EA Final Week 7

Suppose that a financial crisis causes AD to fall. Use your diagram to show what happens to output and the price level in the short run. What happens to the unemployment rate?

-A financial crisis leads to a leftward shift of aggregate demand. The equilibrium level of output and the price level will fall. Because the quantity of output is less than the natural rate of output, the unemployment rate will rise above the natural rate of unemployment.

What defines a recession? What is a depression?

-A recession is defined as two consecutive quarters of negative economic growth. -A depression is a severe recession (the definition of a depression is subjective).

What will cause the AD curve to shift?

-Aggregate demand will shift when something other than the overall price level affects consumption, investment, net exports, or government spending. - Consumption: worried about future/retirement people save more, consume less AD shifts left. Market boom, wealth, people spend more. AD shifts right. Investment: new computer firms need and buy, AD shifts right. If pessimistic and cut back AD shifts left.

What happens if there is a worldwide drought that drives up the costs of production? Great Depression due to demand or supply shock (graph in lecture)

-At any given price, firms wish to produce less and aggregate supply shifts left as a result. -As we will see next lecture, it is much more difficult for policymakers to deal with supply shocks than demand shocks. - This is because there is an unfortunate choice between fighting inflation and fighting unemployment. -Once again wages, prices and perceptions adjust in the long run and the aggregate supply curve will shift back to the right. • The economy will return to its long-run equilibrium: - Great Depression was a suppy shock, growth rate stable but not price level.

'The AD curve slopes downwards because it is the horizontal sum of the demand curves for individual goods.' True or False, Explain.

-False. To understand why AD curve slopes downwards: Recall that GDP (which we denote as Y) is the sum of consumption (C), investment (I), government purchases (G) and net exports (NX): Y = C + I + G + NX Each of these four components contributes to the AD for goods and services. For now, we assume that government spending is fixed by policy. The other three components of spending - consumption, investment and net exports - depend on economic conditions and, in particular, on the price level. To understand the downwards slope of the AD curve, therefore, we must examine how the price level affects the quantity of goods and services demanded for consumption, investment and net exports.

What would cause the LR AS curve to shift?

-If technology improves or if there is a change in the supply of productive factors, then aggregate supply will shift and the natural rate of output will change. • Long-run economic growth can be modelled as a continual shifting in the longrun aggregate supply curve. Labour: increase in immigration-more workers, LRAS shifts right or change in natural rate of unemployment (if it rose, LRAS would shift left) Capital: increase in capital stock, shifts LRAS right Natural Resources: new minerals shifts right, etc Technology: computers, shifts it right. etc. Even things like more open trade shift right.

Unemployment is classified as a lagging indicator. Explain what this means and why unemployment is classed as such.

-Lagging indicator is an indicator which occurs after changes in economic activity have occurred. The unemployment rate is a measure of the number of people who are both jobless and looking for a job. This measurement is considered a lagging indicator, confirming but not foreshadowing long-term market trends.

'Whenever the economy enters a recession, its long-run AS curve shifts to the left.'

-Only changes in the economy that alter the natural rate of output shifts the long-run AS curve. Because output in the classical model depends on labour, capital, natural resources and technological knowledge, we can categorize shifts in the long-run AS curve as arising from these sources.

What is the crowding out effect?

-Suggest shifts in AD could be smaller than initial injection. Aggregate demand is offset because G raises r. -When the government increases spending, the income of households and firms will increase. Because households and firms are now wealthier, they will want to make more purchases. They will demand more money to do so. This raises the equilibrium interest rate. • At higher interest rates, investment spending falls and the initial shift in aggregate demand is not as large.

Two Causes of Economic Fluctuations: Shifts in AD & AS. What happens if there is pessimism in the economy and people cut spending?

