ECON112: Set 3

If T > G, the output gap is

A surplus

AD = Y = real GDP =

C + I + G + NX

AD =

C + I + G + NX = Y

So the consumption equation becomes

C = c with line above it + c(Y - T* + tY) therefore simplifying to C = C + cY - cT* - ctY

Y and u respond

Oppositely

Increasing consumption moves SR to reach Y*, government addresses stagflation, and AD shifts

Outwards

Graph AD shock

Page 3 side 2

Graph LRAS shift to the left

Page 3 side 2

Why shouldn't central banks aim for zero inflation?

Costs of reducing inflation - increase in unemployment (often concentrated among those on low incomes) Allows for real wages to adjust (preventing wages from being sticky) - money illusion Don't want deflation --> decrease value of money

Graph AD shock and explain what is happening

Page 4 Side 1 If expected inflation rate is slow to adjust, expansionary fiscal and/or monetary policy can shift AD to the right As expected inflation rate adjusts, SRAS shifts down

In the long run Pi^A =

Pi^E

Why shouldn't monetary and fiscal policymakers try to stabilise the economy?

Policy (especially fiscal) works with a lag -monetary policy may take up to 6 months (and fiscal longer) to have an effect -by the time the policy takes effect, conditions may have changed and the economy may overshoot If a recession is caused by a shock to LRAS, then expanding AD will just cause inflation

Risk of governments doing nothing for stagflation

Politically problematic to "do nothing", especially if the adjustment policy takes time

SRAS has a _______ slope

Positive

Why is the SRAS curve upwards sloping?

Possibly due to the misperceptions theory, the sticky-wage theory, and the sticky-price theory

Deflation =

Price decrease

What is the sticky-price theory?

Prices of some goods and services adjusts slowly in response to changing economic conditions, due in part to 'menu costs' e.g. an unexpectedly low inflation rate rare leaves some firms with higher than desired pricesm\ which depresses their sales and leads them to cut back production

Disinflation =

Prices still rising but at a lower rate (inflation decreases)

How can the government resolve a budget deficit?

Print money to finance spending (increase inflation) Borrow money (BUT IT MUST BE PAID BACK)

How would government pushes for affordable housing have contributed to the global financial crisis?

Private companies (e.g. Fannie May and Freddie Mac) were guaranteed full support from the government Told them they had a minimum proportion of loans that had to be made to low income people Help subprime buyers get houses

National savings =

Private savings + public savings

Fiscal policy is better at addressing ______ periods of recession/expansion

Prolonged

Surpluses and deficits affect

Public policy May result in increased interest rates

What s the sacrifice ratio?

The number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point I.e. in decreasing inflation, how much would output decrease, therefore increasing unemployment

Tools of stabilisation policy

Fiscal policy: Government purchases (or spending): direct effect Taxes and transfers: indirect effect Monetary policy: Setting the OCR (reserve requirements, OMO)

If the reserve bank fells inflation is too high but the economy is at Y*, what would the reserve bank do?

Tighten the MPR (higher r for every pi, MPR)

What is the interest-rate effect?

Increased inflation rates cause prices to rise, so consumers hold more money. This decreased the currency in banks, decreasing the supply of loanable funds, causing the interest rate to increase, decreasing investment and thus decreasing consumption

Risks of expansionary fiscal or monetary policy on stagflation

Increased inflation, increased government deficit, overshot in correction and arrive at an expansionary gap

Quantity of output supplied =

Natural rate of output + alpha(Actual inflation rate - expected inflation rate) Where alpha is a number that determines how much output responds to unexpected changes in the inflation rate

The LRAS curve is vertical at the

Natural rate of output, also referred to as potential output or full-employment output

The expectations-augmented Phillips curve suggests Unemployment rate =

Natural rate of unemployment - alpha(u-U*)

Practice question 1: Econfield conditions: C = 70 + 0.75(Y-T) I = 50 G = 30 NX = 15 T = 12 + 0.2Y Y* = 500 a) Calculate the income-expenditure multiplier for Econfield b) What is the short-run equilibrium output (i.e. AD = SRAS = Y)? At the short run equilibrium, what is the budget deficit (surplus)? Show all your working c) What change in G is required to eliminate the output gap? d) What change inT is required to eliminate the output gap?

a) Alpha = 1/(1-(0.75*(1-0.2))) = 1/4 = 2.5 b) AD = SRAS = Y = C+I+G+NX Y = C* + c(Y-T) + I + G + NX Y = 390 c) 390-500 = Y-Y* change in Y = alpha*change in G =44 d) Budget deficit = T - G =12 + 0.2Y - 30 =60 --> SURPLUS Change in Y = alpha (-c times change in T*) Change in T* = 58.67 Therefore decrease tax by 58.67 (what does this mean though)

Lessons learned from the GFC

Need to avoid housing bubbles Govts. need to be aware of the unintended consequences of making housing 'too affordable' Debt needs to be used more carefully Need to have a plan for addressing the 'too big to fail' problem Need to be aware of the risk of unlikely events

NINJAs stands for

No Income, No Jobs or Assets

What is the sticky-wage theory?

