ECONOMICS 200

BASIC ECONOMIC ISSUES

Unit 21: Unemployment

• Continued from the last lecture…

U.S. Unemployment Rate Trend

Natural rate of

unemployment

Unemployment rate

Explaining the Natural Rate of

Unemployment: A Summary

The natural rate of unemployment consists of

• frictional unemployment

▫ It takes time to search for the right jobs

▫ Occurs even if there are enough jobs to go around

• structural unemployment

▫ When wage is above eq’m, not enough jobs

▫ Due to min. wages, labor unions, efficiency wages

In later chapters, we will learn about cyclical unemployment, the short-term fluctuations in unemployment associated with business cycles.

Cyclical Unemployment

• Results from recessions when many businesses all at once don’t see enough demand for their services to justify hiring.

Policy Implication

• Cyclical unemployment:

▫ Pump up demand with temporary spending in creases or tax cuts or with reductions in interest rates.

Unemployment Rate in Selected

Countries

Comparison of the Unemployment

Rates• Since 1980s, U.S. had relatively low

unemployment compared to Europe but also relatively low wage growth. (Tradeoff!)

• Greater supply of labor (low unemployment) leads to a lower price (lower wages).

• Wages are based on productivity of workers. Best long term policy for high wages is to improve productivity.

Unemployment Rate by Education

Attainment

U.S. Unemployment Rate (2008) by

County

Summary of Unemployment

• The unemployment rate is the percentage of those who would like to work who do not have jobs.

• Unemployment and labor force participation vary widely across demographic groups.

• The natural rate of unemployment is the normal rate of unemployment around which the actual rate fluctuates. Cyclical unemployment is the deviation of unemployment from its natural rate and is connected to short-term economic fluctuations.

Summary of Unemployment

• The natural rate includes frictional unemployment and structural unemployment.

• Frictional unemployment occurs when workers take time to search for the right jobs.

• Structural unemployment occurs when above-equilibrium wages result in a surplus of labor.

• Three reasons for above-equilibrium wages include minimum wage laws, unions, and efficiency wages

Unit 22: Inflation

1962 2010

Unit 22: Inflation

1970s$2000

2011$16,640

Unit 22: Inflation

• Inflation represents an overall increase in price level, measured over a combination of all goods and services.

• It is not about the increase in any particular price.

How to Measure Inflation?

• By defining a basket of goods, with the quantity of each good in the basket chosen to represent typical consumption levels, then tracking how the overall price of the basket changes with time.

• Common measures:▫ GDP deflator▫ Consumer price index▫ Producer price index▫ Wholesale price index

GDP Deflator

• The GDP deflator is a measure of the overall level of prices.

• Definition:

• One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next.

GDP deflator = 100 x nominal GDP

real GDP

Example of GDP Deflator

year

Nominal

GDP

Real

GDP

GDP

Deflator

2007 $6000 $6000

2008 $8250 $7200

2009 $10,800 $8400

Compute the GDP deflator in each year:

2007: 100 x (6000/6000) = 100.0

100.0

2008: 100 x (8250/7200) = 114.6

114.6

2009: 100 x (10,800/8400) = 128.6

128.6

14.6%

12.2%

Consumer Price Index

• The CPI measures the typical consumer’s cost of living

• The basis of cost of living adjustments (COLAs) in many contracts and in Social Security

CPI’s Basket

43%

17%

15%

6%

6%

6%4% 3% Housing

Transportation

Food & Beverages

Medical care

Recreation

Education andcommunication

Apparel

Other

How Consumer Price Index is Calculated

1. Fix the “basket.”The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket.”

2. Find the prices.The BLS collects data on the prices of all the goods in the basket.

3. Compute the basket’s cost.Use the prices to compute the total cost of the basket.

How the CPI Is Calculated

4. Choose a base year and compute the index.The CPI in any year equals

100 xcost of basket in current year

cost of basket in base year

How Inflation is Calculated Using CPI

5. Compute the inflation rate.The percentage change in the CPI from the preceding period.

CPI this year – CPI last year

CPI last year

Inflation

ratex 100%=

$3.00

$2.50

$2.00

price of

latte

$122009

$112008

$102007

price of

pizzayear

$12 x 4 + $3 x 10 = $78

$11 x 4 + $2.5 x 10 = $69

$10 x 4 + $2 x 10 = $60

cost of basket

Example of Calculating CPI

• Compute CPI in each year using 2007 as base

2007: 100 x ($60/$60) = 100

2008: 100 x ($69/$60) = 115

2009: 100 x ($78/$60) = 130

basket: {4 pizzas, 10 lattes}

Inflation rate:

15%115 – 100

100x 100%=

13%130 – 115

115x 100%=

Another Example of CPI – Substitution

BiasCPI basket:

{10 lbs beef, 20 lbs chicken}

The CPI basket cost $120

in 2004, the base year.

