NATIONAL INCOME AND PRICE DETERMINATION

1. NATIONAL INCOME AND PRICE DETERMINATION

2. Shifters of Aggregate Demand AD = C + I + G + X Change in Consumer Spending Change in Government Spending Change in Investment Spending Net EXport Spending Shifters of Aggregate Supply AS = I + R + A + P Change in Inflationary Expectations Change in Resource Prices Change in Actions of the Government Change in Productivity (Investment) 2

3. Answer and identify shifter: C.I.G.X or I.R.A.P B A D A D B A A C A major increase in productivity. A 3

4. Putting AD and AS together to get Equilibrium Price Level and Output 4

5. How does this cartoon relate to Aggregate Demand? 5

6. LRAS SRAS It can also happen that this occurs at the long-run equilibrium point, but not necessarily. Aggregate Price Level AD Aggregate Output Macroeconomic equilibrium occurs at the intersection of aggregate demand and short-run aggregate supply. **Handout

9. As we have learned a Demand Shock can effect equilibrium: (demand shocks are shifts in the AD curve and Supply shocks are shifts in the SRAS)

10. Shocks • Demand shock causes Ag. Price Level and Ag. Output to move in the same direction • Supply Shock causes them to move in opposite directions

11. Shocks cont. • Demand shocks have short-run effects on Ag. Output because the economy is self-correcting in the long run • In a recessionary gap, an eventual fall in nominal wages moves the economy to long-run equilibrium (wages are sticky—slow to move-- in the SR) • In an inflationary gap, an eventual rise in nominal wages moves the economy to long run equilibrium

12. To sum it up… Shocks cause a shift in the Aggregate Demand or Supply and can also lead to Recessionary Gaps or Inflationary Gaps or Stagflation Stagflation is inflation and falling output and is caused by a negative supply shock

13. What’s it look like?

14. Inflationary Gap Output is high and unemployment is less than NRU LRAS Price Level AS Actual GDP above potential GDP PL1 AD1 QY Q1 GDPR 14

15. Example: Assume the government increases spending. What happens to PL and Output? LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 15

16. Recessionary Gap Output low and unemployment is more than NRU LRAS Price Level AS1 Actual GDP below potential GDP PL1 AD Q1 QY GDPR 16

17. Example: Assume the price of oil increases drastically. What happens to PL and Output? LRAS Price Level AS1 AS PL1 Stagflation Stagnate Economy + Inflation PLe AD Q1 QY GDPR 17

18. What about the long run? Baby Steps

19. Assume the government increases spending. What happens to PL and Output? LRAS Price Level AS PL and Q will Increase PL1 PLe AD1 AD QY Q1 GDPR 19

20. Now, what will happen in the LONG RUN? Inflation means workers seek higher wages and production costs increase LRAS Price Level AS1 AS PL2 Back to full employment with higher price level PL1 PLe AD1 AD QY Q1 GDPR 20

21. Assume consumers increase spending. What happens to PL and Output? LRAS Price Level AS PL1 PLe AD1 AD QY Q1 GDPR 21

22. Now, what will happen in the LONG RUN? Inflation means workers seek higher wages and production costs increase LRAS Price Level AS1 AS PL2 Back to full employment with higher price level PL1 PLe AD1 AD QY Q1 GDPR 22

23. Supply shocks and demand shocks can cause recessions

24. Long Term Equilibrium • To summarize how an economy responds to recessions/inflation we focus on Output Gap which is the % difference between actual aggregate output and potential output. Actual Aggregate Output-Potential Output x 100 Potential Output In the Long Run the economy is self-correcting but many times Governments are not willing to wait that long which brings about Macroeconomic Policy