PriceLevel

Real GDP($Trillions)

0

Long run AS curve: A vertical line indicating all possible output and price level combinations the economy could end up in the long run

Long run AS curve

YFE

Some economists (Mankiw included) believe the

economy is “self-correcting”—that is,

forces are present that push the economy to long-run (or full-employment)

equilibrium.

(How does it work?)

PriceLevel

Real GDP($Trillions)

0

AD1

AS1

Long Run AS Curve

YFE Y3 Y2

AD2

AS2

P1

P3

P2

P4

E

HJ

KLet AD shift from AD1 to AD2

Positive demand shock P and Y

Change in short-run equilibrium

Y > YFEWage

RateUnit Cost

PY until Y =YFE

Long-run adjustment process

PriceLevel

Real GDP($Trillions)

0

AD

AS

E

B

F

6 10 14

100

140

Why is point E a short-run equilibrium?

•At point B, the price level is 140 and AS = $14 trillion. But equilibrium GDP is equal to $6 trillion when the price level is 140—we know this from the AD curve.

•At point E, the price level is consistent with an output level of $10 along both AS and AD curves

Fiscal Policy

The Employment Act of 1946 establishes a

responsibility for the Federal government to

“promote maximum employment, production, and purchasing power.

Fiscal policy is the use of the spending and taxing powers of government to influence total spending and thereby to stabilize real GDP, employment, and prices.

PriceLevel

Real GDP($Trillions)

0

AD1

AS

Effect of a Demand Shock

AD2

10 12 13.5

E

H J

100

130

Increase in government spending

Issue: Why did the economy move from point E to point H—instead of E to J?

G GDPMultiplier Effect

AD curve shifts rightward

Unit cost P

Money Demand

Interest rate

C and I GDP

Movement along new AD curve

Movement along AS curve

Net result: GDP increases, but by less due to the effect of an increase in the price level

PriceLevel

Real GDP($Trillions)

0

AD2

AS

Effect of a decrease in taxes

AD1

1086.5

EK

S

100

T↓ GDPMultiplier Effect

AD curve shifts rightward

Unit cost P

Money Demand

Interest rate

C and I GDP

Movement along new AD curve

Movement along AS curve

Net result: GDP increases, but by less due to the effect of an increase in the price level

YD C

The use of the instruments of monetary policy to change total spending in the economy and thereby influence total output and employment.

PriceLevel

Real GDP($Trillions)

0

AD2

AS

Effect of a decrease in the money supply

AD1

1086.5

EK

S

100

M GDP

AD curve shifts Leftward

Unit cost P

Money Demand

Interest rate

C and

I GDP

Movement along new AD curve

Movement along AS curve

Net result: GDP decreases, but by less due to the effect of an decrease in the price level

Interest

rate

C and I

8

10

12

14

16

18

20

79:01 79:07 80:01 80:07 81:01 81:07 82:01 82:07 83:01

Federal Funds

Recessions are shaded

6

8

10

12

14

16

18

20

80 82 84 86 88 90 92

Mortgage Interest Rates

Recessions are shadedConventional 30 year

www.economagic.com

Mortgage rate

Monthly Payment1

8% $807.14

10% $965.33

12% $1,131.47

14% $1,303.36

16% $1,479.23

1 Does not include prorated insurance or property taxes.

Monthly payments on a $110,000 30 year mortgage note

400

800

1200

1600

2000

2400

80 82 84 86 88 90 92

Monthly Housing Starts

Recessions are shadedData in thousands of units

www.economagic.gov

More recently, the Fed raised the

federal funds rate six times between May 99 and May 2000—from 4.75% to 6.5

%.

The Fed reversed course at the beginning of 2001 and reduced the

federal funds rate 11 times that year!

The following factors could shift the (short-run) aggregate supply schedule up to the left:

•An increase in the price of a basic commodity—e.g., petroleum, natural gas, wheat, soybeans.

•An increase in average money wages and benefits not restricted to just one industry or sector of the economy.

•An increase in the average markup over unit cost not restricted to just one industry or sector of the economy.

PriceLevel

Real GDP($Trillions)

0

AD2

AS1

Effect of an increase in petroleum prices

AD1

1086.5

E

S

100

AS2

130

Date Price ($)Jan. 1972 1.79Dec. 1973 4.68Jan. 1974 10.84

April 1979 14.55June 1979 18.00

Nov 1979 24.00

Aug. 1980 30.00Oct. 1981 34.00

Price of One Barrel of 340 crude oil

Source: The Petroleum Economist

I’d call that a shock,wouldn’t you? The story

of Joseph (see Old Testament)suggests buffer stocks

as the remedy forsupply-shock

inflation

Productivity () means the average output of a worker

per year, or alternatively: = GDP/N

where N is total employment and Y is real GDP.

depends onthe efficiency with

which labor is employedin the production of

goods & services

Let denote average annual compensation of employees (including benefits). Thus unit labor cost (UCL) is defined as:

ULC = /

Notice that compensationcan rise with no effect on ULC,

so long as productivitykeeps pace

Annual Percent Change In Productivity, Compensation, and Unit Labor Cost

U.S., 1971-83

Source: Economic Report of the President, Table B-49

Year

83828180797877767574737271

12

10

8

6

4

2

0

-2

-4

Output per hour

Compensation

per hour

Unit labor cost

The Classical view of Fiscal policy

Friends, we believe that fiscal policy is unnecessary and

ineffective. The economy is doing just fine without meddling by

Washington.

The Federal Budget

Let:

•G denote federal spending for goods and services in a fiscal year (Oct. 1 thru Sept. 30).

•TX is federal tax receipts.

•TR is federal transfer payments.

•T is federal net taxes (TX - TR)

The Federal budget is an annual statement of expenditures, tax receipts, and surplus or deficit of the government of the U.S.

If G exceeds T in a fiscal year, then we have a federal deficit.

If, however, T exceeds G, then we have

a federal surplus.

•Crowding out is the idea that an increase in one component of spending will cause a decrease in other spending components.

•An increase in G may cause a decrease in C, IP, or both—that is, government spending may “crowd out” private spending.

Inte

rest

Rat

e

Trillions of Dollars

Crowding Out With an Initial Budget Deficit

Total Supply of Funds (Saving)

D1 = IP + G1 - T

H5%

0 1.75

D2 = IP + G2 - T

7%

2.05 2.25

A C

B •Increase in G = AH•Decrease in C = AC•Decrease in IP = CH

Inte

rest

Rat

e

Trillions of Dollars

Effects of a Reduction in the Government Surplus

S1 = Savings + T – G1

D = Investment

B

5%

0 1.75

S2 = Savings + T – G2

AH

7%

C

1.25 1.55

President Clinton’s economic strategy appears to have been effective in reducing interest rates

2000 = 100

2000 = 100