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Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001)

Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001). Ch. 14: Aggregate Demand and Aggregate Supply. Short-run. In the long-run the economy follows a trend line. From year to year, economy diverges from this trend.

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Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001)

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  1. Mankiw: Brief Principles of Macroeconomics, Second Edition (Harcourt, 2001) Ch. 14: Aggregate Demand and Aggregate Supply

  2. Short-run • In the long-run the economy follows a trend line. • From year to year, economy diverges from this trend. • Recessions are when the size of the economy shrinks for two quarters. • Unemployment rises during recessions. Econ 202 Dr. Ugur Aker

  3. Econ 202 Dr. Ugur Aker

  4. Econ 202 Dr. Ugur Aker

  5. Econ 202 Dr. Ugur Aker

  6. Economic Fluctuations • Economic fluctuations are irregular and unpredictable. • Business cycles do not follow similar periods. • The last recession was in 1991. • Before that we had recessions in 1970, 1974-75, 1980, and 1982. • Most macroeconomic variables move together. • When real GDP increases, so do consumption, home sales, imports, etc. • As output falls, unemployment increases. Econ 202 Dr. Ugur Aker

  7. Review of Long Run • Growth of GDP depends on resources (capital, labor) and technology. • Productivity growth determines improved standard of living. • Investments increase capital and technology and contribute to productivity growth. • Savings in an economy has to match the investments. The two are equated by real interest rate. Econ 202 Dr. Ugur Aker

  8. Review of Long Run • Unemployment is never zero. Full employment implies operating at the natural rate of unemployment. • Increases in the available money in an economic system lead to rising price level. • Inflation pushes up the nominal interest rate while real interest rate is determined as savings are matched with investments. • Trade balance and net foreign investment determine the real exchange rate. Econ 202 Dr. Ugur Aker

  9. Review of Long Run • Real variables do not get affected by monetary policies. • Real GDP • Real interest rates • Real savings • Real investments • Real exchange rates Econ 202 Dr. Ugur Aker

  10. Review of Long Run • Monetary policies affect nominal variables in the long run. • Price level • Inflation • Nominal interest rate • Nominal exchange rate • This is the classical dichotomy: money is neutral in the long run. Econ 202 Dr. Ugur Aker

  11. Short Run • Short run is the period when adjustment takes place from money supply increase to price level increase. • Short run can be as short as immediate or as long as a number of years. • During the short run monetary policies do affect real variables. • Short run will be discussed using aggregate demand and aggregate supply curves. Econ 202 Dr. Ugur Aker

  12. Short Run • Since in the short run both price level and real GDP respond, we will concentrate on their behavior using AD and AS. • AD shows total spending in the economy (C+I+G+NX) in the short run as the price level changes. • AS shows total output (Y) in the economy as the price level changes. Econ 202 Dr. Ugur Aker

  13. Aggregate Demand Curve • As the price level falls, the aggregate demand increases. • As P falls, C increases because of wealth effect. • The real value of bank accounts, loans you gave, contractual payments due to you increase. P Y Econ 202 Dr. Ugur Aker

  14. Aggregate Demand Curve • As the price level falls, the aggregate demand increases. • As P falls, I increases because of interest rate effect. • Lower P means lower demand for money. Households use their excess money to provide savings to the financial market. Interest rates fall. P Y Econ 202 Dr. Ugur Aker

  15. Aggregate Demand Curve • As the price level falls, the aggregate demand increases. • As P falls, NX increases because of exchange rate effect. • As P falls in the US, real exchange rate [¥/$(P$/P¥)] falls and stimulates exports and discourages imports. P Y Econ 202 Dr. Ugur Aker

  16. Aggregate Demand Curve P C+I+G+NX Y Econ 202 Dr. Ugur Aker

  17. Shifts in AD • Because AD is comprised of C+I+G+NX, any increase in one of these components will shift the AD to the right and any decrease in one of these components will shift the AD to the left. • Any increase (or decrease) in C or I or G or NX that is NOT RELATED to changes in the price level will shift the AD. Econ 202 Dr. Ugur Aker

