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National Income and Price Determination

National Income and Price Determination. Unit Goals: The student will be able to. Understand three keys facts about economic fluctuations Identify the determinants of aggregate demand and aggregate supply.

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National Income and Price Determination

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  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 Fluctuations 1 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. 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 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. 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 CAPITALTECHNOLOGICAL 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 • http://www.khanacademy.org/finance-economics/macroeconomics/v/long-run-aggregate-supply

  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 realwage means that a firm’s realcosts 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.

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