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EC4004 LECTURE 19
Aggregate Supply & Supply crises
Stephen [email protected]
LAST TIMEAggregate Demand:
AD = C + I + G + X-M
TODAY.Aggregate Supply & Aggregate Demand (Cht 20)
NEWS.
China, US, EU out of recession thanks to stimulus programmes.Read www.irisheconomy.ie, Philip Lane’s posts; Read Ronanlyons.com. Live Register decreased from 425,500 in September to 422,500 in October, a fall of 3,000.. 1st fall since Jan. 2007, when the total was 156,600, and may reflect a rise in emigration.
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FROM LAST TIMEAggregate Demand:
AD = C + I + G + X-M
Increase in C,I, G, (X-M)
Increase in the aggregate demand curve
SHIFTS IN THE AGGREGATE DEMAND CURVE
Inflation
Real National Income
AD
2.0%
Y1U = 5%
Shifts in AD will be caused by changes in
factors affecting C, I, G and (X-M) (exogenous
factors) e.g. increasing income
tax rates affect consumption
AD2
Y2U = 2%
Any exogenous factor causing C,
I or G to rise, or a trade surplus
causes a shift to the right in AD
This would cause a rise in national
income (economic growth) and lead to
a fall in unemployment (U = 2%) (and vice versa)
CHANGES IN AD: CONSUMPTION
Exogenous factors affecting consumption:Tax rates
Incomes – short term and expected income over lifetimeWage increasesCreditInterest ratesWealth
PropertySharesSavingsBonds
CHANGES IN AD: INVESTMENT
Spending on:
Machinery
Equipment
Buildings
Infrastructure
Influenced by:
Expected rates of return
Interest rates
Expectations of future sales
Expectations of future inflation rates
CHANGES IN AD: GOVERNMENT
Defence
Health
Social Welfare
Education
Foreign Aid
Regions
Industry
Law and Order
KEY VARIABLES
(Write these down)
Inflation
Growth
Unemployment
Balance of Payments (X-M)
KEY POLICIES
Monetary Policy
Don’t have one. (ECB)
Fiscal Policy
Government spending & government income (taxes & borrowing)
Supply-Side Policy
Aggregate supply. Next lecture!
NOW. AGGREGATE SUPPLY
AS: CAPACITY OF THE ECONOMY
Depends on
Costs of Production
Technology
Education and Training
Incentives
Tax regime
Capital stock
Productivity
Labour Market
AGGREGATE SUPPLYInflation
Real National Income
The shape of the AScurve is important in
determining the outcome in the economy
AS
Yf
This shape reflects a Keynesian view of the AS curve.
Yf represents ‘Full Employment Output’ –
at this point the economy is working to full capacity and cannot
produce any more.
Y1
An output level of Y1 would suggest the
economy is working below full capacity and
there would be widespread
unemployment.Economy starts to overheat
Between Y1 and Yf, increases in capacity are possible but the nearer the economy gets to Yf,
the more problems are experienced with acquiring
resources to boost production (production bottlenecks) especially labour skills
shortages.
AGGREGATE SUPPLYInflation
Real National Income
AS1 AS2
Yf1 Yf2
Increases in capacity can occur
as a result of a shift in AS (akin to a shift outwards of
the Production Possibility Frontier)
(PPF)
AGGREGATE SUPPLYInflation
Real National Income
SRAS
Short run aggregate supply (SRAS)
assumes firms only able to increase output at higher
costs (e.g. overtime payments) thereby pushing up price
level
SRAS 1
SRAS 2
SRAS assumes costs such as
overall wage rate remain fixed,
changes in such costs cause a shift in the SRAS curve
(exogenous shocks – input
costs)
AGGREGATE SUPPLYInflation
Real National Income
LRASClassical
economists assume the long run
aggregate supply curve (LRAS) is
vertical (perfectly inelastic).
This is because they believe that in the long
run, there will be no unemployment of resources because
markets will clear, thus whatever the rate of
inflation, firms will supply the maximum capacity of
the economy.
Yf
AGGREGATE SUPPLY
For our analysis, we will assume the AS
curve looks like this!
