EQ: What happens to equilibrium price and quantity when there is a change in supply or demand? The main thing that affects Supply is production costs. Costs of factors of production affect supply: Employee Wage Rates Costs of Production Materials Real Estate Costs (Rent, Taxes, etc.) Costs to purchase new equipment Advertising, utility, and maintenance costs When costs go down, Supply increases and the Supply curve shifts to the right. When costs go up, Supply decreases and the Supply curve shifts to the left.
EQ: What is the difference between change in supply and change in quantity supplied? The Change in Supply Process: First, any cost associated with production changes, increasing or decreasing production costs. Next, the Supply curve shifts: Increase in costs = Left shift = decrease in supply Decrease in costs = Right shift = increase in supply Lastly, the quantity demanded changes because the equilibrium price changes: Left shift = decrease in Quantity Demanded Right shift = increase in Quantity Demanded
EQ: What happens to equilibrium price and quantity when there is a change in supply or demand? The following things affect change in demand: Consumer Income Preferences of Consumers Prices of Related Goods (complements & substitutes) Number of Buyers in the Market Expectation of Future Prices When income goes down, Demand decreases and the Demand curve shifts to the left. When income goes up, Demand increases and the Demand curve shifts to the right.
EQ: What is the difference between change in demand and change in quantity demanded? The Change in Demand Process: First, a variable that is one of the determinants of demand changes. Next, the Demand curve shifts: Left shift = decrease in demand Right shift = increase in demand Lastly, the quantity supplied changes because the equilibrium price changes: Left shift = decrease in Quantity Supplied Right shift = increase in Quantity Supplied
EQ: What happens to equilibrium price and quantity when there is a change in supply or demand? Change Eq Price Eq Quantity Demand Increases Increases Increases Demand Decreases Decreases Decreases Supply Increases Decreases Increases Supply Decreases Increases Decreases This table shows the four possible changes in demand and supply and the effect of each change on the equilibrium price and quantity.
EQ: What kinds of trade-offs have to be made when pursuing the 3 economic goals? Economic Growth-Full Employment Trade-Offs Okun s Law (or Okun s rule of thumb ) Real GDP & unemployment are negatively related. This seems good, because we want Real GDP to go up and unemployment to go down. However, it is deceiving... The goal is NOT low unemployment, it is full employment. Full employment means that we have some unemployment (frictional and structural). The more unemployment falls below full employment: Unemployment gets lower and lower (closer to 0%) We are moving farther away from our goal of full employment
EQ: What kinds of trade-offs have to be made when pursuing the 3 economic goals? Economic Growth-Full Employment Trade-Offs When the unemployment rate is equal to or lower than the natural unemployment rate (i.e., no cyc. unemployment): There is a trade-off between growth and full employment. As Real GDP goes up, unemployment decreases still, deteriorating frictional/structural unemployment and moving farther away from full employment. So what s wrong with falling below full employment? When economic growth is so great that we fall below full employment, the increase in unemployment in the coming recession will be more severe. It s like stretching a rubber band the more you stretch it, the greater the response when you let it go. In the long run, unemployment will increase as a reaction.
EQ: What kinds of trade-offs have to be made when pursuing the 3 economic goals? Price Level-Full Employment Trade-Offs The Phillips Curve indicates that there is a negative relationship between unemployment and inflation, such that: A lower unemployment rate would cause inflation. A higher unemployment rate would alleviate inflation. So, it would seem that a trade-off must be made between inflation and unemployment. That is, you have to pick your poison. When the theory of the Natural Unemployment Rate was introduced in the 1960 s, the inflationunemployment relationship was not so clear.
EQ: What Causes Changes in Aggregate Demand? Aggregate Demand = Total Expenditures Anything that changes Total Expenditures will change Aggregate Demand Total Expenditures is made up of: Consumption Investment Government Spending Net Exports Anything that changes any of the four components of TE will change AD.
