Chapter 32

After all nominal wage adjustments play out,

the economy should return to its full-employment level of output and its natural rate of unemployment. Thus, the long-run Phillips Curve is vertical at the natural rate of unemployment.

Economic growth

the increase in GDP per capita of an economy

The new classical view suggests that

the long-run aggregate supply curve is vertical

Comparing the short-run and long-run Phillips curve suggests that:

there is a short-run but not a long-run tradeoff between inflation and unemployment

If aggregate demand increases at a faster rate than long-run aggregate supply:

there will be upward pressure on the price level

Debt

to owe Deficit - surplus

The Laffer Curve relates tax rates to total tax revenues and suggests that,

under some circumstances, cuts in tax rates will expand the tax base (output and income) and increase tax revenues.

The short-run aggregate supply curve slopes

upward, because nominal wages and other input prices are fixed. With diminishing marginal product of labor, firms require higher output prices to increase the quantity of real output supplied.

LRAS is

vertical Wages/prices flexible

Put another way, supply-side economists are concerned

with the disincentive effect of higher taxes that will reduce economic activity and real GDP.

According to the real business cycle theory of recessions, a leftward shift in agregate supply from ASuR1 to ASLR2

would lead to a subsequent decrease in agregate demand from AD to AD2

Supply-side fiscal policies

• When producers focus on emploving contractionary fiscal policies to foster increased production • Affects AD, SRAS, & potential output in the short-run

short-run aggregate supply curve AS in Figure 32.1a ©. This curve is based on three assumptions:

(1) The initial price level is P1, (2) firms and workers have established nominal wages on the expectation that this price level will persist, and (3) the price level is flexible both upward and downward

Accelerating inflation

- The cycle of the inflation rate constantly increasing from the government trying to make the unemployment rate below the natural rate. (This causes expected inflation to rise, and then actual inflation, and then expected...)

The natural rate of unemployment or the full-employment, unemployment rate is estimated as

4.5-5.5%

Suppose nominal GDP is $5000 billion, real GDP is $4000 billion, and the money supply is $1000 billion. In this hypothetical economy, the velocity of money is:

5

Normal inflation and unemploymen

5% unemployment rate 2% inflation

Suppose that an economy is in long-run equilibrium. If the price level and real GDP both decline simultaneously and those changes were caused by only one curve shifting, then those changes are best explained as the result of:

?

Laffer Curve

A curve relating government tax rates and tax revenues and on which a particular tax rate (between zero and 100 percent) maximizes tax revenues.

Phillips Curve

A curve showing the relationship between the unemployment rate (on the horizontal axis) and the annual rate of increase in the price level on the vertical axis).

Budget

A plan of god's receipts and expenses needed to efficiently function

disinflation

A reduction in the rate of inflation.

An increase in the expected inflation rate will cause which of the following?

A rightward shift in the short-run Phillips curve Correct. The short-run Phillips curve is drawn for a given expected inflation rate and so it shifts as inflationary expectations change. An increase in the expected inflation rate shifts the short-run Phillips curve to the right, which implies a higher unemployment rate for any given expected inflation rate.

supply-side economics

A view of macroeconomics that emphasizes the role of costs and aggregate supply in explaining inflation, unemployment, and economic growth.

The inability of outsiders to underbid insiders for jobs suggests that:

A) the economy will self-correct only slowly, if at all

If theres expan fiscal and cont. monetary, then

AD shifts right and then left So RGDP, PL, UN are indeterminate

The unemployment rate is 6% and the CPI is increasing at 5%

AD/AS graph is at eq

LO32.4 Discuss why there is no long-run trade-off between inflation and unemployment.

Although there is a short-run trade-off between inflation and unemployment, there is no long-run trade-off. Workers will adapt their expectations to new inflation realities, and when they do, the unemployment rate will return to the natural rate. So the long-run Phillips Curve is vertical at the natural rate, meaning that higher rates of inflation do not permanently "buy the economy less unemployment.

In order to finance gov deficit spending and the interest on debt, there's

An increase in demand for dollars Action is seen in Loanable funds market

Explain the short-run trade-off between inflation and unemployment (the Phillips Curve).

