Chapter 8 – Business Cycle AS/AD, (condensed)

Is the market economy of U.S. stable?How do we know?What can keep the economy stable?Government or Private Enterprise?

GDP 2007 to 2010

Stable or Unstable?

• Prior to the 1930s, conventional wisdom was a market-driven economy, which was inherently stable.– Business cycles (ups and downs in the economy)

were short-lived, and the market seemed to correct (regulate) itself.

– There was no need for government intervention – that is, the prevailing view dictated a policy of laissez faire..

• Laissez faire: the doctrine of “leave it alone,” of nonintervention by government in the market mechanism.

A Self-Regulating Economy

• Classical economics: the economy “self-adjusts” to any deviations from its long-term growth trend.– In this view, wages and prices are flexible.– If there are excess goods, the producer can

• Lower prices and sell more, eliminating excess goods.• Decrease output and lay off workers. Laid-off workers

compete for jobs by asking for lower wages. At lower wages, firms will hire more workers.

– This is the essence of Say’s Law.

A Self-Regulating Economy

Say’s Law: supply creates its own demand. Whatever was produced would be sold. All workers who sought employment would be

hired. This would occur because people have time to

adjust prices and wages downward. The economy therefore is self-regulating.

Macro Failure

• The self-adjustment mechanism did not work during the Great Depression.– John Maynard Keynes analyzed the situation

and concluded that self-adjustment could not occur because of “an insufficiency of effective demand.”

– He asserted that a market-driven economy was, in fact, inherently unstable.

• He concluded that the government must intervene by increasing aggregate demand.

Government Intervention

• For an underperforming economy, Keynes proposed that the government intervene to– By more output.– Employ more people.– Provide more income transfers.– Make more money available.

• For an overheated economy, Keynes proposed the opposite.– Higher taxes.– Spending reductions.– Reduce availability of money.

Business Cycle• The four parts of a modern

business cycle are– The peak, where GDP

maximizes.– Recession, where GDP

declines.– The trough, where GDP

minimizes.– Recovery, where GDP

increases.• These are variations

around a growth trend that slopes upward.

Terms Associated with the Business Cycle• Economic growth: real GDP grows faster

than 3%. Expansion.• Growth recession: real GDP grows, but

slower than 3%. The economy expands too slowly.

• Recession: real GDP contracts (for two or more consecutive quarters).

• Depression: an extremely deep recession.

What is Aggregate Demand? A schedule or curve showing amounts of

real output that buyers collectively desire to purchase at each possible price level.

Think: Why does AD slope downward?

Aggregate Demand

• Aggregate demand (AD): the total quantity of output (real GDP) demanded at alternative price levels in a given time period, ceteris paribus.– The collective behavior of all buyers in the

marketplace.– It comprises all goods and services.

• AD slopes downward; people will buy more goods and services at lower price levels, and vice versa.

Aggregate Demand (AD)

• Why does AD slope downward?– Real balances effect: the cash you hold is

worth more when the price level falls, so you can buy more.

– Foreign trade effect: lower price levels in the United States convince customers to buy more American goods and fewer foreign goods.

– Interest rate effect: lower interest rates promote more borrowing and more spending.

Effect on AD

Why an Increase in Price Level Reduces Quantity of

Real GDP Demanded

Why a Decrease in Price Level Raises Quantity of

Real GDP Demanded

Wealth

When P rises, consumers are poorer in real terms. This primarily decreases the demand for consumption goods.

When P falls, consumers are wealthier in real terms. This primarily increases the demand for consumption goods.

Interest Rate

When P rises, individuals save less, which increases the equilibrium interest rate. Higher interest rates reduce the quantity demanded of investment goods.

When P falls, individuals can afford to save more, which decreases the equilibrium interest rate. Lower interest rates increase the quantity demanded of investment goods.

International Trade

When P rises in the United States, all else equal, goods and services produced elsewhere are less expensive. Imports rise and exports fall so that net exports fall.

When P falls in the United States, all else equal, goods and services produced elsewhere are more expensive. Imports fall and exports rise so net exports fall.

ASSUMPTION for Aggregate demand IS: If Price level is decreasing, so are incomes.

Economy moves down its AD curve

Moves to lower price level

*remember circular flow model- (when consumers pay lower prices for goods and services – Less nominal income flows to resource suppliers .

Difference between Quantity of AD and Change of ADQAD = movement up or down as result of

price level changing (ONLY)

Change in AD =Change in any of the component parts of AD (C + I + G + Net Exports)

Shifts of Aggregate Demand

Curve shifts right or left according to stimuli.

