Ch 10

 Analyze the impact of unanticipated changes in aggregate demand and short run aggregate supply  Evaluate the economy’s self-correcting mechanism

 Anticipated change – foreseen in time to make adjustments  Unanticipated change – not foreseen, appropriate adjustments were not made

Price Level P2P2 AD P1P1 Y1Y1 Y2Y2 A change in the price level represents a movement along the curve Output

Price Level AD 0 Changes in things besides the price level shift the curve and (AD 1 ) increase or (AD 2 ) decrease aggregate demand Output AD 1 AD 2

 1. Increases in real wealth shift AD right ◦ a. Stock market ◦ b. Housing prices ◦ Example: The 1990s “new economy”

 2. When the interest rate falls, AD shifts right because borrowing (for consumption and investment) becomes cheaper

 3. When people are optimistic about the future, AD shifts right ◦ Consumer sentiment index ◦ “Animal Spirits” – Keynes ◦ “Irrational Exuberance” – Greenspan

 4. When expected inflation is high, AD shifts right ◦ Less incentive to save, spend now  5. If other countries’ incomes are rising, AD shifts right ◦ Demand for U.S. exports increases as other countries prosper ◦ The larger the trade sector, the bigger the shift

 6. When the dollar depreciates, AD shifts right ◦ Imports become more expensive ◦ Exports become cheaper ◦ So, NX will rise

Increase in AD (shift right)Decrease in AD (shift left) ↑ in real wealth, stock mkt, housing prices ↓ in real wealth, stock mkt, housing prices ↓ in real interest rate ↑ in real interest rate Optimism about the futurePessimism about the future ↑ in expected inflation ↓ expected inflation ↑ real incomes abroad ↓ real incomes abroad ↓ value of nation’s currency ↑ value of nation’s currency

 Permanent change in production conditions ◦ Shift LRAS ◦ Shift SRAS  Temporary change in production conditions ◦ Shift SRAS

Price Level LRAS 1 Output (real GDP) An increase in the economy’s production capacity will shift LRAS right LRAS 2

 Improvements in resource base ◦ Physical capital investment ◦ Human capital investment  Improvements in technology  Institutional and government policy changes ◦ Easy to conduct business ◦ Enforce contracts fairly ◦ Protect private property rights Ch 16 Sources of Economic Growth

Increase in LRAS (shift right)Decrease in LRAS (shift left) ↑ in supply of resources ↓ in supply of resources Technology and productivity improvements Technology and productivity deteriorations Institutional changes that improve efficiency of resource use Institutional changes that reduce efficiency of resource use Note: Rightward shifts are much more common in the U.S. than leftward shifts, thank goodness!

Price Level P2P2 SRAS P1P1 Y2Y2 Y1Y1 Increase in price level will increase quantity supplied in the short run Output

Price Level SRAS 0 Changes in things besides the price level shift the curve and (SRAS 1 ) increase or (SRAS 2 ) decrease short run aggregate supply Output (real GDP) SRAS 1 SRAS 2

 1. When resource prices fall, SRAS shifts right ◦ If the change is long-term, LRAS will shift also  2. When expected inflation is low, SRAS shifts right ◦ No benefit from holding onto goods to sell at a later date

 3. Favorable supply shocks shift SRAS right ◦ Supply shock – unexpected event that temporarily increases or decreases aggregate supply ◦ Examples: OPEC increases output, favorable growing conditions

Increase in SRAS (shift right)Decrease in SRAS (shift left) ↓ in resource prices (production costs) ↑ in resource prices (production costs) ↓ in expected inflation ↑ in expected inflation Favorable supply shocks like good weather or lower prices of oil Unfavorable supply shocks like bad weather or higher prices of oil

 Holding fiscal and monetary policy constant  Ceteris Paribus (one change at a time)

 Do not cause equilibrium disruptions  Decision makers plan for change  No booms and busts  Graph long run, steady economic growth: ◦ Long run equilibrium is the same as short run equilibrium (no disequilibrium)  Higher output  Lower price level

Price Level LRAS 1 LRAS 2 Output SRAS 2 AD YF1YF1 YF2YF2 E1E1 E2E2 P1P1 P2P2 SRAS 1

 Cause equilibrium disruptions, disequilibrium ◦ Increase in AD ◦ Decrease in AD ◦ Increase in SRAS ◦ Decrease in SRAS  No economic growth is occurring ◦ Booms and busts ◦ LRAS will not shift  Graphing ◦ What is the short run equilibrium? ◦ How do we return to long run equilibrium?

