Econ: Section 3

AD/AS model & Phillips model

1) Increasing AD with demand side policies causes greater inflation and increases unemployment 2) SRAS curve decreases with supply side factors causing inflation. The producers will have to lay off labors due to greater cost of production. Unemployment increase.

Deflation

A decrease in the general price level, over a period of time. (e.g It helped America after the Civil War and helped America back on its feet after the Great Depression) AD decreases, SRAS increases, Price falls.

Phillips Curve

A graph showing the relationship between inflation and unemployment . The theory states that unemployment can be reduced in the short run by increasing price level (inflation) at a faster rate. Conversely, inflation can be lowered at the cost of possibly increased unemployment and slower economic growth Short-run trade-off between unemployment and inflation X-axis: Unemployment rate; Y-axis: Inflation rate

Basket of goods

A list of *common goods* that are often consumed by HYPOTHETICAL household

Depression

A long-term economic state characterized by unemployment and low prices and low levels of trade and investment. Everything goes down at MACRO-EQUILIBRIUM showing FULL EMPLOYMENT.

Demand shock

A sudden surprise event that temporarily increase or decrease demand for goods and services (e.g 9/11 - economical and political uncertainty drove demand down in tourism)

Supply Shock

A sudden surprise event that temporarily increase or decrease supply for goods and services (e.g Intervention in Iraq - cutting off oil causing decrease in Factors of Productions)

Inflation

A sustained rise in prices. Measured by the CPI. COST: increase uncertainty of businesses; exports become less competitive in foreign market; decrease in purchasing power; rich will do fine but poor will suffer

Hyperinflation

A very high rate of inflation - 100% or more (e.g Zimbabwae in 2000s printed money to pay debts to IMF until 2009, then they use US and South Africa currency instead)

Recession

An economic slowdown of the economy which results in rising unemployment, increased business failures, declining economic growth and higher personal bankruptcies. AD decrease.

Anticipated inflation

An inflation rate that has been correctly forecast

Inflationary growth

Any growth caused by activity which will eventually result in inflation. (e.g creating money to spur the economy or setting your currency low to spur exports - China) Everything goes up. *(Change in) AD>SRAS>LRAS

Shift in AS

Any resources/Factors of Production price (e.g Oil price) Price of raw materials Technology and education - quantity and quality of labor Natural disaster Corporate tax Employee wages Labor endowment (income) Permanent international trade barriers Permanent business regulation Quantity and Quality of capital investment (PPC) Change in legislation

Extreme demand pull inflation

As AD increases, demand for goods and services increases, causing cost of production to increase, so AS decreases. AD increase, SRAS decrease, Price rises.

Labour market and inflation

As unemployment falls, some labour shortages may occur where skilled labour is in short supply. This puts extra pressure on wages to rise, and since wages are usually a high percentage of total costs, prices may rise as firms pass on these costs to their customers GRAPH: X-axis: #of workers; Y-axis: Average real wage rate; AS: labor; AD: company

Shift in AD

Consumer nominal wealth Consumer expectation and confidence Personal tax Planned INVESTMENT spending Business profit expectation GOVERNMENT PURCHASE MONEY SUPPLY NET EXPORT SPENDING National income aboard/Foreign income exchange

Moderate view of AS

Curve=we would like to achieve economic growth as long as inflation does not OUTPACE growth Below the full employment point means not fully employed, not efficient (inside the PPC)

What are the different types of employment?

Cyclical, Frictional, Structural, Classical, Seasonal, Natural

Inflation: A Good Thing?

Deflation is dangerous. Some might say even more dangerous. People get laid off, spend less, prices get cheaper, which leads to people waiting to make purchases as they think that prices will continue to fall, so firms cut costs and lay off workers to reduce prices further, but consumers have less money to spend so they still don't buy, so more people get laid off, and so on. So we should increase inflation and grow demand so prices can rise, and people will stop getting laid off.

