ECO1000 Economics Lecture Ten, 2004

Class Test Two Reminder for Internal Students Wednesday May 26, 5-8 pm 25 multiple choice questions Covers Lectures 6 – 10 (Chapters 7-16) Same deal as test one (online etc)

Outline or Plan of Today’s Lecture Material Covered: Module Seven Reading: Text Chapter 16 Topics: Aggregate Demand and Aggregate Supply

Purpose or Objectives of Today’s Lecture You will be able to: Work with a key macroeconomic model Model changes in the economy due to changes economic variables Think about policy implications (in preparation for next week’s work)

Economic Fluctuations

What Are Economic Fluctuations? Economic fluctuations are the ups and downs in economic activity from year to year. In most years production of goods and services rises but in some years normal growth does not occur, causing a recession. A recession is a period of declining real GDP, falling incomes, and rising unemployment. A depression is a severe recession.

Growth over time Real GDP ($b) Years Long term average Recession ‘Boom’

Characteristics of Economic Fluctuations Economic fluctuations are irregular and unpredictable. Most macroeconomic variables are related and fluctuate together. As output falls, unemployment rises and vice versa

The Short Run and The Long Run

How Long is the Long Run? The long run can be considered to be a period of at least several years. The short run is a period of about one to two years. This is a bit like asking, “How long is the present?” (i.e. When does the present become the future?)

Incidentally… the present lasts for as long as you can hold the cube (below) in focus before it transposes itself (back becomes front or vice versa)

In the Short Run & the Long Run… We have previously used two ideas: classical dichotomy and money neutrality In the short run, it is now more or less accepted that real and nominal variables move together We need a new model with which to analyse short and long run economic fluctuations.

Explaining the Fluctuations Using the AD-AS Model

The Space in Which AD-AS is Mapped Two variables are used to develop a model to analyse the short-run fluctuations. The economy’s output of goods and services measured by real GDP. The overall price level measured by the CPI or the GDP deflator. AD-AS are plotted in output-price level space.

Aggregate Demand and Aggregate Supply The aggregate demand curve shows the quantity of goods and services that households, firms, and the government want to buy at any price level. The aggregate supply curve shows the quantity of goods and services that firms choose to produce and want to sell at any price level.

The Aggregate Demand Curve The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

The Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand P1P1 Y1Y1 1. A decrease in the price level P2P2 2. Leads to an increase in quantity demanded 3. And an increase in output Y2Y2

Explaining the Negative Slope of the Aggregate Demand Curve: Three Theories Pigou’s wealth effect Keynes’ interest rate effect Mundell-Fleming’s exchange-rate effect

Pigou’s Wealth Effect Consumers feel wealthier, which stimulates the demand for consumption goods. A decrease in the price level makes consumers feel more wealthy. This encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded.

Keynes’ Interest-Rate Effect The lower the price level, the less money households need to hold to buy the goods and services they want. A lower price level reduces the interest rate, which encourages greater spending on investment goods. The increase in investment spending means a larger quantity of goods and services demanded.

Mundell-Fleming’s Exchange-Rate Effect When the prices of domestic goods decreases, net exports increase. A fall in the Australian price level causes Australian interest rates to fall. The real exchange rate depreciates, which stimulates Australian net exports. The increase in net export spending means a larger quantity of goods and services demanded.

Shifts in the Aggregate Demand Curve Shifts in the aggregate demand curve may arise because of changes in: Private behaviour: Changes in spending plans by consumers or firms. Public policy: Changes in fiscal or monetary policy. Anything that causes buyers to want to purchase more or less than before will cause the aggregate demand curve to shift.

Shifts in the Aggregate Demand Curve Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1 Y2Y2 D2D2

The Aggregate Supply Curve In the long run, the aggregate-supply curve is vertical. In the short run, the aggregate-supply curve is upward sloping.

The Long-Run Aggregate Supply Curve The long-run aggregate supply depends on the economy’s resources and level of technology. The price level does not affect these variables in the long run. The long-run aggregate supply curve is vertical at the natural rate of output.

The Long-Run Aggregate Supply Curve Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P1P1 P2P2 1. A Change in the Price Level 2. Does not change the natural rate of output in the long run

Shifts in the Long-Run Aggregate Supply Curve Any change in the factors that determine the long-run aggregate supply will cause the curve to shift. An event that reduces the economy’s potential output shifts the curve to the left. Any event that increases the economy’s potential output shifts the curve to the right.

