Feb 20, 2015 HW Check – Recessions in U.S. History Grades are posted. Let me know of any errors. I submit grades next Mon. Assembly seating: far right facing the stage, rows B-E Tonight’s HW Aggregate Supply and Demand Practice

Recessions in U.S. History Which recession is the most severe? Why? Explain. Similarities? Oil -- 1990-1991, 1981-1982, 1973-1975 Speculative Bubbles - 2007-2009 (housing bubble), 2001 (dot-com bubble), The Great Depression (stock bubble) High interest rates/Fed's monetary policy - 2001, 1990-1991, 1981-1982, The Great Depression Differences? Stagflation - 1973-1975, 1981-1982

Unit 2: Economic Fluctuations and Fiscal Policy

Aggregate Supply and Demand Model The AS-AD model helps us understand economic fluctuations. Aggregate = added all together; combining all prices and all quantities. Aggregate Demand – total consumption by entire population for all goods and services Aggregate Supply –total output (total production of all goods and services). Price Level LRAS SRAS AD Real GDP

Aggregate Demand

What is Aggregate Demand? Aggregate Demand is all the goods and services (real GDP) that buyers are willing and able to purchase at different price levels. The demand for everything by everyone in the US. Inverse relationship between price level and Real GDP. If the price level: Increases (Inflation), then real GDP demanded falls. Decreases (deflation), the real GDP demanded increases.

Aggregate Demand Curve Price Level AD is the demand by consumers, businesses, government, and foreign countries Changes in price level cause a move along the curve AD = C + I + G + Xn Real domestic output (GDPR)

Why is AD downward sloping? Wealth Effect- Higher price levels reduce the purchasing power of money This decreases the quantity of expenditures Lower price levels increase purchasing power and increase expenditures Example: If the balance in your bank was $50,000, but inflation erodes your purchasing power, you will likely reduce your spending. So…Price Level goes up, GDP demanded goes down.

Why is AD downward sloping? 2. Interest-Rate Effect When the price level increases, lenders need to charge higher interest rates to get a REAL return on their loans. Higher interest rates discourage consumer spending and business investment. WHY? Example: An increase in prices leads to an increase in the interest rate from 5% to 25%. You are less likely to take out loans to expand your business. Result…Price Level goes up, GDP demanded goes down (and Vice Versa). The interest rate effect – as the price level increase, purchasing power decrease and as a result, people either save less or must borrow more to maintain their consumption. This reduced the supply of loanable money drives up the interest rate. As the interest rate increases, business buy less capital and consumers buy fewer durable good.

Why is AD downward sloping? 3. Net Export Effect When U.S. price level rises, foreign buyers purchase fewer U.S. goods and Americans buy more foreign goods Exports fall and imports rise causing real GDP demanded to fall. (XN Decreases) Example: If prices triple in the US, Canada will no longer buy US goods causing quantity demanded of US products to fall. Again, Price Level goes up, GDP demanded goes down (and Vice Versa).

Determinants/Shifters of Aggregate Demand GDP = C + I + G + Xn

Shifts in Aggregate Demand Price Level An increase in spending will shift AD right, and decrease in spending shifts it left AD1 AD = C + I + G + Xn AD2 Real domestic output (GDPR) 12

Shifters of Aggregate Demand Change in Consumer Spending Consumer Wealth (Boom in the stock market…) Consumer Expectations (People fear a recession…) Interest Rate (Increase/decrease cost of borrowing…) Taxes (Decrease in income taxes…) 2. Change in Investment Spending Interest Rate (Increase/decrease cost of borrowing…) Future Business Expectations (Optimistic…) Business Taxes (Higher corporate taxes means…)

Shifters of Aggregate Demand Change in Government Spending (War…) (Nationalized heath care…) (Decrease in defense spending…) Change in Net Exports (X-M) Exchange Rates (If the us dollar depreciates relative to the euro…) National Income Compared to Abroad (If a major importer has a recession…) (If the US has a recession…) If dollar depreciates, more Europeans will buy US products causing Net Exports to increase AD = GDP = C + I + G + Xn

Aggregate Demand Consumers respond to high levels of debt by reducing their purchases of consumer goods. Component of AD? Change in AD? Increase or decrease? Resulting AD shift? Price Level Consumption AD Real GDP

How does this cartoon relate to Aggregate Demand?

