Econ 102 Discussion Section 8 (Chapter 12, 13) March 20, 2015

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1 Econ 102 Discussion Section 8 (Chapter 12, 13) March 20, 2015 The Multiplier and Shifting the Aggregate Expenditures Function The multiplier effect describes how changes in autonomous expenditures lead to changes in real GDP. In general, the multiplier can be described with the following formula: ΔY 1 Multiplier = = ΔAE!"#$ 1 MPC Tutorial: Determining how spending needs to change to reach full employment GDP Step 1: Determine the MPC (if applicable) You may not always be given the MPC to use for the multiplier. If not use the information in the question to determine the MPC Step 2: Determine ΔY The change in GDP in these questions can be defined as follows: ΔY = Y!" Y!, where Y! is equilibrium GDP Step 3: Solve for ΔAE!"#$ Example Using the information below, answer questions a) e) (the numbers are in billions) When GDP = 0, C = 1000 When GDP = 1000, C = 1750 Planned Investment = 900 Government Spending = 400 Net Export = -300 a) What is the aggregated expenditure function? b) What is the equilibrium level of real GDP? c) What is the multiplier? d) If potential GDP is $10000 billion, is the economy at full employment? If not, what is the condition of the economy? e) If the economy is not at full employment, by how much should government spending increase so that the economy can move to the full employment level of GDP? f) Repeat d) and e) when instead, the potential GDP is $6000 billion. Draw the graph to exhibit the change in government spending. Page 1

2 Econ 102 Discussion Section 8 (Chapter 12, 13) March 20, 2015 Aggregate Supply and Demand: Summary The Aggregate Demand Curve The aggregate demand curve (AD) shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world Why is the aggregate demand curve downward sloping? Wealth effect: Prices => Value of wealth => Consumption Interest rate effect: Prices => Money Demand => Interest Rates => C, I International trade effect: Prices => relative prices of domestic goods => NX The Aggregate Demand Curve and the Income-Expenditure Model Because of the wealth effect and the interest rate effect, a drop in the price level leads to an increase planned aggregate expenditures, relating the income-expenditure model to the downward slope in aggregate demand. Shifts of the Aggregate Demand Curve Changes in expectations: Optimism of consumers and firms => Aggregate demand Changes in foreign variables: exchange rate, domestic GDP growth => Aggregate demand Fiscal policy: Government purchases or Taxes => Aggregate demand Monetary policy: interest rate => Aggregate demand The Aggregate Supply Curve The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy. The short-run aggregate supply curve (SRAS) shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken as fixed. v Why is the short-run aggregate supply curve upward sloping? Sticky wages: Prices => Revenue but unchanged labor cost => Profit per unit of output => Output Sticky Prices: Price but the price of the product does not change (menu cost, contract) => sales => output Page 2

3 Econ 102 Discussion Section 8 (Chapter 12, 13) March 20, 2015 Shifts of the Short-run Aggregate Supply Curve Changes in labor, capital and technology Unexpected changes in price of an important natural resource (higher oil price, lower SRAS) Expected changes in future price level. (Higher expected future price level, lower SRAS today) Adjustment of workers and firms to errors in past expectations about price level. (underestimateà lower SRAS today) The long-run aggregate supply curve (LRAS) shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. LRAS depends only on Potential Output: the level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible, and we were at full employment AD-AS Equilibrium A short-run equilibrium occurs at the point where the AD curve intersects with the SRAS curve. A long-run equilibrium occurs when the AD, SRAS, and LRAS curve all intersect. How does AD and SRAS move in the automatic mechanism under different conditions? Decline in Aggregate Demand (interest rate rises, or firms being pessimistic about future) which leads to a recession in the short run. (Key: firms and workers adjust to the price level being lower than expected) Increase in Aggregate Demand (interest rate declines, or firms being optimistic about future) which leads to a short run expansion. (Key: firms and workers adjust to the price level being higher than expected) Supply shock (oil prices rise) which causes stagflation in the short run. (Key: Unemployment and falling output makes the workers be willing to accept lower wages) Note: Alternative way of moving back to LR equilibrium is through government intervention. (Fiscal policy, monetary policy after Midterm 2) Dynamic AD/AS In the dynamic model we assume that the LRAS will shift to the right in most years as increases in the labor force combined with technological change increase productivity. These same factors also cause the SRAS to shift to the right in most years as well (though this is not always the case such as the recession). This increase in population and income will also lead to an increase in AD, though not always as much as SRAS/LRAS. As a result, it is possible to have a recession even as AD is growing. Page 3

4 Econ 102 Discussion Section 8 (Chapter 12, 13) March 20, 2015 Examples In each of the following cases, suppose the economy is initially in its long-run equilibrium. Assume that there is no change in potential GDP. Analyze both short-run and long-run effects towards output (Y), price level (P) and unemployment in each scenario. Graphically illustrate using AD-AS model. 1) A recession triggered by panicked investors. 2) An expansion as a result of confident investors. 3) An abrupt increase in oil price. Page 4

5 Econ 102 Discussion Section 8 (Chapter 12, 13) March 20, 2015 Practice Problems 1. Deflation will a) shift up/right the aggregate demand line b) increase the quantity of aggregate output demanded c) shift down/left the aggregate demand line d) decrease the quantity of aggregate output demanded 2. Decreased optimism about the future will a) shift up/right the aggregate demand line b) increase the quantity of aggregate output demanded c) shift down/left the aggregate demand line d) decrease the quantity of aggregate output demanded 3. An increase in oil prices causes a shock, causing a(n) in the short-run aggregate price level and a(n) in short-run aggregate output. a) demand, increase, increase b) demand, decrease, decrease c) supply, increase, decrease d) supply, decrease, increase 4. An economy begins in its long-run equilibrium and then a negative demand shock causes aggregate GDP to fall below potential. What can the government do to get the economy back to its long-run equilibrium? a) Raise government purchases b) Raise interest rates c) Raise taxes d) Raise the minimum wage 5. An economy begins in its long-run equilibrium and then a negative demand shock causes aggregate GDP to fall below potential. With no government intervention, how will the economy transition back to potential GDP in the long run? a) Households will become wealthier, shifting aggregate demand back to the right. b) Commodity prices will fall, shifting aggregate demand back to the right. c) Productivity will fall, shifting short-run aggregate supply to the right. d) Nominal wages will fall, shifting short-run aggregate supply to the right. 6. Workers expect inflation to rise from 3% to 5% next year. As a result this should a) Shift the short run aggregate supply curve to the left b) Move the economy up along a stationary short run aggregate supply curve c) Move the economy down along a stationary short run aggregate supply curve d) Shift the short run aggregate supply to the right Page 5

6 Econ 102 Discussion Section 8 (Chapter 12, 13) March 20, If the economy is in long run equilibrium, an increase in autonomous consumption will: a) Lead to inflation and no change in output in the short run b) Lead to deflation and an increase in output in the short run c) Lead to no change in prices and an increase in output in the long run d) Lead to inflation and no change in output in the long run 8. If the economy is in long run equilibrium, a decrease in government spending will a) Lead to deflation and no change in output in the long run b) Lead to deflation and lower output in the long run c) Lead to no change in prices and lower output in the short run d) Lead to deflation and no change in output in the short run 9. If the economy is in long run equilibrium, a negative supply shock will a) Lead to deflation and no change in output in the long run b) Lead to inflation and lower output in the short run c) Lead to inflation and lower output in the long run d) Lead to deflation and lower output in the short run 10. If current output exceeds potential, if there is no government intervention then: a) Short run aggregate demand will decrease, bringing the economy to long run equilibrium b) Short run aggregate supply will decrease, bringing the economy into long run equilibrium c) Long run aggregate supply will increase, bringing the economy into long run equilibrium d) Not enough information 11. Suppose the economy is at full employment and firms become more optimistic about the future profitability of new investment. Which of the following will happen in the short run? a) Output will decline. b) Prices will decline. c) Unemployment will decline. d) The aggregate demand curve will shift to the left. 12. The automatic mechanism the price level in the case of and the price level in the case of. a) raises; recession; lowers; expansion b) raises; expansion raises; recession c) lowers; expansion; lowers; recession d) lowers; recession; raises; expansion Answers: 1. b) 2. c) 3. c) 4. a) 5. d) 6. a) 7. d) 8. a) 9. b) 10. b) 11. c) 12.d) Page 6