  18. Changes in Consumption • If households decide to consume more at each and every level of prices because they are confident of the future of social security, the AD will shift right. • If social security taxes increase, thus reducing the disposable income of the households, AD will shift left. Econ 202 Dr. Ugur Aker

  19. Changes in Investment • If businesses become less confident about the future and postpone their expansion plans, investments fall and AD shifts left. • If the government passes an investment tax credit law, AD shift right. • If the Fed increases the money supply, thus lowering the interest rates in the short run, investments will be stimulated, shifting AD to the right. Econ 202 Dr. Ugur Aker

  20. Changes in Government Purchases • If Congress decides to increase the federal budget to pay more for the military or the states decide to increase their education budgets, G will increase, shifting AD to the right. • Reducing government spending will shift AD to the left. Econ 202 Dr. Ugur Aker

  21. Changes in Net Exports • If Mexico experiences rapid growth, it will increase its purchases of American goods and services, shifting AD to the right. • If war breaks out in the Middle East and investors flock to the US as a safe haven, the dollar appreciates and net exports fall, shifting AD to the left. Econ 202 Dr. Ugur Aker

  22. Aggregate Supply • Total quantity of goods and services firms produce at each and every price level. • Just like aggregate demand, the price level is measured on the vertical axis and GDP on the horizontal axis. • In the long run, the economy operates at full employment. • Regardless of the price level, an economy that operates at full employment will produce the constant amount. Econ 202 Dr. Ugur Aker

  23. Aggregate Supply P When the economy is operating at the full employment level, the output produced will not be affected by the price level. In the long run, it is the labor, capital and technology that determines the GDP. Y* Econ 202 Dr. Ugur Aker

  24. Aggregate Supply • Any force that shifts the Production Possibilities Frontier outward would shift the long run aggregate supply (LRAS) curve right. Capital goods P Consumption goods GDP Econ 202 Dr. Ugur Aker

  25. Shifts in LRAS • Change in Labor • Change in Capital • Change in Natural Resources • Change in Technology Econ 202 Dr. Ugur Aker

  26. Impact of Labor Changes • Immigration would shift LRAS right. • Emigration would shift LRAS left. • Drop in the natural rate of unemployment would shift LRAS right. • A large jump in minimum wage would raise the natural rate of unemployment and shift LRAS left. • If job searches become more efficient or if the unemployed search harder, the natural rate of unemployment would fall. Econ 202 Dr. Ugur Aker

  27. Impact of Capital Changes • An increase in the capital stock will shift the LRAS right. • An increase in the education levels of the population is an increase in human capital; it would shift the LRAS right. • Destruction or loss or obsoleteness of capital would shift LRAS left. Econ 202 Dr. Ugur Aker

  28. Impact of Natural Resources • Discovery of new resources would shift LRAS right. • Increase in the relative prices of raw materials would shift the LRAS left. • Climate change may shift the LRAS, too. Econ 202 Dr. Ugur Aker

  29. Impact of Technology • New machines, new ways of doing things, expanding international trade all improve technology. • Improvements in technology shift LRAS right. • Regulations that increase the cost of production shift the LRAS left. Econ 202 Dr. Ugur Aker

  30. Long Run Shifts in AD and AS AS1990 AS2000 Aggregate supply shifts to the right through time because of increases in capital, labor and technology. In the meantime, the growth of money supply shifts the AD to the right. As long as the growth rate of money supply exceeds the growth rate of the GDP, the price level will rise. AS1980 P2000 AD2000 P1990 P1980 AD1990 AD1980 Y2000 Y1980 Y1990 Econ 202 Dr. Ugur Aker

  31. Short Run Aggregate Supply • Contrary to LRAS, the short run aggregate supply curve is upward sloping. • During the short run, changes in the price level will affect the total output of the economy because the firms will respond to price level changes. • Remember that relative prices are not changing; it is the price level that is changing. Econ 202 Dr. Ugur Aker