A. Compute the CPI in 2005.

B. What was the CPI inflation rate from 2005-

2006?

price

of beef

price of

chicken

2004 $4 $4

2005 $5 $5

2006 $9 $6

AnswersA. Compute the CPI in 2005:

Cost of CPI basket in 2005

= ($5 x 10) + ($5 x 20) = $150

CPI in 2005 = 100 x ($150/$120) = 125

B. What was the inflation rate from 2005-2006?

Cost of CPI basket in 2006

= ($9 x 10) + ($6 x 20) = $210

CPI in 2006 = 100 x ($210/$120) = 175

CPI inflation rate = (175 – 125)/125 = 40%

Another Example of CPI – Substitution

BiasCPI basket:

{10 lbs beef,

20 lbs chicken}

2004-5: Households bought CPI basket.

2006: Households bought {5 lbs beef, 25 lbs chicken}.

A. Compute cost of the 2006 household basket.

B. Compute % increase in cost of household basket over 2005-6, compare to CPI inflation rate.

beef chickencost of CPI

basket

2004 $4 $4 $120

2005 $5 $5 $150

2006 $9 $6 $210

Answers

A. Compute cost of the 2006 household basket.

($9 x 5) + ($6 x 25) = $195

B. Compute % increase in cost of household basket over 2005-6, compare to CPI inflation rate.

Rate of increase: ($195 – $150)/$150 = 30%

CPI inflation rate from previous problem = 40%

beef chickencost of CPI

basket

2004 $4 $4 $120

2005 $5 $5 $150

2006 $9 $6 $210

• CPI basket:

{10 lbs beef, 20 lbs chicken}

• Households basket in 2006:

{5 lbs beef, 25 lbs chicken}

Problems with the CPI:

Substitution Bias• Over time, some prices rise faster than others.

• Consumers substitute toward goods that become relatively cheaper.

• The CPI misses this substitution because it uses a fixed basket of goods.

• Thus, the CPI overstates increases in the cost of living.

Problems with the CPI:

Introduction of New Goods• The introduction of new goods increases variety,

allows consumers to find products that more closely meet their needs.

• In effect, dollars become more valuable.

• The CPI misses this effect because it uses a fixed basket of goods.

• Thus, the CPI overstates increases in the cost of living.

Problems with the CPI:

Unmeasured Quality Change• Improvements in the quality of goods in the

basket increase the value of each dollar.

• The BLS tries to account for quality changes but probably misses some, as quality is hard to measure.

• Thus, the CPI overstates increases in the cost of living.

Problems with the CPI

• Each of these problems causes the CPI to overstate cost of living increases.

• The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year.

• This is important because Social Security payments and many contracts have COLAs tied to the CPI.

Two Measures of Inflation (1950-2009)

Contrasting the CPI and GDP Deflator

• Capital goods:▫ Excluded from CPI▫ Included in GDP deflator (if produced domestically)

• Imported consumer goods:▫ Included in CPI▫ Excluded from GDP deflator

• The basket▫ CPI uses fixed basket▫ GDP deflator uses basket of currently produced goods

and services▫ This matters if different prices are changing by different

amounts.

Example: CPI vs. GDP deflator

In each scenario, determine the effects on the CPI and the GDP deflator.

A. Starbucks raises the price of Frappuccinos.

B. Caterpillar raises the price of the industrial

tractors it manufactures at its Illinois factory.

C. Armani raises the price of the Italian jeans it

sells in the U.S.

Answers

A. Starbucks raises the price of Frappuccinos.

The CPI and GDP deflator both rise.

B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory.

The GDP deflator rises, the CPI does not.

C. Armani raises the price of the Italian jeans it sells in the U.S.

The CPI rises, the GDP deflator does not.

U.S. Inflation Trend

Causes for Inflation

• Higher costs in the economy being passed on in prices

• High level of demand in the economy

Is Inflation Bad?