EQ: What Causes Changes in Aggregate Demand? Changes in Consumption will change AD. Consumption is affected by: Wealth & Income how much money people have. When people have more money, consumption is higher. When people have less money, consumption is lower. Interest Rates how much people have to pay to borrow money that they want to spend. When interest rates are higher, people borrow less and consumption is lower. When interest rates are lower, people borrow more and consumption is higher. Taxes money paid to governments (it reduces the amount of money available to spend). Higher taxes mean less money to spend on consumption. Lower taxes mean more money to spend on consumption. When consumption is higher, aggregate demand increases. When consumption is lower, aggregate demand decreases.
EQ: What Causes Changes in Aggregate Demand? Changes in Investment will change AD. Investment is affected by: Expectations about Rate of Return on Investment estimate of how much profit will be earned on an investment. Interest Rates percentage of money paid out for borrowing money to make an investment. An investment will only be made if the expected rate of return is significantly higher than the interest rate paid for borrowing money to make the investment. When interest rates are higher or rates of return are lower, businesses will make fewer investments. When interest rates are lower or rates of return are higher, businesses will make more investments. When investment is higher, aggregate demand increases. When investment is lower, aggregate demand decreases.
EQ: What Causes Changes in Aggregate Demand? Changes in Gov t Spending will change AD. Government Spending is affected by the political process. When government spending is higher, aggregate demand increases. When government spending is lower, aggregate demand decreases.
EQ: What Causes Changes in Short Run Aggregate Supply? In a product market, supply is determined by costs of production. In the aggregate market, SRAS is determined by the economy s overall production costs. Factor Prices wage rates (cost of labor), costs of capital (machinery, parts, inventory, services), and costs of natural resources (real estate, raw materials). Basically, the any cost or bill paid by a business. An increase in the prices of inputs will increase the costs of production for businesses in an economy. A decrease in the prices of inputs will decrease the costs of production for businesses in an economy. Factor Productivity how much output can be produced with each unit of a factor of production. Factors that are more productive (like educated or skilled workers) will produce more output in an economy. An increase in the productivity of inputs will decrease the costs of production for businesses in an economy. A decrease in the productivity of inputs will increase the costs of production for businesses in an economy.
EQ: What Causes Changes in Short Run Aggregate Supply? In the aggregate market, SRAS is determined by the economy s overall production costs (continued). Supply Shocks unusual events that affect the prices and productivity of inputs (i.e., factors) in the production process. Examples include bad weather (ice storms), natural disasters (Hurricane Katrina, earthquakes), terrorist activity (like 9/11), and cold weather (flu season). Adverse supply shocks increase factor prices and decrease factor productivity, resulting in increased production costs. Beneficial supply shocks decrease factor prices and increase factor productivity, resulting in decreased production costs. When production costs are higher, SRAS decreases. When production costs are lower, SRAS increases.
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? So, what happens when AD changes? Increases in Consumption (C), Investment (I), Government Spending (G), & Net Exports (X) will: Increase Total Expenditures ( TE) Increase Aggregate Demand ( AD) Right shift of the AD Curve Decreases in Consumption (C), Investment (I), Government Spending (G), & Net Exports (X) will : Decrease Total Expenditures ( TE) Decrease Aggregate Demand ( AD) Left shift of the AD Curve
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? Aggregate Market The AD curve moved to here. SRAS Price Level (CPI) The AD curve started here. TE = C + I + G + X TE = AD -If C, I, G, or X increase, then TE will increase. -If TE increases, then AD will increase. -The AD curve will shift right. Economic Output (Real GDP) AD AD
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? The AD curve started here. Aggregate Market SRAS Price Level (CPI) The AD curve moved to here. TE = C + I + G + X TE = AD -If C, I, G, or X decrease, then TE will decrease. -If TE decreases, then AD will decrease. -The AD curve will shift left. AD AD Economic Output (Real GDP)
