Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Five Output, Business Cycles, and Employment Macroeconomics by Curtis, Irvine and Begg Canadian Edition, McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd.Chapter 52 Learning Outcomes This chapter explains: Short-run aggregate demand and supply Equilibrium output and potential output Changes in equilibrium output and income Business cycles and output gaps Okun’s Law: output gaps and unemployment rates Adjustments to output gaps The role for macroeconomic policy

©2007 McGraw-Hill Ryerson Ltd.Chapter 5.13 A Short-Run Aggregate Demand and Aggregate Supply Model Short run –Constant prices for factors of production –Fixed supply of labour, capital and technology The short-run AD/AS model is closely related to the national accounts framework.

©2007 McGraw-Hill Ryerson Ltd.Chapter 5.14 The Aggregate Demand and Supply Model The intersection of the AD and AS shows real output measured by the expenditure approach (AD) equals to real income measured by the income approach (AS) at the price level given by the GDP Deflator AD 2005 AS 2005 Y = Real GDP (1997 $)‏ GDP Deflator

©2007 McGraw-Hill Ryerson Ltd.Chapter 5.15 Aggregate Demand planned aggregate expenditure priceAggregate Demand (AD) is planned aggregate expenditure on final good and service (C + I + G + NX) at different price levels Negative relationship –Wealth Effect –Interest rate Effect –Substitution Effect

©2007 McGraw-Hill Ryerson Ltd.Chapter 5.16 The Aggregate Demand Curve The AD curve shows planned aggregate expenditure at different prices Y0Y0 P0P0 AD Real GDP and Income GDP Deflator Y1Y1 P1P1 A B

©2007 McGraw-Hill Ryerson Ltd.Chapter 5.17 Aggregate Supply Aggregate Supply (AS) is output business would produce at different price levels, all other conditions constant. Positive Relationship Unit Production Cost

©2007 McGraw-Hill Ryerson Ltd.Chapter 5.18 The Aggregate Supply Curve The AS curve shows aggregate output as measured by real GDP at different prices Y2Y2 P2P2 AS Real GDP and Income GDP Deflator Y3Y3 P3P3 C D

©2007 McGraw-Hill Ryerson Ltd.Chapter 5.19 Equilibrium Real GDP and Price The intersection of the AD and AS gives equilibrium real GDP and price at A AD 2005 AS 2005 Y = Real GDP (1997 $)‏ GDP Deflator A P0P0 Y1Y1 Y0Y0

©2007 McGraw-Hill Ryerson Ltd.Chapter Equilibrium Output and Potential Output Short-run equilibrium is determined by AD and AS conditions. Potential output –Full employment output –Not the maximum output – Allow for “equilibrium unemployment” Actual Output

©2007 McGraw-Hill Ryerson Ltd.Chapter Potential GDP Potential GDP is the economy’s output when the markets for factor inputs are in equilibrium YpYp P1P1 P2P2 GDP Deflator Real GDP Y p is not affected by changes in the price level

©2007 McGraw-Hill Ryerson Ltd.Chapter Recession Recovery and Boom Potential and Actual GDP in Canada Figure 5.6 Potential GDP Actual GDP

©2007 McGraw-Hill Ryerson Ltd.Chapter Business Cycles and Output Gaps Business cycles cause differences between actual and potential GDP Output Gaps measure the difference between actual and potential GDP Inflationary gaps and Recessionary gaps

©2007 McGraw-Hill Ryerson Ltd.Chapter The Output Gap in Canada, Figure 5.7

©2007 McGraw-Hill Ryerson Ltd.Chapter Output Gaps and Unemployment Rates Unemployment Rate (u)‏ Natural Unemployment Rate (u n )‏ Okun’s Law

©2007 McGraw-Hill Ryerson Ltd.Chapter Okun’s Law A C B gY 1 gY 2 gY p 0Δu<0Δu>0 Growth in Real GDP Change in Unemployment Rate At Point A gY 1 > gY p, the demand for labour inputs is growing faster than labour force, the unemployment rate falls At Point B gY = gY p, the demand for labour inputs is equal to labour force, the unemployment rate does not change At Point C gY 1 < gY p, the demand for labour inputs is growing slower than labour force, the unemployment rate increases Figure 5.9

©2007 McGraw-Hill Ryerson Ltd.Chapter Okun’s Law The Effect of Growth in Real GDP on Unemployment Application Box 5.2 Change in u rate = 0.11 – (growth in Y – growth in Y p )‏

©2007 McGraw-Hill Ryerson Ltd.Chapter Equilibrium Unemployment Frictional unemployment –entry and exit of workers –workers changing jobs Structural unemployment –mismatch between skills/experience of supply of labour and skill/experience requirements of employers (labour demand)‏

©2007 McGraw-Hill Ryerson Ltd.Chapter Cyclical Unemployment NAIRU – nonaccelerating inflation rate of unemployment Recessionary output gap –reduced demand for labour –cyclical unemployment Inflationary output gap –increased demand for labour –cyclical “over” employment

©2007 McGraw-Hill Ryerson Ltd.Chapter Adjustments to Eliminate Output Gaps A recessionary gap results in lower wage rates and other factor prices. AS shifts down, and equilibrium output increases to eliminate the gap. Y0Y0 P0P0 AD 0 AS 0 Real GDP GDP Deflator P1P1 AS 1 YpYp Recessionary gap

©2007 McGraw-Hill Ryerson Ltd.Chapter Adjustments to Eliminate Output Gaps A inflationary gap raises factor prices and costs. AS shifts up, and equilibrium output decreases to eliminate the gap. Y0Y0 P0P0 AD 0 AS 0 Real GDP GDP Deflator P1P1 AS 1 YpYp Inflationary gap

©2007 McGraw-Hill Ryerson Ltd.Chapter The Role for Macroeconomic Policy Why are output gaps, especially recessionary gaps, persistent? –The flexibility or rigidity of wage and prices Can government policy work to eliminate output gap? –Fiscal Policy –Monetary Policy

©2007 McGraw-Hill Ryerson Ltd.Chapter 523 Chapter Summary The Aggregate and Supply model provides a framework for our study of operation of the economy –Aggregate Demand –Aggregate Supply –Short-run Equilibrium Real GDP and Price Potential outputPotential output is the economy’s output at full employment level Business CyclesBusiness Cycles are short-run fluctuations of actual real GDP around its potential

©2007 McGraw-Hill Ryerson Ltd.Chapter 524 Chapter Summary Output GapsOutput Gaps are the differences between actual real GDP and its potential Okun’s LawOkun’s Law makes a link between output gaps and unemployment rate Inflationary Gaps and Recessionary GapsInflationary Gaps and Recessionary Gaps adjustsActual output adjusts to potential output over time if factor prices are flexible Fiscal and Monetary policyFiscal and Monetary policy are tools government and monetary authorities use