• If all prices and wages rose at the same time and everyone knew it was going to happen, it wouldn’t make any difference to the real economy.

• In the real world, inflation isn’t evenly distributed and fully predictable. Benefits to some and costs to others.

▫ Losers: lend/invest money at a fixed rate of interest

▫ Winners: borrowed at a fixed rate

Indexing

• Refers to the practice of having adjustments made for inflation automatically.

• Examples:

▫ Adjustable rate mortgage loan.

▫ US treasury bond

▫ Union contracts/Social Security COLA adjustments

Problems with Inflation

• Businesses ends up with short-term focus instead of long term productivity growth

• Price signals become unclear.

• Examples of “hyperinflation” (over 20-40% a month):

▫ 1920: Germany

▫ 1980s: Argentina, Bolivia, Israel.

▫ 2008: Zimbabwe

Problems of InflationYakir Plessner: “Inflation destroys the measuring rod of the economy. When inflation proceeds at, say, 400 percent annually, the average monthly rate is over 14 percent. A dollar received for sales at the end of the month is worth about 13 cents less than a dollar spent for productive inputs at the beginning of the month... Consumers face problems, too. Ordinarily, when people shop they use a data bank stored in their memory to assess the prices they are asked to pay. But when prices change continuously, people find themselves in the dark… This makes the task of executing a household budget rather difficult. The governmental budget process was rendered useless for similar reasons.”

Problems of Inflation

V.S. Naipaul: “Another negative aspect of inflation is to worry about productivity and even technology. Now that is the secret of all progress: productivity. But you really can get no more than 3 or 4 per cent per annum improvement in productivity anywhere in the world. With inflation like ours you can get 10 per cent in one day, if you know when and where to invest. It is much more important to protect your working capital than to think about long-term thins like technology and productivity- though you try to do both.”

Causes of Inflation

• Always a matter of too much money chasing too little goods.

• Policy tools is to reduce demand so there is less money chasing goods.

▫ Tax

▫ Cut government spending

▫ Higher interest rate

Level of Price and the Value of Money

• Inflation is more about the value of money than value of the good.

• Example:

▫ P is the price of a candy bar in dollars.

▫ 1/P is the value of a dollar measured in candy bars

P = $2, the value of $1 is ½ candy bar

P = $3, the value of $1 is 1/3 candy bar

• Inflation drives up prices and drives down the value of money.

Determinant of Value of Money• Supply and Demand

• Money supply:

▫ In real world, determined by Federal Reserve, the banking system, consumers.

▫ In this model, we assume the Fed precisely controls MS and sets it at some fixed amount.

• Money Demand:▫ Refers to how much wealth people want to hold in

liquid form.▫ Depends on P: An increase in P reduces the value

of money, so more money is required to buy g&s.

47

The Money Supply-Demand Diagram

Value of Money, 1/P

Price Level, P

Quantity of Money

1 1

¾ 1.33

½ 2

¼ 4

As the value of money rises, the price level falls.

48

The Money Supply-Demand Diagram

Value of Money, 1/P

Price Level, P

Quantity of Money

1

¾

½

¼

1

1.33

2

4

MS1

$1000

The Fed sets MSat some fixed value, regardless of P.

49

The Money Supply-Demand Diagram

Value of Money, 1/P

Price Level, P

Quantity of Money

1

¾

½

¼

1

1.33

2

4MD1

A fall in value of money (or increase in P) increases the quantity of money demanded:

50

MS1

$1000

Value of Money, 1/P

Price Level, P

Quantity of Money

1

¾

½

¼

1

1.33

2

4

The Money Supply-Demand Diagram

MD1

P adjusts to equate quantity of money demanded with money supply.

eq’m price level

eq’m value

of money

A

51

MS1

$1000

The Effects of a Monetary Injection

Value of Money, 1/P

Price Level, P

Quantity of Money

1

¾

½

¼

1

1.33

2

4MD1

eq’m price level

eq’m value

of money

A

MS2

$2000

B

Then the value of money falls, and P rises.

Suppose the Fed increases the money supply.

52

A Brief Look at the Adjustment Process

How does this work? Short version:

▫ At the initial P, an increase in MS causes

excess supply of money.

▫ People get rid of their excess money by spending it

on g&s or by loaning it to others, who spend it.