-The aggregate demand curve shifts to the left, lowering the overall price level. • Let's focus on the sticky wage theory to understand the effects of this. Because nominal wages are fixed, this unexpected fall in the price level temporarily raises real wages, causing firms to reduce employment and production.(pessimistic attitudes can be self-fulfilling). -After enough time has passed, the economy will heal itself and output will return to its natural rate. As people's expectations about prices catch up with reality, the fall in the expected price level alters wages, prices, and perceptions. • Because the overall price level is lower (and because unemployment is high), workers will agree to employment contracts that pay lower wages. • The reduction in the wage lowers the cost of production, firms will hire more workers, more will be produced, and the aggregate supply shifts to the right. The economy eventually returns to the long-run equilibrium -In the long run, the shift in the aggregate demand curve is reflected fully in the price level and not in the level of output.

What is the Aggregate Demand Curve? What components does it consist of?

-The aggregate demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level. -𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁X. The sum of consumption, investment, government purchases, and net exports. -highlights the inverse relationship between price level and national income (downward sloping). A fall in level of prices, raises quantity of goods and services demanded

What is the case for active stabilization? Against? What are the forms of lags?

-The causes of economic fluctuations are well understood. Monetary and fiscal policy can effectively prevent or soften economic downturns. - Not using these tools to stabilise the economy is foolish. Ex: improved real GDP after WWII w active policy. -While it may work in theory it is difficult to get right. Inherent and unpredictable lags in implementation. Inside lags: policymakers taking time to respond to shocks. Recognize problem then figure out something to do. Esp. long in fiscal policy Outside lags: time for policy to have intended effect on the economy. Large for monetary policy. Actually need to plan out their investing.

What does the Aggregate Supply curve tell us? What affects its shape?

-shows the quantity of goods and services that firms wish to produce and sell at any price. -The time horizon is crucial to the shape: in the LR the AS is vertical, in the SR it is upward sloping.

What do all three theories suggest? Could an equation represent that?

All of these theories suggest that output deviates from its natural rate when the price level deviates from the price that people expect. -Mathematically, we can express the relationship as: 𝐴𝑆 = 𝑌𝑁 + 𝑎(𝑃𝑎𝑐𝑡𝑢𝑎𝑙 − 𝑃𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑) • AS is aggregate supply, 𝑌𝑁 is the natural rate of output, 𝑃𝑎𝑐𝑡𝑢𝑎𝑙 is the actual price level, and 𝑃𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 is the expected price level. • 𝑎 measures how sensitive output is to unexpected changes in the price. • When people's expectations are correct (and the actual price equals the expected price), then the AS curve is vertical.

What happens when the CB increases the supply of money? What about when it decreases the supply of money? When & how would policymakers intervene?

An increased supply of money moves the money supply line right. Thus the interest rate will decrease. Lower r means increased quantity of goods and services demanded at a given price level (people less likely to keep money in savings, firms more likely to invest and buy things) so Y increases. Vice Versa. -policymakers may choose to intervene in the short run to dampen economic fluctuations. The central bank might... - lower interest rates during a recession (to shorten the recession's duration). - raise interest rates during an expansion (to combat inflation).

Which of the following is an automatic stabilizer? Spending on state-run schools. Military spending. Spending on a space programme. Or none.

Automatic stabilizers are increases in government spending or reductions in taxes that take place during recessions (and vice versa during economic expansions). An example of an automatic stabiliser is spending on unemployment benefits. Government spending on unemployment benefits will automatically increase during recessions when people are out of work. None of these government expenditures would be classified as an automatic stabilizer because they do not closely depend on the state of the economy.

A coincident indicator is

Changes at the same time as changes in economic activity. An example is industrial production.

What are automatic stabilizers? What are examples? What is the impact of a strict balanced budget?

Changes in fiscal policy that stimulate AD when the economy goes into a recession, without policy makers having to take deliberate action. -Most important is progressive tax system. If incomes fall, automatic tax cuts. And likewise increases taxes if higher income. -Government spending: welfare spending increases during a recession and vice-versa. A strict balanced budget eliminates such automatic stabilizers. Output and unemployment would be even more volatile than they already are.

If firms adjusted their prices every day, then the short-run AS curve would be horizontal.' T or F and explain.

False. A horizontal AS implies that prices are sticky and take time to adjust.

The long-run AS curve is vertical because economic forces do not affect long-run AS.' T or F and explain.