Inflation
Real National Income
AS
PUTTING AD AND AS TOGETHER
Inflation
Real National Income
AS
Yf
AD
2.0%
Y1
In this situation, the economy would be
operating at less than capacity, there would be unemployment and the
economy might be growing only slowly.
AD 1
Y2
2.5%
A shift in the AD curve to AD1 as a result of a
change in any or all of the factors affecting AD would increase growth, reduce unemployment but at a cost of higher inflation (a trade-off)
Putting AD and AS togetherInflation
Real National Income
AS
Yf
AD
2.0%
Y1
AD1
Y2
2.5%AD2
3.5%
Further increases in AD would lead to
successively smaller increases in growth
and employment at the cost of ever higher
inflation.
Y3
SUSTAINED GROWTH
Inflation
Real National Income
AD
AS
2.0%
Y1
AS1
Y2
AD2
Sustained growth (not to be confused
with sustainable economic growth)
occurs when AS and AD rise at similar rates – national income can rise
without effects on inflation
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HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND
!Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.
!Fiscal policy influences saving, investment, and growth in the long run.
!In the short run, fiscal policy primarily affects the aggregate demand.
!Fiscal policy can be used to alter government purchases or to change taxes.
CHANGES IN GOVERNMENT PURCHASES
!There are two macroeconomic effects from the change in government purchases: !
!The multiplier effect
!The crowding-out effect
THE MULTIPLIER EFFECT
Aggregate demand, AD1
Quantityof Output
0
PriceLevel
AD2 1. An increase in government
purchases of !20 billion initially increases aggregate demand
by !20 billion…
!20 billion
AD3
2. …but the multiplier effect can amplify the shift in aggregate demand.
THE CROWDING-OUT EFFECT
Fiscal policy may not affect the economy as strongly as predicted by the multiplier.
An increase in government purchases causes the interest rate to rise.
A higher interest rate reduces investment spending.
THE CROWDING-OUT EFFECT
When the government increases its purchases by "20 billion, the aggregate demand for goods and services could rise by more or less than "20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.
AUTOMATIC STABILIZERS
Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.
Automatic stabilizers include the tax system and some forms of government spending.
FINALLY.
FROM WWW.PROGRESSIVE-ECONOMY.IE:SOME HOME TRUTHS
SOME HOME TRUTHS• Ireland’s bloated public sector: Before the current
recession Ireland’s government spending as a proportion of GDP was the lowest of any economy in the Euro Area, 33.6% in the years 2002-2006, compared to a Euro Area average of 47.4% . France, Belgium and Austria, have a public sector which is proportionately 1# times greater than Ireland, at over 50% of GDP.
• There is no scope to raise taxes: In the same 2002-2006 period Ireland’s tax take was also the lowest of any Euro Area economy, at 34.9% of GDP compared to Euro Area average of 44.9% of GDP.
• Ireland has a uniquely high level of public debt:
• Ireland’s public debt level will rise to 96.2% of GDP in 2011, compared to 135.4% for Greece, 117.8% for Italy, 104% for Belgium and a Euro Area average of 88.2%.
• There’s no scope for fiscal stimulus: Ireland’s output gap relative to potential GDP is expected to be up to 8.5% of GDP in 2009 and will still be as high as 5.4% of GDP in 2011, the largest in the Euro Area and compared to averages for the Euro Area as a whole of 3.6% this year and 2.5% in 2011.
• Ireland has become uncompetitive internationally: 2002-2006, price deflator for Ireland’s exports fell at an annual average rate of 2.7% and the price deflator for imports fell at an annual average rate of 2.3%, compared to Euro Area average rises of 0.5% and 0.7%. Ireland’s growth of per capita labour productivity was an annual average 2.2% compared to just 1.2% for the Euro Area, and 1.6% for Britain and 2.1% for the US
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WRITE DOWN2 THINGS YOU
REMEMBER FROM TODAY.
SUMMARY
Aggregate Demand
& Aggregate Supply
Fiscal Policy
Some home truths from TASC Blog.