Price of loans and Interest Rates

Demand for loan decreases; Interest Rates decreases Demand for loan increases; Interest Rates increases

What are the different types of inflation?

Demand pull inflation, Cost-push inflation, Hyperinflation, Creeping inflation, Stagflation

Interest rate effect

During inflation, people may increase their borrowing, which will raise interest rates. When interest rates rise, spending will be reduced.

Deflationary growth

Everything BUT Price goes up. Price falls. (e.g In the 1800s, the general trend of price levels in peacetime was downward) *(Change in) SRAS & LRAS>AD

Fiscal Policy

Government influence on Consumption and Government spending. Taxation and Government spending. Inflation: Taxation rises; Government spending falls. (Have to cut consumer spending by tax and reduce disposable income.) Recession: Taxation falls; Government spending rises. (Increase consumer's disposable income and consumers will spend more. BUT Government is running a deficit budget because it spends more than it collects in taxes.)

Monetary Policy

Government/Central Bank. Interest Rates and Money Supply. Inflation: Interest Rates rises; Money Supply falls. Recession: Interest Rates falls; Money Supply rises.

Non-inflationary growth

Growth of economic activity without any tendency to inflation of prices. Everything BUT Price goes up. Price stays the same. Increase in RGDP. *They change by the same magnitude.

CONS of Demand side policy

In Phillips Curve, with expansionary fiscal policy (lower tax and higher government spending) to solve unemployment and monetary policy (lower interest rates and more money supply) will temporarily decrease unemployment but also increase inflationary pressure. In the AD/AS model, this can be indicated by increase in AD. However, as the employers have to pay more labors with wage inflation, eventually they will have to lay people off, causing Unemployment to go back to the ORIGINAL RATE but with a greater inflation. In the AD/AS model, this can be shown with decrease in SRAS to meet the greater Price Level at the same RGDP.

PROS of Supply side policy

Increase productivity overtime by education and incentive to make resources more efficient. More output will lead to decrease in Price, which is opposite of stagflation. *refer to PPC curve

Cost push inflation

Increases in the price level (inflation) resulting from an increase in resource costs (e.g raw material prices) and hence in per unit production costs; inflation caused by reductions in aggregate supply. Cost increases, availability decreases, output decreases. SRAS decrease.

Demand pull inflation

Inflation caused primarily by excess aggregate demand. Consumer driven inflation - consumers are trying to spend more economy can produce. AD increase.

Real balance effect

Inflation causes the value of bank balances fall. Purchasing power declines with inflation. In order to maintain the purchasing power of these balance, you spend less. This is acting to maintain their real money balances. AD falls.

Creeping inflation

Inflation in the range of 1-3% per year Central Bank and Government see this as a good thing and use fiscal and monetary policies to keep in check

Unanticipated inflation

Inflation that catches people by surprise; consumers and producers predicted it incorrectly

Price inflation and Unemployment

Inverse relation. Phillips curve: reducing unemployment below a certain level would cause increasing inflation.

Inflationary Gap

It is an "above full employment" equilibrium. The relative increase in real GDP causes an economy to increase its consumption, which causes prices to rise in the long run. Greater inflationary pressure.

Difficulty in Supply side policy

It is difficult to get people to get back to school or leave their home for job relocation. It is also hard to research or execute supply side policies, whereas it is very easy to use demand side policies.

Limitations of CPI

It may only underlie the rate of inflation but not measure it. It is not specific to each person's household: -do not consume all the basket of goods; not identical -categories weighs differently to each individuals -new goods are continually introduced to the market and old goods continually drop out of the market -quality of the product changes over time (e.g telephones)

Consumer Price Index/Retail Price index

Measure the average level of the prices of a basket of goods and services consumed by *typical households*

Macroeconomic equilibrium

Occurs when the quantity of RGDP demanded equals the quantity of RGDP supplied at the point of intersection of the AD curve and the AS curve.