Nominal wages are slow to adjust, or are ;sticky; in the short run, due to long-term labour contracts, social norms, ideas of fairness, etc. e.g. an unexpectedly low inflation rate raises the real wage which causes firms to hire fewer workers and produce a smaller quantity of goods and services

u* =

Non-accelerating rate of inflation

Why is the aggregate demand curve downwards sloping?

Not because of the law of demands An increase in the inflation rate decreases the quantity of goods and services demanded due to 3 effects

In the AD-AS model, prices are

Not fixed

The cost of disinflation depends on what?

How quickly expectations of inflation fall

What is money illusion?

If prices increase,e real wages (purchasing power --> what nominal wages can buy) decrease Therefore when P doesn't change, no extra money comes in, so theres no incentive to increase wages so they stay sticky

What was the 'false' reassurance of offering sub-prime loans?

If the loans aren't repaid, there's at least a house to fall back on

Fiscal policy has two effects on AD

Multiplier effect Crowding-out effect

A change in pi on the LRAS curve results in what kind of movement

Movement along the curve but not changes to output

Income effect =

If there is a target amount of required savings in mind, a higher return reduces the amount that has to be saved now

Graph disinflationary monetary policy (Phillips Curve)

Lec 33 Page 4

Graph the contractionary monetary policy

Lec 33 Page 4

Draw AS-AD model

Lecture 33 Page 1

Graphically, a recessionary or expansionary gap is

Left -recessionary - or right - expansionary - of the LRAS

Problem with monetary policy:

Liquidity trap mean the issue isn't resolved, therefore many central banks have turned to other options (instead of reducing interest rates)

There are two types of aggregate supply

Long run Short run

If policymakers expand AD, they can do what to unemployment but only at the cost of what?

Lower Higher inflation

If policymakers contract AD, they can do what to inflation but only at what cost?

Lower Temporarily higher unemployment

What are the long run costs of contractionary monetary policy?

Lower inflation

To decrease unemployment, one could

Lower minimum wage, help school leavers find jobs (decrease frictional unemployment-->search time), etc.

What are the short run costs of contractionary monetary policy?

Lower output Higher unemployment

How do taxes change the amount by which output changes in response to a change in autonomous spending?

Lowers the multiplier, less fluctuations

How do automatic stabilisers help offset the inflexibility of fiscal policy?

Mechanisms in the economy that change the amount by which output changes in response to a change in autonomous spending

Policymakers had far more knowledge about how to fight recessions than was the case in the 1930s, so many past mistakes avoided. E.g.

Monetary and fiscal policy was used to expand AD Large banks were typically kept afloat to maintain confidence in the banking system

MPR =

Monetary policy rate

Monetary policy response

NZ OCR dropped from 8.25 in June, 2008 to 2.5 in April 2009 -benchmark interest rates much lower in other countries

Multiplier with income tax formula

(alpha) = 1/1-c(1-t)

RBNZ target inflation

1-3%

Within the context of the AD-AS model, there are two categories of sources of inflation:

1. Aggregate demand shocks 2. Aggregate supply shocks a) Inflation shocks to SRAS b) Decline in LRAS

US policy responses to credit crunch:

1. Bail out banks (including buying bad debts off banks) to ensure credit markets did not collapse -some banks are too big to let them collapse -but moral hazard problem 2. Expand money supply increase supply, decrease interest rates, increase loans

Policymakers may respond to a recession in one of the following ways:

1. Do nothing and wait for prices and wages to adjust 2. Take action to increase aggregate demand by using fiscal and/or monetary policy

Three complications of fiscal policy being used as a stabilisation tool:

1. Fiscal policy and the supply side 2. The problem of deficits (T<G)* 3. The relative inflexibility of fiscal policy

What are the four propagation of the GFC?

1. House prices fell dramatically in many countries, leading to mortgage defaults - many banks facing solvency (some were bailed out, some went bankrupt) and consumption fell 2. Credit crunch = banks stopped lending - consumption and investment fell 3. Stock (share) prices fell - consumption fell 4. All of these factors contributed to falling AD (Y decreases and unemployment increases)

NZ and elsewhere policy responses:

1. Increase G or decrease T 2. Decrease interest rates

What are the 6 elements of the GFC?

1. Large decline in asset prices 2. Insolvencies at financial institutions (reduction in consumer/business confidence) 3. Decline in confidence in financial institutions 4. Credit crunch 5. Economic downturn 6. Vicious circle

What are two causes of economic fluctuations?

1. Shifts in aggregate demand 2. An adverse shift in aggregate supply

What are the five contemporary debates over macroeconomics we looked at?

1. Should monetary and fiscal policymakers try to stabilise the economy 2. Should monetary policy be made by rule rather than by discretion 3. Should central banks aim for zero inflation 4. Should the government balance its budget 5. Should tax laws be reformed to encourage savings

Multiplier effect formula

1/(1-c)

What happened in the Great Depression?