How does this cartoon relate to Aggregate Demand?

Aggregate Supply

What is Aggregate Supply? The supply for everything by all firms. Aggregate Supply is the amount of goods and services (real GDP) that firms will produce in an economy at different price levels. The supply for everything by all firms. AS depends on the quantity of labor and capital and the level of technology. Aggregate Supply differentiates between short run and long-run and has two different curves. Short-run Aggregate Supply Wages and Resource Prices will not increase as price levels increase. Long-run Aggregate Supply Wages and Resource Prices will increase as price levels increase.

Refresher… In the short run, at least one input is fixed. The long run is a period of time long enough for firms to change any of their inputs, thus all costs are variable.

Short-Run Aggregate Supply In the short run, wages and resource prices will NOT increase (“sticky”) as price levels increase. Example: If a firm currently makes 100 units that are sold for $1 each. The only cost is $80 of labor. How much is profit? Profit = $100 - $80 = $20 What happens in the SHORT-RUN if price level doubles? Now 100 units sell for $2, TR=$200. How much is profit? Profit = $120 With higher profits, the firm has the incentive to increase production.

AS is upward sloping bc In the short run, many costs that producers face are fixed. The largest fixed cost tends to be wages paid to workers. Wages are often determined by contracts and even when they are not, employers are slow to increase or decrease them in response to economic conditions. When the price level rises, the production costs do not rise by the same proportion as the rise in the price of the unit so profits tend to rise in the short run. Higher profits incentivize producers to increase output.

Aggregate Supply Curve Price Level AS AS is the production of all the firms in the economy Real domestic output (GDPR) 23

Long-Run Aggregate Supply (potential Real GDP) In the long run, wages and resource prices WILL increase as price levels increase. Same Example: The firm has TR of $100 an uses $80 of labor. Profit = $20. What happens in the LONG-RUN if price level doubles? Now TR=$200 In the LONG RUN workers demand higher wages to match prices. So labor costs double to $160 Profit = $40, but REAL profit is unchanged. If REAL profit doesn’t change the firm has no incentive to increase output. Output is determined by the resources that exist in the economy  full employment

Long run Aggregate Supply In Long Run, price level increases but GDP doesn’t LRAS Price level Long-run Aggregate Supply Full-Employment (Trend Line) QY GDPR In the long run the economy will be producing at full employment. Natural level of real GDP

Shifts in Aggregate Supply An increase or decrease in national production can shift the curve right or left AS2 Price Level AS AS1 Real domestic output (GDPR) 26

Determinants/ Shifters Aggregate Supply R. A. P. 1. Change in Resource (labor, capital) Prices Prices of Domestic and Imported Resources (Increase in price of Canadian lumber…) (Decrease in price of Chinese steel…) Supply Shocks (Negative Supply shock…) (Positive Supply shock…) 27

Shifters of Aggregate Supply (NOT Government Spending) 2. Change in Actions of the Government (NOT Government Spending) Taxes on Producers (Lower corporate taxes…) Subsidies for Domestic Producers (Lower subsidies for domestic farmers…) Government Regulations (EPA inspections required to operate a farm…) 3. Change in Productivity Technology (Computer virus that destroy half the computers…) Human Capital

Aggregate Supply Unions are more effective so that wage rates increase. Determinant of AS? Input costs or productivity? Change in AS? Increase or decrease? Resulting AS curve? Price Level AS Real GDP

What causes Business Cycles? Partner Discussion Using the info from the Recession in U.S History handout, answer the following: 1. What factors might cause spending (AD) in the economy to change? 2. What factors would increase or decrease production (AS)?

