1. National Income and Price
Determination

2. Unit Goals: The student will be able to . . .
Understand three keys facts about economic fluctuations
Identify the determinants of aggregate demand and aggregate supply.
Use the aggregate expenditure and the AD/AS models to analyze the economy and determine real output and price level.
Use the concept of the multiplier effect.
Explain the shortcomings of the AD/AS model including sticky wages and prices.

3. Unit Three: National Income + Price Determination
Aggregate demand
Determinants of aggregate demand
Multiplier and crowding-out effects
Aggregate supply
Short-run and long-run analyses
Sticky versus flexible wages and prices
Determinants of aggregate supply
Macroeconomic equilibrium
Real output and price level
Short and long run
Actual versus full-employment output
Business cycle and economic fluctuations

4. Three Keys Facts about Economic Fluctuations1
ECONOMIC FLUCTUATIONS ARE IRREGULAR AND UNPREDICTABLE
Fluctuations often called business cycle (periods of expansions and contractions)

5. Three Keys Facts about Economic Fluctuations
2 MOST MACROECONOMIC QUANTITIES FLUCTUATE TOGETHER
Real GDP monitors short-run changes in the economy
When real GDP falls in a recession, so do
Personal income
Corporate profits
Consumer spending
Investment spending
Industrial production
Retail sales
Home sales
Auto sales

6. Three Keys Facts about Economic Fluctuations
3 AS OUTPUT FALLS, UNEMPLOYMENT RISES
Changes in an economy’s output of goods and services are correlated with changes in the economy’s utilization of its labor force
Decrease in production = decrease in workers needed

7. The Basic Model of Economic Fluctuations
Focuses on the behavior of TWO variables 1. Economy’s output of goods and services as measured by real GDP 2. The overall price level as measured by the CPI Model of aggregate demand and aggregate supply: Used to explain short-run fluctuations in economic activity around its long-run trend Vertical axis – overall price level in the economy Horizontal axis – overall quantity of goods and services

8. Aggregate Demand (AD) Curve
Shows us the quantity of all goods and services that households, firms, and the government want to buy at any given price level

9. Aggregate Demand Curve
Downward sloping
Inverse relationship between the quantity of real output demanded and the price level
Lower price level = greater amount of output demanded
Higher price level = decreased amount of output demanded

10. Measures GDP Aggregate Demand GDP is the sum of C + I + G + (X-M)
1. Consumption – spending by domestic households on goods and services
2. Investment – spending by firms on capital equipment and by households on real estate or homes
3. Government spending – spending by governments on goods and services
4. Net Exports – exports minus imports
Measures GDP

11. The Aggregate Demand Curve
Downward sloping curve inversely related to the average price level
P = Average price level
Y = Real National Output Levels (rGDP)

12. ASSUME that government spending is fixed by policy The other three components of spending (consumption, investment, and net exports) depend on - Price level

13. Movement along the AD curve
A change in the price level of a nation’s output will lead to a movement along the AD curve and a change in the quantity of national output demanded.

14. Three reasons for the inverse relationship between the average price level (PL) and real national output (rGDP)
Wealth Effect
Interest-Rate Effect
Exchange-Rate Effect

15. The Price Level and Consumption: The Wealth Effect
Higher price levels reduce the purchasing power or the real value of the household’s wealth and savings The public feels poorer with higher price levels so they demand a lower quantity of the nation’s output.

16. The Wealth Effect
Lower price levels mean that your dollars become more valuable because you can buy more goods and services. Decrease in price levels makes consumers wealthier which encourages them to spend more.

17. The Price Level and Investment: The Interest-Rate Effect
Higher price levels will cause banks to raise the interest rates on loans.
At high interest rates, the quantity demanded of products and capital for which households and firms must borrow decreases.

18. The Interest-Rate Effect
Lower price levels cause households to invest in interest-bearing savings accounts or bonds. Banks will use this extra cash-flow to lower interest rates for other borrowers.

19. The Price Level and the Foreign Market: The Net-Export Effect
Higher price levels cause goods and services produced in a given country to become less attractive to foreign consumers and imports to become more attractive to domestic consumers.

20. The Net-Export Effect
Lower price levels in U.S. increase the amount of U.S. goods and services demanded from abroad and decreases the domestic demand for imports.

21. Question of the Day 11.28/11.29
When price levels in Japan decrease
Japan will sell more exports and purchase more imports.
Japan will sell less exports and purchase more imports.
Japan will sell less exports and purchase less imports.
Japan will sell more exports and purchase less imports.

22. Quick Summary
Three distinct but related reasons why a fall in CPI increases rGDP
1. Consumers are wealthier which stimulates the demand for consumption goods
2. Interest rates fall which stimulates the demand for investment goods.
3. The exchange rate depreciates which stimulates the demand for net exports.
These 3 are the reasons why the aggregate demand curve slopes downward, ceteris paribus.
Assumes that the money supply is fixed.