  32. Explanations for SRAS Slope • The misperceptions theory. • Firms are more aware of their own markets than the general economy. A rise in the general price level may be interpreted as a favorable change for their industry. • Workers may view an increase in their nominal wages as a relative improvement and supply more labor even though their real wages haven’t changed. • Misperception arise from the difference between expected price level and the actual price level. Econ 202 Dr. Ugur Aker

  33. Explanations for SRAS Slope • The sticky-wage theory. • Firms negotiate nominal wages with their workers. • When firms negotiate nominal wages, they have designed the wage according to expected price level. • If the general price level rises, the real wage paid to the workers have fallen. • Firms’ cost of production falls and they produce more. Econ 202 Dr. Ugur Aker

  34. Explanations for SRAS Slope • The sticky-price theory. • Firms establish and announce their prices in accordance with an expected price level in the future. • Firms do not change their prices immediately to respond to changing conditions. • If the general price level has increased but some firms have kept their announced prices constant for a while, demand for their products will increase and production will increase as well. Econ 202 Dr. Ugur Aker

  35. Short Run Aggregate Supply Until the misperceptions are eliminated, or real wages adjust, or prices adjust the SRAS will be upward sloping. As soon as the adjustment is complete, the SRAS will become LRAS. In other words, once expected price level matches the actual price level, SRAS=LRAS. Econ 202 Dr. Ugur Aker

  36. Shifts in SRAS • Any force that shifts the LRAS curve will shift the SRAS in the same direction, as well. • The expected price level determines how the firms will set nominal wages or their own prices. • Any change in the expected price level will shift the SRAS. Econ 202 Dr. Ugur Aker

  37. Misperceptions and Expected Price Level • Firms expect price level to rise. • Firms observe their prices lagging behind the expected price level. • Their profits fall and firms cut down on production. Econ 202 Dr. Ugur Aker

  38. Sticky Wage and Expected Price Level • Firms expect price level to rise. • They raise the nominal wage. • At the moment the actual price level is lower than the expected price level. • The real wage the firm is paying is now higher. • Cost of production is higher. • Firms cut back on production at the same price level. Econ 202 Dr. Ugur Aker

  39. Sticky Price and Expected Price Level • Firms expect higher price level in the future. • They raise their own prices. • They lose customers. • They cut down on production. Econ 202 Dr. Ugur Aker

  40. Expected Price Level P Rise in expected price level Fall in expected price level Y Econ 202 Dr. Ugur Aker

  41. Long Run Equilibrium P LRAS SRAS AD Y Econ 202 Dr. Ugur Aker

  42. How the Economy Adjusts LRAS C or I or G or NX drops. AD shifts left. Y and P both drop. Expected price level falls. SRAS shifts right until long run equilibrium is reached. SRAS SRAS P1 P2 P3 AD AD Y1 Y2 Econ 202 Dr. Ugur Aker

  43. Policy Dilemmas • How long will the recession last? • Should the government wait for the economy to reach full employment on its own? • Should the government respond to the drop of the AD by stimulating AD? • If the government decides to interfere, should it be through monetary policy or fiscal policy? Econ 202 Dr. Ugur Aker

  44. Examples • During the Great Depression GDP fell by 27 percent and unemployment rose to 25 percent because of AD shift to the left. • Money supply decreased. • Wealth evaporated with the stock market crash and consumption fell. • Bank failures created a credit crunch and a fall in investments. • Increased protection brought international trade to a standstill: a technological calamity and a shift of LRAS to the left. Econ 202 Dr. Ugur Aker

  45. Examples • During WWII the government purchases increased five fold shifting AD to the right. • Unemployment fell. • Price level rose. • JFK engineered a shift of AD to the right to drag the economy out of recession. • Tax cuts increased consumption expenditures. Econ 202 Dr. Ugur Aker

  46. AS Shift When the costs of production increase for the economy, SRAS shifts to the left. Price level increases and GDP falls. The slack in the economy forces expected price level to fall and shifts the AS back. If the society complains too much about the stagflation, the government might stimulate the AD to bring the economy back to the long run equilibrium. LRAS SRAS P3 P2 P1 AD Y2 Y1 Econ 202 Dr. Ugur Aker

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