False. In the long run, an economy's production of goods and services (its real GDP) depends on its supplies of labour, capital and natural resources, and on the available technology used to turn these factors of production into goods and services. Because the price level does not affect these long-run determinants of real GDP, the long-run AS curve is vertical

According to the interest rate effect, aggregate demand slopes downward (is negatively related to the price) because lower prices

One reason why aggregate demand is negatively related to the price is because lower prices lead to more investment spending. As prices are lower, people hold less money and invest (lend) more. This causes interest rates to fall which increases investment spending.

What is fiscal policy? What do such changes do to the AD curve?

Fiscal policy refers to the government's choices regarding the overall level of taxes or government purchases. -Remember AD is Y=C+I+G+NX. An increase in government spending will shift AD right, and decrease will shift AD left. Similar changes occur with tax cuts or tax increases. (AD shifts further right if tax cut seen as permanent)

What is the multiplier effect?

Government spending of 1,000 increases aggregated demand by more than 1,000. -Why? One person's expenditure becomes another person's income. There is a positive feedback effect as higher demand leads to higher income, which in turn leads to even higher demand. Suppose 90% marginal propensity to consume from $1. So .90 spent, .10 saved. Say you spend 2,000. That turns into 1,800 then 1,620 and so on

Use the sticky wage theory of AS to explain what will happen to output and the price level in the long run (assuming there is no change in policy). What role does the expected price level play in this adjustment? Be sure to illustrate your analysis with a graph.

If nominal wages are unchanged as the price level falls, firms will be forced to cut back on employment and production. Over time as expectations adjust, the short-run aggregate-supply curve will shift to the right, moving the economy back to the natural rate of output.

Why is the AS curve vertical in the long run? What is the LR quantity of output called?

In the LR, production of goods & services is dependent on supplies of labor, capital, natural resources, & technology--NOT price level. ex: if every input price doubles (wages, rent, sugar), nothing really changes. Prices are nominal variables and arbitrary (classical dichotomy: real variables dont depend on nominal). Depends on factors of production and technology. -The quantity of output produced in the long run is known as the natural rate of output. An economy produces at the natural rate when all factors of production and technology are fully utilised and employment is at its natural rate.

The long-run effect of an increase in the money supply is to

Increase the price level. In the long-run, the level of output is determined by the country's productive capability (as measured by the long-run aggregate supply curve). An increase in the money supply will lower the interest rate which shifts aggregate demand to the right. This raises prices, but not the level of output in the long run.

Would you expect the following variables to be pro-cyclical or countercyclical if GDP was above trend? Explain. Inflation, Unemployment, Employment, Real Wages, Nominal interest rates.

Inflation--procyclical. Unemp--countercyclical. Employment--procyclical. Real Wages--procyclical. Nominal interest rates--procyclical.

What is the theory of liquidity preference? What causes the equilibrium interest rate?

Keynes' theory that the interest rate adjusts to bring money supply and money demand into balance. -The demand for money comes from households and firms, who choose how much of their wealth to hold in the form of money. - The supply of money is determined by the central bank. • In this model, the price level is stuck at some level (this is a model of the short run). - For any given price level, the interest rate adjusts to balance the supply and demand for money Suppose the current interest rate is above the equilibrium interest rate. There is an excess supply of money. The public will want to convert their wealth from money into interest bearing assets. This drives down the interest rate. • Suppose the current interest rate is below the equilibrium interest rate. There is an excess demand for money. The public will want to convert their wealth from interest bearing assets into money. This drives up the interest rate.

Explain three cyclical indicators (leading, lagging, coincident) and give examples

Leading: foretells future changes. So this changes before the change in economic activity (stock market, new home construction, inventory stock) Lagging: changes after the change in real GDP (debt relative to income) Coincident: changes at the same time as real GDP (personal income, industrial production)

What happens to the Aggregate Demand curve: - The UK government lowers the tax rate - The UK government builds a new motorway - The Bank of England lowers the interest rate in the UK - The overall price level in the UK increases

Lowered tax rate: Consumers have more disposable income, higher consumption, AD right. New motorway: More G, moves AD right Lower interest rate: More Invst (cost of borrowing is lower) AD moves right Price level increases: shouldn't shift?