Assuming a stable, upsloping short-run aggregate supply curve, rightward shifts of the aggregate demand curve of various sizes yield the generalization that high rates of inflation are associated with low rates of unemployment, and vice versa. This inverse relationship is known as the Phillips Curve, and empirical data for the 1960s seemed to be consistent with it. In the 1970s and early 1980s, the Phillips Curve apparently shifted rightward, reflecting stagflation simultaneously rising inflation rates and unemployment rates. The higher unemployment rates and inflation rates resulted mainly from huge oil price increases that caused large leftward shifts in the short-run aggregate supply curve (so-called aggregate supply shocks). The Phillips Curve shifted inward toward its original position in the 1980s. By 1989, stagflation had subsided, and the data points for the late 1990s and first half of the first decade of the 2000s were similar to those of the 1960s. The new pattern continued until 2009, when the unemployment rate jumped to 9.3 percent while the inflation rate plummeted to a negative 0.4 percent. As the economy slowly recovered, unemployment and inflation fell simultaneously between 2011 and 2015-a pattern inconsistent with the economy moving along a single fixed Phillips Curve.

What is the long-run outcome of a decrease in the price level?

Assuming eventual downward wage flexibility, a decline in the price level from Pi to P3 in Figure 32.1b § works in the opposite way from a price-level increase. At As time passes, input prices will begin to fall because the economy is producing at below its full- employment output level.

Refer to the diagram. Assume the economy is initially at point b2. In the short run, an increase in aggregate demand will initially move the economy from point b2 to point:

C2

Review

Crowding out 8 steps!

when inflation is high

Each dollar is worth less Less purchasing power So workers are less expensive and unemployment drecreases

When inflation's low

Each dollar is worth more, More purchasing power Workers more expensive and unemployment increases

During the early years of the Great Depression, many economists suggested

Economy correct itself in long run (no gov) emphasis was on short-run problems and policies associated with the business cycle.

GDP per capita

GDP divided by population Key measure for comparing economies

Budget surplus

Good Income, revenue, taxes > expenses outlays, transfers

supply-side fiscal policy

Gov policies that promote econ growth by influencing north short runs and LRAS

If economic growth through investment in the economy's infrastructure is desirable, which of the following policies will most likely achieve this obiective?

Granting tax credits for businesses in the construction sector Correct. Providing incentives to the private sector engaging in investment in infrastructure will increase physical capital.

If the goal is to increase Ig and productivity to increase GDP per capital or growth thru PUBLIC POLICY increase each of the following

Human capital perworker: Gov spending on education, training And/or tax credits for education or training ——- Tech: Gov spending tech and/or tax credits for research and development ——- Physical capital per worker: Gov spending on infrastructure and/or tax credits for Ig on physical capital

Explain the relationship between short-run aggregate supply and long-run aggregate supply.

In macroeconomics, the short run is a period in which nominal wages do not respond to changes in the price level. In contrast, the long run is a period in which nominal wages fully respond to changes in the price level. The short-run aggregate supply curve is upsloping. Because nominal wages are unresponsive to price-level changes, increases in the price level (prices received by firms) increase profits and real output. Conversely, decreases in the price level reduce profits and real output. However, the long-run aggregate supply curve is vertical. With sufficient time for adjustment, nominal wages rise and fall with the price level, moving the economy along a vertical aggregate supply curve at the economy's full-employment output.

LO32.2 Discuss how to apply the "extended" (short-run/long-run) AD-AS model to inflation, recessions, and economic growth.

In the short run, demand-pull inflation raises the price level and real output. Once nominal wages rise to match the increase in the price level, the temporary increase in real output is reversed. In the short run, cost-push inflation raises the price level and lowers real output. Unless the government expands aggregate demand, nominal wages will eventually decline under conditions of recession and the short-run aggregate supply curve will shift back to its initial location. Prices and real output will eventually return to their original levels. If prices and wages are flexible downward, a decline in aggregate demand will lower output and the price level. The decline in the price level will eventually lower nominal wages and shift the short-run aggregate supply curve rightward. Full-employment output will thus be restored. One-time changes in aggregate demand (AD) and aggregate supply (AS) can only cause limited bouts of inflation. Ongoing mild inflation occurs because the Fed purposely increases AD slightly faster than the expansion of long-run AS (driven by the supply factors of economic growth).

