Chapter 10 GGREGTE SUPPLY ND GGREGTE DEMND (Part 2) Putting it Together Equilibrium is where D = S This figure shows SR equilibrium where D = SS (short-run aggregate supply) t a price level of 110, equilibrium RGDP is 16. C 1
The Multiplier and the Price Level in the Short-Run (Chapter 11) In Chapter 11 we derived the multiplier assuming P is fixed. Now we allow P to vary in the short-run. This reduces the size of the multiplier. For example, we know an increase in investment shifts the E curve upward and shifts the D curve rightward. With no change in the price level, real GDP would increase to $18 trillion at point. 1 (1 b + bt + m) The Multiplier and the Price Level in the Short-Run (From Chapter 11, Figure 11.10) ut the price level rises. The E curve shifts downward. Equilibrium expenditure decreases to $17.3 trillion s the price level rises, real GDP increases along the SS curve to $17.3 trillion. The multiplier in the shortrun is smaller than when the price level is fixed. The Multiplier and the Price Level in the Long-Run (From Chapter 11, Figure 11.11) Figure 11.11 illustrates the long-run effects. t point C in part (b), there is an inflationary gap of $1.3 trillion. The economy is operating above full employment potential. The money wage rate starts to rise and the SS curve starts to shift leftward. 2
The Multiplier and the Price Level in the Long- Run The money wage rate will continue to rise and the SS curve will continue to shift leftward,... until real GDP equals potential GDP. In the long run, the multiplier is zero and the price level is much higher. Putting it Together - Explaining Macroeconomic Trends and Fluctuations Long-Run Macroeconomic Equilibrium Long-run macroeconomic equilibrium occurs when actual real GDP equals potential GDP -when the economy is on its LS curve. -Intersection of D, SS and LS curves. Over time, the economy tends to adjust to the long-run equilibrium, i.e., the economy selfcorrects. $64 question: How long does this take?? Putting it Together - djustment to Long-run Equilibrium. Suppose there is a reduction in D causing a recession. The economy at point is belowfull employment equilibrium and unemployment is high a recessionary gap of $0.5 trillion. In the long run, the money wage falls causing the SS to shift downward to the right until the SS curve passes through the long-run equilibrium point at point. This adjustment is called the self-correcting or selfregulating mechanism. D 0 3
Putting it Together - Explaining Macroeconomic Trends and Fluctuations Suppose the economy is at an above-full employment equilibrium at point C inflationary gap 0f $0.5T. In the long run, the money wage rate rises until the SS curve passes through the long-run equilibrium point at point. The self-correcting or self- regulating mechanism. C Economic Growth and Inflation in the S-D Model ecause of labor force growth, capital growth, and technology advances, potential GDP increases. The LS curve shifts rightward. Economic Growth and Inflation in the S- D Model If D increases by more than LS, the price level increases. In the LR this can occur because of excessive growth in the money supply. C 4
Putting it Together - The usiness Cycle in the S-D Model The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate, - but the money wage does not change rapidly enough (price rigidity) to keep real GDP at potential GDP. Equilibrium can occur above full-employment equilibrium at full-employment equilibrium below full-employment equilibrium Putting it Together - Explaining Macroeconomic Trends and Fluctuations Figures (a) and (d) illustrate an above full-employment equilibrium. The amount by which real GDP exceeds potential GDP is called an inflationary gap. Figures (b) and (d) illustrate full-employment equilibrium. (b) Putting it Together - Explaining Macroeconomic Trends and Fluctuations Figures (c) and (d) illustrate below full-employment equilibrium. The amount by which real GDP is less than potential GDP is called a recessionary gap. Finally, figure (d) shows how, as the economy moves from one type of short-run equilibrium to another, real GDP fluctuates around potential GDP in a business cycle. 5
Case Study: Effect of an Increase in ggregate Demand a positive demand shock. Starting from full employment at Point : n increase in aggregate demand shifts the D curve rightward. Firms increase production and the price level rises in the short run (Point ). Case Study: Effect of an Increase in ggregate Demand t the new short-run equilibrium (point ), there is an inflationary gap. In the long-run, the money wage rate begins to rise and the SS curve starts to shift leftward. The price level continues to rise and real GDP continues to decrease until it equals potential GDP at Point C. C D 0 Case Study: Negative Supply Shock The effects of a rise in the price of oil - a negative or adverse supply shock The SS curve shifts leftward. Real GDP decreases and the price level rises. The economy experiences stagflation a recession with increasing prices. - Is there a recessionary or inflationary gap? - What s going to happen in the long-run? 6
Macroeconomic Schools of Thought Macroeconomists can be divided into three broad schools of thought: Classical Keynesian Monetarist Macroeconomic Schools of Thought The Classical View classical macroeconomist believes that the economy is self-regulating/self-correcting and always adjust on its own quickly to full employment. The term classical derives from the name of the founding school of economics that includes dam Smith, David Ricardo, and John Stuart Mill. The new classical view is that business cycle fluctuations are the efficient responses of a wellfunctioning market economy that is bombarded by shocks that arise from the uneven pace of technological change and poor regulation supply oriented. The Classical View ggregate Demand Technological change is the most important source of fluctuations in D and S. technological change that increases the productivity of capital, increases demand for plant and equipment. ggregate Supply Money wages are instantly and completely flexible. Technological change also shifts potential GDP and LS. Policy Taxes and regulation can hinder incentives and create inefficiency. Minimize the dis-incentive effects of taxes and regulation. 7
Macroeconomic Schools of Thought The Keynesian View Keynesians believe the economy is likely to operate at less than full employment and does not self-correct. - Need active fiscal and monetary policy to achieve and maintain full employment. Prices are rigid in the short-run. The new Keynesian view holds that not only are the money wage and resource cost sticky but so are the prices of goods. The Keynesian View ggregate Demand Changes in D drive economic fluctuations demand oriented. Expectations are the main influence on D. For example, pessimism about future profits cause firms to cut investment, I falls => D falls => Y falls. ggregate Supply Money wages are very sticky downward. No self-correcting mechanism in the SR to close recessionary gap. Policy Use fiscal and monetary policy to offset changes in D. Macroeconomic Schools of Thought The Monetarist View monetarist is a macroeconomist who believes that the economy is self-regulating/self correcting and that it will normally operate at full employment, provided that monetary policy is not erratic and that the pace of money growth is kept steady. The term monetarist was coined by Karl runner, to describe his own views and those of Milton Friedman. Think in terms of the Quantity Theory of Money. If Real GDP is growing at 3% per year money growth should be around 3% per year. 8
The Monetarist View ggregate Demand Quantity of money drives D. If Fed keeps growth in money supply steady, D will be steady and fluctuations will be minimized. The economy will operate at full employment. ll recessions are the result of inappropriate monetary policy ggregate Supply Similar to Keynesians - money wages are very sticky downward. No self-correcting mechanism to close recessionary gap in the SR. Policy Similar to classical view. Minimize tax and regulatory disincentives that can reduce potential GDP. Steady growth in the money supply - no stabilization policy. 9