What are procyclical variables? What are countercyclical variables? Give examples

Procyclical: Variables that move in the same direction as GDP (consumer spending, interest rates, wages, employment, inflation) Countercyclical: move in the opposite direction of GDP (unemployment, bankruptcies)

What shifts the SRAS?

Similar to LRAS, but just messed up by sticky wages, sticky prices, and misperceptions. Thus changes in labour, capital, natural resources, and technology shift it. (anything that shift LR shifts SR) -Expectations about future prices also cause a shift. -Suppose, for example, that workers and firms expect a high price level. Workers and firms will agree to high wages to reflect this. This increases production costs and the short-run aggregate supply curve shifts left. • Therefore, an increase in the expected price level shifts the short-run aggregate supply curve to the left and a decrease in the expected price level will shift the short-run aggregate supply curve to the right.

Stagflation occurs when the economy experiences

Stagflation occurs when the short-run aggregate supply curve shifts to the left causing output to fall and prices to rise. There is simultaneously economic stagnation and inflation.

Suppose that the economy is initially in long-run equilibrium. Then suppose there is an increase in military spending due to rising international tensions. According to the model of aggregate demand and aggregate supply, what happens to prices and output in the long run?

The increase in military spending will shift the aggregate demand curve to the right. In the short-run, this will increase output and the price level. In the long-run, however, the level of output is determined by the long-run aggregate supply curve. Output will be unchanged and prices will be higher.

Suppose the price level falls but because of fixed nominal wage contracts, the real wage rises and firms cut back on production. This is a demonstration of the

There are three theories as to why aggregate demand depends on the overall price level in the short run. One of these theories is the sticky-wage theory. This is where wages are slow to respond to changes in the overall price level. Sticky wages imply that real wages will change when the overall price level changes. This affects the cost of production and output will change as a result.

In contrast the short run the AS curve is upward sloping. If price level decreases what happens to quantity of goods and services in the SR? What are the three theories behind the upward sloping SRAS?

They decrease. Sticky Wage theory: Nominal wages are slow to adjust. This is partly due to long-term employment contracts. This implies that an unexpected change in the overall price level may not be immediately met by a change in the wage rate. • If the price level (𝑃) falls and the nominal wage (𝑊) does not, then the real wage (𝑊/𝑃) increases. •**Because lower prices increase real wages, lower prices will cause firms to cut back on production. Sticky Price: Some prices are slower to adjust to economic conditions than others. - The actual process of changing prices (through printing new menus or changing price tags) is more costly for some firms than for others. • If the overall price level in the economy falls unexpectedly, some firms might lag behind and will be stuck with prices that are "too high." - For the firms with prices that are stuck too high, sales will fall and less will be produced. Misperceptions: Suppose that overall prices in the economy have increased unexpectedly (that is, the prices have increased unexpectedly in all markets). • The factory owner wakes up one morning and sees that cupcakes are more expensive. The owner might erroneously believe that prices have changed only in the market for cupcakes. - For example, the owner might think that the demand for cupcakes has increased overnight. Due to this misperception, the factory owner will increase their production even though nothing has actually changed in the market for cupcakes.

When an increase in government purchases increases the income of some people, and those people spend some of that increase in income on additional consumer goods, we have seen a demonstration of

This is an example of the multiplier effect. Government spending increases income, which increases spending, which increases income yet again.

Suppose a wave of investor and consumer optimism has increased spending so that the current level of output exceeds the long-run natural rate. If policy makers choose to engage in activist stabilization policy, they should decrease

To more quickly return the economy to its long-run level of output, policy makers should decrease government spending, which shifts the aggregate demand curve to the left.

Why does the AD Curve slope downward (i.e. the negative relationship between price level and aggregate demand)-what are the three reasons?

