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P R I N C I P L E S O F. F O U R T H E D I T I O N. 0. Aggregate Demand and Aggregate Supply. 33. Second Midterm. This coming Thursday, regular lecture time. It will cover chapters 26, 27, 28, and whatever we discuss today. Scantron form; No. 2 pencils; Ink pens;

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slide1

P R I N C I P L E S O F

FOURTH EDITION

0

Aggregate Demand and Aggregate Supply

33

second midterm
Second Midterm
  • This coming Thursday, regular lecture time.
  • It will cover chapters 26, 27, 28, and whatever we discuss today.
  • Scantron form;
  • No. 2 pencils;
  • Ink pens;
  • Non-programmable calculator;
  • Picture ID.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

long run v s short run
Long run v.s. short run
  • Long run growth: what determines long-run output (and the related employment…)?
  • Short run fluctuations: what determines short-run output (and the related employment…)?
    • Aggregate demand and aggregate supply.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

in this chapter look for the answers to these questions
In this chapter, look for the answers to these questions:

0

  • What are economic fluctuations? What are their characteristics?
  • How does the model of aggregate demand and aggregate supply explain economic fluctuations?
  • Why does the Aggregate-Demand curve slope downward? What shifts the AD curve?
  • What is the slope of the Aggregate-Supply curve in the short run? In the long run? What shifts the AS curve(s)?

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

introduction
Introduction

0

  • Over the long run, real GDP grows about 3% per year on average.
  • In the short run, GDP fluctuates around its trend.
    • recessions: periods of falling real incomes and rising unemployment
    • depressions: severe recessions (very rare)
  • Short-run economic fluctuations are often called business cycles.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

three facts about economic fluctuations

$

Three Facts About Economic Fluctuations

0

FACT 1: Economic fluctuations are irregular and unpredictable.

U.S. real GDP, billions of 2000 dollars

The shaded bars are recessions

three facts about economic fluctuations7

$

Three Facts About Economic Fluctuations

0

FACT 2: Most macroeconomic quantities fluctuate together.

Investment spending, billions of 2000 dollars

three facts about economic fluctuations8
Three Facts About Economic Fluctuations

0

FACT 3: As output falls, unemployment rises.

Unemployment rate, percent of labor force

explaining the short run fluctuations
Explaining the short-run fluctuations
  • Warning! This chapter is very theoretical.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

introduction continued
Introduction, continued

0

  • Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial.
  • Most economists use the model of aggregate demand and aggregate supply to study fluctuations.
  • This model differs from the classical economic theories economists use to explain the long run.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

classical economics
Classical Economics

0

  • The previous chapters are based on the ideas of classical economics, especially:
  • The Classical Dichotomy, the separation of variables into two groups:
    • real – quantities, relative prices
    • nominal – measured in terms of money
  • The neutrality of money: Changes in the money supply affect nominal but not real variables.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

classical economics12
Classical Economics

0

  • Most economists believe classical theory describes the world in the long run, but not the short run.
  • In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate).
  • To study the short run, we use a new model.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the model of aggregate demand and aggregate supply

P

The price level

SRAS

P1

AD

Y

Y1

Real GDP, the quantity of output

The Model of Aggregate Demand and Aggregate Supply

0

“Short-Run Aggregate Supply”

The model determines the eq’m price level

“Aggregate Demand”

and the eq’m level of output (real GDP).

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the aggregate demand ad curve

P

P2

P1

AD

Y

Y2

Y1

The Aggregate-Demand (AD) Curve

0

The AD curve shows the quantity of all g&s demanded in the economy at any given price level.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

why the ad curve slopes downward

P

P2

P1

AD

Y

Y2

Y1

Why the ADCurve Slopes Downward

0

Y = C + I + G

C, I, G are the components of agg. Demand for a closed economy.

Assume G fixed by govt policy.

To understand the slope of AD, must determine how a change in P affects C, I, and NX.

