LECTURE 18. AS/AD in demand-deficient Ireland: Unemployment and Deflation

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1 LECTURE 18 AS/AD in demand-deficient Ireland: Unemployment and Deflation

2 THE AGGREGATE SUPPLY CURVE Aggregate supply curve Each possible price level Quantity of goods & services All nation s businesses - willing to produce All other determinants constant Aggregate supply curve Slopes upward Specified period of time

3 An aggregate supply curve S Price Level A Real GDP

4 THE AGGREGATE SUPPLY CURVE Unit profit = Price Unit cost Aggregate supply curve - slopes upward Firms purchase inputs Prices fixed for some period of time Higher selling prices output Production more attractive Aggregate supply curve Shifts outward/right More output produced Any given price level

5 THE AGGREGATE SUPPLY CURVE Aggregate supply curve Nominal wage rate increase Higher real production costs Aggregate supply curve shifts inward/left Higher real production costs Aggregate supply curve shifts inward/left Prices of other inputs increase

6 A shift of the aggregate supply curve S1 (higher wages) S0 (lower wages) Price Level (P) 100 S1 B A S0 0 5,500 6,000 Real GDP (Y)

7 THE AGGREGATE SUPPLY CURVE Aggregate supply curve Technology & productivity improve Decrease business costs Aggregate supply curve shift outward/right Available supply of labor & capital better Labor force - grows or improves in quality Capital stock increases (investment) Aggregate supply curve shifts outward/right

8 EQUILIBRIUM: AGGREGATE DEMAND & SUPPLY Equilibrium GDP Aggregate demand curve intersects Aggregate supply curve Equilibrium price level Aggregate quantity demanded equals Aggregate quantity supplied

9 Equilibrium of real GDP and the price level Price Level (P) 130 D S E D S 0 5,200 5,600 6,000 6,400 6,800 Real GDP (Y)

10 EQUILIBRIUM: AGGREGATE DEMAND & SUPPLY For price level > Equilibrium price level Aggregate quantity supplied exceeds Aggregate quantity demanded Price level falls Production falls Inventories increase Prices forced down

11 EQUILIBRIUM: AGGREGATE DEMAND & SUPPLY For price level < Equilibrium price level Aggregate quantity demanded exceeds Aggregate quantity supplied Shortage of goods Prices increase Price level rise Production rise Inventories decrease

12 Price Level Aggregate Quantity Demanded Aggregate Quantity Supplied Balance of Supply and Demand Prices will be: ,400 6,200 6,000 5,800 5,600 5,600 5,800 6,000 6,200 6,400 Demand exceeds supply Demand exceeds supply Demand equals supply Supply exceeds demand Supply exceeds demand Rising Rising Unchanged Falling falling Determination of the equilibrium price level

13 INFLATION AND THE MULTIPLIER Actual numerical value of multiplier Smaller oversimplified multiplier formula Aggregate supply curve slopes upward Any increase in aggregate demand Price level increase Erodes purchasing power of consumer wealth Reduces net exports Inflation reduces value of multiplier

14 Inflation and the multiplier D1 Price Level (P) 130 D S E0 E1 $800 billion D0 S A D1 0 6,000 6,400 Real GDP (Y) 6,800

15 RECESSIONARY & INFLATIONARY GAPS Recessionary gap Equilibrium GDP < Potential GDP Aggregate demand weak Inflationary gap Equilibrium GDP > Potential GDP Excess aggregate demand

16 Recessionary and inflationary gaps revisited Potential GDP 45 Real Expenditure Price Level D0 E S E C+I0+G+(X-IM) B Recessionary gap 6,000 7,000 Potential GDP Real GDP S B Recessionary gap D0 0 6,0007,000 Real GDP

17 Recessionary and inflationary gaps revisited Potential GDP 45 Real Expenditure Price Level E C+I1+G+(X-IM) 7,000 Potential GDP Real GDP D1 E S S D1 0 7,000 Real GDP

18 Recessionary and inflationary gaps revisited Real Expenditure Price Level Inflationary gap Potential GDP B 7,0008,000 Potential GDP D2 Inflationary E B gap S 45 C+I2+G+(X-IM) E S Real GDP D2 0 7,0008,000 Real GDP

19 ADJUSTING TO A RECESSIONARY GAP Deflation or Unemployment? Recessionary gap Equilibrium GDP < Potential GDP Cyclical unemployment Aggregate supply shift outward/right Increase GDP to Potential GDP Prices decline Wages may fall

