Combined Chapters

1. Combined Chapters Aggregate Supply/Aggregate Demand Fiscal Classical/Keynesian Multiplier

2. CHAPTER 10-Real GDP and PL in Long Run

3. GDP 2007 to 2010

4. OK… One more time….. Component parts of GDP? C + I + G + (X-M) = GDP Long-Run Aggregate Supply Curve (LRAS) • A vertical line representing the real output of goods and services after full adjustment has occurred • It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

5. The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve

6. Output Growth and the Long-Run Aggregate Supply Curve (cont'd) LRAS is vertical Input prices fully adjust to changes in output prices Suppliers have no incentive to increase output Unemployment is at the natural rate Determined by endowments and technology (or existing resources)

7. Output Growth and the Long-Run Aggregate Supply Curve (cont'd) Growth is shown by outward shifts of either the production possibilities curve or the LRAS curve caused by Growth of population and the labor-force participation rate Capital accumulation Improvements in technology

8. Think: Why does AD slope downward? Vertical axis represents Price level for ALL final goods And services The aggregate price level Is measured by either GDP Deflator or CPI Price level The horizontal axis represents the real quantity of all G&S purchased as measured by the level of REAL GDP AD Real domestic output, GDP

9. Figure 10-4 The Aggregate Demand Curve As the price level rises, real GDP declines

10. ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes.

11. There are 3 Reasons that cause the Aggregate Demand Curve to be downward sloping. Real Balance Effect (Wealth effect) Interest Rate Effect International Trade Effect

12. Real Balance Effect • Price level falls- causes purchasing power to rise… translates into more money to spend or monetary wealth improves. • Real Balance Effect (or wealth effect) – Higher price level means less consumption spending.

13. Real Balance Effect The change in the purchasing power of dollar- Relates to assets that result from a change in the price level

14. Interest Rate Effect • Inverse relationship between price level and quantity demanded of GDP – because households and businesses adjust to interest rates for those interest-sensitive purchases. • Price level falls (bundle of goods costs less) rest of money into savings, more money available for borrowing interest rate down. • Think of money as stationary… demand drives up price of money.

15. Interest Rate continued • Now if bundle of goods increases… want to purchase interest sensitive good, cost to borrow is up. • An increase in money demand will drive up the price paid for its use … use of money = interest rate • As price level rises, houses and firms require more money to handle transactions…

16. International Trade Effect (Open Economy Effect) FYI: An open economy is global, a closed economy is domestic. The Open Economy Effect Higher price levels result in foreigners’ desiring to buy fewer American-made goods while Americans desire more foreign-made goods (i.e., net exports fall). Equivalent to a reduction in the amount of real goods and services purchased in the U.S. When Demand for exports decreases, this is an unfavorable balance of trade (imports exceed exports)

17. Macro AD vs Micro D Aggregate Demand versus Demand for a Single Good When the aggregate demand curve is derived, we are looking at the entire circular flow of income and product. When a market demand curve is derived, we are looking at a single product in one market only.

18. Change in QAD and Change in AD What is the difference? PL PL A B AD 2 AD1 GDP GDP

19. DETERMINANTS OF AGGREGATE DEMAND Change in Consumer Spending Consumption • Consumer Wealth • Consumer Expectations (expect higher prices) • Interest rate (interest sensitive durables) • Taxes

20. Changes in Investment Spending • Real Interest Rates (rates high- not much I taking place) • Expected Future Sales (health of economy- confidence is big) • Business Taxes (higher taxes less profit)

21. Government Spending This will be discussed further, but anytime government spends, it has an affect on GDP. Infrastructure – Health CareSupplies for military Education Etc.

22. Net Export Spending • National Income Abroad-(when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. – U.S. exports rise) • Exchange Rates- Price of one nation’s currency in terms of another. Dollar vs Euro • Our currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro. • Depreciation of nation’s currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.

23. Long-Run Equilibrium and the Price Level For the economy as a whole, long-run equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).

24. Figure 10-5 Long-Run Economywide Equilibrium

25. SRAS Period where adjustment occurs.

26. AD and SRAS

27. Real Rate Of Interest D2 D1 Money Supply Can a Change in Money Supply Change AD? Probably… but it is a chain of events.MS changes, then Interest Rates, then chance in consumption and investment. Then Change in AD

28. Long Run Aggregate Supply P LRASLR Price level Long-run Aggregate Supply Full-Employment Q Qf Real domestic output, GDP

29. Price level LRAS SRAS1 Short-run effects of an unanticipated increase in AD P P 100 105 AD2 AD1 Goods &Services(real GDP) Y Y F 2 Unanticipated Increase in Aggregate Demand • In response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2).