1920s, population felt wealthy, so they invested in stock, stock prices rose higher than the actual value of products, people became aware of this and sold their stock, this resulted in too many sales, stock market crashed, investment in companies decreased, output decreased, unemployment increased

If inflation decreases from 4% to 2%, using the NZ sacrifice ratio, how much does output decrease by?

5*2 Decreases by 10%

So if pi^A < Pi^E => then SRAS

<LRAS

So if pi^A > Pi^E => then SRAS

>LRAS

Collateralised debt obligation (CDO) =

A debt instrument backed up by some underlying asset (e.g. mortgages)

How does an adverse shift in aggregate supply cause an economic fluctuation?

A decrease in one of the determinants of AS shifts the curve to the left Y<Y* u increases pi increases

How can a decrease in the expected inflation rate shift the SRAS curve?

A decrease in the expected inflation rate raises the quantity of goods and services supplied and shifts the SRAS curve to the right

If T < G, the output gap is

A deficit

The recession was due in large part to

A drop in AD

An adverse supply shock gives policy makers what

A less favourable trade-off between inflation and unemployment

To reduce inflation, an economy must endure

A period of high unemployment and low output When the RBNZ combats inflation, the economy moves down the SRPC The economy experiences lower inflation but at the cost of higher unemployment

What are the two possible causes of economic fluctuations?

A shift in aggregate demand and a shift in aggregate supply

Ranking of CDO

AAA, AA, A, BB, B

Suppose the economy is initially in long run equilibrium. Then following the success of Lorde in the American music industry, there is a huge increase in demand for NZ made clothes. What would this do to AD? What could the Reserve Bank do to bring the economy back to full employment? Graph this

AD would shit out, resulting in an expansionary gap. AD and monetary policy (expansionary gap) - increase in pi^e, SRAS shifts left - BRNZ increases OCR, raising interest rates, decreasing I and C - Shifts AD back to AD1 - Y < Y*; pi < pi^E - As pi^E adjust down, SRAS shifts back

An alternative model for analysing short run economic fluctuations

AS AD model

Once people anticipate inflation, the only way to get unemployment below the natural rate is for actual inflation to be

Above the anticipated rate

In the long run, expected inflation always adjusts to

Actual

ADAS model stands for

Aggregate demand and aggregate supply

Any event or policy that changes consumption, investment, government purchases, or net exports at a given inflation rate will shift the

Aggregate demand curve

When the RBNZ contracts growth in the money supply to reduce inflation, it moves the economy where? This results in

Along the short-run Phillips curve Temporarily high unemployment

What is a supply shock?

An event that directly alters the firm's costs and, as a result, the prices they charge

What is the crowding out effect?

An increase in government purchases causes the interest rate to rise. A higher interest rate reduces investment spending, reducing demand. This reduction in demand that results when a fiscal expansion raises the interest rate

How can an increase in the expected inflation rate shift the SRAS curve?

An increase in the expected inflation rate reduces the quantity of goods and services supplied and shifts the SRAS curve to the left

A rise in the inflation rate on the AD-AS model results in

An increase in the quantity of real GDP supplied and a decrease in the quantity of real GDP demanded, other influences on production and expenditure remaining the same

What might shift the LRAS curve?

Any change in the economy that alters the natural rate of output

What is the NZ sacrifice ratio?

Approximately 5%

What is stagflation?

As output falls: unemployment and inflation rates rise

Why is the Keynesian model not ideal for analysing short-run economic fluctuations?

Assumes quantity adjustments Wages and prices are fixed in the short run Doesn't account for inflation

If T = G, the budget is

Balanced

Causes of the credit crunch

Banks and finance companies lending mortgage to risky borrowers (NINJAs) When these borrowers (especially in the US) could not repay their mortgages and started defaulting, more houses come back into the market - supply greater than demand, house prices start to fall Many banks and financial institutions become insolvent Banks become reluctant to lend - credit crunch

What was the credit crunch?

Banks had more money than they knew what to do with so they started lending to risky borrowers

Prime borrowers =

Borrowers with a high credit rating, good income, and high deposit

Sub-prime borrowers =

Borrowers with a low credit rating, below average income, and little or no deposit

Quantitative easing =

Central Bank buying financial assets from private institutions in an attempt to increase money supply and lower long-term interest rates

Forward guidance =

Central Bank indicating what must happen before monetary policy is tightened

Pi^expected won't _____ immediately

Change

Y* --> u*, so anything that would change Y* would do what to u*

Change it inversely

In the long-run, expected inflation adjusts to

Changes in actual inflation

What is the misperceptions theory?