Y1

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the wealth effect p and c
The Wealth Effect (P and C )

0

  • Suppose P rises.
  • The dollars people hold buy fewer g&s, so real wealth is lower.
  • People feel poorer, so they spend less.
  • Thus, an increase in P causes a fall in C

…which means a smaller quantity of g&s demanded.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the interest rate effect p and i
The Interest-Rate Effect (P and I )

0

  • Suppose P rises.
  • Buying g&s requires more dollars.
  • To get these dollars, people sell some of their bonds or other assets, which drives up interest rates.

…which increases the cost of borrowing to fund investment projects.

  • Thus, an increase in P causes a increase in I

…which means a smaller quantity of g&s demanded.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the slope of the ad curve summary

P

P2

Y

Y2

The Slope of the ADCurve: Summary

0

An increase in P reduces the quantity of g&s demanded because:

  • the wealth effect (C falls)

P1

  • the interest-rate effect (I falls)

AD

Y1

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

why the ad curve might shift

P

P1

AD2

AD1

Y

Y1

Y2

Why the ADCurve Might Shift

0

Any event that changes C, I, G – except a change in P – will shift the AD curve.

Example: A stock market boom makes households feel wealthier, consume more, and the AD curve shifts right.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

ad shifts arising from things affecting c
ADShifts arising from things affecting C:

0

  • The world becomes more uncertain, people decide to save more: C falls, AD shifts left
  • The stock market crashes, the consumer confidence drops: C falls, AD shifts left
  • tax cut: C falls, AD shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

ad shifts arising from things affecting i
ADShifts Arising from things affecting I

0

  • Firms decide to upgrade their computers:I rises, AD shifts right
  • Firms become pessimistic about future demand:I falls, AD shifts left
  • Central bank uses monetary policy to reduce interest rates:I rises, AD shifts right
  • Investment Tax Credit or other tax incentive: I rises, AD shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

ad shifts arising from changes in g
ADShifts Arising from Changes in G

0

  • Congress increases spending on homeland security:G rises, AD shifts right
  • State govts cut spending on road construction:G falls, AD shifts left

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

a c t i v e l e a r n i n g 1 exercise
ACTIVE LEARNING 1: Exercise

0

Try this without looking at your notes.

What happens to the AD curve in each of the following scenarios?

A. A ten-year-old investment tax credit expires.

B. A fall in prices increases the real value of consumers’ wealth.

C. State governments eliminates sales taxes.

22

a c t i v e l e a r n i n g 1 answers
ACTIVE LEARNING 1: Answers

0

A. A ten-year-old investment tax credit expires.

I falls, AD curve shifts left.

B. A fall in prices increases the real value of consumers’ wealth.

Move down along AD curve (wealth-effect).

C. State governments eliminates sales taxes. C rises, AD shifts right.

23

second midterm25
Second-midterm
  • -Pen & No. 2 Pencil
  • -Scantron F-288 Par-L (same as last time)
  • -non-programmable calculator -UCI ID

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the aggregate supply as curves

LRAS

P

SRAS

Y

The Aggregate-Supply (AS) Curves

0

The AS curve shows the total quantity of g&s firms produce and sell at any given price level.

In the short run, AS is upward-sloping.

In the long run, AS is vertical.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the long run aggregate supply curve lras

LRAS

P

Y

The Long-Run Aggregate-Supply Curve (LRAS)

0

The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate.

YN is also called potential output or full-employment output.

YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

why lras is vertical

LRAS

P

P1

P2

Y

Why LRASIs Vertical

0

YN depends on the economy’s stocks of labor, capital, and natural resources, and on the level of technology.

An increase in P

does not affect any of these, so it does not affect YN.

(Classical dichotomy)

YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

why the lras curve might shift

LRAS1

LRAS2

P

Y

YN

Why the LRASCurve Might Shift

0

Any event that changes any of the determinants of YN will shift LRAS.

Example: Immigration increases L, causing YN to rise.

YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

lras shifts arising from changes in l
LRASShifts Arising from Changes in L

0

  • The Baby Boom generation retires:L falls, LRAS shifts left
  • New govt policies reduce the natural rate of unemployment: the % of the labor force normally employed rises, LRAS shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

lras shifts arising from changes in physical or human capital
LRASShifts Arising from Changes in Physical or Human Capital

0

  • Investment in factories or equipment:K rises, LRAS shifts right
  • More people get college degrees: Human capital rises, LRAS shifts right
  • Earthquakes or hurricanes destroy factories: K falls, LRAS shifts left

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

lras shifts arising from changes in natural resources
LRASShifts Arising from Changes in Natural Resources

0

  • A change in weather patterns makes farming more difficult:LRAS shifts left
  • Discovery of new mineral deposits: LRAS shifts right
  • Reduction in supply of imported oil or other resources:LRAS shifts right

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

lras shifts arising from changes in technology
LRASShifts Arising from Changes in Technology

0

  • Technological advances allow more output to be produced from a given bundle of inputs:LRAS shifts right.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

in short
In short:
  • Anything that affects growth shifts LRAS!

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

using ad as to depict lr growth and inflation

LRAS1990

P

LRAS1980

LRAS2000

P2000

P1990

AD2000

P1980

AD1990

AD1980

Y

Using AD& ASto Depict LRGrowth and Inflation

0

Over the long run, tech. progress shifts LRAS to the right

and growth in the aggregate demand shifts AD to the right.

Result: ongoing inflation and growth in output.

Y2000

Y1980

Y1990

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

short run aggregate supply sras

P

SRAS

P2

P1

Y

Y1

Y2

Short Run Aggregate Supply (SRAS)

0

The SRAS curve is upward sloping:

Over the period of 1-2 years, an increase in P

causes an increase in the quantity of g & s supplied.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

why the slope of sras matters

P

Phi

SRAS

Phi

ADhi

Plo

Plo

ADlo

Y

Ylo

Yhi

Why the Slope of SRASMatters

0

If AS is vertical, fluctuations in ADdo not cause fluctuations in output or employment.

LRAS

If AS slopes up, then shifts in ADdo affect output and employment.

AD1

Y1

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

three theories of sras
Three Theories of SRAS

0

In each,

  • some type of market imperfection
  • result: Output deviates from its natural rate when the actual price level deviates from the price level people expected.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

three theories of sras39

P

SRAS

When P > PE

the expected price level

PE

When P < PE

Y

YN

Y < YN

Y > YN

Three Theories of SRAS

0

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the sticky wage theory
The Sticky-Wage Theory

0

  • Imperfection: Nominal wages are sticky in the short run,they adjust sluggishly.
    • Due to labor contracts, social norms.
  • Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the sticky wage theory41
The Sticky-Wage Theory

0

  • The labor contract sets nominal wages according to expected prices.
  • If P > PE, revenue is higher, but labor cost is not.

Production is more profitable, so firms increase output and employment.

  • Hence, higher P causes higher Y, so the SRAS curve slopes upward.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the sticky wage theory42

Output

Expected price level

Natural rate of output (long-run)

a > 0, measures how much Y responds to unexpected changes in P

Actual price level

The Sticky-Wage Theory

0

The sticky wage theory implies Y deviates from YN when Pdeviates from PE.

Y = YN + a(P– PE)

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

sras and lras
SRASand LRAS

0

  • The imperfections in these theories are temporary. Over time,
    • sticky wages and prices become flexible
    • misperceptions are corrected
  • In the LR,
    • PE = P
    • AS curve is vertical

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

sras and lras44

LRAS

P

SRAS

PE

Y

SRASand LRAS

0

Y = YN + a(P– PE)

In the long run, PE = P

and Y = YN.

YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

why the sras curve might shift

LRAS

P

SRAS

SRAS

PE

PE

Y

Why the SRASCurve Might Shift

0

Everything that shifts LRAS shifts SRAS, too.

Also, PE shifts SRAS:

If PE rises,

workers & firms set higher wages.

At each P, production is less profitable, Y falls, SRAS shifts left.

YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the long run equilibrium

P

Y

The Long-Run Equilibrium

0

In the long-run equilibrium,

PE = P,

Y = YN ,

and unemployment is at its natural rate.

LRAS

SRAS

PE

AD

YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

economic fluctuations
Economic Fluctuations

0

  • Caused by events that shift the AD and/or AS curves.
  • Four steps to analyzing economic fluctuations:

1.Determine whether the event shifts AD or AS.

