MACROECONOMICS BY CURTIS, IRVINE, AND BEGG SECOND CANADIAN EDITION MCGRAW-HILL RYERSON, © Chapter 5 Output, Business Cycles, and Employment

Learning Outcomes ©2010 McGraw-Hill Ryerson Ltd. Chapter 5 2 This chapter explains: Short-run aggregate demand and supply Equilibrium output and potential output Business cycles and output gaps Okun’s Law: output gaps & unemployment Adjustments to output gaps The role of macroeconomic policy

A Short-Run AD/AS Model ©2010 McGraw-Hill Ryerson Ltd. Chapter An introduction to the AD/AS model developed in detail in the chapters that follow Short run assumptions: Constant factor-prices esp. money wage rates Fixed supply of labour, stock of capital, & technology As a result: ∆output  ∆employment & ∆capital utilization

The AD/S Model in a Diagram ©2010 McGraw-Hill Ryerson Ltd. Chapter AD = (C+I+G+X-Z) at different P levels. AS = P at different rates of real output AS reflects unit costs of production [(W+BI)/Y] at constant input prices P = GDP deflator P Y Real GDP GDP deflator AS 2008 AD

Aggregate Demand (AD) ©2010 McGraw-Hill Ryerson Ltd. Chapter Downward sloping AD from three effects of ∆P:  Interest rate effect  ↑ P  ↑ i  ↑ finance cost  ↓ Expenditure  Substitution effect  ↑ P  ↑ P CAN /P US  ↓ X + ↑ Z  ↓ Expenditure  Wealth effect  ↑ P  ↓ (Nominal Wealth)/P  ↓ Expenditure

Aggregate Demand 6 The AD curve:  Shows ∆expenditure caused by ∆P  Assumes all determinants of expenditure except price are constant  Slope of AD = ─ ∆P/∆Y  Position of AD: factors other than P that affect expenditure ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1

The Aggregate Demand Curve ©2010 McGraw-Hill Ryerson Ltd. Chapter The AD curve: Planned aggregate expenditure: (C+I+G+X-Z) at different prices, ceteris paribus ∆P  i effect + Substitution effect + Wealth effect  ∆Y/∆P < 0 P Y AD P0P0 Y0Y0 P1P1 Y1Y1 A B

Aggregate Supply (AS) ©2010 McGraw-Hill Ryerson Ltd. Chapter Upward sloping AS curve: From national accounts: Price = unit cost: ∆Y  ∆(Y/N)  ∆(W/Y) (Y/N ≡ labour productivity) ↑ Y  ↓ (Y/N)  ↑ unit labour cost  ↑ P

Aggregate Supply The AS Curve:  Shows relationship between ∆Output & ∆P  Assumes money wage rates & other input prices are constant  Slope of AS = ∆P/∆Y > 0  Position of AS: input prices & other production conditions ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 9

The Aggregate Supply Curve ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 The AS curve shows output (Y) businesses would produce at different prices (P) ↑ Y  ↑ unit costs  ↑P ∆P/∆Y > 0 P Y Real GDP & Income GDP Deflator AS Y2Y2 Y3Y3 P2P2 P3P3 10

Equilibrium Real GDP and Price ©2010 McGraw-Hill Ryerson Ltd. Chapter Equilibrium: AD = AS At P 0,Y 0 : AD = AS Planned expenditure on current output = business sector current production At P 1 : AD < AS Y 1 < Y 2  unplanned ↑ inventory  ↓ Y P Y AS AD A C B P0P0 P1P1 Y0Y0 Y1Y1 Y2Y2 Unplanned ↑ in inventories

Stability of AD/AS Equilibrium ©2010 McGraw-Hill Ryerson Ltd. Chapter Equilibrium AD = AS  Planned expenditure buys current output  Business revenues = costs including profit  No ∆Y Disequilibrium AD ≠ AS  Unplanned ∆ in inventories  Business revenues ≠ costs including profit  ∆Y  AD = AS  Equilibrium

Equilibrium Real GDP and Price ©2010 McGraw-Hill Ryerson Ltd. Chapter A Numerical Example: AD: Y = 1000 – 2P AS Y = P In Equilibrium AD = AS 1000 – 2P= P 12P = 1200 P = 100 Y = 800