Keynesian AS

Realizes social safety nets, so Classical monetarist's AS will not work Horizontal=because labor unions wages won't go bellow a certain level, and after reaching full employment, Vertical=all jobs are taken If we try to push further, we need more AS (labors) with increase wages so income will increase causing inflation *wages are downward sticky (wages rises easily but resist to fall)

Business Cycle

Recurrent swings from boom/peak, recession, depress, recovery/expansionary then back to boom and a repetition of the sequence. X-axis: Time; Y-axis: RGDP

Long run Phillips Curve

Relationship between the inflation rate and the unemployment rate in the long run, looks at long-term natural rate of unemployment. At Natural unemployment: 4-8%

Product market and inflation

Rising demand and output puts pressure on scarce resources and can lead to suppliers raising prices to widen profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap)

Deflationary expansion

SRAS increase, Price falls, RGDP increase. Causing expansionary gap.

Aggregate Demand

Sum total demand for goods and services in an economy AD=C+I+G+(X-M) Downward sloping because: Income effect, Substitute effect, Theory of demand

Aggregate Supply

The total supply of all the goods and services available in an economy

Classical monetarist's AS

Vertical=economy is always at a level of full employment (all jobs are gone BUT NOT 0% unemployment) Believing that the opportunity cost of not working is too great due to the lack of welfare and social safety net

Classical unemployment

WHAT: "real-wage" unemployment WHEN: unions or employers demand for higher real wages *Higher real wages cause the demand for labor to fall (cost for producer is now higher) and the supply of labor to increase (more unemployment) SOLUTION: minimum wages, spoken/unspoken agreements between employers and workers which hold wages above market clearing rates

Natural unemployment

WHAT: frictional+structural+seasonal WHEN: always when the labor market clears - the demand and supply for labor is in equilibrium; when all the jobs that are currently available are taken

Seasonal unemployment

WHAT: seasonality changing demand or supply SOLUTION: job training, job relocation (e.g workers from Maritimes to Alberta), subsidy for transportation

Frictional unemployment

WHEN: people entering, re-entering, switching, finding the right job; new entrants into labor market *not really a problem, inevitable consequence of a growing economy SOLUTION: education, job training, social ties, working age regulation, job relocation (e.g work in abroad)

Structural unemployment

WHEN: structure of the economy changes; more serious than frictional unemployment; or technological change (e.g machines over humans) WHAT: significant jobs loss, may result in overall fall in demand for a product SOLUTION: education, job training, job relocation (e.g work in abroad)

Cyclical (Demand deficient) unemployment

WHY: business recession WHEN: total demand is insufficient to create full employment; labor market is NOT in equilibrium, deficiency of AD for goods and services and labor markets not working smoothly SOLUTION: monetary and fiscal policy

Stagflation

When there are increasing inflation and unemployment (happens simultaneously) Phillips Curve shifting. (e.g SRAS curve decreased due to OPEC increasing oil prices in 1970s. Inflation occurred, price level rose, output fell - decrease in SRAS. The producers will have to lay off labors due to greater cost of production. Unemployment increase)

Net export effect

When there is inflation, domestic prices will be increasing relative to foreign prices, which reduces aggregate demand through a fall in net exports (X-M)

Full employment equilibrium

Where real GDP=Potential GDP (PPC) All jobs that are currently available in the job market is taken.

PROS of Demand side policy

With fiscal and monetary policy, the government and the central bank can keep in check of the creeping inflation. Also they can control inflation through manipulating the consumption of the basket of goods by tax and interest rates. It also creates a TEMPORARILY increase in RGDP.

Contractionary/Recessionary Gap

Wwhere an economy is operating at below its full-employment equilibrium. The level of RGDP is currently lower then it is at full-employment, which puts downward pressure on prices in the long run.

Long-run Aggregate Supply

the relationship between the real GDP and the price level when there is full employment *Shifts only when there is a permanent change in SRAS. (e.g permanent increase in oil price)