20 The elimination of a recessionary gap Potential GDP Price Level (P) 100 D S0 E B S1 D 5,0006,000 Real GDP (Y) F S0 S1 Recessionary gap

21 ADJUSTING TO A RECESSIONARY GAP Wages & prices rarely fall Institutional factors Psychological resistance to wage reduction Business cycles less severe Economy - get stuck Recessionary gap - long period Firms don t want to lose best employees

22 ADJUSTING TO A RECESSIONARY GAP Self-correcting mechanism? Workers need jobs Willing to cut wages Firms willing to cut prices Economy s self-correcting mechanism Money wages react Recessionary or Inflationary gap Shift - aggregate supply curve Change: Equilibrium GDP & Equilibrium price level

23 ADJUSTING TO INFLATIONARY GAP: INFLATION Inflationary gap Equilibrium GDP > Potential GDP Tight labor market; Jobs plentiful Rising wages Increase business costs Prices increase Aggregate supply curve shifts inward/left Decrease GDP to Potential GDP Higher price level

24 Price Level (P) Potential GDP The elimination of an inflationary gap S1 S0 D B F E S1 S0 Inflationary gap D Real GDP (Y)

25 ADJUSTING TO INFLATIONARY GAP: INFLATION Self-correcting mechanism Takes time Stagflation Inflation and economic stagnation Normal after excessive aggregate demand

26 STAGFLATION FROM A SUPPLY SHOCK Higher energy prices Aggregate supply shift inward Oil shocks Adverse supply shocks Rising prices Inward shift of aggregate supply Falling production

27 Stagflation from an adverse shift in aggregate supply S1 Price Level (2000=100) D A 36.0 E 31.8 S1 S0 D S0 4,275 4,342 Real GDP

28 APPLYING MODEL TO A GROWING ECONOMY Every year Aggregate demand grows Shift right Growing population More demand: consumer & investment goods Increased government purchases Aggregate supply shift right More workers Investment & technology Improve productivity

29 Aggregate supply & demand analysis: growing economy Price Level (P) (2000=100) D0 D1 A S0 S1 S0 S1 D0 11,000 11,330 Real GDP (Y) in Billions of 2000 Dollars B D1

30 APPLYING MODEL TO A GROWING ECONOMY Demand-side fluctuations For Aggregate supply grows, and If: Aggregate demand grows faster Faster growth If: Aggregate demand grows slower Slower growth Less inflation More inflation

31 The effects of faster growth of aggregate demand D2 S0 S1 120 D0 C Price Level (P) (2000=100) 113 A D2 S0 S1 D0 11,000 11,500 Real GDP (Y) in Billions of 2000 Dollars

32 The effects of slower growth of aggregate demand Price Level (P) (2000=100) D0 D3 115 A 113 S0 S1 S0 D3 S1 D0 11,00011,165 Real GDP (Y) in Billions of 2000 Dollars E

33 APPLYING MODEL TO A GROWING ECONOMY Supply-side fluctuations For Aggregate demand grows, and If: Aggregate supply shifts inward Real output decline slightly If: Aggregate supply grows faster Favorable supply shock Faster economic growth Lower inflation Prices rapid increase

34 A ROLE FOR STABILIZATION POLICY Economy s self-correcting mechanism Works slowly Government stabilization policy Improve workings of free market

35 STOP. Write down 2 things you remember.

36 LECTURE 19 Monetary Policy, AS/AD

37 MONETARY POLICY Monetary policy ECB System Change Interest rates Money supply Aimed - affect the economy

38 MONEY AND INCOME: DIFFERENCE Money At one point in time E.g.: money stock (M1) Income Over a period of time E.g.: nominal GDP per year

39 THE ECB SYSTEM

40 IMPLEMENTING MONETARY POLICY Open-market operations ECB s purchase / sale Government securities Transactions: Open market Pays: newly created bank reserves The ECB lower interest rates Purchase: Treasury bills (T-bills)

41 IMPLEMENTING MONETARY POLICY Market for bank reserves Supply curve ECB policy Upward-sloping Demand curve Banks required to hold reserves Reflects Demand for transaction deposits banks Depends on real GDP & price level Downward-sloping

