CHAPTER 8 “A Framework for Macroeconomic Analysis”

ECONOMICS: EXPLORE & APPLYby Ayers and Collinge CHAPTER 8“A Framework for Macroeconomic Analysis”

Learning Objectives • Contrast the perspectives of classical economist to those of Keynesians. • Describe how full-employment output can change. • Explain why the price level does not matter in the long run. • Interpret and apply the aggregate demand-aggregate supply model.

Learning Objectives 5. Relate the difference between demand-side and supply-side inflation in the long run. 6. (E&A) Interpret how the war against terrorism can cause both inflation and lower output, and ways in which these effects might be countered.

8.1KEYNESIAN SHORT-RUN AND CLASSICAL LONG-RUN PERSPECTIVE • When we answer macroeconomic questions about employment, output, and inflation we must provide near term events with a long-run perspective. • This context is called the long-run, which involves underlying economic forces that make themselves felt over time. • In contrast, the short run represents more immediate and transitory economic developments.

John Maynard Keynes • British economist who wrote “The General Theory of Employment, Interest and Money” in 1936. • Developed the emergence of macroeconomics as a field of analysis separate from microeconomics. • Offered a new short-run perspective that came to be known as Keynesian economics.

Keynesian Short-Run and Classical Long-Run Perspectives • Macroeconomic theory can be placed within two broad categories.. • Keynesian, which suggest that government action is an appropriate response to short-run macroeconomic problems; • Classical, which suggest that a steady policy aimed at the long-run best allows the economy to take care of itself.

The Phillips Curve • The Phillips curve is a graphical representation of data that depicted a distinct curvilinear tradeoff between low unemployment and low inflation during the 1960’s. • Data past the decade of the 1960’s shows no systematic relationship between unemployment and inflation.

The Phillips Curve Inflation Rate Phillips Curve Unemployment Rate

Rational Expectations • In the modern world, people are more likely to have rational expectations in which they can predict the implications of government policy action and thus cannot be systematically tricked. • With rational expectations, we keep up with the news analyses and base our expectations on the best information available to us. • The idea of rational expectations provides support to classical arguments that the government should step back and let the macroeconomy take care of itself.

8.2MODELING THE LONG RUN • A fundamental macroeconomic goal is is to obtain full-employment output, also termed full-employment GDP. • The existence of a natural rate of unemployment implies that the long-run tendency is towards full-employment GDP. • Actual real GDP in the U.S. has generally been close to the full-employment potential.

Long-Run Aggregate Supply • The economy supplies full employment output in the long run, no matter the price level. • Because the price level is irrelevant to the potential for full-employment output, long-run aggregate supply is always vertical. • The desire of people to receive income pushes unemployment down toward its natural rate which leads to full employment output in the long run.

Full-Employment GDP would fall Starting Full-Employment GDP Long-Run Aggregate Supply Long-Run Aggregate Supply Price Level The effect of fewer resources or poorer technology. Real GDP

Starting Full-Employment GDP Full-Employment GDP would rise Long-Run Aggregate Supply Long-Run Aggregate Supply Price Level The effect of more resources or better technology. Real GDP

Aggregate Demand Aggregate demand relates how much real GDP consumers, businesses, and government will purchase at each price level. Aggregate demand has a downward slope.

Aggregate Demand Aggregate demand slopes downward because: 1) consumers get more goods and services for each dollar they spend and, 2) consumers spend more money out of their current incomes because the lower price level increases the value of their savings. Price Level Aggregate Demand Real GDP

Aggregate Demand Price level decreases Aggregate purchases increase Price level increases Aggregate purchases decrease

Aggregate Demand • Purchasing power effect: A lower price level allows consumers to receive more goods and services for any given number of dollars they spend. • Wealth effect: A lower price level causes consumers to spend more money out of their current incomes because the lower price level increases the value of the money they have saved. • These two effects combined explain the inverse relationship between the price level and the quantity of GDP Demanded.

Long-Run Macro Equilibrium Long-Run Aggregate Supply Price Level A Too high Full-employment price level Aggregate Demand Too low GDP with Unemployment GDP with Overheating Real GDP Full-Employment GDP

8.3ROOT CAUSES OF INFALTION • Demand-pull inflation: When a rightward shift in aggregate demand moves the economy to both a higher output and a higher price level. • Cost-push inflation: When firms adjust their inflationary expectations downward, it may cause the economy to move up the aggregate demand curve to a point with higher prices and lower output.

