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ECN 304 Chapter 24

ECN 304 Chapter 24. Determination of Income and Prices. Key Topics. Aggregate Demand Monetarist view: Y = (1/P) M x V shifter: M Keynesian view: Y = C + I + G + NX real balances exchange rates shifters: I, G, T, NX, M, expectations Crowding out: is it complete?

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ECN 304 Chapter 24

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  1. ECN 304 Chapter 24 Determination of Income and Prices

  2. Key Topics Aggregate Demand Monetarist view: Y = (1/P) M x V shifter: M Keynesian view: Y = C + I + G + NX real balances exchange rates shifters: I, G, T, NX, M, expectations Crowding out: is it complete? Aggregate Supply; shifters Equilibrium

  3. Aggregate Demand Definition The economy’s desired spending on all final goods and services at various price levels Yad = C + I + G + NX P Yad

  4. Aggregate Demand The Monetarist View Equation of Exchange: M x V = P x Y Y = (1/P) M x V For given M and V, increasing P by 20% reduces Y by 20% P Yad

  5. Aggregate Demand The Monetarist View: Shifters Y = (1/P) M x V Increasing M shifts the Aggregate Demand to the right P Yad

  6. Aggregate Demand The Keynesian View • Yad = C + I + G + NX • Consumption, C, depends on • real income, Y • expectations • interest rates • Business investment, I, depends on • expectations • interest rates

  7. Aggregate Demand The Keynesian View (cont.) • Yad = C + I + G + NX • Government spending, G, depends on • Congress’ decisions • Net eXports, NX = exports - imports, • domestic price level • foreign price level • exchange rate

  8. Aggregate Demand The Keynesian View: Slope • real balances effect • P  (M/P)i C, I, NX Yad • exchange-rate effect • P  (P/Pforeign) NX Yad

  9. Aggregate Demand The Keynesian View: Shifters • Government spending • G  Yad • Expectations • C, I  Yad • Taxes • T  (Y - T)  C  Yad

  10. Aggregate Demand The Keynesian View: Shifters • Money supply • M  i   I  Yad • Foreign price levels • Pforeign  NX  Yad

  11. The Crowding-Out Debate Monetarist Critique of Keynesian View • Monetarist view: • Only M can change aggregate demand • Increased G “crowds out” C, I, and NX completely • G  Yad   i C, I, NX  Yad • Keynesian view: crowding out is partial • In a recession, there may be crowding in.

  12. The Aggregate Supply Definition The quantity of final goods and services that the economy wants to sell at various prices, during a given period P Yas

  13. The Aggregate Supply Slope At higher prices, producers receive more profit per unit sold and are willing to produce more goods P Yas

  14. The Aggregate Supply Shifters • Wage rates • Other input costs • Technology • Taxes that affect MC • Taxes on profits P Yas

  15. Equilibrium: Short Run If Yad > Yas, P rises P Yas

  16. Aggregate Supply: Long Run The Natural Rate of Output • Labor supply = Labor demand • When inflation expectations are accurate P Yas Yn

  17. Aggregate Supply: Long Run • High Y creates wage inflation • Higher wages shift the aggregate supply curve • Wage inflation stops when Y = Yn P Yas Yn Long-run Aggr. Supply is vertical

  18. Views of theSelf-Correcting Mechanism • Activists (often Keynsians) • mechanism is slow, especially in recession • Keynes: “In the long run we are all dead.” • Nonactivists (often monetarists) • mechanism is quick • fiscal and monetary policy are slow and unreliable.

  19. Does the Natural Rate Change? Real business cycle theory • Quick adjustment to natural rate. • Changes in Y are due to changes in the natural rate, Yn. • Implies prices should rise during a recession, but they don’t.

  20. Does the Natural Rate Change? Hysteresis • Some unemployment becomes permanent. • unemploymenthomelessness • long periods of unemployment don’t look good on a résumé.

  21. The Phillips Curve Inflation Rate • Early view: stable curve • Modern view: expected inflation raises the Phillips curve. Unemployment Rate 0

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