Result: increased demand for goods.

▫ But supply of goods does not increase,

so prices must rise.

(Other things happen in the short run, which we will study in later chapters.)

Result from graph: Increasing MS causes P to rise.

Inflation Hawks vs. Inflation Doves

• Inflation Hawks: Reduce inflation to zero to improve long term stability

• Inflation Doves: Low percentage of inflation can help wages to be less sticky. Help deflation.

Summary of Inflation

• How money supply affects inflation

• Money supply doesn’t affect real variables such as real GDF

• The costs of inflation

Unit 23: The Balance of Trade

• What is balance of trade?

▫ Merchandise trade balance: gap between exports and imports of goods

▫ Current account balance: captures the comprehensive picture of a nation’s trade.

Trade in goods, services, investment income, and unilateral transfer

Current Account Balance (2009)

Exports Imports Balance

Merchandise trade $1,068 billion $1,575 billion -$507 billion

Service trade $502 billion $370 billion $132 billion

Investment income $588 billion $467 billion $121 billion

Unilateral transfers --- --- -$125 billion

TOTAL -$379 billion

U.S. Current Account Balance Trend

Relationship Between Balance of Trade

and National Savings and Investment• Balance of trade involves flows of financial

capital going back and forth across national borders

• Trade deficit = Nation on net borrow from abroad

• Trade surplus = Net lending or investing abroad

The Flow of Capital

• Net capital outflow (NCO): domestic residents’ purchases of foreign assets

minus foreigners’ purchases of domestic assets

• NCO is also called net foreign investment.

Foreign Investments

The flow of capital abroad takes two forms:

▫ Foreign direct investment: Domestic residents actively manage the foreign investment, e.g., McDonalds opens a fast-food outlet in China

▫ Foreign portfolio investment: Domestic residents purchase foreign stocks or bonds, supplying “loanable funds” to a foreign firm.

Variables that Influence NCO

• Real interest rates paid on foreign assets

• Real interest rates paid on domestic assets

• Perceived risks of holding foreign assets

• Govt policies affecting foreign ownership of domestic assets

The Flow of Capital

NCO measures the imbalance in a country’s trade in assets:

▫ When NCO > 0, “capital outflow”

Domestic purchases of foreign assets exceed

foreign purchases of domestic assets.

▫ When NCO < 0, “capital inflow”

Foreign purchases of domestic assets exceed

domestic purchases of foreign assets.

The Equality of Net Export (NX) and

Net Capital Outflow (NCO)• An accounting identity: NCO = NX

▫ arises because every transaction that affects NX also affects NCO by the same amount (and vice versa)

• When a foreigner purchases a good from the U.S.,

▫ U.S. exports and NX increase

▫ the foreigner pays with currency or assets, so the U.S. acquires some foreign assets, causing NCO to rise.

The Equality of Net Export (NX) and

Net Capital Outflow (NCO)• An accounting identity: NCO = NX

▫ arises because every transaction that affects NXalso affects NCO by the same amount (and vice versa)

• When a U.S. citizen buys foreign goods,

▫ U.S. imports rise, NX falls

▫ the U.S. buyer pays with U.S. dollars or assets, so the other country acquires U.S. assets, causing U.S. NCO to fall.

Saving, Investment, and International Flows

of Goods & Assets

Y = C + I + G + NX accounting identity

Y – C – G = I + NX rearranging terms

S = I + NX since S = Y – C – G

S = I + NCO since NX = NCO

• When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow.

• When S < I, foreigners are financing some of the country’s investment, and NCO < 0.

Case Study: The U.S. Trade Deficit• The U.S. trade deficit reached record levels in

2006 and remained high in 2007-2008.

• Recall, NX = S – I = NCO.

A trade deficit means I > S, so the nation borrows the difference from foreigners.

• In 2007, foreign purchases of U.S. assets exceeded U.S. purchases of foreign assets by $775 million.

• Such deficits have been the norm since 1980…

-6%

-3%

0%

3%

6%

9%

12%

15%

18%

21%

24%

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

U.S. Saving, Investment, and NCO, 1950-2009

Saving

Net Capital Outflow

(% o

f G

DP

) Investment

National Savings and Investment

Identity• Domestic Savings + Inflows of Foreign Capitals

= Domestic Investment + Government Borrowing

Because quantity supplied has to equal to quantity

Case Study: The U.S. Trade Deficit

Why U.S. saving has been less than investment:

▫ In the 1980s and early 2000s,

huge govt budget deficits and low private saving

depressed national saving.