Equilibrium Output vs Potential Output ©2010 McGraw-Hill Ryerson Ltd. Chapter Y e ≡ equilibrium Y from AD = AS Y P ≡ Potential output Y P = ‘full employment’ of labour & capital Y P = Benchmark for macro performance Y e = Y P is a policy target

Potential GDP ©2010 McGraw-Hill Ryerson Ltd. Chapter Potential GDP is determined by the economy’s: Labour force, Capital stock & Technology. ∆Y P / ∆P = 0 P P1P1 P0P0 YPYP YPYP Y

Potential and Actual GDP, Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter The deviation of actual real GDP from the potential GDP can be seen in following plot Note: A recessionary gap starting in A recovery and boom from 1983 to A recession and recovery of the 1990s.

Potential and Actual GDP in Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter In the period actual Y fluctuated around Y P In recession years actual Y < Y P  ↑ unemployment rates In boom years Y>Y P  inflationary pressure

Business Cycles and Output Gaps Business cycles ≡ fluctuations in Y growth Business cycles  Y ≠ Y P  output gaps Output Gap ≡ Y – Y P, or in a growing economy: ©2010 McGraw-Hill Ryerson Ltd. Chapter

Business Cycles and Output Gaps ©2010 McGraw-Hill Ryerson Ltd. Chapter Output gaps indicate macro performance Y – Y P < 0  recessionary gap  High unemployment, low inflation pressure Y – Y P > 0  inflationary gap  Low unemployment, inflationary pressure Y =Y P : ‘full employment’, stable inflation

The Output Gap in Canada, ©2010 McGraw-Hill Ryerson Ltd. Chapter Output Gap %

Output Gaps ©2010 McGraw-Hill Ryerson Ltd. Chapter Y P P AS 0 P 1 P 0 AD 1 AD 0 Y 0 Y P Y 1 Y Recessionary gap Inflationary gap Assume Y P and AS 0 Recessionary gap: AD 0  P 0 Y 0, Y 0 < Y P Inflationary gap: AD 1 > AD 0  P 1 Y 1 Y 1 >Y P

Output Gaps & Unemployment Rates ©2010 McGraw-Hill Ryerson Ltd. Chapter Okun’s law: links unemployment to GDP growth & output gaps Unemployment rate, u: ∆Y  ∆employment with the result that : e.g. ∆Y/Y = 2.0% & ∆Y P /Y P = 0  ∆u = – 1.5%

Okun’s Law ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.4 Growth of Y, Y P Change in Unemployment Rate ∆u 0 ∆u = - ½ (gY – gY P ) gY P gY 1 gY 2 23

Empirical Test of Okun’s Law in Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter

Adjustment to Recessionary Gap 25 PP0PP0 YPYP AS 0 AS 1 ∆w AD Y 0 Y P Y Recessionary gap = Y 0 – Y P < 0 High unemployment  ↓ money wage, w  ↓ unit labour costs  ↓ shift in AS  AS 1 Equil with Y = Y P gap P1P1 Chapter 5.5 ©2010 McGraw-Hill Ryerson Ltd.

Adjustment to Inflationary Gap 26 P Y P AS 4 ∆w AS 3 AD gap YPYP Y3Y3 Y P3P3 P4P4 Inflationary gap Y 3 > Y P > 0 Low unemployment  ↑ money wage  ↑ unit labour costs  ↑ shift in AS, AS 3  AS 4  Equil with Y = Y P ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.5

The Role for Macroeconomic Policy ©2010 McGraw-Hill Ryerson Ltd. Chapter Why are recessionary gaps persistent?  Wage and prices adjust slowly  Pessimism re future employ, incomes & markets etc. depresses demand recovery Macroeconomic policy  Fiscal policy & monetary policy  Manage AD  Y = Y P & π = π*

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter 5 28 The Aggregate and Supply model explains determination of equilibrium Y and P. Potential output (Y P ) is the economy’s output at full employment level Business Cycles are short-run fluctuations of actual real GDP around its potential

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter 5 29 Output Gaps: Y e ≠ Y P Inflationary Gaps and Recessionary Gaps: Y > Y P & Y < Y P Okun’s Law links output gaps & unemployment Factor price flexibility  Adjustments to gaps Fiscal and Monetary policy  AD management Adjust Y  Y P & π  π*