Price Level Real GDP ($Trillions) 0 Long run AS curve: A vertical line indicating all possible output and price level combinations the economy could end up in the long run Long run AS curve Y FE

Some economists (Mankiw included) believe the economy is “self- correcting”—that is, forces are present that push the economy to long-run (or full-employment) equilibrium. (How does it work?)

Price Level Real GDP ($Trillions) 0 AD 1 AS 1 Long Run AS Curve Y FE Y3Y3 Y2Y2 AD 2 AS 2 P1P1 P3P3 P2P2 P4P4 E H J K Let AD shift from AD 1 to AD 2

Positive demand shock P  and Y  Change in short-run equilibrium Y > Y FE Wage Rate  Unit Cost  PP Y  until Y =Y FE Long-run adjustment process

Price Level Real GDP ($Trillions) 0 AD AS E B F Why is point E a short-run equilibrium? At point B, the price level is 140 and AS = $14 trillion. But equilibrium GDP is equal to $6 trillion when the price level is 140—we know this from the AD curve. At point E, the price level is consistent with an output level of $10 along both AS and AD curves

Fiscal Policy The Employment Act of 1946 establishes a responsibility for the Federal government to “promote maximum employment, production, and purchasing power. Fiscal policy is the use of the spending and taxing powers of government to influence total spending and thereby to stabilize real GDP, employment, and prices.

Price Level Real GDP ($Trillions) 0 AD 1 AS Effect of a Demand Shock AD E H J Increase in government spending Issue: Why did the economy move from point E to point H— instead of E to J?

GG GDP  Multiplier Effect AD curve shifts rightward Unit cost  PP Money Demand  Interest rate  C and I  GDP  Movement along new AD curve Movement along AS curve Net result: GDP increases, but by less due to the effect of an increase in the price level

Price Level Real GDP ($Trillions) 0 AD 2 AS Effect of a decrease in taxes AD E K S 100

T↓T↓ GDP  Multiplier Effect AD curve shifts rightward Unit cost  PP Money Demand  Interest rate  C and I  GDP  Movement along new AD curve Movement along AS curve Net result: GDP increases, but by less due to the effect of an increase in the price level YD  CC

The use of the instruments of monetary policy to change total spending in the economy and thereby influence total output and employment.

Price Level Real GDP ($Trillions) 0 AD 2 AS Effect of a decrease in the money supply AD E K S 100

M  GDP  AD curve shifts Leftward Unit cost  P  Money Demand  Interest rate  C and I  GDP  Movement along new AD curve Movement along AS curve Net result: GDP decreases, but by less due to the effect of an decrease in the price level Interest rate  C and I 

Conventional 30 year

Mortgage rate Monthly Payment 1 8%$ %$ %$1, %$1, %$1, Does not include prorated insurance or property taxes. Monthly payments on a $110, year mortgage note

Data in thousands of units

More recently, the Fed raised the federal funds rate six times between May 99 and May 2000— from 4.75% to 6.5 %.

The Fed reversed course at the beginning of 2001 and reduced the federal funds rate 11 times that year!

The following factors could shift the (short-run) aggregate supply schedule up to the left: An increase in the price of a basic commodity—e.g., petroleum, natural gas, wheat, soybeans. An increase in average money wages and benefits not restricted to just one industry or sector of the economy. An increase in the average markup over unit cost not restricted to just one industry or sector of the economy.

Price Level Real GDP ($Trillions) 0 AD 2 AS 1 Effect of an increase in petroleum prices AD E S 100 AS 2 130

Price of One Barrel of 34 0 crude oil Source: The Petroleum Economist I’d call that a shock, wouldn’t you? The story of Joseph (see Old Testament) suggests buffer stocks as the remedy for supply-shock inflation

Productivity (  ) means the average output of a worker per year, or alternatively:  = GDP/N where N is total employment and Y is real GDP.  depends on the efficiency with which labor is employed in the production of goods & services

 Let  denote average annual compensation of employees (including benefits). Thus unit labor cost (UCL) is defined as: ULC =  /  Notice that compensation can rise with no effect on ULC, so long as productivity keeps pace

The Classical view of Fiscal policy Friends, we believe that fiscal policy is unnecessary and ineffective. The economy is doing just fine without meddling by Washington.

The Federal Budget Let: G denote federal spending for goods and services in a fiscal year (Oct. 1 thru Sept. 30). TX is federal tax receipts. TR is federal transfer payments. T is federal net taxes (TX - TR) The Federal budget is an annual statement of expenditures, tax receipts, and surplus or deficit of the government of the U.S.

If G exceeds T in a fiscal year, then we have a federal deficit. If, however, T exceeds G, then we have a federal surplus.

Crowding out is the idea that an increase in one component of spending will cause a decrease in other spending components. An increase in G may cause a decrease in C, I P, or both—that is, government spending may “crowd out” private spending.

Interest Rate Trillions of Dollars Crowding Out With an Initial Budget Deficit Total Supply of Funds (Saving) D 1 = I P + G 1 - T H 5% D 2 = I P + G 2 - T 7% A C B Increase in G = AH Decrease in C = AC Decrease in I P = CH

Interest Rate Trillions of Dollars Effects of a Reduction in the Government Surplus S 1 = Savings + T – G 1 D = Investment B 5% S 2 = Savings + T – G 2 A H 7% C

President Clinton’s economic strategy appears to have been effective in reducing interest rates

2000 = 100