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? What happens when SRAS changes? Increases in Factor Prices, Decreases in Factor Productivity, & Adverse Supply Shocks will: Increase Production Costs ( TC) Decrease Short Run Aggregate Supply ( SRAS) Left shift of the SRAS Curve Decreases in Factor Prices, Increases in Factor Productivity, & Beneficial Supply Shocks will: Decrease Production Costs ( TC) Increase Short Run Aggregate Supply ( SRAS) Right shift of the SRAS Curve
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? Price Level (CPI) -Production costs decrease when: -Factor Prices decrease. -Factor Productivity increases. -Beneficial Supply Shocks. -When production costs decrease, SRAS increases. -The SRAS curve will shift right. Aggregate Market The SRAS curve started here. SRAS SRAS The SRAS curve moved to here. AD Economic Output (Real GDP)
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? Aggregate Market SRAS SRAS Price Level (CPI) The SRAS curve moved to here. -Production costs increase when: -Factor Prices increase. -Factor Productivity decreases. -Adverse Supply Shocks. -When production costs increase, SRAS decreases. -The SRAS curve will shift left. The SRAS curve started here. AD Economic Output (Real GDP)
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? When income increases for consumers in an economy: Total Expenditures increases, Aggregate Demand increases, The AD curve shifts to the right. When there is a beneficial supply shock: Production costs decrease, Short-Run Aggregate Supply increases, The SRAS curve shifts to the right. When utility costs for businesses increase: Production costs increase, Short-Run Aggregate Supply decreases, The SRAS curve shifts to the left. When government spending decreases: Total Expenditures decreases, Aggregate Demand decreases, The AD curve shifts to the left.
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? On the aggregate market graph: Price Level is represented on the vertical axis. Real GDP is represented on the horizontal axis. What about unemployment? Remember Okun s Law? Real GDP and unemployment are negatively related. We can assume: If Real GDP goes up, unemployment will go down. If Real GDP 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!
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? Here s a summary of how changes in AD and SRAS affect Real GDP, Unemployment, and the Price Level: Change Price Level Real GDP Unemployment Rate AD Increases Increases Increases Decreases AD Decreases Decreases Decreases Increases SRAS Increases Decreases Increases Decreases SRAS 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 Price Level, Real GDP, and the Unemployment Rate.
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? 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 AD curve to the right This is a: Shift in a curve for the AD curve. Movement along a curve for the SRAS curve. The economic impact of this change: Increase in the Price Level (inflation goes up) Increase in Real GDP (economic growth) Decrease in Unemployment
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? Price Level 1. Spending increases 2. TE and AD both Increase 3. AD Curve shifts right SRAS PL e PL e 4. The intersection point of the AD and SRAS Curves moves along the SRAS Curve up and right 5. Price Level Increases 6. Real GDP Increases 7. Unemployment Decreases AD Real GDP e Real GDP e AD Real GDP
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? 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 AD curve to the left This is a: Shift in a curve for the AD curve. Movement along a curve for the SRAS curve. The economic impact of this change: Decrease in the Price Level (decrease in inflation) Decrease in Real GDP (economic recession) Increase in Unemployment
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? Price Level 1. Spending decreases 2. TE and AD both Decrease 3. AD Curve shifts left SRAS PL e PL e 4. The intersection point of the AD and SRAS Curves moves along the SRAS Curve down and left 5. Price Level Decreases 6. Real GDP Decreases 7. Unemployment Increases Real GDP e Real GDP e AD AD Real GDP
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? 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 SRAS curve to the right This is a: Shift in a curve for the SRAS curve. Movement along a curve for the AD curve. The economic impact of this change: Decrease in the Price Level (decrease in inflation) Increase in Real GDP (economic growth) Decrease in Unemployment
