Chapter 9 “Short-Run Instability”

1. ECONOMICS: EXPLORE & APPLYby Ayers and Collinge Chapter 9“Short-Run Instability”

2. Learning Objectives • Explain why wages and prices might be slow to adjust downward, and what significance this can have. • Discuss how fiscal policy to stabilize the economy is subject to lags, and how the lags can be overcome automatically. • Explain how balancing the full-employment budget is consistent with a budget deficit. • Identify the characteristics, and significance of short-run aggregate supply.

3. Learning Objectives • Describe demand –pull and cost-push inflation, and how they can be part of an inflationary spiral. • Detail the differences between classical and Keynesian analysis. • (E&A) Analyze the rationale and limitations of deficit spending.

4. 9.1SHORT RUN STICKINES ALONG AD • Whenever there is an economic downturn, members of the press and the public call on government to do something about it. • The economic downturn of March 2001 led President Bush and Congress to to authorize the refunding of some tax payments back to the taxpayer in August that year. • There had been budget surpluses for the previous four years. • Taxpayers received up to $300 per person or $600 per couple.

5. Short Run Instabilities • Because of the shock of 9/11/01, instead of being energized, there was no discernable increase in consumer spending. • To bring the economy out of what appeared to be a deepening recession the President and Congress enacted $100 billion worth of new spending and tax cuts. • To correct short-run instabilities, Keynesians argue for government action, while classical economist emphasize that markets are capable of self-adjustment.

6. The Macro Policy debate Keynesians Take action to manage aggregate demand. Meaning to shift the aggregate demand curve itself.. Classicalist Wait for a movement along aggregate demand. The economy can self-adjust.

7. When a market is not in equilibrium, the forces of supply and demand will cause price to change until the equilibrium comes about. Wage and price adjustments will lead to a long-run macro equilibrium. The new long-run equilibrium is characterized by both full employment, and an associated full employment output. The Classical Analysis

8. Keynesians dismiss the classicalist analysis as irrelevant in the short run. Their rationale is the existence of downwardly sticky wages and sticky prices. Sticky refers to an inflexibility that makes it difficult for wages and prices to fall The stickiness can be due to labor contracts or human psychology. Rigidities exist in both labor markets and output markets. The Keynesian Analysis

9. Long-Run Macro Equilibrium Long-Run Aggregate Supply Wages and prices may be downwardly sticky preventing the economy from rapidly moving to a full-employment equilibrium. Price Level A Actual price level Full-employment price level Aggregate Demand Actual Output Full-Employment GDP Real GDP

10. Long-Run Macro Equilibrium Long-Run Aggregate Supply In the long-run prices will fall from point A to the full-employment output, but wage and price rigidity might prevent it from doing so in the short-run. Price Level A Actual price level Full-employment price level Aggregate Demand Actual Output Real GDP Full-Employment GDP

11. 9.2FISCAL POLICY TO STABILIZE THE BUSINESS CYCLE • Fiscal policy refers to the government’s policy toward taxing and spending. • Keynesians commonly advocate using expansionary fiscal policy (increased government spending or reduced taxation) to stimulate (shift) aggregate demand. • Shifting aggregate demand can also be accomplished through monetary policy • Monetary policy involves varying the quantity of money available to spend.

12. Expansionary fiscal policy is increased government spending or reduced taxes to stimulate AD. The economy starts at an unemployment equilibrium Aggregate demand Long-Run Aggregate Supply Price Level Fiscal Stimulus increases aggregate Demand. Current sticky price level. Starting Aggregate Demand Real GDP

13. Keynesians and Fiscal Policy • When the economy overheats – growing so fast that inflation threatens – government can use contractionary fiscal policy. • Both expansionary and contractionary fiscal policy are examples of discretionary policy. • Public Policy which is adjusted at the discretion of lawmakers.

14. Fiscal Policy Lags • Recognition Lag:It takes time to know that a recession is at hand. • Action Lag:Tax and spending bills are not passed overnight. • Implementation Lag: Planning government spending takes time. It also takes time before tax changes can take effect.

15. Keynesians and Fiscal Policy • Instead of discretionary policy, lawmakers can rely on automatic stabilizers. • Automatic stabilizers are components of existing fiscal policies that stimulate the economy when it is sluggish, and act as a drag when it overheats. • The U.S. has automatic stabilizers embedded within its system of of taxation and spending.

16. On the tax side.. Personal and corporate incomes fall during recession and so do U.S. personal and corporate income taxes. Alternatively, if the economy is booming, income taxes collect more revenue. No policy action is necessary. On the spending side.. Payments for welfare, unemployment, and other social programs rise when the economy slows, and provides a safety net for people. Conversely, this spending falls when the economy heats up. Again no policy action is necessary. Automatic Stabilizers

17. Balancing the Budget • If the economy is at full employment, fiscal policy should be neutral. • The neutral fiscal policy could generate a balanced budget (federal). • When the economy is overheating the government would run a budget surplus. • When economic health is poor, the government would choose a budget deficit.