Changes in the overall inflation rate temporarily mislead suppliers about what is happening in the markets in which they sell their output e.g. an unexpectedly low inflation rate leads to some suppliers to think their relative prices have fallen, which induces a fall in production

Huge drop in OCR gets

Consumers spending

When the government cuts personal income taxes, it increases households' take-home pay (disposable income) which in turn increases _______, ignoring __________ in the meantime

Consumption r (monetary policy)

AD may shift due to

Consumption Investment Government purchases Net exports

Shifts in AD arise from changes in:

Consumption Investment Government purchases Net exports

If the goal is to reduce inflation, the RBNZ has to pursue _______ monetary policy

Contractionary increase r (via increasing OCR)

Sustained budget deficits lead to

Crowding out effect (increased r, decreased T)

The crowding-out effect tends to ______ the effects of fiscal policy on AD

Dampen

Because stagflation has two effects policymakers who can influence aggregate demand cannot offset both of these adverse effects simultaneously so they can

Decrease unemployment, thus increasing inflation Decrease inflation, increasing unemployment

If T < G, the budget is

Deficit

Why should the government balance its budget?

Deficits --> debt which has to be serviced - future generations face higher taxes or less spending (or even more debt) - Greek public debt/GDP: 150% ++ since 1991 Deficits lower national saving --> increase r, I decreases

What does the monetary rule do?

Describes how a RB takes action in response to changes in the state of the economy

What is an example of a decline in potential output that is a source of inflation?

Destruction of physical or human capital (war, disaster, earthquake, severe drought, flooding)

Short run fluctuations in output and inflation rate should be viewed as

Deviations from the continuing long-run trends

The short-run aggregate supply curve shows

Different quantities of output that all firms produce and sell at different rates of inflation

In NZ, RBNZ governor has sole responsibility for monetary policy. He is expected to keep inflation between 1-3% but it is up to him how he achieves this. This is _________

Discretion (but with a target), rather than a rule (e.g. Taylor Rule)

Why shouldn't monetary policy be made by rule rather than by discretion? (CON of setting a rule, PRO of discretion)

Discretion gives flexibility to respond to situations like the Asian Crisis and GFC

Taxes adjust a household's

Disposable income

Possible policy responses to stagflation

Do nothing Expansionary fiscal (increase G or decrease T) or monetary policy (decrease interest rates)

The inflation rate __________ labour, capital, natural resources and technology in the long run

Does not affect

Why should monetary policy be made by rule rather than by discretion? (PRO of setting a rule, CON of discretion)

Doesn't limit incompetence or abuse of power - e.g. CB could use monetary policy to try and influence election outcomes Time inconsistency of policy - e.g.if CB uses loose monetary policy to try and reduce unemployment; future commitments to low inflation are less credible BUT CB can achieve this credibility through a track record of pursing price stability

The aggregate demand curve is ________ sloping

Downwards

In the 1970s, policymakers faced two choices when OPEC (oil cartel) cut output and raised worldwide prices of petroleum

EXPANSIONARY POLICIES CONTRACTIONARY POLICIES

How can government purchases have a multiplier effect on AD?

Each dollar spent by the government can raise the AD for goods and services by more than a dollar

When did the concept of a stable Phillips curve break down in the US

Early 70s

Monetary policy is _______ to implement compared to fiscal policy, but its not without _______ too

Easier and quicker Problems

How would loose monetary policy likely contributed to the housing bubble have contributed to the global financial crisis?

Easy access to money; low interest rates (at the beginning) -lower interest rate, increased borrowing as repayment is cheaper But, can form interest rate expectations so people borrow too much money and a sudden interest rate rise makes it difficult to repay

Stabilisers do the job but aren't as

Efficient

An economy in SR equilibrium can still experience

Either a recessionary or expansionary gap

When AD=SRAS, real GDP might

Equal, exceed, or be less than potential GDP (Y)

Liquidity trap =

Even zero short-term interest rates fail to stimulate the economy as households and banks hoard cash

How can you stabilise economic fluctuations?

Expansionary policies Contractionary policies

What are three complications to the use of fiscal policy:

FP affects AD as well as potential output The problem of deficits FP is not flexible

What happens in stagflation?

Falling output, rising prices, and increased unemployment

What are contractionary policies?

Fight inflation by contracting AD and enduring even higher unemployment i.e. decrease G or increase T and r

What are expansionary policies?

Fight the unemployment battle by expanding AD and accelerating inflation i.e. increase G or decrease T or decrease r

How does correction occur in the AS-AD model in a recession?

Firms and workers reduce expectations of future inflation (prices are expected to increase at a lower rate)(SRAS moves down) Lower inflation leads to lower real interest rates; slides the economy down along the AD curve, increasing Y Y is back to Y* at lower inflation rates

With an expansionary gap in the AS-AD model, inflation tends to rise. This corrects by

Firms and workers to expect inflation rates to increase, moving the SRAS up (higher inflation at every level of output) Higher inflation leads to higher real interest rates; slides the economy up along the AD curve, decreasing Y Y is back at Y*, but at higher inflation rates

Will output really return to Y*? (Neo) classical response:

Fiscal and monetary policy have problems Solution may be worse than the problem

How can the fiscal policy and the supply side cause a complication by using the fiscal policy as a stabilisation?

