Chapter 11 Macro

Say's Law

"supply creates its own demand"

SRAD curve is downward sloping because

(a) the wealth effect, Higher prices lead to lower real wealth, which reduces the level of consumption (b) the interest rate effect, a higher price level will mean a greater demand for money (higher price, higher Q/gdp demanded), which will tend to drive up interest rates and reduce investment spending (c) the foreign price effect, which holds that a rise in the price level will make domestic goods relatively more expensive, discouraging exports and encouraging imports.

Potential GDP

LRAS- • Potential GDP the quantity that an economy can produce by fully employing its existing levels of labor, physical capital, and technology, in the context of its existing market and legal institutions

Rise in confidence // AD

a rise in confidence is associated with higher consumption and investment demand, it will lead to an outward shift in the AD curve, and a move of the equilibrium, from E0 to E1, to a higher quantity of output and a higher price level, as shown in Figure (a).

full employment gdp

another name for potential GDP, when the economy is producing at its potential and unemployment is at the natural rate of unemployment

interest rate effect

as prices for outputs rise, the same purchases will take more money or credit to accomplish.(prices go up, due to the fact that it is costing more to produce) This additional demand for money and credit will push interest rates higher. In turn, higher interest rates will reduce borrowing by businesses for investment purposes and reduce borrowing by households for homes and cars—thus reducing consumption and investment spending. (Higher rates, causing people to reduce their consumption)

the wealth effect

as the price level increases, the buying power of savings that people have stored up in bank accounts and other assets will diminish, eaten away to some extent by inflation. Because a rise in the price level reduces people's wealth, consumption spending will fall as the price level rises.(People will end up buying less, due to inflated prices. )

Cyclical Unemployment

bounces up and down according to the short-run movements of GDP -US Long run the unemployment rate typically hovers around 5% (give or take one percentage point or so), when the economy is healthy shown by how close the economy is to the potential or full employment level of GDP relatively low cyclical unemployment for an economy occurs when the level of output is close to potential GDP high cyclical unemployment arises when the output is substantially to the left of potential GDP on the AD/AS diagram

Aggregate Demand shifts (Real GDP/price level wise)

o a shift of the aggregate demand curve to the right leads to a greater real GDP and to upward pressure on the price level. o a shift of aggregate demand to the left leads to a lower real GDP and a lower price level o Whether these changes in output and price level are relatively large or relatively small, and how the change in equilibrium relates to potential GDP, depends on whether the shift in the AD curve is happening in the relatively flat or relatively steep portion of the AS curve

price level

price level is an index number such as the GDP deflator that measures the average price of the things we buy.

aggregate supply

refers to the total quantity of output (i.e. real GDP) firms will produce and sell.

A decrease in the price of inputs (AS)

shift the SRAS curve to the right, providing an incentive for more to be produced at every given price level for outputs (where the outward shift of SRAS to the right allowed the economy to expand, unemployment to fall, and inflation to decline)

SRAS is upward sloping because

shows the positive relationship between the price level and the level of real GDP) 1. When the price level of outputs increases, the price level for inputs remains fixed (the opportunity for additional production profits encourage production) - AS is near horiziontal on the left and near vertical on the right (exponential line) - In the long run, it is vertical line at the level of potential output. (which is the maximum level of output the economy can produce with its existing levels of workers, physical capital, technology, and economic institutions.)

Intermediate Zone

- (between SRAS curve and LRAS curve) If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ei, then we might expect unemployment and inflation to move in opposing directions. , a shift of AD to the right will move output closer to potential GDP and thus reduce unemployment, but will also lead to a higher price level and upward pressure on inflation. a shift of AD to the left will move output further from potential GDP and raise unemployment, but will also lead to a lower price level and downward pressure on inflation. • dividing the SRAS curve into different zones works as a diagnostic test that can be applied to an economy • First, figure out what zone the economy is in and then the economic issues, tradeoffs, and policy choices will be clarified. Some economists believe that the economy is strongly predisposed to be in one zone or another. • hard-line Keynesian economists believe that the economies are in the Keynesian zone most of the time, and so they view the neoclassical zone as a theoretical abstraction. ------Conversely, hard-line neoclassical economists argue that economies are in the neoclassical zone most of the time and that the Keynesian zone is a distraction

Decrease in confidence // AD

- Usually low during a recession - confidence can sometimes rise or fall for reasons that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure (like a president state of union address shift to the left, contributes to causing a recession) lower Q output and lower P level

Possible effects of high input prices

- reduced GDP or recession, higher unemployment because the economy is now further away from potential GDP, and an inflationary higher price level as well.