23. Shifts in the AD curve
To the right If C, I, G, or Net Exports increase To the left If C, I, G, or Net Exports decrease

24. Shifts arising from consumption
To the left – Americans become more preoccupied with saving rather than spending (AD decreases at every PL) Increasing taxes discourages spending (AD decreases at every PL) To the right – Stock market boom makes people wealthier and less concerned about saving (AD increases at every PL) Cutting taxes encourages spending (AD increases at every PL)

25. Shifts Arising from Investment
To the left – Firms are pessimistic about business conditions (AD will decrease at every PL) Repeal of an investment tax credit (AD will decrease at every PL) Decrease in money supply increases interest rate (AD will decrease at every PL) To the right – Computer company introduces the first touch screen and other companies want to catch up (AD will increase at every PL) Investment tax credit (AD will increase at every PL) Increase in money supply lowers interest rate (AD will increase at every PL)

26. Shift arising from Government Purchases
The most direct way that policy makers shift the AD curve is through government purchases. To the left – Congress decides to spend less on the military (AD will decrease at every level) State governments cut education spending (AD will decrease at every PL) To the right – Congress decides to purchase new weapons systems. (AD will increase at every PL) State governments build more highways (AD will increase at every PL)

27. Shifts arising from Net Exports
To the left – Europe experiences a recession (AD will decrease at every PL) Appreciation of U.S.D. (AD will decrease at every PL) To the right – Europe recovers from a recession (AD will increase at every PL) Depreciation of U.S.D. (AD will increase at every PL)

28. Quick Review
The three facts about economic fluctuation The three reasons that the AD curve is downward sloping The reasons why the AD curve might shift to the left or to the right HW: Complete quick quiz on p. 733

29. Question of the Day
Which of the following would switch the AD curve to the right?
Higher taxes
A recession
A government sponsored investment credit
Negative expectations
Appreciation of domestic currency
If we go off the “fiscal cliff” (an increase in taxes and a decrease in government spending), in which direction will the AD curve shift?
To the right
To the left
It will not shift but there will be movement along the curve.
I need more information.
To the right and to the left.

30. The Aggregate-Supply Curve
Illustrates the total quantity of goods and services that firms produce and sell at any given price level.
Unlike the AD curve (which is always downward sloping), the AS curve depends on the time period under examination

31. Short-Run VS. Long-Run AS
Short-run AS – upward sloping Long-run AS – vertical

32. Long-run AS Land Labor Capital Technological knowledge
In the long run, an economy’s production of goods and services (real GDP) depends on its supplies of
Land
Labor
Capital
Technological knowledge
PL does not affect these long-run determinants of real GDP.
Resources, not price, determine the total quantity of goods and services supplied.

33. ****Curve is vertical at natural rate of output*****
LONG-RUN AS
Based on classical macroeconomic theory that real variables (real GDP) do not depend on nominal variables (level of prices)
This works out over a period of years.
****Curve is vertical at natural rate of
output*****

34. LONG-RUN AS
“Natural rate of output” because it illustrates what the economy produces when employment is at its natural rate.
The Natural Rate of Output is the level of production toward which the economy gravitates in the long run.

35. Shifting the long-run AS Curve
Arise from changes in resources:
LAND
LABOR
CAPITAL TECHNOLOGICAL KNOWLEDGE

36. SHIFTS IN LRAS (LONG-RUN AGGREGATE SUPPLY
LABOR To the left - Increase in emigration (fewer workers) Congress raises minimum wage To the right – Increase in immigration (greater number of workers) Job-training program from the structurally unemployed

37. SHIFTS IN LRAS (LONG-RUN AGGREGATE SUPPLY
Land and Natural Resources To the left – Negative change in the weather pattern The destruction of a natural resource (rainforests) To the right – Discovery of oil, gold, etc. Positive change in weather pattern

38. SHIFTS IN LRAS (LONG-RUN AGGREGATE SUPPLY
Capital To the left – decrease in economy’s capital stock (amount) Less machines or less college degrees To the right – increase in economy’s capital stock (amount) More machines or more capital goods

39. SHIFTS IN LRAS (LONG-RUN AGGREGATE SUPPLY
Technological Knowledge To the left – Safety standards imposed on production To the right – Invention of the computer Industrial revolution

40. Long-Run Growth and Inflation
The two most important forces that can shift LRAS and AD are
Technology (shift LRAS to the right)
Fed increasing money supply (shift AD to the right)
Short-run fluctuations GDP and PL should be understood as deviations from the continuing long-run trends.

41. The Key Difference . . .
Between the economy in the short run and the economy in the long run is the behavior of aggregate supply.