▫ In the 1990s,

national saving increased as the economy grew,

but domestic investment increased even faster

due to the information technology boom.

Case Study: The U.S. Trade Deficit

• Is the U.S. trade deficit a problem?

▫ The extra capital stock from the ’90s investment boom may well yield large returns.

▫ The fall in saving of the ’80s and ’00s, while not desirable, at least did not depress domestic investment, since firms could borrow from abroad.

• A country, like a person, can go into debt for good reasons or bad ones. A trade deficit is not necessarily a problem, but might be a symptom of a problem.

Case Study: The U.S. Trade Deficit

People abroad owned $23.4 trillion in U.S. assets.

U.S. residents owned $19.9 trillion in foreign assets.

U.S.’ net indebtedness to other countries = $3.5 trillion.

Higher than every other country’s net indebtedness.

So, U.S. is “the world’s biggest debtor nation.”

• So far, the U.S. earns higher interest rates on foreign assets than it pays on its debts to foreigners.

• But if U.S. debt continues to grow, foreigners may demand higher interest rates, and servicing the debt would become a drain on U.S. income.

Unexpected Implication about Trade

Deficit in Macroeconomics

• Trade deficits are caused by patterns of national savings and investment.

• Unfair foreign trade practices, contrary to the argument one often hears, have nothing to do with U.S. trade deficits.

• Trade deficits are not primarily determined by a higher level of trade or by greater exposure to the world economy.

Unexpected Implication about Trade

Deficit in Macroeconomics• Bilateral trade deficits, trade deficit with one

other country, have no macroeconomic importance. There are reasons to worry about a nation’s overall trade balance, but that can easily be made up of surpluses with some countries and deficits with others.

• High-income countries tend to run trade surpluses and this be net investors abroad, investing in low income countries.

Unit 24: Aggregate Supply and

Aggregate Demand• Aggregate supply: describes the productive

ability of the macroeconomy▫ Limited by the potential output

• Aggregate demand: Made up of the five components ▫ Consumption▫ Investment▫ Government▫ Exports▫ Imports

Aggregate Supply and Aggregate

Demand• Aggregate supply must equals to aggregate

demand.

• Say’s Law: Supply creates its own demand

▫ What happens to recession?

• Keynes’ Law: Demand creates its own supply

▫ What happens to the production limit?

In the Short Run…

• Aggregate demand may not increase smoothly with aggregate supply for two main reasons:

▫ Fluctuation in investor or consumer sentiment

Generate recessions and inflations

▫ Price and Wage stickiness

Unemployment

In the long run…

• Aggregate supply determines the size of the economy

78The Model of Aggregate Demand

and Aggregate Supply

P

Y

AD

SRAS

P1

Y1

The price level

Real GDP, the quantity of output

The model

determines the

eq’m price level

and eq’m output

(real GDP).

“Aggregate

Demand”

“Short run

Aggregate

Supply”

The Aggregate-Demand (AD) Curve

The AD curve

shows the

quantity of

all g&s

demanded

in the economy

at any given

price level.

P

Y

AD

P1

Y1

P2

Y2

Why the AD Curve Slopes Downward

Y = C + I + G + NX

Assume G fixed

by govt policy.

To understand

the slope of AD,

must determine

how a change in P

affects C, I, and

NX.

P

Y

AD

P1

Y1

P2

Y2 Y1

The Wealth Effect (P and C )

Suppose P rises.

• The dollars people hold buy fewer g&s, so real wealth is lower.

• People feel poorer.

Result: C falls.

The Interest-Rate Effect (P and I )

Suppose P rises.

• Buying g&s requires more dollars.

• To get these dollars, people sell bonds or other assets.

• This drives up interest rates.

Result: I falls.(Recall, I depends negatively on interest rates.)

The Exchange-Rate Effect (P and NX )

Suppose P rises.

• U.S. interest rates rise (the interest-rate effect).

• Foreign investors desire more U.S. bonds.

• Higher demand for $ in foreign exchange market.

• U.S. exchange rate appreciates.

• U.S. exports more expensive to people abroad, imports cheaper to U.S. residents.

Result: NX falls.