Fiscal policy affects AD as well as potential output -INCREASE AD *Increase government spending, transfer payments *Decrease taxes -INCREASE Y* * Increase government spending on skills training programmes, research and development, etc. may lead to improvements in human capital and technological process

How does fiscal policy influence aggregate demand?

Fiscal policy influences saving, investment, and growth in the long run In the short run, fiscal policy primarily affects AD

What is fiscal policy?

Fiscal policy refers to the governments choices regarding the overall level of government purchases (G), transfer payments (TR) or taxes(T)

What determines how quickly the short-run trade off disappears?

How quickly expectations adjust

What is aggregate supply shock?

Generic term for both an inflation shock (to SRAS) or a shock to potential output (to LRAS) -inflation shocks will eventually self correct in the long run -shocks to potential output will not return to the original Y*

GFC =

Global Financial Crisis

AAA are

Good loans Prime borrowers Ideal, known to pay back debts

What government policies may have contributed to to the Global Financial Crisis?

Government push (especially in the US) for affordable housing Banks "too big to fail" Loose monetary policy likely contributed to the housing bubble

Global financial crisis fiscal policy response:

Government spending was increased in many countries, including in NZ

How would banks being too big to fail have contributed to the global financial crisis?

Governments (explicitly or implicitly) guarantee that they will bail out any bank that gets into trouble They do this to increase confidence in banks and thus increase economic growth But this leads to moral hazard as risky behaviours are rewarded

Which was more severe: Great Depression or the Global Financial Crisis?

Great Depression

Contractionary monetary policy can also be called

Hawkish policy Tightening MPR

Substitution effect =

Higher returns increase savings, substituting away from consumption

In the long-run Phillips curve, a shift to the right will ______ unemployment and ________ output for any given rate of inflation

Higher, lower

When taxes change, what happens?

Households save some of this additional income Households also spend some of it on consumer goods Increased household spending (consumption) shifts the AD curve to the right

What was a main cause of the GFC?

Housing bubble

Expected inflation measures what?

How much people expect the overall price level to change

Why is inflation bad in short run fluctuations?

In recessions and expansions deflation/inflation matters

How can shifts in aggregate demand cause economic fluctuations?

In the SR, shifts in AD cause fluctuations in the economy's output of goods and services Output decreases: pi<pi^expected; Y < Y* As inflationary expectations adjust over time, SRAS shifts down: pi decreases; Y = Y*

A decrease in the inflation rate reduces the quantity of goods and services supplied in the short run so both pi and Y move

In the same direction

If the RBNZ pursues contractionary monetary policy, what happens?

Increase OCR Increase interest rates Decrease investment Increased saving Decrease consumption AD falls Unemployment increases Output decreases

Basic idea of the crowding out effect:

Increase in G = increase AD = increase demand for money = increase interest rates

Increase government spending can decrease taxes leading to

Increased AD but this can lead to budget deficits or brings in national savings

Between 1996 and 2006, price of an average American house ________________ but by 2008, it started to ______

Increased by 80% Decrease

What does contractionary policy do on the Phillips Curve?

Moves the economy down along the SRPC, but in the long run, expected inflation falls, and the SRPC shifts to the left

Draw graph 2 of the cost-push inflation whereby the government implements a policy and explain whats happening in it:

Increased input costs Y<Y* Stagflation: high unemployment, high inflation If the government implements expansionary fiscal or monetary policy, AD shifts out, Y=Y* but inflation is higher Lec 31 Page 5

Increases in C, I, G or NX result in

Increases in AD

What are inflation shocks/shocks to SRAS?

Increases in wages or the price of inputs (or raw materials) unrelated to the business cycle

What doesn't affect long-run Phillips curves?

Inflation

An adverse supply shock gives policymakers a less favourable trade off between

Inflation and unemployment

The Phillips curve describes a negative relationship between

Inflation and unemployment

What doesn't affect the LRAS curve?

Inflation rates

Reserve (central) banks worry about expansionary gaps (Y>Y*). not growth per se because these gaps are likely to be

Inflationary

To increase unemployment, one could

Introduce efficiency wages, raise the lowest wage, or form unions, etc.

In the AD-AS model, I is

Irrelevant of planning or actual

Why is the Keynesian model a good analysis of short run economic fluctuations?

It analyses unemployment

Why might reserve bank changes to the OCR not work?

It changes r but this may not effect the population due to fixed loans being unable to change, therefore irrelevant

AD-AS model is greater than the Keynesian model because

It connects output and prices (inflation) directly

With shifts in AD to the right, what happens to inflation?

It continually increases

How does increased confidence in banks lead to increased economic growth?

It increases investment in companies, increasing company production, increasing output, decreasing unemployment, and increasing GDP

An economy's production of goods and services in the long run depends on

Its supplies of labour, capital, natural resources, and the available technology used to turn these factors of production into goods and services

The inflation targeting regime of the RBNZ is acting as an instrument to lock in the low inflation environment by

Keeping inflationary expectations low

Fiscal policy does not

Kick in immediately

A target for the RBNZ cash rate affects the __________________ which influences aggregate demand

Money market equilibrium

When there are more goods and services in the economy, what happens and why?