Budget deficit

Income, revenue, taxes < expenses outlays, transfers Means national debt increases

Goal is to increase productivity and labor force participation rate

Increase age when individuals can collect retirement benefits Increase spending programs

Increase in MS means

Increase in supply of Loanable funds

Expansionary fiscal policy does what to i

Increases Contractionary fiscal decreases interest rates

stagflation

Inflation accompanied by stagnation in the rate of growth of output and an increase in unemployment in the economy; simultaneous increases in the inflation rate and the unemployment rate.

"A recession became the Great Depression because the Fed allowed the money supply to fall by 35% during the 1930s." This statement is most closely associated with which school of thought?

Monetarism

2nd long run conclusion

Neutrality of money Change in MS has no effect on real variables Real variables are RGDP, real wages, etc

Short run

Nominal wages dont respond to changes in PL

Productivity

Output per worker

Assume an economy is in long-run equilibrium and the central bank engages in an expansionary monetary policy for a prolonged time period. If the velocity of money is constant, which of the following is true according to the quantity theory of money?

Price level will increase at the same rate as the money supply. Correct. According to the quantity theory of money, velocity and real output are assumed to be constant in the long run, and therefore the price level rises proportionally to changes in the money supply.

The supply of funds in Loanable funds market comes from

Private savings (businesses and households) Gov sector (budget surpluses) Federal reserve (money supply) Foreign sector

Suppose a country's government increases the allowable deduction for individual retirement accounts per person. Holding all other influences constant, how would this policy action affect the country's loanable funds market, its production possibilities curve, and its long-run aggregate supply (LRAS) curve?

Private savings would increase and real interest rates would decrease in the loanable funds market, the nation's production possibilities curve would shift outward, and its LAS curve would shift to the right.

The demand for funds come from

Private sector (business investment and consumer borrowing) Gov sector (budget deficits) Foreign sector

Refer to the diagram. If the economy's tax rate is currently set at c, a decrease in the tax rate to b will: (Above the mid pt on laffer curve)

Pt c to pt a Curve pts top to bottom: D C B A

One long run conclusion

Quantity theory of money Changes in PL are directly proportional to changes in MS

Suppose that an economy with flexible wages and prices is in long-run equilibrium when the central bank contracts the money supply. What is the long-run effect on real output in the economy?

Real output is unchanged. Correct. When the economy is at full employment, changes in the money supply have no effect on real output in the long run.

Pl falls

Reduce production and employment

Long run does

Respond to PL changes

Refer to the diagram. Stagflation would be represented by:

Rightward shift of the curve

Normal CPI

Search

Private Domestic Investment

Simulates economic growth Ig is spending on capital stock Greater capital stock increases capacity of econ to produce goods/services

If Ig decreases

Slower econ growth Bc capital goods produced relative to productive capacity Long run impact of crowding out is lower rate of physical capital accumaultion and less econ growth

aggregate supply shocks

Sudden, large changes in resource costs that shift an economy's aggregate supply curve.

LO32.5 Explain the relationship among tax rates, tax revenues, and aggregate supply.

Supply-side economists focus attention on government policies, such as high taxation, that impede the expansion of aggregate supply. The Laffer Curve relates tax rates to levels of tax revenue and suggests that under some circumstances, cuts in tax rates will expand the tax base (output and income and increase tax revenues. Most economists, however, believe that the United States is currently operating in the range of the Laffer Curve where tax rates and tax revenues move in the same, not opposite, direction. Today's economists recognize the importance of considering supply-side effects in designing optimal fiscal policy.

long-run vertical Phillips Curve

The Phillips Curve after all nominal wages have adjusted to changes in the rate of inflation; a line emanating straight upward at the economy's natural rate of unemployment.

Gov. Budget Balance

The difference between tax revenue and gov spending Gov recipe it's, revenue, and income (mostly earned thru taxes) Gov expenses or outlays are gov spending or transfers

Steady advances in technological development will result in which of the following?

The long-run aggregate supply curve will shift to the right, resulting in economic growth and a lower natural unemployment rate. Correct. Advances in technological development will result in economic growth, shifting the LAS curve to the right, resulting in a higher full employment level of output.