2. Determine whether curve shifts left or right.

3. Use AD-AS diagram to see how the shift changes Y and P in the short run.

4. Use AD-AS diagram to see how economy moves from new SR eq’m to new LR eq’m.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the effects of a shift in ad

LRAS

P

SRAS1

SRAS2

P1

P2

B

AD1

P3

C

AD2

Y

YN

Y2

The Effects of a Shift in AD

0

Event: stock market crash

1. affects C, AD curve

2. C falls, so AD shifts left

3. SR eq’m at B. P and Y lower,unemp higher

4. Over time, PE falls, SRAS shifts right,until LR eq’m at C.Y and unemp back at initial levels.

A

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

two big ad shifts 1 the great depression
Two Big AD Shifts: 1. The Great Depression

0

From 1929-1933,

  • money supply fell 28% due to problems in banking system
  • stock prices fell 90%, reducing C and I
  • Y fell 27%
  • P fell 22%
  • unemp rose from 3% to 25%

U.S. Real GDP, billions of 2000 dollars

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

two big ad shifts 2 the world war ii boom
Two Big AD Shifts: 2. The World War II Boom

0

From 1939-1944,

  • govt outlays rose from $9.1 billion to $91.3 billion
  • Y rose 90%
  • P rose 20%
  • unemp fell from 17% to 1%

U.S. Real GDP, billions of 2000 dollars

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

a c t i v e l e a r n i n g 2 answers

LRAS

P

SRAS2

SRAS1

C

P3

B

P2

AD2

P1

AD1

Y

YN

Y2

ACTIVE LEARNING 2: Answers

0

Event: a tax cut

1. affects C, AD curve

2. shifts AD right

3. SR eq’m at point B. P and Y higher,unemp lower

4. Over time, PE rises, SRAS shifts left,until LR eq’m at C.Y and unemp back at initial levels.

A

51

john maynard keynes 1883 1946
John Maynard Keynes,1883-1946

0

  • The General Theory of Employment, Interest, and Money, 1936
  • Argued recessions and depressions can result from inadequate demand; policymakers should shift AD.
  • Famous critique of classical theory:

The long run is a misleading guide to current affairs. In the long run, we are all dead.

Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

conclusion
CONCLUSION

0

  • This chapter has introduced the model of aggregate demand and aggregate supply, which helps explain economic fluctuations.
  • Keep in mind: these fluctuations are deviations from the long-run trends explained by the models we learned in previous chapters.
  • In the next chapter, we will learn how policymakers can affect aggregate demand with fiscal and monetary policy.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

chapter summary
CHAPTER SUMMARY

0

  • Short-run fluctuations in GDP and other macroeconomic quantities are irregular and unpredictable. Recessions are periods of falling real GDP and rising unemployment.
  • Economists analyze fluctuations using the model of aggregate demand and aggregate supply.
  • The aggregate demand curve slopes downward because a change in the price level has a wealth effect on consumption, an interest-rate effect on investment, and an exchange-rate effect on net exports.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

chapter summary55
CHAPTER SUMMARY

0

  • Anything that changes C, I, G, or NX– except a change in the price level – will shift the aggregate demand curve.
  • The long-run aggregate supply curve is vertical, because changes in the price level do not affect output in the long run.
  • In the long run, output is determined by labor, capital, natural resources, and technology; changes in any of these will shift the long-run aggregate supply curve.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

chapter summary56
CHAPTER SUMMARY

0

  • In the short run, output deviates from its natural rate when the price level is different than expected, leading to an upward-sloping short-run aggregate supply curve. The three theories proposed to explain this upward slope are the sticky wage theory, the sticky price theory, and the misperceptions theory.
  • The short-run aggregate-supply curve shifts in response to changes in the expected price level and to anything that shifts the long-run aggregate supply curve.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

chapter summary57
CHAPTER SUMMARY

0

  • Economic fluctuations are caused by shifts in aggregate demand and aggregate supply.
  • When aggregate demand falls, output and the price level fall in the short run. Over time, a change in expectations causes wages, prices, and perceptions to adjust, and the short-run aggregate supply curve shifts rightward. In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