More money circulates so the money supply grows. Then, AD increases so interest rates decrease and consumers spend more

So if pi^A = Pi^E => then SRAS =

LRAS

Shifts in the LRAS curve arise due to

Labour Capital Natural resources Technological knowledge

Why the SRAS curve might shift?

Labour Capital Natural resources Technology Expected inflation rate

Critics of active policy emphasise that policy affects the economy with a ____ and our ability to forecast future economic conditions is poor, both of which can lead to policy being

Lag Destabilising

Draw the AD-AS curve with SRAS

Lec 28 -1 page

Graph LRAS curve:

Lec 28 Page 2

Graph LRAS with AD and show the long run equilibrium

Lec 28 Page 2

Graph three long run trends in different years with AD Show graphically that in the LR, technological process shifts long-run aggregate supply and growth in the money supply shifts AD leading to growth in output and ongoing inflation

Lec 28 Page 3

Draw the graph of the SRAS curve

Lec 28 Page 4

Draw graph showing the SRAS curve

Lec 28 Page 5

Draw a graph where the SRAS curve shifts to the right

Lec 28 Page 6

Draw the long run equilibrium

Lec 28 Page 6

Draw a graph that depicts a decrease in AD causing output to fall in the SR but over time, the SRAS curve shifts and output returns returns to its natural rate

Lec 28 Page 6 If pi^A < pi^E, SRAS shifts DOWN so output returns to potential

Draw a graph that shows an adverse shift in the SRAS curve causing output to fall and therefore the inflation rate to rise

Lec 28 Page 7

Draw an example of a upwards shift in the aggregate demand curve

Lec 28 Page 2

Draw graphically the multiplier effect in the AD-AS model

Lec 29 Page 3

Graph the crowding out effect

Lec 29 Page 5

Draw a graph of adjustment to LR equilibrium in AS-AD model (expansionary gap)

Lec 31 Page 1

Draw graphically the demand-pull inflation

Lec 31 Page 5

Graph decline in potential output as a source of inflation

Lec 31 Page 6

Graph adjustment to LR equilibrium in AS-AD model (recessionary gap)

Lec 31 Page 2 Recessionary gap = falling inflation rate Un-utilised resources Increased unemployment

Graph how the banks raising the r to address too high inflation and explain whats happening

Lec 32 Page 2 AD shifts down Recessionary gap: decrease Y and increase unemployment Over time, SRAS shifts down; Y = Y* at lower inflation rates

Draw the model of AD and AS

Lec 32 Page 3

Draw the model of the Phillips curve

Lec 32 Page 3

Dynamics of AD-AS and the short run Phillips curve: draw a graph assuming that AD did not increase AS EXPECTED; Pi^A < Pi^E; u > u*

Lec 32 Page 3

Dynamics of AD-AS and the short run Phillips curve: draw a graph assuming that AD increased GREATER THAN EXPECTED; Pi^A > Pi^E; u < u*

Lec 32 Page 3

Dynamics of AD-AS and the short run Phillips curve: draw a graph assuming that AD increased just AS EXPECTED; Pi^A = Pi^E; u = u*. Also draw this on a Phillips Curve

Lec 32 Page 3

Draw the long run Phillips curve and AD-AS combined and the long-run Phillips curve model and explain what is happening

Lec 32 Page 4

Graph short-run and long-run Phillips curve

Lec 32 Page 4

Graph the short run Phillips curve equilibrium

Lec 32 Page 4

Expectations and the short-run Phillips curve graph

Lec 32 Page 5

Draw graphs that depict any change in the economy's productive capacity

Lec 33 Page 2

Draw graphs of the AS-AD model and the Phillips curve for an adverse shift in AS lowering output and increasing unemployment, raising the inflation rate, and giving policymakers a less favourable trade-off between unemployment and inflation

Lec 33 Page 3

Graph the following situations: a) The economy is below its long run equilibrium (in recession). Now the government starts an expansionary fiscal policy. Show the effects b) The economy is in its long-run equilibrium. Now there is a discovery of a new technology for transforming orange juice into fuel at very cheap costs On both AS-AD graph and Phillips Curve

Pull out page 1 Book 2

Benefits of expansionary fiscal or monetary policy on stagflation

Pushes Y back towards Y*

QSRAS =

QLRAS + alpha(pi^A - pi^E)

Other options to monetary policy response;

Quantitative easing Forward guidance

Common theme of why the SRAS curve is upwards sloping

Quantity of output supplied in SR is different from LR output when the inflation rate os different from what people expected

An increase in the overall level of prices in the economy tends to _____ the quantity of goods and services supplied

Raise

Aggregate demand = Y =

Real GDP = actual output

Why should central banks aim for zero inflation?

