How can we analyze economic fluctuations? Aggregate Demand and Aggregate Supply

Event: Government Intervention The Aggregate Model Used to explain or predict the effects of macroeconomic events or policies on equilibrium price and output Effect: Uncertainty causing less consumption and investment Lower price and gdp Event: Tsunamis Effect: More Governmental intervention to spend more money Higher price and gdp Event: Government Intervention

the total demand for domestic goods in an economy Aggregate Demand Shows the relationship between PRICE LEVELS (y) And REAL GDP (X) the total demand for domestic goods in an economy GDP = Consumption + Investment + Government Spending + Exports – Imports

What does this look like?

Why is it downward sloping? 1) Foreign Sector Substitution effect: If prices rise domestically Look internationally If prices fall domestically Buy more domestically

Why is it downward sloping? 2) Interest rate effect: If prices rise  Need to borrow more Interest rates rise Investment falls Consumption falls If prices fall  Need to borrow less Interest rates fall Investment increases Consumption increases

Why is it downward sloping? 3) The Wealth effect: If price rises  The purchasing power falls The quantity of domestic output demanded falls

Changing any of the components: How do we shift AD? Changing any of the components: Consumption Investment Government Spending Exports Imports

Shifts of AD Consumption will… Investment will… Increase AD if… Decrease AD if… More wealth Less wealth More optimistic Less optimistic Less taxes More taxes Increase AD if… Decrease AD if… Lower real interest rate Higher real interest rate Higher expected returns Lower expected returns Due to future expectations about profitability

AD SHIFTS: G and NX (X-M) Government spending will Net Exports Increase AD if… Decrease AD if… Weak Domestic Currency (more exports, less imports) Strong Domestic Currency (less exports, more imports) Strong Foreign Economies (Export more) Weak Foreign Economies (we export less) Increase AD with more spending Decrease AD with less spending

Representations of Shifts in the AD Increase of AD (right) Decrease in AD (left)

How would you bolster Japan’s Aggregate Demand? As a team of economists, you receive $1 million dollars to help “bolster” the Japanese economy. Strategize how you will use this money to increase your component of Aggregate Demand after the tsunami and earthquake in Japan. How will your response “rebuild” the economy?

MPC MPC in Economics means Marginal Propensity to Consume. This refers to the means of measuring the proportion of how much is spent to how much is saved. This is known in business but is actually commonly used by individuals on their everyday lives and on how they budget.

Government Spending Multiplier Change to any component of AD (C + Ig + G + Xn) has a “ripple effect” Results in a multiplied effect on GDP Important as a small change in spending leads to a large change in GDP Calculated by: 1 or 1 MPS 1- MPC

Government Spending Multiplier Examples: 1/MPS .25 MPS change = multiplier of 4 .33 MPS change = multiplier of 3 MPC of .75 = 1/.25 (MPS) = multiplier of 4 If gov spending increases by $20 X 4 = GDP increases by $80

Aggregate Supply PL (Y) And Real GDP (x) the summation of all individual supply curves in an economy or total output in an economy

SHORT RUN VS. LONG RUN SHORT RUN: PD. OF TIME WITH STICKY PRICES AND WAGES LONG RUN: PD. OF TIME WHEN PRICES AND WAGES ARE FLEXIBLE Input $ do not adjust to changes in the Price Level Keynesian school Input $ are flexible and adjust to changes in Price Level Classical school

Short-Run Aggregate Supply (SRAS) As prices increase: Firms produce more for a greater profit As prices decrease: sales will fall, and producers produce less PL SRAS GDPR

Productivity (technology) Input Prices Laws, regulations, taxes HOW TO SHIFT THE SRAS Productivity (technology) Input Prices Laws, regulations, taxes Expected Inflation

Shifts of SRAS Productivity will… Input Prices will… Increase SRAS if… Decrease SRAS if… Improvements in technology Natural Disasters destroy resources Novel Techniques introduced Labor Force is reduced in size because of strikes or epidemics Increase SRAS if… Decrease SRAS if… Lower cost of production Higher cost of production

Shifts of SRAS Laws and Regulations will… Expected Inflation will… Increase SRAS if… Decrease SRAS if… Lower taxes Higher taxes Lower wages Higher wages Increase SRAS if… Decrease SRAS if… Prices are expected to

