ECO1000 Economics

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ECO1000Economics

• Lecture Ten, 2004

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Class Test Two Reminder for Internal Students

• Wednesday May 26, 5-8 pm
• 25 multiple choice questions
• Covers Lectures 6 10 (Chapters 7-16)
• Same deal as test one (online etc)

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Outline or Plan of Todays Lecture

• Material Covered Module Seven
• Reading Text Chapter 16
• Topics Aggregate Demand and Aggregate Supply

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Purpose or Objectives of Todays Lecture

• You will be able to
• Work with a key macroeconomic model
• Model changes in the economy due to changes
  economic variables
• Think about policy implications (in preparation
  for next weeks work)

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Economic Fluctuations
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What Are Economic Fluctuations?

• Economic fluctuations are the ups and downs in
  economic activity from year to year.
• In most years production of goods and services
  rises but in some years normal growth does not
  occur, causing a recession.
• A recession is a period of declining real GDP,
  falling incomes, and rising unemployment.
• A depression is a severe recession.

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Growth over time
Boom
Real GDP (b)
Recession
Years
Long term average
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(No Transcript)
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Characteristics of Economic Fluctuations

• Economic fluctuations are irregular and
  unpredictable.
• Most macroeconomic variables are related and
  fluctuate together.
• As output falls, unemployment rises and vice
  versa

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The Short Run and The Long Run
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How Long is the Long Run?

• The long run can be considered to be a period of
  at least several years.
• The short run is a period of about one to two
  years.
• This is a bit like asking, How long is the
  present? (i.e. When does the present become the
  future?)

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Incidentally the present lasts for as long as
you can hold the cube (below) in focus before it
transposes itself (back becomes front or vice
versa)
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In the Short Run the Long Run

• We have previously used two ideas classical
  dichotomy and money neutrality
• In the short run, it is now more or less accepted
  that real and nominal variables move together
• We need a new model with which to analyse short
  and long run economic fluctuations.

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Explaining the Fluctuations Using the AD-AS Model
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The Space in Which AD-AS is Mapped

• Two variables are used to develop a model to
  analyse the short-run fluctuations.
• The economys output of goods and services
  measured by real GDP.
• The overall price level measured by the CPI or
  the GDP deflator.
• AD-AS are plotted in output-price level space.

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Aggregate Demand and Aggregate Supply

• The aggregate demand curve shows the quantity of
  goods and services that households, firms, and
  the government want to buy at any price level.
• The aggregate supply curve shows the quantity of
  goods and services that firms choose to produce
  and want to sell at any price level.

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The Aggregate Demand Curve

• The four components of GDP (Y) contribute to the
  aggregate demand for goods and services.
• Y C I G NX

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The Aggregate Demand Curve
2. Leads to an increase in quantity demanded
P1
1. A decrease in the pricelevel
P2
Y2
0
Y1
3. And an increase in output
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Explaining the Negative Slope of the Aggregate
Demand Curve Three Theories

• Pigous wealth effect
• Keynes interest rate effect
• Mundell-Flemings exchange-rate effect

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Pigous Wealth Effect

• Consumers feel wealthier, which stimulates the
  demand for consumption goods.
• A decrease in the price level makes consumers
  feel more wealthy.
• This encourages them to spend more.
• The increase in consumer spending means a larger
  quantity of goods and services demanded.

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Keynes Interest-Rate Effect

• The lower the price level, the less money
  households need to hold to buy the goods and
  services they want.
• A lower price level reduces the interest rate,
  which encourages greater spending on investment
  goods.
• The increase in investment spending means a
  larger quantity of goods and services demanded.

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Mundell-Flemings Exchange-Rate Effect

• When the prices of domestic goods decreases, net
  exports increase.
• A fall in the Australian price level causes
  Australian interest rates to fall.
• The real exchange rate depreciates, which
  stimulates Australian net exports.
• The increase in net export spending means a
  larger quantity of goods and services demanded.

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Shifts in the Aggregate Demand Curve

• Shifts in the aggregate demand curve may arise
  because of changes in
• Private behaviour Changes in spending plans by
  consumers or firms.
• Public policy Changes in fiscal or monetary
  policy.
• Anything that causes buyers to want to purchase
  more or less than before will cause the aggregate
  demand curve to shift.

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Shifts in the Aggregate Demand Curve
P1
D2
0
Y1
Y2
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The Aggregate Supply Curve

• In the long run, the aggregate-supply curve is
  vertical.
• In the short run, the aggregate-supply curve is
  upward sloping.

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The Long-Run Aggregate Supply Curve

• The long-run aggregate supply depends on the
  economys resources and level of technology.
• The price level does not affect these variables
  in the long run.
• The long-run aggregate supply curve is vertical
  at the natural rate of output.

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The Long-Run Aggregate Supply Curve
Price Level
P1
P2
2. Does not change the natural rate of output in
the long run
1. A Change in the Price Level
0
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Shifts in the Long-Run Aggregate Supply Curve

• Any change in the factors that determine the
  long-run aggregate supply will cause the curve to
  shift.
• An event that reduces the economys potential
  output shifts the curve to the left.
• Any event that increases the economys potential
  output shifts the curve to the right.

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The Short-Run Aggregate Supply Curve

• In the short run, an increase in the overall
  level of prices in the economy tends to raise the
  quantity of goods and services supplied.
• A decrease in the level of prices tends to reduce
  the quantity of goods and services supplied.