chapter summary58
CHAPTER SUMMARY

0

  • A fall in aggregate supply results in stagflation – falling output and rising prices. Wages, prices, and perceptions adjust over time, and the economy recovers.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

fiscal policy and aggregate demand
Fiscal Policy and Aggregate Demand

0

  • Fiscal policy: the setting of the level of govt spending and taxation by govt policymakers
  • Expansionary fiscal policy
    • an increase in G and/or decrease in T
    • shifts AD right
  • Contractionary fiscal policy
    • a decrease in G and/or increase in T
    • shifts AD left
  • Fiscal policy has two effects on AD.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the multiplier effect
The Multiplier Effect

0

  • If the govt buys $20b of planes from Boeing, Boeing’s revenue increases by $20b.
  • This is distributed to Boeing’s workers (as wages) and owners (as profits or stock dividends).
  • These people are also consumers, and will spend a portion of the extra income.
  • This extra consumption causes further increases in aggregate demand.

Multiplier effect: the additional shifts in ADthat result when fiscal policy increases income and thereby increases consumer spending

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the multiplier effect61

P

AD3

AD2

AD1

$20 billion

Y2

Y3

Y

Y1

The Multiplier Effect

0

A $20b increase in G initially shifts ADto the right by $20b.

The increase in Y causes C to rise, which shifts AD further to the right.

P1

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

marginal propensity to consume
Marginal Propensity to Consume

0

  • How big is the multiplier effect? It depends on how much consumers respond to increases in income.
  • Marginal propensity to consume (MPC): the fraction of extra income that households consume rather than save
  • E.g., if MPC = 0.8 and income rises $100, C rises $80.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

a formula for the multiplier

1

Y =

G

The multiplier

1 – MPC

A Formula for the Multiplier

0

Notation: G is the change in G, Y and C are the ultimate changes in Y and C

Y = C + I + G + NX identity

Y = C + GI and NX do not change

Y = MPCY + G because C = MPCY

solved for Y

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

a formula for the multiplier64

1

Y =

G

The multiplier

1 – MPC

A Formula for the Multiplier

0

The size of the multiplier depends on MPC.

e.g., if MPC = 0.5 multiplier = 2

if MPC = 0.75 multiplier = 4

if MPC = 0.9 multiplier = 10

A bigger MPC means changes in Y cause bigger changes in C, which in turn cause more changes in Y.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

other applications of the multiplier effect
Other Applications of the Multiplier Effect

0

  • The multiplier effect: each $1 increase in G can generate more than a $1 increase in agg demand.
  • Also true for the other components of GDP.

Example: Suppose a recession overseas reduces demand for U.S. net exports by $10b.

Initially, agg demand falls by $10b.

The fall in Y causes C to fall, which further reduces agg demand and income.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

changes in taxes
Changes in Taxes

0

  • A tax cut increases households’ take-home pay.
  • Households respond by spending a portion of this extra income, shifting AD to the right.
  • The size of the shift is affected by the multiplier and crowding-out effects.
  • Another factor: whether households perceive the tax cut to be temporary or permanent.
    • A permanent tax cut causes a bigger increase in C – and a bigger shift in the AD curve – than a temporary tax cut.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

a c t i v e l e a r n i n g 3 exercise
ACTIVE LEARNING 3: Exercise

0

The economy is in recession. Shifting the AD curve rightward by $200b would end the recession.

A. If MPC = .8 and there is no crowding out, how much should Congress increase Gto end the recession?

B. If there is crowding out, will Congress need to increase G more or less than this amount?

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

70

a c t i v e l e a r n i n g 3 answers
ACTIVE LEARNING 3: Answers

0

The economy is in recession. Shifting the AD curve rightward by $200b would end the recession.

A. If MPC = .8 and there is no crowding out, how much should Congress increase Gto end the recession?

Multiplier = 1/(1 – .8) = 5

Increase G by $40bto shift agg demand by 5 x $40b = $200b.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

71

a c t i v e l e a r n i n g 3 answers69
ACTIVE LEARNING 3: Answers

0

The economy is in recession. Shifting the AD curve rightward by $200b would end the recession.