The Slope of the AD Curve: Summary

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

P

Y

AD

P1

Y1

the wealth effect

(C falls)

P2

Y2

the interest-rate

effect (I falls)

the exchange-rate

effect (NX falls)

Why the AD Curve Might Shift

Any event that changes

C, I, G, or NX

– except a change in P –

will shift the AD curve.

Example:

A stock market boom

makes households feel

wealthier, C rises,

the AD curve shifts right.

P

Y

AD1

AD2

Y2

P1

Y1

Why the AD Curve Might Shift

• Changes in C

▫ Stock market boom/crash

▫ Preferences re: consumption/saving tradeoff

▫ Tax hikes/cuts

• Changes in I

▫ Firms buy new computers, equipment, factories

▫ Expectations, optimism/pessimism

▫ Interest rates, monetary policy

▫ Investment Tax Credit or other tax incentives

Why the AD Curve Might Shift

• Changes in G

▫ Federal spending, e.g., defense

▫ State & local spending, e.g., roads, schools

• Changes in NX

▫ Booms/recessions in countries that buy our exports.

▫ Appreciation/depreciation resulting from international speculation in foreign exchange market

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

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

B. The U.S. exchange rate falls.

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

D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains.

The Aggregate-Demand curve

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

I falls, AD curve shifts left.

B. The U.S. exchange rate falls.

NX rises, AD curve shifts right.

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

Move down along AD curve (wealth-effect).

D. State governments replace sales taxes with new taxes on interest, dividends, and capital gains.

C rises, AD shifts right.

Answers

The Aggregate-Supply (AS) Curves

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

P

Y

SRAS

LRAS

AS is:

upward-sloping

in short run

vertical in

long run

The Long-Run Aggregate-Supply Curve (LRAS)

The potential output

(YN) is the amount of

output

the economy produces

when unemployment

is at its natural rate.

YN is also called

natural rate of

output or full-

employment output

or potential GDP.

P

Y

LRAS

YN

Why LRAS Is Vertical

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

An increase in P

P

Y

LRAS

P1

does not affect

any of these,

so it does not

affect YN.

P2

YN

Why the LRAS Curve Might Shift

Any event that

changes any of the

determinants of YN

will shift LRAS.

Example:

Immigration

increases L,

causing YN to rise.

P

Y

LRAS1

YN

LRAS2

YN’

Why the LRAS Curve Might Shift

• Changes in L or natural rate of unemployment

▫ Immigration

▫ Baby-boomers retire

▫ Govt policies reduce natural u-rate

• Changes in K or H

▫ Investment in factories, equipment

▫ More people get college degrees

▫ Factories destroyed by a hurricane

Why the LRAS Curve Might Shift

• Changes in natural resources

▫ Discovery of new mineral deposits

▫ Reduction in supply of imported oil

▫ Changing weather patterns that affect agricultural production

• Changes in technology

▫ Productivity improvements from technological progress

LRAS1980

Using AD & AS to Depict LR Growth and Inflation

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

P

Y

AD1990

LRAS1990

AD1980

Y1990

and growth in the

money supply shifts

AD to the right.

Y1980

AD2000

LRAS2000

Y2000

P1980Result:

ongoing inflation

and growth in

output.

P1990

P2000

Short Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping:

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

P

Y

SRAS

causes an

increase in the

quantity of g & s

supplied. Y2

P1

Y1

P2

Why the Slope of SRAS Matters

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

P

Y

AD1

SRAS

LRAS

ADhi

ADlo

Y1

If AS slopes up,

then shifts in AD

do affect output

and employment.

Plo

Ylo

Phi

Yhi

Phi

Plo

Three Theories of SRAS

In each,

▫ some type of market imperfection

▫ result:

Output deviates from its potential

when the actual price level deviates

from the price level people expected.

1. The Sticky-Wage Theory

• 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.

1. The Sticky-Wage Theory

• 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.

2. The Sticky-Price Theory

• Imperfection: Many prices are sticky in the short run.

▫ Due to menu costs, the costs of adjusting prices.

▫ Examples: cost of printing new menus, the time required to change price tags

• Firms set sticky prices in advance based on PE.

2. The Sticky-Price Theory

• Suppose the Fed increases the money supply unexpectedly. In the long run, P will rise.

• In the short run, firms without menu costs can raise their prices immediately.

• Firms with menu costs wait to raise prices. Meantime, their prices are relatively low,

which increases demand for their products,so they increase output and employment.