Wealth Effect (Prices & Consumption)-a decrease in price level makes consumers effectively wealthier, encourages them to spend more. Thus increase in consumer spending means more g&s demanded. Interest Rate Effect (Prices & Investment)-As prices fall, the same quantity of purchases can be made with less money. Households will save the excess money and the increased supply of savings lowers the interest rate. This encourages firms to borrow and invest. Exchange Rate Effect (Prices & NX)-Because lower prices lead to lower interest rates, there is less demand for the domestic currency (because domestic assets are less attractive). The value of the domestic currency falls, which encourages exports and discourages imports.

What happens when there is a change in price level or income rises in the economy?

With a higher price level, people will demand more money, so MD shifts right. With MD shifted right, the r increases. Higher r makes people more likely to save rather than invest. On the AD curve a higher P means output Y decreases. There is a negative relationship between price and aggregate demand.

Explain whether each of the following events shifts the short-run AS curve, the long-run AS curve, the AD curve, both, or neither. For each event that does shift a curve, use a diagram to illustrate the effect on the economy. a. Households decide to save a larger share of their income. b. Cattle farmers suffer a prolonged period of foot-and-mouth disease which cuts average cattle herd sizes by 80 per cent. c. Increased job opportunities overseas cause many people to leave the country

a. Left-ward shift of AD curve only. Greater household saving means less household consumption at every price level so the whole AD curve shifts to the left. b. Neither. The AD-AS-LRAS model doesn't reflect sector specific shocks. c. Left-ward shift of AD and AS curves. More people moving abroad means fewer households to drive consumer spending so AD shifts to the left. People moving abroad also means wages must rise here to encourage some workers to stay. This drives up the cost of production so the AS curve shifts to the left.

The economy is in a recession with high unemployment and low output. a. Use a graph of aggregate demand and aggregate supply to illustrate the current situation. Be sure to include the aggregate demand curve, the short-run aggregate supply curve, and the long-run aggregate supply curve. b. Identify an open-market operation that would restore the economy to its natural rate. c. Use a graph of the money market to illustrate the effect of this open-market operation. Show the resulting change in the interest rate. d. Use a graph similar to the one in part (a) to show the effect of the open-market operation on output and the price level. Explain in words why the policy has the effect that you have shown in the graph.

a. The current situation is the short-run equilibrium at point A where the output is below the natural level and unemployment is higher than the natural rate. b. The central bank's bond traders can buy bonds in open market operations so to increase the money supply, that will lead in an increase in the aggregate demand (shift outwards from AD1 to AD2 and restore the economy to its natural rate at the long-run equilibrium (point B). c. The money-supply curve shifts to the right from MS1 to MS2, as shown in the figure below. The result is a fall in the interest rate. d. Considering again the graph in part (a) the open market operations have restored the natural level of output at the expense of inflation. Point B, the long-run equilibrium involves higher general level of prices. This example is a demonstration of the neutrality of money as discussed in the lecture and the textbook. An increase in the money supply will boost the economy in times of recession by reducing unemployment and restoring production but in the long run the increase in money supply is translated into inflation and has no real effects. Recall that the growth is considered exogenous in these models.

Explain how each of the following developments would affect the supply of money, the demand for money and the interest rate. Illustrate your answers with diagrams. a. The central bank's bond traders buy bonds in open market operations. b. An increase in credit card availability reduces the cash people hold. c. A wave of optimism boosts business investment and expands aggregate demand .d. An increase in oil prices shifts the short-run aggregate supply curve to the left.

a. The money-supply curve shifts to the right from MS1 to MS2, as shown in the figure below. The result is a fall in the interest rate. b. People holding less cash shifts the money-demand curve inwards from MD1 to MD2, as shown in the figure below. The interest rate falls. c. A wave of consumer optimism increases aggregate demand, the money-demand curve shifts to the right from MD1 to MD2, as shown in figure below. The result is an increase in the interest rate. d. Cost of production has now increased requiring more money to facilitate the same transactions. Money-demand shifts outwards from MD1 to MD2. Interest rates will rise.

Which of the following statements is true regarding the long-run aggregate supply curve? The long-run aggregate supply curve

is vertical because an equal change in all prices and wages leaves output unaffected. When all prices and wages in the economy change by the same amount, this will have no effect on the amount that is produced. This is because nothing has actually changed, we have only changed the unit of measurement