Stagflation

- this pattern of a shift to the left in SRAS leading to a stagnant economy with high unemployment and inflation

The AD/AS model can convey a number of interlocking relationships between the four macroeconomic goals of growth

1. Unemployment 2. Inflation 3. Sustainable balance for trade • AD/AS framework is flexible enough to accommodate both the Keynes' law approach that focuses on aggregate demand and the short run, while also including the Say's law approach that focuses on aggregate supply and the long run.

2 broad categories that can cause AD to shift

1. changes in the behavior of consumers or firms 2. changes in government tax or spending policy.

2 reasons as to why inflation will persist over time

1. if the government continually attempts to stimulate aggregate demand in a way that keeps pushing the AD curve when it is already in the steep portion of the SRAS curve 2. if inflation has been occurring for several years, a certain level of inflation may come to be expected (example - if consumers, workers, and businesses all expect prices and wages to rise by a certain amount, then these expected rises in the price level can become built into the annual increases of prices, wages, and interest rates of the economy. These two reasons are interrelated, because if a government fosters a macroeconomic environment with inflationary pressures, then people will grow to expect inflation. However, the AD/AS diagram does not show these patterns of ongoing or expected inflation in a direct way.

Two of the most important factors that can lead to shifts in AS

1. productivity growth 2. input prices. Cost of labor/wages the cost of imported goods that are used as inputs for other products ** Same for these two cases, lower price shifts the AS curve to the right, and higher prices shift AS to the left

4 components of Aggregate Demand

Consumption 2. Investment 3. government spending 4. net exports (exports minus imports). (determined by a number of factors, such as price level.

2 types of unemployment

Cyclical and Natural Rate

Potential GDP and Unemployment

If equilibrium is close to real gdp of Potential, good low unemployment, if it is far left, high unemployment

Productivity and AS

Productivity means how much output can be produced with a given quantity of labor. One measure of this is output per worker or GDP per capita • Over time, productivity grows so that the same quantity of labor can produce more output. • Higher productivity -- shifts to the right (firms can produce a greater quantity of output at every price level - firms can produce a greater quantity of output at every price level

Two ways Inflationary pressures may rise

The AD/AS framework implies two ways that inflationary pressures may arise 1. if aggregate demand continues to shift to the right when the economy is already at or near potential GDP and full employment, thus pushing the macroeconomic equilibrium into the steep portion of the AS curve. (In this situation, the aggregate demand in the economy has soared so high that firms in the economy are not capable of producing additional goods, because labor and physical capital are fully employed, and so additional increases in aggregate demand can only result in a rise in the price level.) 2. a rise in input prices that affects many or most firms across the economy—perhaps an important input to production like oil or labor—and causes the aggregate supply curve to shift back to the left the shift of the SRAS curve to the left also increases the price level from P0 at the original equilibrium (E0) to a higher price level of P1 at the new equilibrium (E1). In effect, the rise in input prices ends up, after the final output is produced and sold, being passed along in the form of a higher price level for outputs.

Natural Rate of Unemployment

This baseline level of unemployment that occurs year-in and year-out - determined by how well the structures of market and government institutions in the economy lead to a matching of workers and employers in the labor market factors that determine this are not shown separately in the AD/AS model, although they are implicitly part of what determines potential GDP or full employment GDP in a given economy.

aggregate demand equation -

consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M): C + I + G + X - M

neoclassical economists

economists who generally emphasize the importance of aggregate supply in determining the size of the macroeconomy over the long run

foreign price effect

if prices rise in the United States while remaining fixed in other countries, then goods in the United States will be relatively more expensive compared to goods in the rest of the world Exports will be more expensive, and the quantity of exports will fall Imports from abroad will be relatively cheaper, so the quantity of imports will rise ****Thus, a higher domestic price level, relative to price levels in other countries, will reduce net export expenditures.

AS shift right/left comparison [prices, productivity]

o If the AS curve shifts back to the left, the combination of lower output, higher unemployment, and higher inflation, called stagflation, occurs. (high prices, low productivity) BAD THINGS HAPPEN o If AS shifts out to the right, a combination of lower inflation, higher output, and lower unemployment is possible. (productivity and low prices) GOOD THINGS HAPPEN

aggregate supply curve

shows the total quantity of output (i.e. real GDP) that firms will produce and sell at each price level.- slopes up, because as the price level for outputs rises, with the price of inputs remaining fixed, firms have an incentive to produce more and to earn higher profits. - Horizontal axis real GDP—that is, the level of GDP adjusted for inflation - Vertical Axis Price Level **Different from inflation rate which is the percentage change between price levels over time. - The slope of an AS curve changes from nearly flat at its far left to nearly vertical at its far right. (exponential) • As price level rises, aggregate quantity of services/supplies rises • the AS curve describes how suppliers will react to a higher price level for final outputs of goods and services, while holding the prices of inputs like labor and energy constant. • If firms across the economy face a situation where the price level of what they produce and sell is rising, but their costs of production are not rising, then the lure of higher profits will induce them to expand production. • At the far left of the aggregate supply curve, the level of output in the economy is far below potential GDP

aggregate demand curve

shows the total spending on domestic goods and services at each price level. • The horizontal axis shows real GDP and the vertical axis shows the price level. • The AD curve slopes down, which means that increases in the price level of outputs lead to a lower quantity of total spending. - how changes in the price level affect the different components of aggregate demand