42. Khan Academy

43. Question of the Day, Dec. 4 + 5
Please draw a long-term aggregate supply curve
On your graph, please show the impact of a hurricane that destroyed factories along the eastern seaboard.

44. The SRAS Curve
In the short run, the AS curve is upward sloping. Over a matter of months and even a couple of years, price levels impact supply. An increase in overall PL will increase supply. A decrease in overall PL will decrease supply.

45. WHY IS THE SRAS CURVE UPWARD SLOPING?
The Sticky-Wage Theory
The Sticky-Price Theory
The Misperceptions Theory
Three theories used to explain why the SRAS curve deviates from its long-term trend.

46. The Sticky-Wage Theory
Nominal wages are slow to adjust to price level changes. Wages are “sticky” in the short run. Prices decrease, a salaried employee will still make their salary for the duration of the contract. The effect: Higher real wage means that a firm’s real costs have risen. Firms will hire less and produce fewer goods and services. Decrease in supply.

47. The Sticky-Price Theory
Prices of some goods and services adjust slowly to changing economic conditions Adjustment is slow because of MENU COSTS (the cost of adjusting prices) Businesses announce prices based on expectations . What happens when the economy contracts? Some firms can react immediately, others lag behind. The effect: Sales will decline for those that lag They will have to cut back. Decrease in supply.

48. SRAS
Prices and wages might be sticky in the short run. Wages and prices – slow to adjust.

49. The Misperceptions Theory
Changes in overall price level can temporarily mislead suppliers about what is happening in their own individual market. Scenario: Overall price level falls below what is expected. A card maker might think that the price of cards has fallen RELATIVE to the rest of the market. The card maker might choose to make less cards. Workers might see a fall in their nominal wage before they notice price level changes. The reward to work is temporarily low and he/she may cut back on hours. Supply is decreased.

50. Summary
Three explanations for the upward sloping aggregate supply curve: Sticky Wages Sticky Prices Misperceptions Output deviates from its natural rate when the price level deviates from the price level that people expected.

51. The SRAS Curve
Tells us the quantity of goods and services supplied in the short run for any given level of prices. Upward sloping because of sticky wages, sticky prices, and misperceptions. What might shift the SRAS?

52. Shifting the SRAS
Everything that shifts the LRAS curve will shift the SRAS curve . . .
Influx of immigrants (LABOR)
Discovery of oil (LAND)
Faster computers (Capital)
Industrial Revolution (Technological knowledge)
AND . . .

53. Changes in unit labor costs: Unit labor costs are wage costs adjusted for the level of productivity. A rise in unit labor costs might be brought about by firms paying higher wages or a fall in the level of productivity
Commodity prices: Changes to raw material costs and other components e.g. the prices of oil, copper, rubber, iron ore, aluminum and other inputs will affect a firm’s costs
Exchange rates: Costs might be affected by a change in the exchange rate which causes fluctuations in the prices of imported products.
A fall (depreciation) in the exchange rate increases the costs of importing raw materials and component supplies from overseas

54. Government taxation and subsidies:
An increase in taxes to meet environmental objectives will cause higher costs and an inward shift in the SRAS curve
Lower duty on petrol and diesel would lower costs and cause an outward shift in SRAS
The price of imports:
Cheaper imports from a lower-cost country has the effect of shifting out SRAS
A reduction in a tariff on imports or an increase in the size of an import quota will also boost the supply available at each price level
The exchange rate affects how much a business must pay for imported raw materials and components

55. Expectations of price level.
When expectations change, the SRAS curve shifts.
An increase in the expected price level of business costs reduces the quantity of goods and services supplied and shifts the SRAS to the left.
A decrease in the expected price level of business costs raises the quantity of goods and services supplied and shifts the SRAS to the right.

57. Draw six graphs.
On the first, show a shift in AD to the right. Provide four reasons. On the second, show a shift in AD to the left. Provide four reasons. On the third, show a shift in LRAS to the right. Provide four reasons. On the fourth, show a shift in LRAS to the left. Provide four reasons. On the fifth, show a shift of SRAS to the right. Provide five reasons. On the sixth, show a shift of SRAS to the left. Provide five reasons.

58. December 6 + 7
Florida orange groves experience a prolonged period of below freezing temperatures. This will A. Shift the LRAS curve to the left. B. Shift the SRAS curve to the left C. Shift the AD curve to the right. D. All of the above. E. Only A + B are correct.

59. AD + AS
The basic tools to analyze fluctuations in the economy. Specifically, we can use AD + AS to examine the two basic causes of short-run fluctuations. We begin by assuming long-run equilibrium.

60. AD + AS
- Point A illustrates the natural rate of output for the economy
- SRAS passes through A (where AD meets LRAS) which means that wages, price, and perceptions have adjusted to this long-run equilibrium.