30. LRAS1 LRAS2 Price level SRAS1 SRAS2 P P 1 2 AD Goods &Services(real GDP) Y Y Y Y F2 F2 F1 F Growth in Aggregate Supply • Here we illustrate the impact of economic growth due to capital formation or a technological advancement, for example. • Both LRAS and SRASincrease (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2. • A sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2).

31. Price level LRAS SRAS2 (Pr2) SRAS1 (Pr1) B A P P 100 110 AD Goods &Services(real GDP) Y Y F 2 Effects of Adverse Supply Shock • The higher resource prices shift the SRAS curve to the left; in the short-run, the price level rises to P110 and output falls to Y2. • What happens in the long-run depends on whether the reduction in the supply of resources is temporary or permanent. • If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A). • If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium.

32. INCREASES IN AD: DEMAND-PULL INFLATION P AS AD1 AD2 P2 Price Level P1 Q Q2 Q1 Qf Real Domestic Output, GDP

33. DECREASES IN AS: COST-PUSH INFLATION AS2 P AS1 b P2 Price Level a P1 AD1 Q Q1 Qf Real Domestic Output, GDP

35. Non-governmental actions that shift AS • Shift AS left: • Raw materials cost rise • Wages rise faster than productivity • Worker productivity decreases • Obsolescence • Wars • Natural disasters

36. Fiscal Policy • Governmental actions that shift AD • Shift AD right: • Govt spending increases • Taxes decreases • Money Supply increases • Shift AD left: • G decreases • T increases • MS decreases

37. Chapter 11 Classical vs. Keynesian

38. CLASSICAL BELIEVES:Markets will behave according to S&D. In other words. S&D will respond accordingly to “Inflationary Gap, Recessionary Gap, and long run stability when all curves intersect.

39. Basic Macroeconomic Relationships Say’s Law How Classical Works (or not) Interest Rate and Investment Income and Consumption (or savings) Changes in spending and changes in output

40. SAY’S LAW Economists agree Says law works in Barter economy and disagree about if it works in a money economy. Supply creates its own demand… baker bakes enough bread to trade for what he wants. That works. Classical economics believes it works in money economy and here is why.

41. The Classical Model (cont'd) Classical economists—Adam Smith, J.B. Say, David Ricardo, John Stuart Mill, Thomas Malthus, A.C. Pigou, and others—wrote from the 1770s to the 1930s. They assumed wages and prices were flexible, and that competitive markets existed throughout the economy.

42. The Classical Model (cont'd) Assumptions of the classical model Pure competition exists. Wages and prices are flexible. People are motivated by self-interest. People cannot be fooled by money illusion.

43. The Classical Model Consequences of The Assumptions If the role of government in the economy is minimal, If pure competition prevails, and all prices and wages are flexible, If people are self-interested, and do not experience money illusion, Then problems in the macroeconomy will be temporary and the market will correct itself.

44. Classical Theory Classical economists believed that prices, wages and interest rates are flexible. Say’s law says when economy produces a certain level of real GDP, it also generates the income needed to purchase that level of real GDP.) hence, always capable of achieving the natural level of GDP. Fallacy here: no guarantee that the income received will be used to purchase g & s.----some will be saved. But theory would be redeemed, if the savings goes into equal needed amounts of investment.

45. Classical belief on wages and prices • Believed all markets competitive- (S&D * Key) – adjust to surplus and shortage…. • If oversupply of labor, wage rates drop and S&D of labor will be in sinc. • What holds for wages also applies to prices. • Prices adjust quickly to surplus or shortages • Equilibrium established again.

46. Three States of the Economy • Real GDP is less than Natural Real GDP (recessionary gap) • Real GDP is more than Natural Real GDP (inflationary gap) • Real GDP is equal to Natural Real GDP. What is Natural Real GDP? Real GDP that is produced at the natural unemployment rate. (which we agree around 5%)

47. Key: Wage rates and prices will adjust quickly to surplus or shortage In recession- unemployment rate higher than natural rate. Surplus exists in labor market Drives down wage rate++++++++++++++ 4) In inflationary gap, unemployment lower than natural rate 5) Shortage exists in labor market 6) Drives up the wage rate

48. Effect of a Decrease in Aggregate Demand in the Classical Model

49. BOTH THEORIES CLASSICAL AND KEYNESIAN DO AGREE…… TWO THINGS WE CAN DO WITH DISPOSABLE INCOME- SPEND OR SAVE! We all know that consumption is 2/3 (or more) of GDP

50. ***Classical theorists say, the funds from aggregate savings eventually borrowed and turned into investment expenditures which are a component of real GDP BUT…. What if no or low savings? Theory breaks down here – have to have equal amounts of investment for savings. (the idea here is that savings leads to investment) This is true… but it probably won’t do it by itself. Needs assistance through monetary or perhaps fiscal policy.