Keynesian Zone

that portion of the SRAS curve on the far left which is relatively flat. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like Ek, then certain statements about the economic situation will follow. the equilibrium level of real GDP is far below potential GDP, the economy is in recession, and cyclical unemployment is high. If aggregate demand shifted to the right or left in the Keynesian zone, it will determine the resulting level of output (and thus unemployment). inflationary price pressure is not much of a worry in the Keynesian zone, since the price level does not vary much in this zone.

economists view on the 3 effects on AD

these effects are controversial, in part because they do not seem to be very large - For this reason, the aggregate demand curve in slopes downward fairly steeply; the steep slope indicates that .... - a higher price level for final outputs reduces aggregate demand for all three of these reasons, but that the change in the quantity of aggregate demand as a result of changes in price level is not very large.

aggregate demand

total spending - refers to the amount of total spending on domestic goods and services in an economy. (Strictly speaking, AD is what economists call total planned expenditure.

LRAS curve

vertical line at potential GDP showing no relationship between the price level for output and real GDP in the long run

Neoclassical Zone

which is the near-vertical portion on the right-hand side. If the AD curve crosses this portion of the SRAS curve at an equilibrium point like En where output is at or near potential GDP, then the size of potential GDP pretty much determines the level of output in the economy Since the equilibrium is near potential GDP, cyclical unemployment is low in this economy, although structural unemployment may remain an issue shifts of aggregate demand to the right or the left have little effect on the level of output or employment. The only way to increase the size of the real GDP in the neoclassical zone is for AS to shift to the right. However, shifts in AD in the neoclassical zone will create pressures to change the price level.

shifts in AS curve (directions)

• When AS shifts right at every price level, a greater quantity of real GDP is produced • When AS shift left-> at every price level, a lower quantity of real GDP is produced

Keynesian law

• "Demand creates its own supply." • John Maynard Keynes never wrote it down - but it is a significant idea in Macro and is a useful simplification that conveys a certain point of view • Wrote The General Theory of Employment, Interest, and Money during the Great Depression • Thus, Keynes argued that the Great Depression—and many ordinary recessions as well—were not caused by a drop in the ability of the economy to supply goods as measured by labor, physical capital, or technology. He argued the economy often produced less than its full potential, not because it was technically impossible to produce more with the existing workers and machines, but because a lack of demand in the economy as a whole led to inadequate incentives for firms to produce. In such cases, he argued, the level of GDP in the economy was not primarily determined by the potential of what the economy could supply, but rather by the amount of total demand.• Keynes' law seems to apply fairly well in the short run of a few months to a few years, when many firms experience either a drop in demand for their output during a recession or so much demand that they have trouble producing enough during an economic boom

supply shock shifts

• AS curve can also shift due to shocks to input goods or labor Ex - unsuspected early freezes on agricultural products, shift to the left due to less products available • Also shocks to the labor market Ex- fewer workers available (all went to fight war and stopped their production)

How input prices shift the supply curve

• Examples of widely used inputs - Wages and energy products An increase (cause the SRAS curve to shift to the left, which means that at each given price level for outputs, a higher price for inputs will discourage production because it will reduce the possibilities for earning profits.) a decrease (shifts right)

Gov macro policies on the AD curve (directions and spending)

• Higher government spending shift to the right • Lower government spending shift to the left Taxes--> • Tax policy can also effect consumption and investment spending - Tax cuts increase consumption demand - Tax increases decrease consumption demand - Investment Demand Lower tax rates and tax reductions that benefit specific kinds of investment. Shifting C or I will shift the AD curve as a whole. • During a recession, when unemployment is high and many businesses are suffering low profits or even losses, the U.S. Congress often passes tax cuts

Short run and long run AS

• In the short run, if demand is too low (or too high), it is possible for producers to supply less GDP (or more GDP) than potential • Short run- regular aggregate supply curve • Long Run AS - vertical line at potential GDP- producers are limited to producing at potential GDP.

