“ I believe myself to be writing a book on economic theory which will largely revolutionize—not, I suppose, at once but in the course of the next ten years— the way the world thinks about economic problems. ” -- John Maynard Keynes The book, The General Theory of Employment, Interest, and Money, systematically analyzed the relationship between changes in aggregate expenditure and changes in GDP. In any particular year, the level of GDP is determined mainly by the level of aggregate expenditure.

Actual and Potential GDP Potential output : Maximum sustainable output level consistent with the economy’s resources, (on the production possibilities curve.) Actual and potential output will be equal when the economy is at full employment.

Here we illustrate both actual and potential GDP. Note the gap (shaded area) between actual and potential GDP during periods of recession. Historically Speaking Real GDP (billions of 2000 $) 1970 recession recession 1980 recession 1982 recession recession 2001 recession 1960 recession 8,000 6,000 4,000 2, ,000 Potential GDP 12,000 Actual GDP

Aggregate Supply and Potential GDP Aggregate supply (AS) slopes up, because as the price level for outputs rises, with the price of inputs remaining fixed, firms have an incentive to produce more and to earn higher profits.

In the long run, the level of real GDP is determined by the number of workers, the capital stock, and the available technology, none of which are affected by changes in the price level. Changes in the price level do not affect the level of real GDP. The level of real GDP in the long run is called potential GDP, or full-employment GDP. Price Level Goods & Services (real GDP) LRAS YFYF

Price Level Goods & Services (real GDP) LRAS 1 Y F,1 LRAS 2 Y F,2 a.Minimum wage b.Public policy

Price Level Goods & Services (real GDP) SRAS a.Firms are often slower to cut wages than raise them

Price Level Goods & Services (real GDP) SRAS 1 SRAS 2

a.Expected higher reduces supply b.Expected lower increases supply

a.If workers and firms are adjusting to prices being higher than expected the curve will shift left. b. If they are adjusting to prices being lower than expected the curve will shift right.

An unexpected event that causes the SRAS to shift.

1. How will each of the following factors influence aggregate supply in the Short Run: (a) An increase in real wages. (b) 4 hurricanes that destroy half of the orange crop in Florida. (c) An increase in the expected rate of inflation. (d) An increase in the world price of oil. (e) Abundant rainfall during the growing season. Vote a for an increase in Aggregate Supply Vote b for a decrease in Aggregate Supply

Aggregate Demand for Goods & Services Aggregate demand (AD) curve: shows the various quantities of domestically produced goods & services that purchasers are willing to buy at different price levels. The AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods & services demanded and the price level.

Goods & Services (real GDP) Price Level AD P2P2 Y1Y1 Y2Y2 P1P1 Aggregate Demand Curve When the general price level in the economy declines from P 1 to P 2, the quantity of goods and services purchased will increase from Y 1 to Y 2. A reduction in the price level will increase the quantity of goods & services demanded.

1.The Wealth Effect: A lower price level increases the purchasing power of the fixed quantity of money. 2.The Interest Rate Effect: a lower price level will reduce the demand for money and lower the real interest rate, which then stimulates additional purchases during the current period. 3.The International Trade Effect: A lower price level will make domestically produced goods less expensive relative to foreign goods.

Each of these factors tends to increase the quantity of goods & services purchased at the lower price level. A lower price level will 1. increase the wealth of people holding the fixed quantity of money, 2. lead to lower interest rates, and 3. make domestic goods cheaper relative to foreign goods. Goods & Services (real GDP) Price Level AD P2P2 Y1Y1 Y2Y2 P1P1 A reduction in the price level will increase the quantity of goods & services demanded.

Goods & Services (real GDP) Price Level AD 0 AD 1 AD 2

a.Monetary policy lowering interest rates reduces the cost of borrowing and increases consumption and investment.

b.Fiscal policy changes in government purchases shifts the aggregate demand curve by changing the G component. Changing taxes affects the C component.

a.Optimism shifts the curve right b.Pessimism shifts the curve left c.Stock prices, world events affect expectations

Source: Consumer Sentiment Index: A Measure of Optimism Consumer optimism and pessimism regarding the future of the economy. Note how the index turns down prior to (or during) the recessions of the period. Consumer Sentiment Index

a.Foreign economic growth -Increased income shifts the curve right -Decreased income shifts the curve left -The large the trade sector, the larger the effect

b.Exchange rates -Appreciation shifts the curve right -Depreciation shifts the curve left

Effect of Shifts in AD In the Keynesian zone, small shifts in AD, will affect the output level Yk, but will not much affect the price level In the neoclassical zone, small shifts in AD, will have relatively little effect on the output level Yn, but instead will have a greater effect on the price level. In the intermediate zone movement in AD to the right will affect both the output level and the price level.