 Causes: unanticipated ◦ increase in real wealth ◦ fall of the interest rate ◦ optimism about the future ◦ rising incomes abroad, or ◦ depreciation of domestic currency Bull Market

 Short run ◦ Output higher than potential ◦ Price level rises unexpectedly ◦ Resource prices and interest rates fixed ◦ Producer profits are higher than normal  Long run ◦ Resource prices, interest rates rise ◦ SRAS shifts left ◦ Return to full employment, normal profits ◦ Price level permanently higher

Price Level LRAS Output (real GDP) AD 1 YFYF E1E1 e2e2 P 100 P 105 SRAS 1 AD 2 Y2Y2 Too Fast

Price Level LRAS Output (real GDP) AD 1 YFYF E1E1 e2e2 P 100 P 105 SRAS 1 AD 2 Y2Y2 SRAS 2 P 110 E2E2

 Causes: unanticipated ◦ decrease in real wealth ◦ rise of the interest rate ◦ pessimism about the future ◦ falling incomes abroad, or ◦ appreciation of domestic currency Bear Market

 Short run ◦ Output lower than potential ◦ Price level falls unexpectedly ◦ Resource prices and interest rates fixed ◦ Producer profits are lower than normal  Long run ◦ Resource prices, interest rates fall ◦ SRAS shifts right ◦ Return to full employment, normal profits ◦ Price level permanently lower

 Resource prices are “downward sticky” ◦ Long term contracts ◦ Workers hesitant to accept lower wages ◦ Unions  Can make adjustment process slow

Price Level LRAS Output (real GDP) AD 1 YFYF E1E1 e2e2 P 100 P 95 SRAS 1 AD 2 Y2Y2 Too Slow

Price Level LRAS Output (real GDP) AD 1 YFYF E1E1 e2e2 P 100 P 95 SRAS 1 AD 2 Y2Y2 E2E2 SRAS 2 P 90

 Causes: unanticipated, temporary ◦ Favorable supply shock  Good weather  Cheap oil

Price Level LRAS Output (real GDP) AD 1 YFYF E1E1 e2e2 P 100 P 95 SRAS 1 Y2Y2 SRAS 2 Best Party Ever!

Price Level LRAS Output (real GDP) AD 1 YFYF E1E1 e2e2 P 100 P 95 SRAS 1 Y2Y2 SRAS 2 Well, all good things must come to an end. We had fun!

 Short run ◦ Output higher than potential ◦ Price level falls unexpectedly ◦ Resource prices and interest rates fixed ◦ Producer profits are higher than normal  Long run ◦ Favorable conditions come to an end ◦ SRAS shifts left and returns to original position ◦ Return to full employment, normal profits ◦ No changes in prices or output in the long run

 Causes: unanticipated, temporary unfavorable supply shock

 Short run ◦ Output lower than potential ◦ Price level rises unexpectedly ◦ Resource prices and interest rates fixed ◦ Producer profits are lower than normal  Long run ◦ Unfavorable conditions come to an end ◦ SRAS shifts right and returns to original position ◦ Return to full employment, normal profits ◦ No changes in prices or output in the long run

Price Level LRAS Output (real GDP) AD 1 YFYF E1E1 e2e2 P 100 P 105 SRAS 1 Y2Y2 SRAS 2 Ugh, this sucks!

Whew! Glad that’s over. Back to normal Price Level LRAS Output (real GDP) AD 1 YFYF E1E1 e2e2 P 100 P 105 SRAS 1 Y2Y2 SRAS 2

 When AD shifts unexpectedly, the long run impacts are seen only in the price level  When SRAS shifts unexpectedly, there are no long run impacts because the change was temporary  When markets are allowed to adjust, we will always return to full employment and output

 Unanticipated changes in AD or SRAS can disrupt the economy  But changes in ◦ Resource prices ◦ Interest rates  Return the economy to long run equilibrium

 Recession (GDP less than Y F ) ◦ Weak demand for resources causes unemployment ◦ Resource prices then fall ◦ Return to full output  Boom (GDP greater than Y F ) ◦ Strong demand for resources causes greater than normal profits ◦ Resource price then rise ◦ Return to full output

 Recession (GDP less than Y F ) ◦ Weak demand for borrowing ◦ Interest rates then fall ◦ Return to full output  Boom (GDP more than Y F ) ◦ Strong demand for borrowing ◦ Drives up interest rates ◦ Return to full output

 Keynesian Economists: too long!  New Classical Economists: not too long at all!

Period of Expansion Length (in Months)Period of Recession Length (in Months) Oct ‘49 to Jul ’5344Jul ‘53 to May ’5410 May ‘54 to Aug ’5739Aug ‘57 to Apr ’589 Apr ‘58 to Apr ’6024Apr ‘60 to Feb ’6110 Feb ‘61 to Dec ’69105Dec ‘69 to Nov ’7010 Nov ‘70 to Nov ‘7336Nov ‘73 to Mar ’7516 Mar ‘75 to Jan ’8058Jan ‘80 to Jul ’806 Jul ‘80 to Jul ’8112Jul ‘81 to Nov ’8216 Nov ‘82 to Jul ’9092Jul ‘90 Mar ’919 Mar ‘91 to Mar ’01120Mar ‘01 to Nov ’018 Nov ‘01 to Nov ’0773Dec ‘07 to June ‘0918

 Analyze the impact of unanticipated changes in aggregate demand and short run aggregate supply  Evaluate the economy’s self-correcting mechanism