Inflationary pressures on ASAD diagram

• Inflation fluctuates in the short run • Higher inflation rates have typically occurred either during or just after economic booms (After WWI and WWII) • Lower inflation rates - typically during recessions Deflation- when inflation becomes a negative - occurred during the great depression

Importance of AD and AS model (random sorta facts)

• Macroeconomics takes an overall view of the economy, which means that it needs to juggle many different concepts • start with the three macroeconomic goals of growth, low inflation, and low unemployment. • Aggregate demand has four elements: consumption, investment, government spending, and exports less imports. • Aggregate supply reveals how businesses throughout the economy will react to a higher price level for outputs. • Finally, a wide array of economic events and policy decisions can affect aggregate demand and aggregate supply, including government tax and spending decisions; consumer and business confidence; changes in prices of key inputs like oil; and technology that brings higher levels of productivity. • The aggregate demand/aggregate supply model is one of the fundamental diagrams in this course It provides a framework for bringing these factors together in one diagram. Indeed, some version of the AD/AS model will appear in every chapter in the rest of this book.

Recession

• Recession when the equilibrium level of real GDP is substantially below potential GDP -in years of resurgent economic growth the equilibrium will typically be close to potential GDP

Aggregate Demand Shifts directions and why

• Shift to the right at least one of these components in AG equation increased so that a greater amount of total spending would occur at every price level. • Shift to the left at least one of these components decreased so that a lesser amount of total spending would occur at every price level

AS shift effects in quantity and prices

• Shifts effects in Quantity and Prices 1. Shifts in SRAS to the right, lead to a greater level of output and to downward pressure on the price level. (A shift in the SRAS curve to the right will result in a greater real GDP and downward pressure on the price level, if aggregate demand remains unchanged) 2. (technically a shift to the left) A higher price for inputs means that at any given price level for outputs, a lower quantity will be produced so aggregate supply will shift to the left from SRAS0 to AS

AD and taxes/gov

• Tax policy can also effect consumption and investment spending - Tax cuts increase consumption demand - Tax increases decrease consumption demand - Investment Demand Lower tax rates and tax reductions that benefit specific kinds of investment. Shifting C or I will shift the AD curve as a whole. • During a recession, when unemployment is high and many businesses are suffering low profits or even losses, the U.S. Congress often passes tax cuts • The use of government spending and tax cuts can be a useful tool to affect aggregate demand • Other policy tools can shift aggregate demand as well, • Ex - the Federal Reserve can affect interest rates and the availability of credit. Higher interest rates tend to discourage borrowing and thus reduce both household spending on big-ticket items like houses and cars and investment spending by business. Lower interest rates will stimulate consumption and investment demand. Interest rates can also affect exchange rates, which in turn will have effects on the export and import components of aggregate demand.

Components of AD

• The components of aggregate demand are consumption spending (C), investment spending (I), government spending (G), and spending on exports (X) minus imports (M).

equilibrium of AS/AD model

• The intersection of the Aggregate Demand Curve and the Aggregate Supply curve shows the equilibrium level of real GDP and the equilibrium price level in the economy • At a low price, firms don't really have an incentive to produce, even though the consumer quantity demanded will be very high. • As the price level for outputs rises, aggregate supply rises and aggregate demand falls until the equilibrium point is reached.

How changes by consumers and firms can affect AD

• When consumers feel confident about the future of the company, they tend to consume more • Business confidence- if it is high - firms tend to spend more on investment, believing that the future payoff from that investment will be substantial If it drops, consumption and investment spending decline • History- consumer confidence averaged around 90 prior to the Great Recession, and then it fell to below 60 in late 2008, which was the lowest it had been since 1980. Since then, confidence has climbed from a 2011 low of 55.8 back to a level in the low 80s, which is considered close to being considered a healthy state • Rise in confidence a rise in confidence is associated with higher consumption and investment demand, it will lead to an outward shift in the AD curve, and a move of the equilibrium, from E0 to E1, to a higher quantity of output and a higher price level, as shown in Figure (a). • Consumer and business confidence often reflect macroeconomic realities - confidence is usually high when the economy is growing briskly - Usually low during a recession - confidence can sometimes rise or fall for reasons that do not have a close connection to the immediate economy, like a risk of war, election results, foreign policy events, or a pessimistic prediction about the future by a prominent public figure (like a president state of union address shift to the left, contributes to causing a recession) lower Q output and lower P level

Growth and Recession in ADAS diagram

• long-run economic growth due to productivity increases over time will be represented by a gradual shift to the right of aggregate supply • The vertical line representing potential GDP (or the "full employment level of GDP") will gradually shift to the right over time as well • However, the factors that determine the speed of this long-term economic growth rate—like investment in physical and human capital, technology, and whether an economy can take advantage of catch-up growth—do not appear directly in the AD/AS diagram. • Short Run - GDP falls and rises in every economy, as the economy dips into recession or expands out of recession.