Chapter 10 homework Numbers 4, 7, 11, 12 and 18

Chapter 11 From Short-Run to Long-Run Equilibrium: The Model in Action

Changing Aggregate Demand and Short-Run Aggregate Supply Basic changes in aggregate demand or short-run aggregate supply can explain four basic macroeconomic outcomes in the short run:  Increasing aggregate demand Growing economy with a higher price level  Decreasing aggregate demand Recession with lower price levels  Increasing short-run aggregate supply Growing economy with a lower price level  Decreasing short-run aggregate supply Recession with a higher price level

Changing Aggregate Demand Growing economy with a rising price level.  increase in aggregate demand  Business cycle expansion: Demand-Side Inflation AD shifts to the right  increasing prices Example: U.S. recovery of the late 1990s.  US consumers were optimistic, stock prices and home prices were rising (people felt wealthy), CPI increased by about 10%, unemployment fell from 6 to 4%

Figure 11.1(a) Impact of Changing Aggregate Demand on Short-Run Equilibrium

Changing Aggregate Demand Recession with a falling price level.  decrease in aggregate demand  Example: The Great Depression of the 1930s Consumption collapsed, taxes went up and government spending was cut (to balance budget), trade wars reduced exports GDP fell by 27%, unemployment reached 24%, price levels fell by 25% This situation is relatively rare today as governments have tools to prevent a decline in aggregate demand.

Figure 11.1(b) Impact of Changing Aggregate Demand on Short-Run Equilibrium

Changing Short-Run Aggregate Supply Growing economy with a falling price level.  increase in short-run aggregate supply  Example: Hong Kong, Mali, Libya, Bahrain and Oman all experienced lower prices and higher real GDP for at least one year from 2001 to Most often results from new investment, which increases productivity.

Figure 11.2(a) Impact of Changing Short-Run Aggregate Supply on Short-Run Equilibrium

Changing Short-Run Aggregate Supply Recession with a rising price level.  decrease in short-run aggregate supply  Usual pattern of recessions in the United States over the past 30 years. Sometimes called stagflation, or supply-side inflation Can be caused by increases in business taxes, declining productivity, pessimistic expectations and higher energy prices.

Figure 11.2(b) Impact of Changing Short-Run Aggregate Supply on Short-Run Equilibrium

Can we do it? Number 2  From 1948 to 1949, the US price level fell from 24.1 to 23.8 while real GDP fell from $1.64 trillion to $1.63 trillion. Graph this situation using a change in either aggregate demand alone or short-run aggregate supply alone. What economic phenomenon does this illustrate?

Answer??? This is a demand-side or spending recession, as prices and GDP both fall from a reduction in aggregate demand.

The Long-Run Model of Aggregate Demand and Aggregate Supply Illustrates a self-adjusting mechanism that can move the macroeconomy to the full employment level of real GDP.  Based on the classical school of economic thought

The Classical School of Economic Thought Developed as the English economy was entering in the Industrial Revolution.  The first Classical economists wrote during the period from 1776 to Typified by Adam Smith in The Wealth of Nations (1776), classical economists believed the economy achieves full employment equilibrium in the long run. Old…but some economists still believe in it

The Basic Beliefs of the Classical School Usually we are at or very close to the full employment level of real GDP. The economy will tend to generate and maintain full employment without government intervention.  Laissez faire Let do, let go, let pass Any deviations will tend be minor, temporary, and self-correcting.

Basis for the Long-Run Model The long-run belief in full employment depends on three observations regarding the nature of the macro-economy:  Say’s Law  The loanable funds market  Price and wage flexibility

Say’s Law The belief the supply creates its own demand  The act of supplying goods to an economy generates enough income to buy all those same goods and services.

The Loanable Funds Market Say’s law is too simple It ignores saving.  If households save a portion of their incomes, then some of the goods produced in the economy would not be purchased. As a result: Inventories would accumulate. Firms would cut back on production. Unemployment would increase.

The Loanable Funds Market (cont’d) The loanable funds market converts saving into spending by bringing “savers” and “borrowers” together Savers are the suppliers of loanable funds.  Seek the highest possible interest rate. Borrowers are demanders of loanable funds.  Seek the lowest possible interest rate.

The Loanable Funds Market (cont’d) Establishes the equilibrium interest rate  Quantity of funds savers want to save is exactly equal to the quantity of funds that borrowers demand.

Figure 11.3(a) Operation of the Loanable Funds Market

Figure 11.3(b) Operation of the Loanable Funds Market

Price and Wage Flexibility Wages and prices are fully and freely flexible.  They are equally likely to go up or down. This flexibility is crucial to the economy’s long-run self-adjustment process.

Price and Wage Flexibility (cont’d) Suppose that the quantity of aggregate demand is less than the quantity of aggregate supply:  Inventories increase.  Some producers cut the price of their product.  Workers will accept cuts in wages or benefits in order to keep their jobs.

Life Lessons Givebacks and flexible wages:  Worker’s wages generally do not decrease.  Only rarely do workers in a struggling industry voluntarily accept pay cuts. Airline industry In recent years, companies have been asking workers to give up some of their benefits to maintain competitiveness.