New Equilibrium Demand side inflation Starting Equilibrium Demand Side Inflation Long-Run Aggregate Supply Price Level Aggregate Demand Full-Employment GDP Real GDP

Starting Equilibrium Demand side inflation New Equilibrium Demand Side Inflation Long-Run Aggregate Supply Price Level Aggregate Demand Full-Employment GDP Real GDP

Supply Side Inflation and Deflation • Changes on the supply side can also cause either inflation or deflation. • If long-run aggregate supply were to shift to the left, we would see supply side inflation in which the same amount of spending is able to buy fewer goods at higher prices. • Full employment GDP decreases as long-run aggregate supply shifts to the left.

Supply Side Inflation Long-run cost-push inflation Long-Run Aggregate Supply Cost-push inflation can arise from changes in employment practices that lead to higher real production costs. Price Level Aggregate Demand Full-Employment GDP Real GDP

Supply Side deflation New equilibrium Long-run cost-push inflation Long-Run Aggregate Supply Price Level Aggregate Demand Full-Employment GDP Real GDP

8.4CLASSICAL VERSUS KEYNESIAN • Economic analysis influences people’s politics. • Political Liberals often side with the Keynesian perspective which supports large government. • Political conservatives side with the Classical analysis which supports the more laissez faire approach.

8.5 EXPLORE & APPLYFighting Terrorism • As a result of the terrorist attack of 9/11/01, added security measures were imposed throughout the economy. • This meant that it was more expensive to do business. • The security industry prospered, as demand and prices went up in that line of work. • Numerous other industries suffered as they faced higher cost of production and slower deliveries of raw materials.

Higher security • cost shift LRAS left. Price level rises 2. The result is a change in the full employment equilibrium Fighting Terrorism Long-Run Aggregate Supply Price Level Aggregate Demand Full-Employment GDP Real GDP

Fighting Terrorism • This shift can be moderated or even offset by advances in technology. • To the extent that advances in monitoring cameras and scanning cameras can reduce the need for security personnel, the effect is to increase full-employment output, and shift AS to the right.

Fighting Terrorism • The 2001 terrorist attacks had a significant effect on the demand side of the economy. • The shock and uncertainty caused business to postpone new investment, and consumers to postpone new purchases. • The result was a leftward shift in aggregate demand.

First output and employment drop. Price level falls Second, the price level falls Fighting Terrorism Long-Run Aggregate Supply Price Level Aggregate Demand The long run Equilibrium moves lower Full-Employment GDP Real GDP

Fighting Terrorism • The question after the attacks was how long would it take for consumers to resume their former spending patterns. • The government took action by spending additional money to combat the terrorist. • Government also lowered borrowing cost, and increased the money supply

long run short run Keynesian Classical the Phillips Curve inflationary expectations adaptive expectations stagflation rational expectations full-employment output long-run aggregate supply aggregate demand Terms along the Way

purchasing power effect wealth effect full-employment output demand-side inflation supply-side inflation supply shock real business cycle supply side deflation Terms along the Way

Test Yourself • Full-employment GDP • must be equal to actual GDP. • must be less than actual GDP. • must be greater than actual GDP. • could be equal to, greater than, or even less than actual GDP.

Test Yourself 2. Because of the desire of people to have an income, the long-run tendency of the economy is to • move up and down with the business cycle. • produce the full employment level of output. • behave in unpredictable ways. • exhibit stable prices.

Test Yourself 3. “In the long-run we are all dead” is a statement that best expresses • Keynesian economics. • Classical economics. • both Keynesian and Classical economics. • neither Keynesian nor Classical economics

Test Yourself 4. The Phillips curve shows an inverse relationship between ______________ and _________. • inflation; unemployment • GDP; price level • supply-side inflation; demand side inflation • aggregate demand; aggregate supply.

Test Yourself 5. A graph of long-run aggregate supply would show the curve to be • upward sloping to the right. • downward sloping to the right. • vertical. • horizontal.

Test Yourself 6. The aggregate demand curve is ? • upward sloping to the right. • downward sloping to the right. • vertical. • horizontal.

The End! Next Chapter 9 “Inflation"

CHAPTER 8 “A Framework for Macroeconomic Analysis”