These shifts come from any or all components of GDP (C, I, G, X-M)

DETERMINANTS OF AGGREGATE DEMAND

Change in Consumer Spending

•Consumer Wealth (people’s houses fell in value)

•Consumer Expectations (expect higher prices)• Interest rate (interest sensitive durables)

• Taxes

Think in aggregate terms

Changes in Investment Spending Real Interest Rates (rates high- not much I

taking place)

Expected Future Sales (health of economy- confidence is big)

Business Taxes (higher taxes less profit)

Government SpendingThis will be discussed further, but anytime

government spends, it has an affect on GDP.Infrastructure – Health CareSupplies for militaryEducationEtc.

Net Export Spending

National Income Abroad-(when foreign nations do well, their incomes are higher- can buy more U.S. goods and services. – U.S. exports rise)

Exchange Rates- Price of one nation’s currency in terms of another. Dollar vs EuroOur currency appreciates if it takes more foreign $ to buy it.. (depreciates if it takes more of ours to buy theirs.) $1.00 to $1.25 Euro.Depreciation of nation’s currency makes foreign goods more expensive (but attracts foreigners to buy our goods.) Our exports rise. *this is why the Fed has not worried about our low dollar valuation.

Factors That Change Aggregate Demand & Consumption/Interest Rates

Interest Rate ↑ → C↓ → AD↓ Interest Rate ↓ → C ↑ → AD↑

Factors That Change Aggregate Demand & Investment/ Interest Rates

Interest rates ↑ → I↓ → AD↓

Interest rates ↓ → I ↑ → AD↑

Factors That Change Aggregate Demand & Investment/ Business Taxes

Business taxes↑ → I↓ → AD↓

Business taxes↓ → I↑ → AD↑

Long-Run Equilibrium and the Price LevelFor the economy as a whole, long-run

equilibrium occurs at the price level where the aggregate demand curve (AD) crosses the long-run aggregate supply curve (LRAS).

Figure 10-5 Long-Run Economywide Equilibrium

OK… One more time…..Component parts of GDP?

C + I + G + (X-M) = GDP

Long-Run Aggregate Supply Curve (LRAS) A vertical line representing the real output of goods and

services after full adjustment has occurred

It represents the real GDP of the economy under conditions of full employment; the economy is on its production possibilities curve

The Production Possibilities and the Economy’s Long-Run Aggregate Supply Curve

Output Growth and the Long-Run Aggregate Supply Curve (cont'd) LRAS is vertical

Input prices fully adjust to changes in output prices

Suppliers have no incentive to increase output

Unemployment is at the natural rate

Determined by endowments and technology (or existing resources)

Output Growth and the Long-Run Aggregate Supply Curve (cont'd) Growth is shown by outward shifts of

either the production possibilities curve or the LRAS curve caused by

Growth of population and the labor-force participation rate

Capital accumulation

Improvements in technology

What does Long Run Equilibrium Mean? Economy is a full employment Any additional production would be

difficult to achieve. Economy operating at natural rate of

unemployment (anyone wanting job=have it.)

Equate the LRAS curve with bowed line on PPC.

To extend either would be to discover new resources – R&D

Full Employment

The condition that exists when the unemployment rate is equal to the natural unemployment rate.

Full productive capacity has been

Reached.

Image Cylinder= Economy…

Businesses, factories, economynot working at full capacity

Full Employment

AS AD

LRAS

SRAS (short run aggregate supply) Period where adjustment occurs.

Direct relationship

As the output increases that puts upward pressure on price.

Movement on the curve denotes the relationship between price level and real output.

SRAS………….Shift Shift in the curve denotes determinates

that affect more or less real output production at various price levels.

Determinants:Change in input prices (steel, plastic, wool change in resource availability )

Change in productivity (+ = Shift right; - = Shift left) (more for less is the object)

Change in legal environment (contracts, taxes, subsidies)

AD and SRAS

Long Run Aggregate Supply

Pric

e le

vel

Real domestic output, GDPQ

P LRASLR

Long-runAggregate

Supply

Qf

Full-Employment

RealRateOfInterest

Money Supply

D1

D2

Can a Change in Money Supply Change AD?Probably… but it is a chain of events.MS changes, then Interest Rates, then change in consumptionand investment. Then Change in AD

Aggregate Demand and Supply

Macro Equilibrium AS and AD summarize the

market activity of the macro economy.

Macro equilibrium: the combination of price level and real output that is compatible with both AD and AS. Where AD and AS intersect. … at PE and QE.

Macro Failures• Let QF be the goal of

full-employment GDP.• The equilibrium

output QE is undesirable; it does not reach our macro goal.

• Also, AD and AS can shift, meaning that any equilibrium can be unstable.