Putting AD and AS together to get Equilibrium Price Level and Output

Aggregate Supply and Demand Model Business investment increases Real GDP Price Level Unemployment AS Price Level AD Real GDP

Shifters of Aggregate Demand Shifters of Aggregate Supply AD = C + I + G + X Change in Consumer Spending Change in Government Spending Change in Investment Spending Net EXport Spending Shifters of Aggregate Supply AS = R + A + P Change in Resource Prices Change in Actions of the Government Change in Productivity (Investment)

Inflationary and Recessionary Gaps 34

LRAS PL and Q will Increase Example: Assume the government increases spending. What happens to PL and Output? LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 35

Inflationary Gap LRAS Actual GDP above potential GDP Output is high and unemployment is less than NRU LRAS Price Level AS Actual GDP above potential GDP PL1 AD1 QY Q1 GDPR 36

Stagnate Economy + Inflation Example: Assume the price of oil increases drastically. What happens to PL and Output? LRAS Price Level AS1 AS PL1 Stagflation Stagnate Economy + Inflation PLe AD Q1 QY GDPR 37

Recessionary Gap LRAS Actual GDP below potential GDP Output low and unemployment is more than NRU LRAS Price Level AS1 Actual GDP below potential GDP PL1 AD Q1 QY GDPR 38

Short Run and Long Run 39

Shifts in AD or AS change the price level and output in the short run LRAS Price Level AS PLe AD QY GDPR 40

Example: Assume consumers increase spending Example: Assume consumers increase spending. What happens to PL and Output? LRAS Price Level AS PL1 PLe AD1 AD QY Q1 GDPR 41

Now, what will happen in the LONG RUN? Inflation means workers seek higher wages and production costs increase LRAS Price Level AS1 AS PL2 Back to full employment with higher price level PL1 PLe AD1 AD QY Q1 GDPR 42

AS increases as workers accept lower wages and production costs fall Example: Consumer expectations fall and consumer spending plummets. What happens to PL and Output in the Short Run and Long Run? Price Level LRAS AS AS1 AS increases as workers accept lower wages and production costs fall PLe PL1 Short Run -AD Falls, PL and Q fall Long Run- AS Increases as workers accept lower wages and production costs fall. PL goes down, Q goes back to Full Employment PL2 AD AD AD1 Q1 QY GDPR 43

Positive economic growth results from an increase in productive resources, such as labor and capital. With more resources, it is possible to produce more final goods and services, and hence, the natural level of real GDP increases. Positive economic growth is therefore represented by a shift to the right of the LAS curve. Similarly,negative economic growth decreases the natural level of real GDP, causing the LAScurve to shift to the left.

Homework 2008 Recession reading packet. You need to answer the questions at the end of each reading. 1. Taking Out a Mortgage – Prime vs. Subprime 2. Nicole Bradury, Robo-Signer Victim 3. Rise and Fall of Bubbles

Federal Funds Rates May 17, 2013 rate: 0.15%

Discussion Qs What should the government do to address the 2008 financial crisis? Should the US government bail out the banking/financial/insurance industry?

Bailout Spending (as of 5/23/13) 929 Recipients Total disbursement = $606 billion Total returned = $364 billion Total revenues from dividends, interest, and other fees = $116 billion Total net to date = $-126 billion http://projects.propublica.org/bailout/list

Bailout Tracker http://money.cnn.com/news/storysupplement/economy/bailout tracker/ http://projects.propublica.org/bailout/list http://money.cnn.com/news/storysupplement/economy/aig/in dex.html Recovery Act Spending http://www.recovery.gov/Pages/default.aspx

Table 3-1.1, Changes in AD A – “reducing purchases” C Decrease, left Component of AD Direction of AD Resulting Curve A – “reducing purchases” C Decrease, left AD2 B – “reduction in investment” I C – “Gov’t spending increases” G Increase, right AD1 D – “Consumer confidence jumps” E – “investors lose billions” I, C F – “productivity rises” N/A NC, it affects AS AD G – “trade war that reduces exports by more than it reduces imports” Xn