Recall the 6 costs of inflation BUT how high are these for low rates of inflation Zero (inflation) provides a more natural focal point for policymakers than any other other number Reducing inflation has costs in the short-run with long-run benefits A higher target might lead to increases in inflation expectations

Stagflation is a period of

Recession and inflation

Benefit of governments doing nothing for stagflation

Recessionary gap will cause inflation expectations to fall, over time, SRAS moves back down (inflation falls back down)

Why should monetary and fiscal policymakers try to stabilise the economy?

Recessions are bad High inflation isn't good either Fiscal and monetary policy can, to some extent, smooth these fluctuations

An decrease in the overall level of prices in the economy tends to _____ the quantity of goods and services supplied

Reduce

Due to changes in the natural rate of unemployment, policies which improve the functioning of the labour market may help

Reduce the natural rate of unemployment

If pi^A > pi^E, employment is

Reduced

Fluctuations in inflation in recent years have been ________ due to the RBNZ's actions

Relatively small

What happens in contractionary monetary policy?

Reserve bank shifts MPR upwards - higher r for a given rate of inflation --> AD shifts down, recessionary gap, SRAS moves out over time, new long-run equilibrium

The economy may self-correct, i.e.

Return to long-run equilibrium so there may be no real need for active stabilisation policies

What is the exchange-rate effect?

Rising inflation rate tends to increase interest rates This encourages investors to invest in domestic economy instead of other economies Increases money in the country Currency appreciation The real exchange rate increases Exports are less competitive and imports are more attractive Decrease in net exports

What is the wealth effect?

Rising inflation, prices go up, consumers feel less wealthy so their consumption decreases Can occur in opposite order

B are

Risky loans Make up the majority of bundles that banks get other banks to invest in

What must intersect in the AD-AS model for the economy to be in long-run equilibrium

SRAS AD LRAS at a single point of intersection

To fix inflation, one must tradeoff at the expense of unemployment. If unemployment decreases:

SRPS moves up to return to U* short run if at least one input of consumption remains fixed

Was the GFC a supply or demand shock?

SUPPLY: LRAS moved left as some jobs permanently disappeared; offices closed down (e.g. in finance industry) -->fiscal and monetary policy may not help as they don't affect capital which influences LRAS DEMAND: Big frop in AD -->fiscal and monetary policy can help get the economy back to potential output as they influence AD

Why should tax laws be reformed to encourage savings?

Savings and investment are important as these fuel economic growth People respond to incentives if we want them to save more this should be incentivised - e.g. in NZ get $1000 if join Kiwisaver - but, some countries have double taxation of company profits and inheritance taxes (which discourage savings) - in NZ (as elsewhere) it is nominal rate of interest which is taxed, which discourages savings

If more workers are producing more goods (i.e. because u* is lower), the long-run AS (LRAS) curve would also

Shift to the right

Example: Assume the economy is currently in recession so they increase government spending, what does this do and graph this

Shifts the AD curve to the right Technological progress (through some change in government spending) could also shift the LRAS Lec 31 Page 3

The short-run Phillips curve also shifts because of

Shocks to AS

The short-run Phillips curve shifts because of

Shocks to AS

The RBNZ's ability to create unexpected inflation exists only in the

Short-run

Why do policymakers expand AD?

So they can choose a point on the Phillips curve with higher inflation and lower unemployment

Why do policymakers contract AD?

So they can choose a point on the Phillips curve with lower inflation and higher unemployment

NZ fiscal policy responses to GFC:

Spending on the Chch rebuild has (and will continue to) provide a further fiscal stimulus - some of this spending comes from the EarthQuake Commissions (EQC) fund Income tax cuts both personal and corporate took effect in Oct, 2010, but GST was increased at the same time (hence not really a fiscal stimulus - taxes cancel each other out)

Adverse shifts in aggregate supply cause

Stagflation

During the 70s and 80s, the US economy experienced high inflation and high unemployment simultaneously, otherwise known as

Stagflation

Increasing consumption shifts the SRAS backwards resulting in

Stagflation

Three theories explaining the upward slope of the SRAS

Sticky-wage theory Sticky-price theory Misperceptions theory

What does the short-run cPhillips curve show?

The trade off between unemployment and inflation holding constant: - expected inflation rate - natural rate of unemployment

The bulk of bundles are made up of

Sub-prime borrowers

What are the two saving effects?

Substitution and income

If T > G, the budget is

Surplus

Why are deficits a complication from using the fiscal policy as a stabilisation tool?

Sustaining government deficits could reduce saving and investment in new capital goods Lec 31 Page 3

T = T* + tY

T* is a lump sum tax t is a proportional income tax rate

Why shouldn't tax laws be reformed to encourage savings?

Taxes are also needed to raise revenue and redistribute income Tax laws favouring those who save more will favour the rich at the expense of the poor Will higher returns to savings actually increase savings

The developed countries where the effects of the crisis were felt least were those:

That could afford fiscal expansion Where the banking sector has not got involved in sub-prime lending to a high degree

What does the theory of rational expectations suggest?

