Aggregate Demand (AD) Curve Shows us the quantity of all goods and services that households, firms, and the government want to buy at any given price level

Aggregate Demand Curve Downward sloping Inverse relationship between the quantity of real output demanded and the price level Lower price level = greater amount of output demanded Higher price level = decreased amount of output demanded

Measures GDP Aggregate Demand GDP is the sum of C + I + G + (X-M) 1. Consumption – spending by domestic households on goods and services 2. Investment – spending by firms on capital equipment and by households on real estate or homes 3. Government spending – spending by governments on goods and services 4. Net Exports – exports minus imports Measures GDP

The Aggregate Demand Curve Downward sloping curve inversely related to the average price level P = Average price level Y = Real National Output Levels (rGDP)

ASSUME that government spending is fixed by policy The other three components of spending (consumption, investment, and net exports) depend on - Price level

Movement along the AD curve A change in the price level of a nation’s output will lead to a movement along the AD curve and a change in the quantity of national output demanded.

Three reasons for the inverse relationship between the average price level (PL) and real national output (rGDP) Wealth Effect Interest-Rate Effect Exchange-Rate Effect

The Price Level and Consumption: The Wealth Effect Higher price levels reduce the purchasing power or the real value of the household’s wealth and savings The public feels poorer with higher price levels so they demand a lower quantity of the nation’s output.

The Wealth Effect Lower price levels mean that your dollars become more valuable because you can buy more goods and services. Decrease in price levels makes consumers wealthier which encourages them to spend more.

The Price Level and Investment: The Interest-Rate Effect Higher price levels will cause banks to raise the interest rates on loans. At high interest rates, the quantity demanded of products and capital for which households and firms must borrow decreases.

The Interest-Rate Effect Lower price levels cause households to invest in interest-bearing savings accounts or bonds. Banks will use this extra cash-flow to lower interest rates for other borrowers.

The Price Level and the Foreign Market: The Net-Export Effect Higher price levels cause goods and services produced in a given country to become less attractive to foreign consumers and imports to become more attractive to domestic consumers.

The Net-Export Effect Lower price levels in U.S. increase the amount of U.S. goods and services demanded from abroad and decreases the domestic demand for imports.

Question of the Day 11.28/11.29 When price levels in Japan decrease Japan will sell more exports and purchase more imports. Japan will sell less exports and purchase more imports. Japan will sell less exports and purchase less imports. Japan will sell more exports and purchase less imports.

Quick Summary Three distinct but related reasons why a fall in CPI increases rGDP 1. Consumers are wealthier which stimulates the demand for consumption goods 2. Interest rates fall which stimulates the demand for investment goods. 3. The exchange rate depreciates which stimulates the demand for net exports. These 3 are the reasons why the aggregate demand curve slopes downward, ceteris paribus. Assumes that the money supply is fixed.

Shifts in the AD curve To the right . . . If C, I, G, or Net Exports increase To the left . . . If C, I, G, or Net Exports decrease

Shifts arising from consumption To the left – Americans become more preoccupied with saving rather than spending (AD decreases at every PL) Increasing taxes discourages spending (AD decreases at every PL) To the right – Stock market boom makes people wealthier and less concerned about saving (AD increases at every PL) Cutting taxes encourages spending (AD increases at every PL)

Shifts Arising from Investment To the left – Firms are pessimistic about business conditions (AD will decrease at every PL) Repeal of an investment tax credit (AD will decrease at every PL) Decrease in money supply increases interest rate (AD will decrease at every PL) To the right – Computer company introduces the first touch screen and other companies want to catch up (AD will increase at every PL) Investment tax credit (AD will increase at every PL) Increase in money supply lowers interest rate (AD will increase at every PL)

Shift arising from Government Purchases The most direct way that policy makers shift the AD curve is through government purchases. To the left – Congress decides to spend less on the military (AD will decrease at every level) State governments cut education spending (AD will decrease at every PL) To the right – Congress decides to purchase new weapons systems. (AD will increase at every PL) State governments build more highways (AD will increase at every PL)

Shifts arising from Net Exports To the left – Europe experiences a recession (AD will decrease at every PL) Appreciation of U.S.D. (AD will decrease at every PL) To the right – Europe recovers from a recession (AD will increase at every PL) Depreciation of U.S.D. (AD will increase at every PL)

Quick Review The three facts about economic fluctuation The three reasons that the AD curve is downward sloping The reasons why the AD curve might shift to the left or to the right HW: Complete quick quiz on p. 733

The Aggregate-Supply Curve Illustrates the total quantity of goods and services that firms produce and sell at any given price level. Unlike the AD curve (which is always downward sloping), the AS curve depends on the time period under examination

Short-Run VS. Long-Run AD Short-run AD – upward sloping Long-run AD – vertical

Long-run AS In the long run, an economy’s production of goods and services (real GDP) depends on its supplies of land, labor, capital, and technology used to turn these factors of production into goods and services. PL does not affect these long-run determinants of real GDP. The resources, not price, determine the total quantity of goods and services supplied.

****Curve is vertical at natural rate of output***** LONG-RUN AS Based on classical macroeconomic theory that real variables (real GDP) do not depend on nominal variables (level of prices) This works out over a period of years. ****Curve is vertical at natural rate of output*****

WHY LONG-RUN AS MIGHT SHIFT Natural rate of output because it shows when