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The Short-Run Aggregate Supply Curve
Price Level
P0
1. A decrease in the price level
2. Causes the level of output supplied to fall in
the short run
P1
Y1
Y0
0
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Explaining the Positive Slope of the Short-Run
Aggregate Supply Curve

• New classical misperceptions theory
• The Keynesian sticky-wage theory
• The new Keynesian sticky-price theory

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The New Classical Misperceptions Theory

• Changes in the overall price level temporarily
  mislead suppliers about what is happening in the
  markets in which they sell their output.
• A lower price level causes misperceptions about
  relative prices.
• These misperceptions induce suppliers to decrease
  the quantity of goods and services supplied.

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The Keynesian Sticky-Wage Theory

• Nominal wages are slow to adjust, or are sticky
  in the short run.
• Wages do not adjust immediately to a fall in the
  price level.
• A lower price level makes employment and
  production less profitable.
• This induces firms to reduce production.

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The New Keynesian Sticky-Price Theory

• Prices of some goods and services adjust
  sluggishly in response to changing economic
  conditions.
• An unexpected fall in the price level leaves some
  firms with higher-than-desired prices.
• This depresses sales, which induces firms to
  reduce the quantity of goods and services they
  produce.

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Why the Aggregate Supply Curve Might Shift

• Changes in factor (input) prices
• Changes in productivity
• Legal-institutional environment
• Expectations about the price level

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Shifts in the Aggregate Supply Curve
S3
Price Level
Short-run aggregate supply, S1
S2
P1
0
Y0
Y1
Y2
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Changes in Resource Prices

• Changes in the prices of domestic or imported
  resources change firms cost of production.
• An increase in input prices shifts the aggregate
  supply curve to the left.
• A decrease in input prices shifts the aggregate
  supply curve to the right.

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Changes in Productivity

• An improvement in factor productivity allows
  firms to produce more at a lower cost.
• New technologies can increase the output per unit
  of labour or capital.
• The resulting decrease in production costs shifts
  the aggregate supply curve to the right.

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Legal-Institutional Environment

• Taxes and government regulations can increase
  production costs and discourage firms from
  producing.
• The resulting increase in production costs shifts
  the aggregate supply curve to the left.

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Expectations About the Price Level

• Current wages and prices often depend on
  expectations of the price level.
• A higher expected price level shifts the
  short-run aggregate supply curve to the left.
• A lower expected price level shifts the short-run
  aggregate supply curve to the right.

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AD-AS and Long Run Equilibrium
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Long-Run Equilibrium

• The intersection of the aggregate demand curve
  and the long-run aggregate supply curve
  determines the economys equilibrium output and
  price level.
• Output is at its natural rate.
• The short-run aggregate supply curve passes
  through the point of intersection.

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Long-Run Equilibrium
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AD-AS and Economic Fluctuations

• Recession

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Recession

• A recession in the economy may have two causes.
• A decrease in aggregate demand.
• A decrease in aggregate supply.

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A Decrease in Aggregate Demand

• A decrease in one of the determinants of
  aggregate demand shifts the curve to the left.
• Output falls below the natural rate of
  employment.
• Unemployment rises.
• The price level falls.

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A Decrease in Aggregate Demand
3. But over time the SRAS curve shifts and output
returns to its normal rate
2. Causes output to decline
AS2
A
P1
1. A decrease in aggregate demand
B
P2
P3
C
0
Y1
Y2
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A Decrease in Aggregate Supply

• A decrease in one of the determinants of
  aggregate supply shifts the curve to the left.
• Output falls below the natural rate of
  employment.
• Unemployment rises.
• The price level rises.

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A decrease in aggregate supply
Long-run aggregate supply
AS2
Short-run aggregate supply, AS1
B
P2
A
P1
Aggregate demand
0
Y1
Y2
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Possible Responses to Recession
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Stagflation

• Adverse shifts in aggregate supply cause
  stagflationa combination of recession and
  inflation.
• Output falls and prices rise.
• Policymakers who can influence aggregate demand
  cannot offset both of these adverse effects
  simultaneously.

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Policy Response

• Policymakers may respond to a recession in one of
  the following ways
• Do nothing and wait for prices and wages to
  adjust.
• Take action to increase aggregate demand by using
  monetary and fiscal policy.

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Accommodate the Negative AS Shift
Long-run aggregate supply
AS2
Short-run aggregate supply, AS1
C
P3
B
P2
A
P1
AD2
Aggregate demand
0
Y1
Y2
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Concluding Remarks

• The AD-AS model is a popular model used to
  explain and analyse economic fluctuations.
• The effects of shocks to the economic system can
  be modelled.
• We can also (next week) use the ADAS model to
  show the impact that government policies have on
  the system.

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In Light of the Objectives of Todays Lecture

• We now know about
• Economic fluctuations
• Short run and long run fluctuations
• How to build the AD-AS model
• How to use the AD-AS model to show the effects of
  various changes

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Next Week

• Material Covered Module Eight, Parts One and Two
• Reading Chapters 17, 18 and 19
• Topics Monetary and Fiscal Policy and the
  Associated Debates
• This will be the last lecture of content.
• Lecture Twelve will be REVISION

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THE END