That people optimally use all the information they have, including information about government policies, when forecasting the future

What curves do supply shocks shift?

The AS curve and the Phillips Curve

Will output really return to Y*? Keynesian response:

The gap can be large and correction takes time. "In the long run we are all dead"

Why shouldn't the government balance its budget (of balancing the budget)?

The level of debt is often small when calculated as the share of life time income per capita Would cutting spending on education make future generations better off It is reasonable to run deficits during times of recession Debt may be needed to pay for long-term investments that will generate a return; increase Y* Debt can grow forever as long as the nation;s income is growing more quickly Does higher public saving come at the expense of lower private saving> Were surpluses (in NZ) every year from 1994-2008 over-zealous - however this meant there was scope to run deficits when the GFC hit

In demand shocks, the main factors that generates ongoing increases in inflation are increases in

The money supply -because money demand increases too and/or -government prints money due to budget deficits Inflation rates in the rest of the world

The size of the shift in the AD resulting from a tax change is affected by what

The multiplier and the crowding-out effect

There are two macroeconomic effects from the change in government purchases

The multiplier effect The crowding-out effect

The long-run Phillips curve is vertical at

The natural rate of unemployment

What are two limits to fiscal policy flexibility?

The problem of time lags and the legislative process Competing political objectives

Mortgage securitisation =

The process of bundling many mortgage loans together and converting them into tradable financial instruments (debt securities)

What does the aggregate supply curve show

The quantity of goods and services that firms choose to produce and sell at each inflation rate

What does the aggregate demand curve show?

The quantity of goods and services that households, firms, and the government want to buy at each inflation rate Not because of the 'law of demand'

What does the long-run Phillips curve show?

The relationship between inflation and unemployment when the actual inflation equals the expected inflation rate As a result, the long-run Phillips curve is vertical at the natural rate of unemployment

What relationship does the Phillips curve look at

The relationship between inflation rates and unemployment

The trade off between inflation and unemployment described by the Phillips curve holds only in

The short run

What does the Phillips curve illustrate?

The short run relationship between inflation and unemployment

Major adverse chnages in AS can worsen

The short run trade off between unemployment and inflaiton

How do CDOs work?

They were divided up by type of institution into tranches or slices Tranches were ordered, not rated AAA tranches were paid out first, then if any money left AA was paid, etc. Note: income stream still coming from sub-prime mortgages

Types of mechanisms in the economy that change the amount by which output changes in response to a change in autonomous spending

Transfer payments Taxes

Whatever happens in the long run, it always returns to

U*

u =

U* - alpha(pi^A - pi^E)

Insolvent =

Unable to pay owed debts

Only factors that change ________ can shift the LRPC

Unemployment (u* = F+S)

How do transfer payments change the amount by which output changes in response to a change in autonomous spending?

Unemployment benefits allow the unemployed to consume even without a job, so consumption does not fall as much as what it would have been without benefits

What is the natural-rate hypothesis?

Unemployment will eventually return to its natural rate regardless of he rate of inflation

Advocates of active monetary and fiscal policy view the economy as inherently ________ and believe policy can be used to offset this inherent __________

Unstable Instability

In the SRAS, the slope is

Upwards sloping

In the short run, the AS curve is

Upwards sloping

In the long run, the aggregate supply curve is

Vertical

Rising inflation rates cause

Wealth effect Interest-rate effect Exchange-rate effect

What are the three effects s that cause the downwards sloping AD curve?

Wealth effect Interest-rate effect Exchange-rate effect

What are the three reasons the AD curve slopes downward?

Wealth effect Interest-rate effect Exchange-rate effect

Objectives

Week 11

Practice question

Week 11

Slide 15

Week 11

Slide 16

Week 11

Example: draw graph showing the government accommodating the supply shock and state what it does

When short-run AS falls policymakers can accommodate the shift by expanding AD which causes the inflation rate to rise further but keeps output at it natural rate Lec 29 Page 2

Draw graph 1 of the cost-push inflation whereby the government doesn't do anything and explain whats happening in it:

Whereby increased input costs Y < Y*. Stagflation: high unemployment and high inflation rates If government doesn't do anything, over time SRAS 2 shifts back to SRAS 1 Y = Y* Lec 31 Page 5

What does expected inflation explain?

Why there is a tradeoff between inflation and unemployment in the short run but not in the long run

The four components of GDP (Y) contribute to the AD for goods and services

Y = C + I + G + NX

Y axis and x axis of AD-AS model

Y = Inflation rate (pi) X = Quantity of output

In the long run, the AS curve should be vertical at

Y*

What does the fiscal policy affect?

Y* and AD

Actual unemployment formula =

u = u^* - alpha(pi^A - pi^E)

Why are wages difficult to change?

w = VMP = mP*P = marginal product times the price level So wage = marginal cost If w>VMP cost>benefits of workers To gain maximum profits, cut down on workers as wages are sticky Cut down on wages paid and output of goods