EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level?

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1 EQ: How Do Changes in and Affect So, what happens when changes? Increases in Consumption (C), Investment (I), Government Spending (G), & Net Exports (X) will: Increase Total Expenditures ( TE) Increase Aggregate Demand ( ) Right shift of the Curve Decreases in Consumption (C), Investment (I), Government Spending (G), & Net Exports (X) will : Decrease Total Expenditures ( TE) Decrease Aggregate Demand ( ) Left shift of the Curve EQ: How Do Changes in and Affect (CPI) The curve started here. Aggregate Market The curve moved to here. TE = C + I + G + X TE = -If C, I, G, or X increase, then TE will increase. -If TE increases, then will increase. -The curve will shift right. Economic Output ( ) EQ: How Do Changes in and Affect (CPI) The curve moved to here. The curve started here. Aggregate Market Economic Output ( ) TE = C + I + G + X TE = -If C, I, G, or X decrease, then TE will decrease. -If TE decreases, then will decrease. -The curve will shift left. EQ: How Do Changes in and Affect What happens when changes? Increases in Factor s, Decreases in Factor Productivity, & Adverse Supply Shocks will: Increase Production Costs ( TC) Decrease Short Run Aggregate Supply ( ) Left shift of the Curve Decreases in Factor s, Increases in Factor Productivity, & Beneficial Supply Shocks will: Decrease Production Costs ( TC) Increase Short Run Aggregate Supply ( ) Right shift of the Curve

2 EQ: How Do Changes in and Affect (CPI) -Production costs decrease when: -Factor s decrease. -Factor Productivity increases. -Beneficial Supply Shocks. -When production costs decrease, increases. -The curve will shift right. Aggregate Market The curve started here. Economic Output ( ) The curve moved to here. EQ: How Do Changes in and Affect (CPI) The curve moved to here. Aggregate Market -Production costs increase when: -Factor s increase. -Factor Productivity decreases. -Adverse Supply Shocks. -When production costs increase, decreases. -The curve will shift left. Economic Output ( ) The curve started here. EQ: How Do Changes in and Affect When income increases for consumers in an economy: Total Expenditures increases, Aggregate Demand increases, The curve shifts to the right. When there is a beneficial supply shock: Production costs decrease, Short-Run Aggregate Supply increases, The curve shifts to the right. When utility costs for businesses increase: Production costs increase, Short-Run Aggregate Supply decreases, The curve shifts to the left. When government spending decreases: Total Expenditures decreases, Aggregate Demand decreases, The curve shifts to the left. EQ: How Do Changes in and Affect On the aggregate market graph: is represented on the vertical axis. is represented on the horizontal axis. What about unemployment? Okun s Law and unemployment are negatively related. We can assume: If goes up, unemployment will go down. If goes down, unemployment will go up. So, changes in all 3 macroeconomic indicators can be observed and predicted observing changes on an aggregate market graph. Let s see how!

3 EQ: How Do Changes in and Affect Here s a summary of how changes in and affect, Unemployment, and the : Change Unemployment Rate Increases Increases Increases Decreases Decreases Decreases Decreases Increases Increases Decreases Increases Decreases Decreases Increases Decreases Increases This table shows the four possible changes in Aggregate Demand and Short Run Aggregate Supply as well as the effects of each change on the,, and the Unemployment Rate. EQ: How Do Changes in and Affect Let s say we have an increase in spending (Consumption, Investment, Government, or Net Exports): This would: Increase Total Expenditures Increase Aggregate Demand Shift the curve to the right This is a: Shift in a curve for the curve. Movement along a curve for the curve. The economic impact of this change: Increase in the (inflation goes up) Increase in (economic growth) Decrease in Unemployment EQ: How Do Changes in and Affect PL e PL e 1. Spending increases 2. TE and both Increase 3. Curve shifts right 4. The intersection point of the and Curves moves along the Curve up and right 5. Increases 6. Increases 7. Unemployment Decreases EQ: How Do Changes in and Affect Let s say we have a decrease in spending (Consumption, Investment, Government, or Net Exports): This would: Decrease Total Expenditures Decrease Aggregate Demand Shift the curve to the left This is a: Shift in a curve for the curve. Movement along a curve for the curve. The economic impact of this change: Decrease in the (decrease in inflation) Decrease in (economic recession) Increase in Unemployment

4 EQ: How Do Changes in and Affect PL e PL e 1. Spending decreases 2. TE and both Decrease 3. Curve shifts left 4. The intersection point of the and Curves moves along the Curve down and left 5. Decreases 6. Decreases 7. Unemployment Increases EQ: How Do Changes in and Affect Let s say we have a decrease in production costs (change in factor price/productivity or supply shock): This would: Increase Short Run Aggregate Supply Shift the curve to the right This is a: Shift in a curve for the curve. Movement along a curve for the curve. The economic impact of this change: Decrease in the (decrease in inflation) Increase in (economic growth) Decrease in Unemployment EQ: How Do Changes in and Affect PL e PL e 1. Production costs decrease 2. Increases 3. Curve shifts right 4. The intersection point of the and Curves moves along the Curve down and right 5. Decreases 6. Increases 7. Unemployment Decreases EQ: How Do Changes in and Affect Let s say we have an increase in production costs (change in factor price/productivity or supply shock): This would: Decrease Short Run Aggregate Supply Shift the curve to the left This is a: Shift in a curve for the curve. Movement along a curve for the curve. The economic impact of this change: Increase in the (increase in inflation) Decrease in (economic recession) Increase in Unemployment

5 EQ: How Do Changes in and Affect PL e PL e 1. Production costs increase 2. Decreases 3. Curve shifts left 4. The intersection point of the and Curves moves along the Curve up and left 5. Increases 6. Decreases 7. Unemployment Increases When income increases for consumers in an economy, the curve shifts to the right. Increase in Increase in When there is a beneficial supply shock, the curve shifts to the right. Decrease in Increase in When utility costs for businesses increase, the curve shifts to the left. Increase in Decrease in When government spending decreases, the curve shifts to the left. Decrease in Decrease in EQ: What is the Difference between Short Run & Long Run Equilibrium? Short Run Equilibrium The balance between & determined by the forces of aggregate demand () and short run aggregate supply () at a particular level of capital stock in an economy. Short-Run Equilibrium is the actual values of the and determined by and. These values can cause the economy to be in a recessionary gap or an inflationary gap (Lesson 2-9). EQ: What is the Difference between Short Run & Long Run Equilibrium? Long Run Equilibrium The state of the economy in which the forces of and cause to equal Natural. Long Run Equilibrium is rarely achieved by the actual values of and, but the actual values tend to move toward long-run equilibrium, usually passing it after reaching it. When the economy is in long run equilibrium: The economy is experiencing neither an inflationary gap nor a recessionary gap.

6 EQ: What is the Business Cycle? EQ: What is the Business Cycle? In an economy, the Business Cycle is the fluctuation in the short-run equilibrium (i.e., changes in ) which forms a regular pattern and occurs around the long-run trend path of economic output in an economy. The business cycle follows this pattern: 1. Expansion increase in economic activity in an economy (i.e., economic growth). 2. Peak maximum level of economic activity in a business cycle (the switch from expansion to contraction). 3. Contraction decline in economic activity in an economy (i.e., an economic recession). A depression is a particularly severe contraction/recession. 4. Trough minimum level of economic activity in a business cycle (the switch from contraction to expansion). ($) Peak Short-Run Equilibrium Time-Series Graph Peak Trough Time (Months, Years, etc.) Trough Long-Run Trend (Long-Run Equilibrium) EQ: How is the Business Cycle related to Natural? Remember that Natural is the ideal level of economic output. Output that is lower than Natural results in cyclical unemployment and stagnant economic growth. By the way, cyclical unemployment refers to the business cycle (i.e., unemployment due to a contraction). Output that is higher than Natural results in rising inflation and an overheated economy that can promise more extreme unemployment during the next Contraction. EQ: How is the Business Cycle related to Natural? So, Natural is the level of economic growth that an economy would have if there were no fluctuations at all. On the business cycle graph, that is shown as the Long-Run Trend (i.e., Long-Run Equilibrium). On a business cycle graph, the Long-Run Trend is the same thing as Natural. ($) Time (Months, Years, etc.) Long-Run Trend = Natural

7 ? An economy is in a recessionary gap when short-run equilibrium ( ) is less than the long-run trend of economic activity (Natural ), resulting in unemployment higher than the natural rate (cyclical unemployment). is less than Natural : Stagnant economy Unemployment increases (greater than Natural Rate) Measures need to be taken to stimulate the economy and bring back up to be equal to Natural. EQ: What is an Inflationary Gap? An economy is in an inflationary gap when short-run equilibrium ( ) exceeds the long-run trend of economic activity (Natural ), exerting upward pressure on prices in the economy (growing inflation). is greater than Natural : Overheated economy Inflation increases Unemployment rate lower than Natural Rate Measures need to be taken to cool off the economy and bring down to be equal to Natural. Identifying gaps on a time-series graph: Time-Series Graph Inflationary Gap Short-Run Equilibrium is higher than the Long-Run Equilibrium trend line. is greater than Natural Recessionary Gap Short-Run Equilibrium is lower than the Long-Run Equilibrium trend line. is less than Natural ($) Inflationary Gap Recessionary Gap Long-Run Trend = Natural Time (Months, Years, etc.)

8 Difference between contraction & recessionary gap: A contraction is the direction of the Short-Run Equilibrium curve ( decreasing). A recessionary gap is the position of the Short-Run Equilibrium curve relative to the Long-Run Equilibrium trend ( less than Natural ). Difference between expansion & inflationary gap: An expansion is the direction of the Short-Run Equilibrium curve ( increasing). An inflationary gap is the position of the Short-Run Equilibrium curve relative to the Long-Run Equilibrium trend ( greater than Natural ). Identifying gaps on the aggregate market graph: Inflationary Gap Short-Run Equilibrium is higher than the Long-Run Equilibrium trend line. is greater than Natural Recessionary Gap Short-Run Equilibrium is lower than the Long-Run Equilibrium trend line. is less than Natural Long Run Equilibrium = Long Run Aggregate Supply = Natural Long Run Equilibrium = Long Run Aggregate Supply = Natural Inflationary Gap Q N

9 Long Run Equilibrium = Long Run Aggregate Supply = Natural Recessionary Gap Q N Closing gaps: Economic policy is generally focused on closing recessionary and inflationary gaps so that the economy is operating in Long-Run Equilibrium. Closing inflationary gaps is simply an effort to decrease : Left shift of the or curve. Closing recessionary gaps is simply an effort to increase : Right shift of the or curve.