18. 9.3THE SHORT-RUN ADKUSTMENT PROCESS • In the long-run aggregate supply is unaffected by the price causing it to be vertical. • Short-run aggregate supply, the amount of output the economy has to offer in the short-run will slope upward. • In the short-run the amount of output can exceed full employment GDP as workers offer to work overtime, or seek out extra jobs. • Conversely, if workers expect more inflation than actually occurs the work they would offer at the actual price level would be less than the full employment GDP.`

19. Long-Run Aggregate Supply Expected and Actual Price Level Aggregate Demand The Short-Run Aggregate Supply Short-Run Aggregate Supply slopes upward intersecting LRAS at the expected price level. Price Level Full-employment GDP Real GDP

20. Structural rigidities are one reason for the upward sloping SRAS curve. As new spending power is added to the economy, it tends to raise wages and prices where it first hits, before eventually diffusing throughout the economy. The production effect is the second reason for the upward sloping SRAS curve. When the price level rises and labor supply curves remain unchanged, firms can profit by increasing output and employment The Short-Run Aggregate Supply

21. Long-Run equilibrium Short_run unemploymentequilibrium The Short-Run Aggregate Supply Long-Run Aggregate Supply Short-Run Aggregate Supply slopes upward Price Level Expected Price Level Actual Price Level Aggregate Demand Actual GDP Full-employment GDP Real GDP

22. Types of Inflation • 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.

23. Short-Run Aggregate Supply Inflation Output Increases Stimulative Fiscal Policy Price Level The result is an increase in output along with demand-pull inflation. Aggregate Demand Real GDP

24. 2. Moving to full-employment equilibrium without causing inflation. 3. Stimulus in spending causes demand-pull inflation. Fiscal or Monetary Stimulus Long-Run Aggregate Supply Price Level Starting Aggregate Demand Aggregate Demand after Stimulus Real GDP 1. Output increases, but by less than was intended. Full-Employment Output

25. Cost–Push Inflation • Inflation could also arise from an upward shift in the short-run supply curve. • Because the short-run aggregate supply curve intersects long-run aggregate supply at the expected price level, a change in the expected price level will shift the short-run aggregate supply upward. • If the expected price level increases, short-run supply shifts vertically upward. • Likewise if the expected price level decreases , short-run supply shifts downward.

26. Cost Push Inflation Long-Run Aggregate Supply Short-Run Aggregate Supply Price Level Alternative expected price levels Whatever the expected price level may be that is where the short-run aggregate supply and LRAS intersect and long-run equilibrium occur. Full-employment GDP Real GDP

27. Cost Push Inflation • When aggregate supply shifts up, the economy moves up the aggregate demand curve to a point of higher prices and lower output. • Inflation that is caused this way is called cost-push inflation. • Cost push inflation reduces output and increases the price level.

28. 9.4SHORT-RUN PATHS TO LONG-RUN STABILITY • When stimulative government policy increases aggregate demand, the result can be an inflationary spiral. • An inflationary spiral is an ongoing sequence of demand-pull inflation, followed by cost-push inflation, as short-run aggregate supply shifts to reflect higher expectations of inflation.

29. The Inflationary Spiral Inflationary Spiral Long-Run Aggregate Supply Price Level Inflation Expanding Aggregate Demand Fluctuating Output Real GDP

30. SUMMARY OF CLASSICAL AND KEYNESIAN VIEWS CLASSICAL KEYNESIAN The focus is on the long run. The focus is on the short run.

31. SUMMARY OF CLASSICAL AND KEYNESIAN VIEWS CLASSICAL KEYNESIAN Prices and wages adjust upward without difficulty, but are downwardly sticky and thus unable to lead the economy from an unemployment equilibrium to full employment. Prices and wages will adjust upward or downward as needed to reach a full employment equilibrium.

32. SUMMARY OF CLASSICAL AND KEYNESIAN VIEWS CLASSICAL KEYNESIAN Government should actively adjust taxes and spending in order to manage aggregate demand. Government should not attempt to manage aggregate demand.

33. SUMMARY OF CLASSICAL AND KEYNESIAN VIEWS CLASSICAL KEYNESIAN Shortcoming: Remedying unemployment can lead to demand-pull inflation and possibly an inflationary spiral. Shortcoming: Remedying unemployment requires patience.

34. 9.5 EXPLORE & APPLYDeficits and Debt • Per capita debt for each U.S. citizen is over $21,000. • In 2002 the budget deficit was $106 billion, and the gross national debt stood at $6.14 trillion. • The national debt can be thought of as the stock or inventory of past accumulated debt, while deficit can be thought of as a flow that adds to that debt.

35. sticky wages sticky wages and prices unemployment equilibrium fiscal policy expansionary fiscal policy (fiscal stimulus) contractionary fiscal policy (fiscal drag) discretionary policy recognition lag action lag implementation lag automatic stabilizers balanced budget Terms along the Way

36. budget deficit budget surplus full-employment budget national debt short-run aggregate supply structural rigidities the production effect short-run macroeconomic equilibrium demand-pull inflation cost-push inflation inflationary spiral Terms along the Way

37. Test Yourself • When wages and prices are described as being sticky it is meant that they • adjust quickly. • adjust slowly. • never adjust. • do not need to be adjusted.

38. Test Yourself 2. An example of an automatic stabilizer is • the U.S. income tax system. • the Internet. • sticky wages. • the full-employment equilibrium.

39. Test Yourself 3. The federal budget deficit • has not existed since 1997. • is the accumulation of all federal debts. • equals the national debt minus the budget surplus. • is the amount by which government spending exceeds its revenue over the course of a year.

40. Test Yourself 4. Short-run aggregate supply always intersects long-run aggregate supply at • the expected price level. • the actual price level. • the long-run equilibrium price level. • an unemployment equilibrium.

41. Test Yourself 5. In an inflationary spiral, output • always rises. • always falls. • alternatively rises and falls.. • remains constant.

42. The End! Next Chapter 10 “Aggregate Expenditures"