61. Two Causes of Economic Fluctuations
1. The Effects of a Shift in Aggregate Demand
2. The Effects of a Shift in Aggregate Supply
*Function of economics
* Problem solving

62. The Effects of a Shift in Aggregate Demand
Example:
A wave of pessimism occurs.
1. Households reduce spending
2. Delay major purchases
3. The impact: reduction in aggregate demand
4. At any price level, less is demanded
5. AD1 moves to AD2

63. Why?
A decrease in demand causes a decrease in SRAS – HOW? From Point B to A Output falls from Y2 to Y* Price level falls from P2 to P1 The falling level of output indicates That the economy is in a recession. Firms reduce employment The SRAS shifts to the left

65. The Role of Policymakers
How can the government help the economy avoid or recover from a recession?
Increase in government spending increases the quantity of goods and services demanded at any price.
Increase in money supply increases the quantity of goods and services demanded at any price.
Shift AD back to the right.

66. Without government intervention . . .
The recession will remedy itself over a period of time. Reduction in AD, prices fall. Expected price levels fall, as well (Alters wages, prices, perceptions) - Increase in SRAS. - Point A is reached along LRAS Output is back to its natural rate.

67. Review
In the short run, shifts in AD cause fluctuations in the economy’s output of goods and services. In the long run, shifts in AD affect the overall the price level but do not affect output.

69. Question of the Day, December 13 + 14
Assume that a nation is in long-run equilibrium. Draw a correctly labeled graph that shows LRAS, SRAS, and AD. Label the equilibrium output, Y1. Label the equilibrium price level, PL1. How will an appreciation of the nation’s currency shift demand? Please show your answer on a graph. Label the new equilibrium output Y2 and the new price level PL2.

71. You should know . . .
The three reasons why the AD curve slopes downward
Four changes that could shift the AD curve
Why the LRAS curve is vertical
The three reasons that the SRAS curve is upward sloping
Four changes that could shift the LRAS curve
Five changes that could shift the SRAS curve
The effects of a decrease is AD on SRAS
How policymakers can increase AD

72. AD: Should the government get involved?
The Multiplier Effect
The additional shifts in AD that result when expansionary fiscal policy increases income and thereby increases consumer spending.
Government purchases 20 billion dollars of Company X’s tanks and jets
Effects – Company X may hire more workers, pay its current workers more, and they will go out and spend $$.
Government spending increases spending in other sectors of the market

73. Formula for the Multiplier Effect
MPC – Marginal Propensity to Consume The fraction of extra income that a household consumes rather than saves. Example: MPC = ¾ For every extra dollar made, a household will spend 75 cents and save 25 cents. Company X earned 20 billion With a MPC of ¾ - consumer spending will increase by 15 billion.

74. AD: Should the government get involved?
The Crowding-Out Effect
-The offset in AD that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending
Increase in government purchases will raise the interest rate
20 billion to Company X
Incomes increase at Company X and those households that benefit from the multiplier effect.
As households choose to purchase more g + s, they demand their money in a more liquid form.
This increases the demand for money
Increase in income raises the demand for money.

75. The Crowding-Out Effect
The increase in the interest rate reduces the quantity of goods and services demanded. When the government increases its purchases by 20 billion, the AD for goods and services could rise by more or less than 20 billion, depending on whether the multiplier or crowding-out effect is larger.

76. A Shift in Aggregate Supply
SUPPLY SHOCK – An event that directly alter firms’ costs and prices, shifting the AS curve. Negative supply shocks: A drought kills the corn crop for two seasons, driving up the cost of food. A war in the Middle East reduces our access to oil, driving up the cost of oil. Positive Supply shocks: A sudden excess supply of oil Supply shocks are almost always negative: For any given price level, firms supply a smaller quantity of goods and services.

77. A leftward shift in supply, assuming that the economy is in long-run equilibrium

78. AS shifts . . . Output of economy is reduced AND Prices rise
STAGFLATION (a period of falling output and rising prices)

79. Stagflation: What should policy makers do?
DO NOTHING Or SHIFT AD to the Right

80. DO NOTHING?
Output remains depressed at Y2 Wages, prices, and perceptions will adjust to higher production costs. Period of low output and high unemployment puts downward pressure on workers’ wages. Lower wages increases the amount of output supplied. Over time, the SRAS shifts back to its natural rate.

81. Shift AD?
Increase spending Increase money supply Ad shifts to right to prevent the shift in AS from affecting supply. Prices increase but output remains the same. Policy makers accommodate the supply shift.

82. Shifts in AS
Can cause stagflation – recession and inflation Policymakers who can influence AD cannot offset both of these adverse effects simultaneously

83. Your Study Guide + Practice Test