LRPC can shift when

Theres a change in structural and/or frictional unemployment rates

In the short run, changes in aggregate demand (AD) are movements along

a Phillips curve. AS shocks that produce severe cost-push inflation can cause stagflation-simultaneous increases in the inflation rate and the unemployment rate. With these AS shocks, the Phillips curve will shift. Higher input prices will shift the Phillips curve rightward or upward; lower input prices will shift the Phillips curve leftward or downward.

If prices and wages are flexible downward,

a decline in aggregate demand will lower output and the price level.

Short run

a period in which nominal wages and other input prices do not change in response to a change in the price level

Long run

a period sufficiently long for nominal wages and other input prices to change in response to a change in the nation's price level

In the long run, if the economy is operating above full employment,.

a tightening labor market raises nominal wages, the short-run aggregate supply curve shifts to the left, the price level increases, and the economy settles at full employment

Monetarist thought differs from the new classical rational expectations view in that the latter assumes:

an almost instantaneous adjustment of expectations in response to announced changes in policy

As implied by the upsloping short-run aggregate supply (AS) curve, there may

be a short-run trade-off between the rate of inflation and the rate of unemployment. This trade-off is reflected in the Phillips Curve (a downward sloping curve in the short run showing that lower rates of inflation are associated with higher rates of unemployment.

According to the "coordination failure" theory, a recession:

can occur if everyone expects everyone else to curtail spending

According to the mainstream view of the economy, macro instability arises primarily from changes in aggregate demand caused by:

changes in investment spending

According to the monetarist view:

changes in money velocity are small and predictable

Refer to the diagram. If P is the price level and Q is the full-employment output, then the long-run aggregate supply curve:

connects points e, b, and d

Despite the strength of their commitment to supply-side economics, most economists

do recognize that tax policy and other fiscal initiatives do have incentive effects that can affect the level of real GDP.

The decline in the price level will eventually lower

eventually lower nominal wages and shift the short-run aggregate supply curve rightward. Full-employment output will thus be restored.

The Laffer curve illustrates that, in some circumstances, the government can reduce a tax on a good and increase the

government's tax revenue

According to the new classical view, shifts in aggregate demand:

have no effect on real output if they are fully anticipated

Cost-push inflation results from a reduction

in the short-run aggregate supply curve, lowering real output, increasing unemployment, and increasing the price level. Cost-push inflation creates a policy dilemma for the government in that if it engages in an expansionary policy to increase output and reduce unemployment, additional inflation will occur; if it does nothing, the recession will linger until input prices have fallen by enough to return the economy to producing at potential output. If it pursues a contractionary policy to fight inflation, then real output falls and unemployment increases.

balanced budget

income = expenses **remember prep book prob, increases by # given

In order to temporarily reduce the unemployment rate below its natural rate, the government could:

increase the rate of inflation above peoples' expectations

In the short run, demand-pull inflation, caused by an

increasing aggregate demand, raises both the price level and real output.

extending the work hours of part-time and full -time workers, enticing new workers such as homemakers and retirees

into the labor force, and hiring and training the structurally unemployed. Thus, the nation's unemployment rate declines below its natural rate.

What leads to capital formation?

investment spending

One-time changes in aggregate demand (AD) and aggregate supply (AS) can only cause

limited bouts of inflation. Ongoing mild inflation occurs because the Fed purposely increases AD slightly faster than the expansion of long-run AS (driven by the supply factors of economic growth).

the Phillips curve stresses

long-run policies, which extend Aggregate Demand and Supply theory.

Long Run Phillips Curve

natural rate of unemployment

Unless the government expands aggregate demand,

nominal wages will eventually decline under conditions of recession and the short-run aggregate supply curve will shift back to its initial location. Prices and real output will eventually return to their original levels.

Supply-side economists focus their attention

on government policies that can increase aggregate supply, raising real GDP in the long run, and pressuring downward the price level. Generally, supply-side economists favor lower taxes that will increase incentives to save and to invest, to increase labor effort, and generally to increase real GDP.

Refer to the diagram. Suppose the economy is initially at the full-employment output and price level represented by point d. The path that best represents the economy's response to an expansionary monetary policy is the move from point d to:

point c to point a

Refer to the diagram. Assume that wages are initially set on the basis of price level P and that the economy is operating at its full-employment level of Q. The short-run effect of an increase in demand is best reflected by a move from:

point e to point g

If an adverse supply shock initiates an episode of cost-push inflation and the government does nothing in response, there will likely be:

recession