2. How will each of the following factors influence aggregate demand in the United States: (a) An increased fear of recession. (b) An increased fear of inflation. (c) The rapid growth of real income in Canada and Western Europe. (d) A reduction in the real interest rate. (e) A higher price level (be careful). (f) A stock market decline. Vote a for an increase in Aggregate Demand Vote b for a decrease in Aggregate Demand

AD105Price LevelSRAS105 6,900904,500 6,600954,800 6, ,100 6, ,400 5, ,700 5, , What will be the GDP? 2. Will it be long-run equilibrium? 3. What will be the relationship between the actual and natural rates of unemployment?

AD105Price LevelSRAS105 6,300904,500 6,000954,800 5, ,100 5, ,400 5, ,700 4, , What will be the GDP? 2. Will it be long-run equilibrium? 3. What will be the relationship between the actual and natural rates of unemployment? 4. Will this GDP be sustainable?

Start with Equilibrium, then increase LRAS (How?). Price Level LRAS 1 Y F1 P 100 Goods & Services (real GDP) AD SRAS 1 Y F2 LRAS 2 P 95 SRAS 2 Both LRAS and SRAS increase full employment output expands from YF 1 to YF 2. A sustainable, higher level of real output is the result.

Prices are high relative to production costs Unanticipated increase in AD. Supply shock Increased output is unsustainable

Price Level LRAS YFYF Y2Y2 P 100 AD 2 Goods & Services (real GDP) AD 1 Short-run effects of an unanticipated increase in AD SRAS 1 P 105 Improves profits. Output increases Unemployment drops below the natural rate,

AD 2 AD 1 Price Level P 105 YFYF Y2Y2 Goods & Services (real GDP) Long-run effects of an unanticipated increase in AD SRAS 2 P 110 YFYF LRAS SRAS 1 Resource prices will rise. (SRAS shifts) Output will recede to the long-run potential.

Prices are low relative to production costs Unanticipated decrease in AD. Supply shock Causes losses, so production decreases

Price Level LRAS YFYF Y2Y2 P 100 Goods & Services (real GDP) AD 1 Short-run effects of an unanticipated reduction in AD SRAS 1 AD 2 P 95 Profits fall. Output decreases Unemployment rises,

AD 2 AD 1 Price Level LRAS YFYF Y2Y2 P 100 Goods & Services (real GDP) Long-run effects of an unanticipated reduction in AD SRAS 1 P 95 SRAS 2 P 90 YFYF Resource prices adjust down. (SRAS shifts) Output will recede to the long-run potential.

Prices fall Output increases But conditions return to normal SRAS shifts back Due to some favorable supply shock Price Level LRAS YFYF Y2Y2 P 100 Goods & Services (real GDP) AD SRAS 1 SRAS 2 P 95

Quantity of resources Q2Q2 D P r2 Q1Q1 S1S1 Resource Market P r1 S2S2 An adverse supply shock, (crop failure or oil price increase) Decrease in SRAS prices rise from P r1 to P r2. Price Level

AD Price Level YFYF Y2Y2 P 100 Goods & Services (real GDP) P 110 The higher resource prices shift SRAS to the left the price level rises to P 110 and output falls to Y 2. What happens in the long-run depends on whether the supply shock is temporary or permanent. LRAS SRAS 1 (P r1 ) SRAS 2 (P r2 ) Decrease in SRAS

Price Level LRAS YFYF Y2Y2 P 100 Goods & Services (real GDP) AD SRAS 1 (P r1 ) SRAS 2 (P r2 ) P 110 If temporary, resource prices fall in the future, shifting SRAS 2 back to SRAS 1, returning equilibrium to ( A ). If permanent, the productive potential of the economy will shrink ( LRAS shifts left and Y 2 becomes Y F2 ) and ( B ) will become the long-run equilibrium. A B Decrease in SRAS

How Long Does It Take to Return to Potential GDP? Economic Forecasts Following the Recession of 2007–2009

Price Level, Inflation, and the AD-AS Model The actual price level will also differ from the level people anticipated when the rate of inflation differs from what is expected. When the inflation rate is greater than anticipated, profit margins will be attractive and business firms will respond with an expansion in output. When the inflation rate is less than anticipated, profit margins will be unattractive and businesses will reduce their output.