B. If there is crowding out, will Congress need to increase G more or less than this amount?

Crowding out reduces the impact of G on AD.

To offset this, Congress should increase G by a larger amount.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

72

using policy to stabilize the economy
Using Policy to Stabilize the Economy

0

  • Since the Employment Act of 1946, economic stabilization has been a goal of U.S. policy.
  • Economists debate how active a role the govt should take to stabilize the economy.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the case for active stabilization policy
The Case for Active Stabilization Policy

0

  • Keynes: “animal spirits” cause waves of pessimism and optimism among households and firms, leading to shifts in aggregate demand and fluctuations in output and employment.
  • Also, other factors cause fluctuations, e.g.,
    • booms and recessions abroad
    • stock market booms and crashes
  • If policymakers do nothing, these fluctuations are destabilizing to businesses, workers, consumers.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the case for active stabilization policy72
The Case for Active Stabilization Policy

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  • Proponents of active stabilization policy believe the govt should use policy to reduce these fluctuations:
    • when GDP falls below its natural rate, should use expansionary monetary or fiscal policy to prevent or reduce a recession
    • when GDP rises above its natural rate, should use contractionary policy to prevent or reduce an inflationary boom

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

keynesians in the white house
Keynesians in the White House

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1961: John F Kennedy pushed for a tax cut to stimulate agg demand. Several of his economic advisors were followers of Keynes.

2001: George W Bush pushed for a tax cut that helped the economy recover from a recession that had just begun.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

the case against active stabilization policy
The Case Against Active Stabilization Policy

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  • Monetary policy affects economy with a long lag:
    • firms make investment plans in advance, so I takes time to respond to changes in r
    • most economists believe it takes at least 6 months for mon policy to affect output and employment
  • Fiscal policy also works with a long lag:
    • Changes in G and T require Acts of Congress.
    • The legislative process can take months or years.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

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The Case Against Active Stabilization Policy

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  • Due to these long lags, critics of active policy argue that such policies may destabilize the economy rather than help it:

By the time the policies affect agg demand, the economy’s condition may have changed.

  • These critics contend that policymakers should focus on long-run goals, like economic growth and low inflation.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

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CONCLUSION

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  • Policymakers need to consider all the effects of their actions. For example,
    • When Congress cuts taxes, it needs to consider the short-run effects on agg demand and employment, and the long-run effects on saving and growth.
    • When the Fed reduces the rate of money growth, it must take into account not only the long-run effects on inflation, but the short-run effects on output and employment.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

final
Final
  • Thursday, June 12th, 1:30 to 3:30pm.
  • Final will cover chapters 23, 24, 25, 28, and 33.
  • You are suppose to hand in your extra assignment to one of the TAs before or on this Friday (June 5th).
  • You can also give it to me. I will be in my office from 3:00 to 5:00 this Friday.
  • I will curve the class before taking into account the extra-credit assignment.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY

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CHAPTER SUMMARY

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  • In the theory of liquidity preference, the interest rate adjusts to balance the demand for money with the supply of money.
  • The interest-rate effect helps explain why the aggregate-demand curve slopes downward: An increase in the price level raises money demand, which raises the interest rate, which reduces investment, which reduces the aggregate quantity of goods & services demanded.

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CHAPTER SUMMARY

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  • An increase in the money supply causes the interest rate to fall, which stimulates investment and shifts the aggregate demand curve rightward.
  • Expansionary fiscal policy – a spending increase or tax cut – shifts aggregate demand to the right. Contractionary fiscal policy shifts aggregate demand to the left.

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CHAPTER SUMMARY

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  • When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change:

The multiplier effect tends to amplify the effects of fiscal policy on aggregate demand.

The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

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CHAPTER SUMMARY

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  • Economists disagree about how actively policymakers should try to stabilize the economy.

Some argue that the government should use fiscal and monetary policy to combat destabilizing fluctuations in output and employment.

Others argue that policy will end up destabilizing the economy, because policies work with long lags.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY