Lecturer: Dr. Priscilla Twumasi Baffour, Department of Economics Contact Information:

Transcription

1 MACROECONOMIC EQUILIBRIUM AND MONETARY POLICY Lecturer: Dr. Priscilla Twumasi Baffour, Department of Economics Contact Information: College of Education School of Continuing and Distance Education 2014/ /2017

2 Session Overview In this session students are introduced to the concept of macroeconomic equilibrium where both Aggregate Demand and Aggregate Supply are used to determine the general price level and output. The session goes further discuss the impact aggregate demand and supply shocks have on equilibrium output and the general price level. Specifically on demand shocks, it is shown that price and output move in the same direction at the shock, whether positive or negative whiles with a supply shock, price and output move in opposite directions. The session concludes with a discussion on monetary policy in addressing fluctuations in the business cycle. Priscilla T. Baffour Slide 2

3 Session Outline The key topics to be covered in the session are as follows: The key topics to be covered in the session are as follows: Macroeconomic Equilibrium Changes in GDP and the Price Level Aggregate Demand Shocks Aggregate Supply Shocks Monetary policy Expansionary monetary policy Contractionary monetary policy Priscilla T. Baffour Slide 3

4 Learning Outcome After completing this session, you should be able to; Determine equilibrium level of GDP and the price level. Illustrate how an exogenous change in autonomous spending (a demand shock) shifts the aggregate demand curve and cause equilibrium output and price level to move in the same direction. Indicate how an exogenous change in input prices or technology (a supply shock) shifts the short-run aggregate supply curve and causes both output and the price level move in opposite direction. Identify the tools of monetary policy Discuss how expansionary monetary policy is used to boost the economy under a recession Explain how contractionary monetary policy is used to control inflationary pressure Priscilla T. Baffour Slide 4

5 Reading List Chapter 19 of R. G. Lipsey & K. A. Chrystal, Economics, Eleventh Edition, 2004, Oxford University Press Session Slides Watch video on session 11.. Any Other Economics text books available to students Priscilla T. Baffour Slide 5

6 Macroeconomic Equilibrium Within the aggregate demand and supply framework, equilibrium income is obtained at the point where aggregate demand of goods and services is equal to the aggregate supply of goods and services. In other words, macroeconomic equilibrium occurs at the intersection of the AD and SRAS curves and determines the equilibrium values for GDP (income) and the price level. From figure 1 below, Equilibrium occurs at E 0 with GDP equal to Y 0 and the price level P 0. If the price level were P 1 as in figure 2 below P 0, the desired output of firms as given by the SRAS curve would be Y 1 which is less that the desired demand at that level of GDP. The excess desired demand will cause prices to bid up, and output will increase along the SRAS curve. Hence there can be no macroeconomic equilibrium when the price level is below P0 Only at E 0 are desired plans of producers and consumers consistent. Priscilla T. Baffour

7 Macroeconomic Equilibrium (Figure 1) AD SRAS P 0 E 0 0 Y 0 Real GDP Priscilla T. Baffour

8 Macroeconomic Equilibrium (Figure 2) AD SRAS P 0 E 0 P 1 0 Y Y Y Real GDP Priscilla T. Baffour Slide 8

9 Macroeconomic Equilibrium Priscilla T. Baffour Similarly, if the price level is above Po, producers will wish to supply more than the output that is demanded at that price level. Desired demand will not be large enough to purchase everything that firms wish to produce at that price level Therefore only at the combination of GDP and price level given by the intersection of the SRAS and AD curves are desired demand and desired production activities consistent. Macroeconomic equilibrium thus requires that two conditions be satisfied. First, at the prevailing price level, desired demand must be equal to national output. Simply means that economic agents are just willing to buy all that is produced. The second, that at the prevailing price level, firms must wish to produce the prevailing level of national output.

10 Changes in GDP/Output and the Price Level Aggregate demand and aggregate supply curves are used to explain how various shocks to the economy change both real GDP and the price level. A shift in the AD curve is called an aggregate demand shock. A rightward shift in the AD curve results from an increase in aggregate demand(positive Aggregate Demand Shock) A leftward shift in the AD curve indicates a decrease in aggregate demand(negative Aggregate demand shock) A shift in the SRAS curve is called an aggregate supply shock. A rightward shift in the SRAS curve represents an increase in aggregate supply. That at any given price level more real output is supplied A leftward shift in the SRAS curve is a decrease in aggregate supply. That is less real output is supplied at an given price level. Priscilla T. Baffour Slide 10

11 Aggregate Demand Shocks The aggregate demand curves plots demand determined GDP as a function of the price level, therefore anything that alters this outcome for GDP at any specific price level must shift the AD curve. A change in the price level causes a movement along the AD curve. It is only changes in exogenous spending which cause the Aggregate expenditure curve to shift that causes the AD curve to shift (Aggregate demand shock) Aggregate Demand shocks could originate from Changes in spending by the private sector(investment) Changes in Autonomous Private Consumption Changes in monetary(money supply) and fiscal policy (Government spending and taxes) Priscilla T. Baffour Slide 11

12 Aggregate Demand Shocks AD shocks cause the price level and real GDP to change in the same direction. A positive AD shock leads to an increase in both real GDP and the Price Level Real GDP and the Price Level decline with a negative AD shock. Priscilla T. Baffour Slide 12

13 Positive Aggregate Demand Shock Positive Aggregate demand shock results from: Increase in Autonomous Consumption A tax cut for instance increases the disposable income of households thereby increasing consumption. Increase in private sector spending(investment) Optimism about the future, a fall in interest rate makes firms invest more at a given price level. Increase in money supply A fall in the discount rate, open market purchase and a reduction in the reserve required ratio increases money supply Increase in Government Spending or decrease in taxes Priscilla T. Baffour Slide 13

14 Positive Aggregate Demand Shock An increase in autonomous consumption, private spending, money supply and government spending will increase aggregate demand at a given price level and therefore shift the aggregate demand curve to the right. From figure 3 below, a rightward shift of the AD curve from AD 0 to AD 1 causes the price level to move in the same direction (increase). Macroeconomic Equilibrium moves from E 0 to E 1. The price level increases from P 0 to P 1 and real GDP/Output increases from Y 0 to Y 1 reflecting a movement along the SRAS curve. Priscilla T. Baffour Slide 14

15 Positive Demand-Shock (Figure 3) SRAS 0 E 1 P 1 P 0 Price Level Rises E 0 Inflationary Gap Opens AD 0 AD 1 Real GDP Y* Y 1 Autonomous increase in aggregate demand

16 Negative Aggregate Demand Shock A leftward shift in the AD curve results from a decrease in aggregate demand (Negative Aggregate Demand Shock) Negative Aggregate demand shock results from: Decrease in Autonomous Consumption Decrease in private sector spending(investment) A rise in interest rate, pessimism about the future will lead to a decrease in investment. Decrease in money supply An increase in the discount rate, open market sale and a rise in the reserve required ratio increases money supply Decrease in Government Spending or Increase in taxes Priscilla T. Baffour Slide 16

17 Negative Aggregate Demand Shock A decrease in Autonomous Consumption, private spending, money supply, government spending and an increase in taxes will shift the aggregate demand curve to the left. A decrease in aggregate demand, holding SRAS curve constant will result in a decrease in both real GDP/Output and prices. As shown in figure below, a negative aggregate demand shock shifts the AD curve to the left thereby causing the price level and output to move in the same direction. A Decrease in aggregate demand shifts the AD curve to the left from AD 0 to AD 1. Macroeconomic Equilibrium moves from E 0 to E 1. The price level falls from P 0 to P 1 and real GDP/Output falls from Y 0 to Y 1 reflecting a movement along the SRAS curve. Priscilla T. Baffour Slide 17

18 Negative Demand-Shock (Figure 4) SRAS 0 1 E 0 P 0 E 1 AD 0 AD 1 Y1 Y0 Real GDP [i]. Autonomous Fall in Aggregate Demand

19 Aggregate Supply Shocks The SRAS curve shows the quantity of output firms would like to produce and to sell at each price level on the assumption that prices of all inputs remain constant. An aggregate supply shock means a shift in the SRAS curve. Meaning at the same price level, firms are willing to supply more (positive shock) or less (negative shock). Adjustment to a new equilibrium following a shock in aggregate supply involves a movement along the AD curve causing the price level and output to move in opposite direction. There are two main sources of aggregate supply shocks which are of particular importance: Changes in the prices of inputs Increases in productivity Priscilla T. Baffour Slide 19

20 Aggregate Supply Shocks An increase in AS (downward shift of AS curve) will cause a fall in general price level and an increase in output. A decrease in AS (upward shift of AS curve) will cause a rise in general price level and a decrease in output. Examples of AS shocks Oil Price Increases during , , during Gulf war in 1990, and during the late 2000s (i.e. 2007/08) Productivity gains from an upsurge of new technologies in late 1990s In Ghana during the droughts in 1982/83, energy crises in early 1980s, mid 2000s and Priscilla T. Baffour Slide 20

21 Aggregate Supply Shocks Changes in Input Prices The profitability of firms current production is reduced with increases in input prices. Due mainly to increased cost of production As a result, if output prices do not rise, firms will react by reducing production. This means that there will be less output at each price level than before. Thus if input prises rise, the SRAS curve shifts upward indicating a decrease in aggregate supply. That is a fall in output but higher prices Priscilla T. Baffour Slide 21

22 Aggregate Supply Shocks Changes in Productivity Labour Productivity has to do with output per worker. If Labour productivity rises, meaning that each worker can produce more per hour, the unit cost of production will fall as long as wage rate and other input prices remain constant. If cost falls, firms will be willing to sell more at the same price which causes a rightward or downward shift in the aggregate supply curve. Figure 4 below shows the impact of both positive and negative supply shocks on output and the price level. Priscilla T. Baffour Slide 22

23 Graphical Illustration of Supply Shocks (Figure 4) Priscilla T. Baffour Slide 23

24 Priscilla T. Baffour Topic Two MONETARY POLICY

25 Monetary Policy Tools Monetary policy is management of the quantity of money in circulation(money supply) and/or the interest rates for the purpose of reducing a business cycle fluctuations. Although different tools can be employed to conduct monetary policy, the specific objective at any point in time may be different. In a period of recession, the aim of monetary policy is to increase aggregate demand and output. On the other hand, in inflationary periods, monetary policy is used to reduce aggregate demand and reduce the inflationary pressures in the economy. This means monetary policy can be expansionary or restrictive(contractionary) Priscilla T. Baffour Slide 25

26 Types of Monetary Policy There are two main types of monetary policy. Expansionary Monetary Policy Contractionary Monetary Policy Another form of monetary policy is Discretionary Monetary Policy. Priscilla T. Baffour Slide 26

27 Expansionary Monetary Policy Expansionary Monetary policy is an increase in the quantity of money in circulation(money supply) with corresponding reductions in interest rates for the purpose of stimulating aggregate demand and output and to address the problem of low demand and unemployment. Thus, the goal of expansionary monetary policy is to increase aggregate demand and output and to reduce unemployment. Expansionary monetary policy includes: Buying government bonds(open market purchase) Lower discount rate (the rate of interest charged on loans to commercial banks by the central bank) Lower required reserve ratio (increases excess reserves available to commercial banks to create money). Priscilla T. Baffour Slide 27

28 Expansionary Monetary Policy Figure 5 below shows the increase in money supply by using open market operation. The increase in the money supply is shown by a rightward shift in the supply of money curve from Ms 1 to Ms 2. This given the money demand function, leads to a reduction in the interest rate from r 1 to r 2. When the interest rate falls from r 1 to r 2, investment increases from I 1 to I 2. Using the macroeconomic equilibrium, increase in investment shifts the aggregate demand curve from AD 0 to AD 1.this increase real GDP/output. This implies in recessionary periods where output and employment in the economy are below their potential levels. Money supply may be increased to stimulate investment and aggregate demand in the economy. Priscilla T. Baffour Slide 28

29 Graphical Illustration (Figure 5) Priscilla T. Baffour Slide 29

30 Contractionary Monetary Policy Contractionary monetary policy on the other hand is a reduction in the quantity of money in circulation(money supply) with corresponding increase in interest rates for the purpose of reducing a business cycle expansion to address the problem of inflation (too much demand) The primary goal of contractionary monetary policy is to reduce inflation. Contractionary monetary policy includes: Sale of government bond/securities(open market sale Raising the discount rate Raising the required reserve ratio Priscilla T. Baffour Slide 30

31 Questions 1. Show what would happen to the SRAS if a. Investment in transport infrastructure lowers costs of shipping goods and raw materials b. Oil prices rise c. Workers agree to work for lower wages d. There is a technical innovation in manufacturing industry 2. Outline how the interaction of the AD and the SRAS curves determines equilibrium GDP and the price level in response to a. A rise in wage rates b. An increase in investment c. A reduction on government consumption d. A boom in demand in neighboring economies Priscilla T. Baffour Slide 31