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? Price Level 1. Production costs decrease 2. SRAS Increases 3. SRAS Curve shifts right 4. The intersection point of the SRAS and AD Curves moves along the AD Curve down and right 5. Price Level Decreases 6. Real GDP Increases 7. Unemployment Decreases SRAS SRAS PL e PL e Real GDP e Real GDP e AD Real GDP
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? 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 SRAS curve to the left This is a: Shift in a curve for the SRAS curve. Movement along a curve for the AD curve. The economic impact of this change: Increase in the Price Level (increase in inflation) Decrease in Real GDP (economic recession) Increase in Unemployment
EQ: How Do Changes in AD and SRAS Affect Real GDP, Unemployment, & Price Level? Price Level SRAS SRAS PL e PL e 1. Production costs increase 2. SRAS Decreases 3. SRAS Curve shifts left 4. The intersection point of the SRAS and AD Curves moves along the AD Curve up and left 5. Price Level Increases 6. Real GDP Decreases 7. Unemployment Increases Real GDP e Real GDP e AD Real GDP
When income increases for consumers in an economy, the AD curve shifts to the right. Price Level Real GDP When there is a beneficial supply shock, the SRAS curve shifts to the right. Price Level When utility costs for businesses increase, the SRAS curve shifts to the left. Price Level When government spending decreases, the AD curve shifts to the left. Price Level Real GDP Real GDP SRAS AD AD Real GDP SRAS AD AD SRAS SRAS AD SRAS AD SRAS Increase in Price Level Increase in Real GDP Decrease in Price Level Increase in Real GDP Increase in Price Level Decrease in Real GDP Decrease in Price Level Decrease in Real GDP
EQ: What is a Recessionary Gap and an Inflationary Gap? Time-Series Graph Real GDP Long-Run Trend = Natural Real GDP Real GDP ($) Inflationary Gap Recessionary Gap Time (Months, Years, etc.)
EQ: What is a Recessionary Gap and an Inflationary Gap? Long Run Equilibrium = Long Run Aggregate Supply = Natural Real GDP SRAS Price Level Inflationary Gap AD Q N Real GDP e
EQ: What is a Recessionary Gap and an Inflationary Gap? Long Run Equilibrium = Long Run Aggregate Supply = Natural Real GDP SRAS Price Level Recessionary Gap AD Real GDP e Q N
EQ: What is a Recessionary Gap and an Inflationary Gap? 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 Real GDP: Left shift of the AD or SRAS curve. Closing recessionary gaps is simply an effort to increase Real GDP: Right shift of the AD or SRAS curve.
EQ: How does a Recessionary Gap Close According to Classical Economic Theory? Summary of how a recessionary gap is closed according to classical economics: 1. Real GDP is less than Natural Real GDP (by definition). 2. Unemployment is higher than the natural rate of unemployment (i.e., cyclical unemployment). 3. Wage rates fall in the labor market due to a surplus of labor (more job seekers than there are jobs available). 4. Decrease in wages lowers production costs, causing an increase in SRAS and a right shift of the SRAS curve. 5. Real GDP increases toward Natural Real GDP as Short- Run Equilibrium moves toward Long-Run Equilibrium, closing the recessionary gap. 6. This whole process is automatic (i.e., no government intervention).
EQ: How does an Inflationary Gap Close According to Classical Economic Theory? Summary of how an inflationary gap is closed according to classical economics: 1. Real GDP is greater than Natural Real GDP (by definition). 2. Unemployment is lower than the natural rate of unemployment. 3. Wage rates rise in the labor market due to a shortage of labor (more jobs available than there are job-seekers). 4. Increase in wages increases production costs, causing a decrease in SRAS and a left shift of the SRAS curve. 5. Real GDP decreases toward Natural Real GDP as Short-Run Equilibrium moves toward Long-Run Equilibrium, closing the inflationary gap. 6. This whole process is automatic (i.e., no government intervention).
EQ: How Does a Recessionary Gap Close According to Keynesian Economic Theory? Increase in TE Increase in AD Right Shift in AD Curve Increase in Real GDP SRAS Price Level Price Level AD AD Real GDP e Q N
EQ: How Does an Inflationary Gap Close According to Keynesian Economic Theory? Decrease in TE Decrease in AD Left Shift in AD Curve Decrease in Real GDP SRAS Price Level Price Level AD AD Q N Real GDP e
EQ: How can Keynesian Theory be Used to Manage the Economy? During a recessionary gap, the government can increase aggregate spending: Directly by increasing Government Spending on things like building highways. Indirectly by providing businesses incentives to spend money on Investment. Increases in Investment or Government Spending will set off a chain reaction of Consumption spending that will increase TE and close the recessionary gap.