A. A widespread fear of depression on the part of consumers. B. A large purchase of American wheat by Russia. E. A 10 percent reduction in personal income taxes. D. The complete disintegration of OPEC, causing oil prices to fall by one-half. C. A cut in Federal spending for health care. F. An increase in labor productivity. G. Depreciation in the international value of the dollar. H. A decline in the percentage of the American labor force which is unionized. Which way will the AS or AD curves move after:

LRAS G oods & S ervices (real GDP) P rice level Y F SRAS Y F AD P Price level Employment GDP A. A widespread fear of depression on the part of consumers. B. A large purchase of American wheat by Russia. E. A 10 percent reduction in personal income taxes. D. The complete disintegration of OPEC, causing oil prices to fall by one-half. C. A cut in Federal spending for health care. F. An increase in labor productivity. G. Depreciation in the international value of the dollar. H. A decline in the percentage of the American labor force which is unionized.

Recessions: Source: Derived from computerized data supplied by FAME Economics. Expansion and contraction in the U.S. economy since Reductions in real GDP in the top graph relate with increases in the rate of unemployment above the natural rate (bottom graph) ,000 4,000 6,000 8,000 9, % 4 % 6 % 8 % 10 % % Labor force unemployed Real GDP (billions of 1996 $) Actual rate of unemployment Natural rate of unemployment

1.Which of the following would be most likely to cause an increase in current aggregate demand in the United States? a.increased fear that the U.S. economy was going into a recession b.an increase in the real interest rate c.sharp increase in the value of stocks owned by Americans d.a recession in Canada, Mexico, and Western Europe 2.Which of the following will most likely accompany an unanticipated increase in aggregate demand? a.an increase in real output b.an increase in unemployment c.a decrease in real GDP d.a decrease in the demand for resources 3.In the aggregate demand/aggregate supply model, when the output of an economy is less than its long-run potential, the economy will experience a.declining real wages and interest rates that will stimulate employment and real output. b.rising interest rates that will stimulate aggregate demand and restore full employment. c.a budget surplus that will stimulate demand and, thereby, help restore full employment. d.rising real wages and real interest rates that will restore equilibrium at a higher price level.

4.Which of the following will most likely result from an unanticipated decrease in aggregate supply due to unfavorable weather conditions in agricultural areas? a.a decrease in inflation b.a decrease in unemployment c.an increase in the general level of prices d.an increase in the natural rate of unemployment 5.Which of the following will most likely increase aggregate supply in the long run? a.unfavorable weather conditions in agricultural areas b.an increase in the expected inflation rate c.higher real interest rates d.an increase in the rate of capital formation 6.Within the AD/AS model, an unanticipated increase in short-run aggregate supply will cause real output to a.increase and the general level of prices to fall. b.decrease and the general level of prices to rise. c.increase and the general level of prices to rise. d.decrease and the general level of prices to fall.

7. An increase in the long-run aggregate supply curve indicates that a.the natural rate of unemployment has increased. b.unemployment has increased. c.the general level of prices has increased. d.potential real GDP has increased. 8.If the general level of prices is lower than business decision makers anticipated when they entered into long-term contracts for raw materials and other resources, which of the following is most likely to occur? a.an economic boom b.highly attractive profit margins c.output less than the economy’s long-run potential d.a sharp increase in imports 9.When output is less than the economy’s long-run capacity, which of the following is most likely to occur? a.an abnormally low rate of unemployment b.reductions in real interest rates and real resource prices c.a sharp increase in imports d.a government budget surplus

10.Suppose there was a sharp reduction in stock prices and a sharp increase in the world price of crude oil. Within the framework of the AD/AS model, how would these two changes influence the U.S. economy? a.The lower stock prices would increase SRAS, and the higher crude oil prices would reduce AD; as a result, there would be downward pressure on the general level of prices. b.The lower stock prices would reduce SRAS, and the higher crude oil prices would increase AD; as a result, there would be upward pressure on the general level of prices. c.The lower stock prices would increase AD, and the higher crude oil prices would increase SRAS; as a result, output would tend to increase. d.The lower stock prices would reduce AD, and the higher crude oil prices would reduce SRAS; as a result, output would tend to decline.