The Short-Run Aggregate Supply Curve In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied. A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

The Short-Run Aggregate Supply Curve Quantity of Output Price Level 0 Short-run aggregate supply Y1Y1 Y0Y0 2. Causes the level of output supplied to fall in the short run 1. A decrease in the price level P0P0 P1P1

Explaining the Positive Slope of the Short-Run Aggregate Supply Curve New classical misperceptions theory The Keynesian sticky-wage theory The new Keynesian sticky-price theory

The New Classical Misperceptions Theory Changes in the overall price level temporarily mislead suppliers about what is happening in the markets in which they sell their output. A lower price level causes misperceptions about relative prices. These misperceptions induce suppliers to decrease the quantity of goods and services supplied.

The Keynesian Sticky-Wage Theory Nominal wages are slow to adjust, or are ‘sticky’ in the short run. Wages do not adjust immediately to a fall in the price level. A lower price level makes employment and production less profitable. This induces firms to reduce production.

The New Keynesian Sticky- Price Theory Prices of some goods and services adjust sluggishly in response to changing economic conditions. An unexpected fall in the price level leaves some firms with higher-than- desired prices. This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

Why the Aggregate Supply Curve Might Shift Changes in factor (input) prices Changes in productivity Legal-institutional environment Expectations about the price level

Shifts in the Aggregate Supply Curve P1P1 Quantity of Output Price Level 0 Short-run aggregate supply, S 1 Y0Y0 S2S2 Y1Y1 Y2Y2 S3S3

Changes in Resource Prices Changes in the prices of domestic or imported resources change firms’ cost of production. An increase in input prices shifts the aggregate supply curve to the left. A decrease in input prices shifts the aggregate supply curve to the right.

Changes in Productivity An improvement in factor productivity allows firms to produce more at a lower cost. New technologies can increase the output per unit of labour or capital. The resulting decrease in production costs shifts the aggregate supply curve to the right.

Legal-Institutional Environment Taxes and government regulations can increase production costs and discourage firms from producing. The resulting increase in production costs shifts the aggregate supply curve to the left.

Expectations About the Price Level Current wages and prices often depend on expectations of the price level. A higher expected price level shifts the short-run aggregate supply curve to the left. A lower expected price level shifts the short-run aggregate supply curve to the right.

AD-AS and Long Run Equilibrium

Long-Run Equilibrium The intersection of the aggregate demand curve and the long-run aggregate supply curve determines the economy’s equilibrium output and price level. Output is at its ‘natural’ rate. The short-run aggregate supply curve passes through the point of intersection.

Long-Run Equilibrium Natural rate of output Quantity of Output Price Level 0 Equilibrium price Short-run aggregate supply Long-run aggregate supply Aggregate demand A

AD-AS and Economic Fluctuations Recession

A recession in the economy may have two causes. A decrease in aggregate demand. A decrease in aggregate supply.

A Decrease in Aggregate Demand A decrease in one of the determinants of aggregate demand shifts the curve to the left. Output falls below the natural rate of employment. Unemployment rises. The price level falls.

A Decrease in Aggregate Demand Quantity of Output Price Level 0 Short-run aggregate supply, AS 1 Long-run aggregate supply A P1P1 Y1Y1 Aggregate demand, AD 1 Y2Y2 AS 2 B C P2P2 P3P3 1. A decrease in aggregate demand… 2. Causes output to decline 3. But over time the SRAS curve shifts and output returns to its normal rate

A Decrease in Aggregate Supply A decrease in one of the determinants of aggregate supply shifts the curve to the left. Output falls below the natural rate of employment. Unemployment rises. The price level rises.

A decrease in aggregate supply Long-run aggregate supply Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A Y1Y1 P1P1 AS 2 B Y2Y2 P2P2

Possible Responses to Recession

Stagflation Adverse shifts in aggregate supply cause stagflation—a combination of recession and inflation. Output falls and prices rise. Policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously.

Policy Response Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

Accommodate the Negative AS Shift Long-run aggregate supply Short-run aggregate supply, AS 1 Quantity of Output Price Level 0 Aggregate demand A Y1Y1 P1P1 AS 2 B Y2Y2 P2P2 P3P3 C AD 2

Concluding Remarks The AD-AS model is a popular model used to explain and analyse economic fluctuations. The effects of shocks to the economic system can be modelled. We can also (next week) use the ADAS model to show the impact that government policies have on the system.

In Light of the Objectives of Today’s Lecture… We now know about: Economic fluctuations Short run and long run fluctuations How to build the AD-AS model How to use the AD-AS model to show the effects of various changes

Next Week Material Covered: Module Eight, Parts One and Two Reading: Chapters 17, 18 and 19 Topics: Monetary and Fiscal Policy and the Associated Debates This will be the last lecture of content. Lecture Twelve will be REVISION

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