Long-run model of the economy long-run economic growth--trends grow on average at about 3% per year Short-run model recognizes that we observe lots of fluctuations around the trend Referred to as the Business Cycle Keys facts re. economic fluctuations not regular --not predictable
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long-run economic growth--trends
grow on average at about 3% per year
recognizes that we observe lots of fluctuations around the trend
Referred to as the Business Cycle
1 Average weekly hours, manufacturing
2 Average weekly initial claims for unemployment insurance
3 Manufacturers' new orders, consumer goods and materials
4 Vendor performance, slower deliveries diffusion index
5 Manufacturers' new orders, nondefense capital goods
6 Building permits, new private housing units
7 Stock prices, 500 common stocks
8 Money supply, M2
9 Interest rate spread, 10-year Treasury bonds less federal funds
10 Index of consumer expectations
Some controversy regarding the validity of the proposition that we are better at managing the economy--that the economic activity is smoother than it had been.
demand and supply model of the economy
downward sloping AD
upward sloping AS
AD = f(PL; )
AD is the quantity of goods and services that households, firms and the government wants to buy at the different price levels.
As PL increases money in your possession has lower purchasing power. You feel poorer so you spend less.
(less demand from consumers)
As PL increases you need to convert more financial assets into cash. Hence less available for others to borrow in the loanable funds market. This causes r (the real interest rate) to rise so firms invest less.
(less demand from businesses)
As PL rises, U.S. goods become less competitive in world markets. NX falls.
(less demand from foreigners)
More complicated because we need to distinguish the short-run AS from the long-run AS.
In this case real output does not depend on PL.
Classical dichotomy: A real variable--doesn’t depend on a nominal variable.
Short-run AS--SRASShort-run Aggregate Supply
PL increases to PL2
Even though all prices have increased firms mistakenly believe it is a relative price increase. Ppotaotoes has risen but nothing else has. Hence firms produce more potatoes. Labor thinks its wages have risen, but prices of goods hasn’t so supplies more labor. Eventually firms and labor realizes all P’s rose and supply reverts to long-run level
PL rises from PL1 to PL2, but nominal wages don’t adjust--(unanticipated inflation and the labor contracts did not build in wage increases to compensate).
Firms produce more because can sell at higher prices but its costs haven’t risen
But once labor unions negotiate a new contract, move back to LRAS and onto a new SRAS
Menu costs: PL increases but it is costly to adjust prices all at once. But as expectations adjust we move to a new SRAS and back to the LRAS.
SRAS = f(PL; E(PL), )
Equilibrium takes place where AD and SRAS intersect. But there is a difference between long-run equilibrium and short-run equilibrium.
LR equilibrium: at potential output; at natural output.
SR equilbrium: Where AD and SRAS intersect.
1. Shift in the aggregate demand curve--AD shock
2. Shift in the aggregate supply curve--AS shock
--Wave of pessimism shifts the AD curve to the left as in Sept. 11 with consumers spending less.
--Government decides to spend less.
--Foreign recessions cause US exports to fall.
--Oil prices rise.
Recessions are self-correcting. There are natural tendencies that will take us out of recession if we are in a recession.
But these mechanisms take a long time. We may want to speed things up. Purpose of fiscal and monetary policy