INCREASE AND DECREASE IN SRAS DECREASE IN INPUT COSTS INCREASE IN INPUT COSTS SRAS1 PL SRAS PL SRAS1 PL SRAS GDPR GDPR

Long-Run Aggregate Supply (LRAS) Yf GDPR

HOW TO SHIFT THE LRAS CHANGE IN TECHNOLOGY LIKE THE PPF In the Long run, we are at Full Employment (3-5% unemployment) CHANGE IN TECHNOLOGY CHANGE IN LABOR PRODUCTIVITY Increase the Human Capital, or skill level of the workers CHANGE IN CAPITAL

Aggregate Supply and Demand Practice Number Scenario 1 The government increases expenditures on education. 2 There is an increase in the price of oil. 3 Businesses face a pollution tax for their externalities. 4 The value of the yen increases. 5 New technology and better education increase productivity. 6 Interest rates fall with an increase in the money supply (show the effect on AD only) 7 There is an increase in investment across the nation after the tsunami. 8 Unions become more aggressive and wage rates increase. 9 Consumers (not producers) become more confident about the future. 10 Honda cars become extremely popular globally.

Answers 1 AD increase: Government 2 AS decrease: Input Costs 3 AS decrease: Legal Requirements 4 AD decrease: Exports and Imports (NX) 5 AS increase: Productivity 6 AD increase: Consumption and Investment 7 AD increase: Investment 8 9 AD increase: Consumption 10 AS decrease: Expectations

Macroeconomic Equilibrium Intersection between SRAS and AD determines price level (PL) and the current output (GDP) PL LRAS SRAS P AD Yf GDPR Full employment = Yf, any distance away from FE shows unemployment

Inflationary Gap Equilibrium occurs to the right of full employment LRAS SRAS PL P AD YF Y GDPR

Equilibrium occurs to the left of full employment  Recessionary Gap Equilibrium occurs to the left of full employment  SRAS LRAS PL P AD Yf GDPR Y

The Phillips Curve (I O U) Basic Assumptions: Inverse relationship between inflation and unemployment If inflation demand pull If deflation recession Movement along curve changes during business cycle as represented by an increase or decrease of AD

Shows the relationship between inflation and unemployment The Phillips Curve i . . . 4% . . . 2% . PC 5% 7% u Shows the relationship between inflation and unemployment

Effect: Causes movements along the curve Increase in AD PL i% LRAS . . SRAS SRPC  . . P1 i 1    P i AD1 AD   Y YF GDPR un u u% Effect: Causes movements along the curve

Leftward Shift of Aggregate Supply SRAS1 SRPC1 i PL LRAS LRPC SRAS SRPC . .   . . P1 i1   P i AD   Y1 YF GDPR un u1 u% Effect: causes a rightward shift of the Short-run Phillips Curve Stagflation: Increase in Price and Decrease in Output (1970s)

The Short-Run Phillips Curve (SRPC) . . . . . . . . . . 4% . . . SRPC1 2% . SRPC 5% 7% u An increase in the SRPC arises from a leftward shift of the SRAS

The Phillips Song AD Slides it up or down, up or down, up or down, SRAS Shifts it in or out Inflation, Unemployment

The Long Run Phillips Curve The economy can adjust to inflation in the long run due to real wages. The LRPC is vertical at the Natural Rate of Unemployment Increases in the unemployment rate because of more unemployment compensation  rightward shift Decreases in the unemployment rate because of less unemployment compensation  leftward shift

THE SRPC and the LRPC inflation unemployment SRPC 1 LRPC 1 % uN% A A movement from A to B arises from a cyclical change. A shift from SRPC 1 to SRPC 2 arises from a decrease in the SRAS curve. B C  2 %  SRPC 2 u% unemployment

Practice FRQ Assume an economy is operating at full employment. A major political event stops the delivery of foreign oil to the country. a) Draw the Aggregate Model to show how this event affects macroeconomic equilibrium. (Include the SRAS, AD, and LRAS curves.) b) Show how this change affects the Short Run Phillip’s Curve. c) Because of this event, the government is unable to provide unemployment compensation for federal workers. Show the change on the LRPC. Use 4% as the original LRPC.