AS Shifts AS will shift left if

Business costs rise. Business taxes rise. Natural disaster occurs.

AS will shift right if Business costs fall. Business taxes fall. Bounteous harvests occur.

On the graph, AS shifts left away from full-employment GDP.

AD Shifts AD will shift left if

Sending decreases. Expectations get worse. Taxes increase.

AD will shift right if Spending increases. Expectations improve. Taxes decrease.

On the graph, AD shifts left away from full-employment GDP.

Short-Run Instability:Competing Theories

• Classical economists believe the economy will self-regulate and gravitate toward full employment.

• Keynes and his followers do not believe this. They believe the economy might get worse without government intervention.

• In addition, there are controversies about the shape of AS and AD and the potential to shift these curves.

Equilibrium States of the Economy

During the time an economy moves from one equilibrium to another, it is said to be in disequilibrium.

Short-Run Instability:Competing Theories

• Classical economists believe the economy will self-regulate and gravitate toward full employment.

• Keynes and his followers do not believe this. They believe the economy might get worse without government intervention.

• In addition, there are controversies about the shape of AS and AD and the potential to shift these curves.

Keynesian Theory

• This is a demand-side theory.• A recession originates with a deficiency of

spending.– AD is too far to the left.– Policy: increase government spending to shift

AD back to the right.• Inflation originates with an excess in

spending.– AD is too far to the right.– Policy: increase taxes to shift AD back to the

left.

Monetary Theory

• This is also a demand-side theory.– Emphasizes the role of money in financing AD.

• “Tight” money might cause AD to shift too far to the left.– Policy: increase money supply and lower interest

rates to shift AD back to the right.• “Easy” money might cause AD to shift too far

to the right.– Policy: decrease money supply and raise interest

rates to shift AD back to the left.

Supply-Side Theory

• A shift in AS to the left causes output and employment to decrease and inflation to increase.– This problem cannot be corrected by shifting

AD.• Shift AD right and unemployment falls but inflation

worsens.• Shift AD left and inflation is reduced but

unemployment rises.– Policy: devise ways to shift AS back to the

right.

Supply-Side Theories

LRAS

Goods & Services(real GDP)

Price level

P 100

YF

SRAS1

AD1

Unanticipated Increase in Aggregate Demand

In response to an unanticipated increase in AD for goods & services (shift from AD1 to AD2), prices will rise to P105 and output will temporarily exceed full-employment capacity (increases to Y2).

P 105

Y2

AD2

Short-run effects of an unanticipated increase in AD

LRAS1

Goods & Services(real GDP)

Price level

YF

AD

P 1

SRAS1

YF1

SRAS2

YF2

LRAS2

YF2 Here we illustrate the impact of economic growth due to

capital formation or a technological advancement, for example.

Both LRAS and SRAS increase (to LRAS2 and SRAS2); the full employment output of the economy expands from YF1 to YF2.

P 2

Growth in Aggregate Supply

A sustainable, higher level of real output and real income is the result. ***If the money supply is held constant, a new long-run equilibrium will emerge at a larger output rate (YF2) and lower price level (P2).

LRAS

Goods & Services(real GDP)

Price level

AD

YF

P 100

SRAS1 (Pr1)

AP 110

Y2 The higher resource prices shift the SRAS curve to the left; in

the short-run, the price level rises to P110 and output falls to Y2. What happens in the long-run depends on whether the

reduction in the supply of resources is temporary or permanent.

Effects of Adverse Supply Shock

If temporary, resource prices fall in the future, permitting the economy to return to its original equilibrium (A).

If permanent, the productive potential of the economy will shrink (LRAS shifts to the left) and (B) will become the long-run equilibrium.

SRAS2 (Pr2)

B

Pric

e Le

vel

Real Domestic Output, GDP

Q

P ASAD1

INCREASES IN AD: DEMAND-PULL INFLATION

P2

P1

AD2

Qf Q1 Q2

Pric

e Le

vel

Real Domestic Output, GDP

Q

P AS1

AD1

DECREASES IN AS: COST-PUSH INFLATION

P2

QfQ1

a

b

AS2

P1

Long run growth

P

Y

xP1

Yf 1

AD1

Yf 2

LRAS1

AS1

AS2

AD2LRAS2

P2

Consumergoods

Capitalgoods

PPC shif ts out andLRAS shif ts right.

Non-governmental actions that shift AS Shift AS left:

Raw materials cost rise Wages rise faster than productivity Worker productivity decreases Obsolescence Wars Natural disasters

Fiscal Policy Governmental actions that shift AD Shift AD right:

Govt spending increases Taxes decreases Money Supply increases

Shift AD left: G decreases T increases MS decreases