Table 3-1.1, Changes in AS A – “wage rates increase” Input Costs Determinant of AS Change in AS Resulting Curve A – “wage rates increase” Input Costs Decrease, left AS1 B – “increase oil prices” C – “labor productivity increases” Productivity Increase, right AS2 D – “gas discovery decreases energy prices” E – “new efficiency” F – “Gov’t spending increases” N/A NC (affects AD) AS G – “save and invest” NC H - “Low birth rate decrease the LF” NC (until the future) I – “increased skills”

Changes in SRAS and AD Shift in AD/AS Shift Effect on Price Level Effect on Real GDP 1. Business investment increases AD right increase 2. Gov’t increases spending Right Increase 3. Oil discovery causes decrease in price AS Decrease 4. Consumer spending increases 5. Production costs increase Left 6. New tech and better education increase productivity. 7. Consumer confidence increases 8. Net exports decrease 9. “Economic boom in Japan and Europe” 10. “reduce taxes and increase transfer payments” 11. “highest corn and wheat yields” 12. “defense spending was increased” 13. “cuts SS by 10% and fin-aid by 20%” 14. “Begin to buy…to replace failing models’

Recessions in U.S. History AS Draw AD-AS models for each of the recessions. Price Level AD Real GDP

Causes of the 2008 Financial Crisis 2001 Recession Fed lowers interest rates Low interest rates make it cheaper to buy a home INCREASES DEMAND FOR HOMES Subprime loans made home buying more accessible to more individuals 1996-2006, average home prices more than doubles Investment banks  SECURIZATION  Mortgage-backed Securities (CDOs)

2008 Financial Crisis The Crisis of Credit Visualized http://crisisofcredit.com/ 1. Why did America experience a housing boom? 2. How did investment bankers make so much money? 3. How would you assign blame (mortgage lenders, mortgage borrowers, the Federal Reserve?) for the housing market collapse and financial crisis that followed? Why? Any questions?

NBER: Effects of the Financial Crisis and Great Recession on American Households We find that the effects of the recession are widespread: between November 2008 and April 2010 about 39 percent of households had either been unemployed, had negative equity in their house or had been in arrears in their house payments. Reductions in spending were common especially following unemployment. On average expectations about stock market prices and housing prices are pessimistic, particularly long-run expectations. Among workers, expectations about becoming unemployed have recovered somewhat from their low point in May 2009 but still remain high. Overall the data suggest that households are not optimistic about their economic futures. - Sept, 2010 2008 Financial Crisis Dec, 2007- June 2009 Peak to trough – 18 months

https://www. youtube. com/watch https://www.youtube.com/watch?v=LH- HVcIlHGc&list=UUOBwTuxW6hWHiR0Bw9pppIQ https://www.youtube.com/watch?v=zaYCsn3QoQM

Circular Flow and GDP Practice KEY b. $800 million (C+I+G+X-M or wages+dividends+interest+rent) c. Disposable income = $670 d. Household savings = $270 e. no, gov’t had to borrow $70 million f. $290m (borrowing) = $290 (household savings & foreign lending) g. $800m (goes into product market) = $800m (goes into factor market) h. $800m (goes into factor market) = $800 (household income)

#2 Included - investment spending Not included – house was built in 2001 – used and no realtor = no income. Included – gov’t spending Included – exports Not included – non-market transaction Included - investment

#3 Calculating Nominal and Real GDP a. 2010 = $8,000 2011 = $8,866 2012 = $9,650 b. 10.8% ((8866- 8000)/8000)*100 c. 8.8% ((9650- 8866)/8866)*100 d. 2010 = 8,000 2011 = 8,650 2012 = 9,070 e. 8.1% ((8650- 8000)/8000)*100 f. 4.9% ((9070- 8650)/8650)*100 g. 2010 = 100 2011 = 102.5 2012 = 106.4