• Hence, higher P is associated with higher Y, so the SRAS curve slopes upward.

3. The Misperceptions Theory

• Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell.

• If P rises above PE, a firm sees its price rise before realizing all prices are rising.

The firm may believe its relative price is rising, and may increase output and employment.

• So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.

What the 3 Theories Have in Common:

In all 3 theories, Y deviates from YN when P deviates from PE.

Y = YN + a(P – PE)

Output

Natural rate of output

(long-run)

a > 0,

measures how much Y

responds to unexpected

changes in P

Actual price level

Expected price level

What the 3 Theories Have in Common:

P

Y

SRAS

YN

When P > PE

Y > YN

When P < PE

Y < YN

PE

the expected price level

Y = YN + a (P – PE)

SRAS and LRAS

• 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

LRAS

SRAS and LRAS

P

Y

SRAS

PE

YN

In the long run,

PE = P

and

Y = YN.

Y = YN + a(P –PE)

Why the SRAS Curve Might Shift

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.

LRASP

Y

SRAS

PE

YN

SRAS

PE

The Long-Run Equilibrium

In the long-run

equilibrium,

PE = P,

Y = YN ,

and unemployment

is at its natural rate.

P

Y

AD

SRAS

PE

LRAS

YN

Economic Fluctuations

• 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.

LRAS

YN

The Effects of a Shift in AD

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.

P

Y

AD1

SRAS1

AD2

SRAS2P1 A

P2

Y2

B

P3 C

Two Big AD Shifts:

1. The Great Depression

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%

▫ u-rate rose

from 3% to 25%

550

600

650

700

750

800

850

900

19

29

19

30

19

31

19

32

19

33

19

34

U.S. Real GDP, billions of 2000 dollars

Two Big AD Shifts:

2. The World War II Boom

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% 800

1,000

1,200

1,400

1,600

1,800

2,000

19

39

19

40

19

41

19

42

19

43

19

44

U.S. Real GDP, billions of 2000 dollars

• Draw the AD-SRAS-LRAS diagram for the U.S. economy starting in a long-run equilibrium.

• A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment.

Working with the model

Answers

LRAS

YN

P

Y

AD2

SRAS2

AD1

SRAS1

P1

P3 C

P2

Y2

B

A

Event: Boom in Canada

1. Affects NX, 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.

117

LRAS

YN

The Effects of a Shift in SRASEvent: Oil prices rise

1. Increases costs, shifts SRAS(assume LRAS constant)

2. SRAS shifts left

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

From A to B, stagflation, a period of falling output and rising prices.

P

YAD1

SRAS1

SRAS2

P1A

P2

Y2

B

118

LRAS

YN

Accommodating an Adverse Shift in SRASIf policymakers do nothing,

4. Low employment causes wages to fall, SRAS shifts right,until LR eq’m at A.

P

YAD1

SRAS1

SRAS2

P1A

P2

Y2

B

AD2

P3 COr, policymakers

could use fiscal or

monetary policy to

increase AD and

accommodate the AS

shift:

Y back to YN, but

P permanently higher.

The 1970s Oil Shocks and Their Effects

# of unemployed

persons

Real GDP

CPI

+ 1.4 million

+ 2.9%

+ 26%

+ 99%

+ 3.5 million

– 0.7%

+ 21%

+ 138%Real oil prices

1978-801973-75

Application to the Four Main Goals

• Economic growth is captured by the way in which aggregate supply and potential output gradually increase over time. Recessions occur when aggregate demand falls short of potential output.

• When aggregate demand and aggregate supply meet at potential output, there is no cyclical unemployment. The natural rate of unemployment is embodied in the concept of potential output.

Application to the Four Main Goals

• If the aggregate demand exceeds potential output, then the economy faces a situation of too many dollars chasing too few goods, and inflation will result. Also, if the aggregate supply experiences a negative shock, such as higher oil prices, inflation can result.

• Exports, imports, and the balance of trade influence both aggregate demand and aggregate supply in various ways.

Summary of Aggregate Supply and

Aggregate Demand• The model of aggregate supply and aggregate

demand helps in understanding how the goals of growth, inflation, unemployment and the trade balances are related to one another and why certain goals sometimes involve tradeoffs with others.

• The model also helps in determining appropriate macroeconomic policies.