EQ: How can Keynesian Theory be Used to Manage the Economy? During an inflationary gap, the government can decrease aggregate spending: Directly by decreasing Government Spending. Indirectly by implementing restrictions on businesses to spend less on Investment. Decreases in Investment or Government Spending will set off a chain reaction that erodes Consumption spending that will decrease TE and close the inflationary gap.
EQ: What is Expansionary Fiscal Policy? Expansionary fiscal policy is a position that the federal government takes on spending & taxation when the economy is in a recessionary gap and needs to expand. In a recessionary gap, the government wants to increase TE & Real GDP. This means more money in the pockets of households and businesses to increase Consumption and Investment. Also, the government needs to spend more money to increase Government Spending. Increases in Consumption, Investment, and Government Spending will increase Total Expenditures & Real GDP, closing the recessionary gap.
EQ: What is Contractionary Fiscal Policy? Contractionary fiscal policy is a position that the federal government takes on spending & taxation when the economy is in an inflationary gap and needs to contract. In an inflationary gap, the government wants to decrease TE & Real GDP. This means less money in the pockets of households and businesses to decrease Consumption and Investment. Also, the government needs to spend less money to decrease Government Spending. Decreases in Consumption, Investment, and Government Spending will decrease Total Expenditures & Real GDP, closing the inflationary gap.
EQ: How Do Changes in the Money Supply Affect the Aggregate Market? At a very basic level, the money supply is positively related to Total Expenditures, which is positively related to Aggregate Demand. When the money supply increases, Total Expenditures & Aggregate Demand increase. When the money supply decreases, Total Expenditures & Aggregate Demand decrease. Changes in the money supply affect aggregate demand through the interest rate.
EQ: How Do Changes in the Money Supply Affect the Aggregate Market? Increase in the Money Supply SRAS Price Level (CPI) Negative Relationship Decrease in Interest Rates Increase in Consumption & Investment Positive Relationship + Increase in Total Expenditures + Increase in Aggregate Demand Right Shift of the AD Curve AD AD Economic Output (Real GDP)
EQ: How Do Changes in the Money Supply Affect the Aggregate Market? Decrease in the Money Supply SRAS Price Level (CPI) Increase in Interest Rates Decrease in Consumption & Investment + Decrease in Total Expenditures AD + Decrease in Aggregate Demand Left Shift of the AD Curve AD Economic Output (Real GDP)
EQ: What is Expansionary Monetary Policy? To increase aggregate demand, the Fed will increase the money supply using one of its three tools of monetary policy. The increase in the money supply will cause: Decrease in interest rates Increase in Consumption & Investment Increase in Total Expenditures and AD Right shift of the AD curve Increase in Real GDP (closing the recessionary gap) Increase in Price Level Decrease in Unemployment
EQ: What is Expansionary Monetary Policy? Price Level 1. The Fed increases the Money Supply. 2. Interest Rates fall in the Credit Market. 3. Consumption & Investment Increase. SRAS PL e PL e 4. TE and AD both Increase. 5. The AD Curve shifts right. 6. Real GDP Increases, closing the recessionary gap. 7. Price Level Increases. 8. Unemployment Decreases. AD Real GDP e Q N AD Real GDP
EQ: What is Contractionary Monetary Policy? To decrease aggregate demand, the Fed will decrease the money supply using one of its three tools of monetary policy. The decrease in the money supply will cause: Increase in interest rates Decrease in Consumption & Investment Decrease in Total Expenditures and AD Left shift of the AD curve Decrease in Real GDP (closing the inflationary gap) Decrease in Price Level Increase in Unemployment
EQ: What is Contractionary Monetary Policy? Price Level 1. The Fed decreases the Money Supply. 2. Interest Rates rise in the Credit Market. 3. Consumption & Investment Decrease. SRAS PL e PL e 4. TE and AD both Decrease. 5. The AD Curve shifts left. 6. Real GDP Decreases, closing the inflationary gap. 7. Price Level Decreases. 8. Unemployment Increases. Q N Real GDP e AD AD Real GDP