42 The market for bank reserves S Interest Rate D E For given ECB policy For given Y and P S D Quantity of Bank Reserves

43 IMPLEMENTING MONETARY POLICY Market for bank reserves ECB funds rate Interest rate Borrow/lend reserves among banks The ECB lower ECB funds rate Purchase T-bills Additional reserves to market Supply curve shift outward Lower interest rates More bank reserves

44 The effects of an open-market purchase D S0 S1 Interest Rate E A S0 S1 Quantity of Bank Reserves D

45 IMPLEMENTING MONETARY POLICY ECB Wants lower interest rates Purchases government securities In the open market Pays - creating new bank reserves Required reserve no change Actual reserves increased Excess reserves Multiple expansion process

46 IMPLEMENTING MONETARY POLICY Fluctuations People - hold cash Banks - hold excess reserves ECB Wants to increase interest rates In the open market Banks pay: reserves (deposits at the ECB) Multiple contraction process Sells U.S. government securities

47 IMPLEMENTING MONETARY POLICY Expansionary monetary policy ECB buys T-bills T-bills prices increase Demand unchanged Supply (available to private investors) Inward shift

48 Open-market purchases and treasury bill prices S1 S0 Price of a Treasury Bill P1 P0 D B S1 A S0 D Quantity of Treasury Bills

49 IMPLEMENTING MONETARY POLICY Open-market purchase Treasury bills - by the ECB Raises the money supply Drives up T-bill prices Pushes interest rates down Open-market sale - T- bills - by the ECB Reduces the money supply Lowers T-bill prices Raises interest rates

50 OTHER METHODS OF MONETARY CONTROL Lender of last resort Lending to banks Interest rate: discount rate Bank increase excess reserves Increase reserves Discount rate decrease Banks borrow more

51 OTHER METHODS OF MONETARY CONTROL Minimum required reserve ratio Decrease Increase excess reserves Money expansion Lower interest rates Decrease excess reserves Money contraction Higher interest rates 10% since 1992 Increase

52 HOW MONETARY POLICY WORKS Expansionary monetary policy Open-market purchase Lower interest rates Contractionary monetary policy Open-market sale Raise interest rates

53 The effects of monetary policy on interest rates D S0 S1 D S2 S0 Interest Rate E A Interest Rate B E S0 S1 D Bank Reserves (a) Expansionary Monetary Policy S2 S0 Bank Reserves D (b) Contractionary Monetary Polic

54 HOW MONETARY POLICY WORKS Sensitive to monetary policy Investment Net exports Contractionary monetary policy Higher interest rates (r) Lower total spending [C+I+G+ (X-IM)] Lower expenditure schedule Lower aggregate demand Lower investment spending (I)

55 The effect of interest rates on total expenditure Real Expenditure 45 C+I+G+(X-IM) (lower interest rate) C+I+G+(X-IM) C+I+G+(X-IM) (higher interest rate) Real GDP

56 HOW MONETARY POLICY WORKS Expansionary monetary policy Lower interest rates (r) Encourage investment (I) Higher total spending Higher expenditure schedule Multiplier effect on aggregate demand

57 The effect of expansionary monetary policy on total expenditure 45 Real Expenditure E0 E1 C+I1+G+(X-IM) C+I0+G+(X-IM) 0 5,500 6,000 6,500 7,000 Real GDP

58 HOW MONETARY POLICY WORKS Effect of monetary policy On aggregate demand Depends on Sensitivity of interest rates To open-market operations Responsiveness of investment spending To interest rate Size of basic expenditure multiplier

59 MONEY & PRICE LEVEL IN KEYNESIAN MODEL Expansionary monetary policy Increases aggregate quantity demanded At any given price level Causes some inflation Depends on slope of aggregate supply curve

60 Inflationary effects of expansionary monetary policy Price Level D1 D0 500 billion E B S S 0 6,000 6,400 Real GDP D0 D1

61 MONEY & PRICE LEVEL IN KEYNESIAN MODEL Aggregate demand slopes downward Higher price level Reduce purchasing power Depress exports, Stimulate imports Increase quantity of bank deposits demanded Demand curve (bank reserves) shift outward Increase ECBeral funds rate Higher interest rate Discourage investment Lower aggregate quantity demanded

62 The effect of a higher price level on the market for bank reserves D0 D1 S Interest Rate E0 E1 Effect of a higher P S D0 D1 Bank Reserves

63 STOP. Write down 2 things you remember.