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ECO1000 Economics

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Recession. Boom' Characteristics of Economic Fluctuations ... Adverse shifts in aggregate supply cause stagflation a combination of recession and inflation. ... – PowerPoint PPT presentation

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Title: ECO1000 Economics


1
ECO1000Economics
  • Lecture Ten, 2004

2
Class Test Two Reminder for Internal Students
  • Wednesday May 26, 5-8 pm
  • 25 multiple choice questions
  • Covers Lectures 6 10 (Chapters 7-16)
  • Same deal as test one (online etc)

3
Outline or Plan of Todays Lecture
  • Material Covered Module Seven
  • Reading Text Chapter 16
  • Topics Aggregate Demand and Aggregate Supply

4
Purpose or Objectives of Todays Lecture
  • You will be able to
  • Work with a key macroeconomic model
  • Model changes in the economy due to changes
    economic variables
  • Think about policy implications (in preparation
    for next weeks work)

5
Economic Fluctuations
6
What Are Economic Fluctuations?
  • Economic fluctuations are the ups and downs in
    economic activity from year to year.
  • In most years production of goods and services
    rises but in some years normal growth does not
    occur, causing a recession.
  • A recession is a period of declining real GDP,
    falling incomes, and rising unemployment.
  • A depression is a severe recession.

7
Growth over time
Boom
Real GDP (b)
Recession
Years
Long term average
8
(No Transcript)
9
Characteristics of Economic Fluctuations
  • Economic fluctuations are irregular and
    unpredictable.
  • Most macroeconomic variables are related and
    fluctuate together.
  • As output falls, unemployment rises and vice
    versa

10
The Short Run and The Long Run
11
How Long is the Long Run?
  • The long run can be considered to be a period of
    at least several years.
  • The short run is a period of about one to two
    years.
  • This is a bit like asking, How long is the
    present? (i.e. When does the present become the
    future?)

12
Incidentally the present lasts for as long as
you can hold the cube (below) in focus before it
transposes itself (back becomes front or vice
versa)
13
In the Short Run the Long Run
  • We have previously used two ideas classical
    dichotomy and money neutrality
  • In the short run, it is now more or less accepted
    that real and nominal variables move together
  • We need a new model with which to analyse short
    and long run economic fluctuations.

14
Explaining the Fluctuations Using the AD-AS Model
15
The Space in Which AD-AS is Mapped
  • Two variables are used to develop a model to
    analyse the short-run fluctuations.
  • The economys output of goods and services
    measured by real GDP.
  • The overall price level measured by the CPI or
    the GDP deflator.
  • AD-AS are plotted in output-price level space.

16
Aggregate Demand and Aggregate Supply
  • The aggregate demand curve shows the quantity of
    goods and services that households, firms, and
    the government want to buy at any price level.
  • The aggregate supply curve shows the quantity of
    goods and services that firms choose to produce
    and want to sell at any price level.

17
The Aggregate Demand Curve
  • The four components of GDP (Y) contribute to the
    aggregate demand for goods and services.
  • Y C I G NX

18
The Aggregate Demand Curve
2. Leads to an increase in quantity demanded
P1
1. A decrease in the pricelevel
P2
Y2
0
Y1
3. And an increase in output
19
Explaining the Negative Slope of the Aggregate
Demand Curve Three Theories
  • Pigous wealth effect
  • Keynes interest rate effect
  • Mundell-Flemings exchange-rate effect

20
Pigous Wealth Effect
  • Consumers feel wealthier, which stimulates the
    demand for consumption goods.
  • A decrease in the price level makes consumers
    feel more wealthy.
  • This encourages them to spend more.
  • The increase in consumer spending means a larger
    quantity of goods and services demanded.

21
Keynes Interest-Rate Effect
  • The lower the price level, the less money
    households need to hold to buy the goods and
    services they want.
  • A lower price level reduces the interest rate,
    which encourages greater spending on investment
    goods.
  • The increase in investment spending means a
    larger quantity of goods and services demanded.

22
Mundell-Flemings Exchange-Rate Effect
  • When the prices of domestic goods decreases, net
    exports increase.
  • A fall in the Australian price level causes
    Australian interest rates to fall.
  • The real exchange rate depreciates, which
    stimulates Australian net exports.
  • The increase in net export spending means a
    larger quantity of goods and services demanded.

23
Shifts in the Aggregate Demand Curve
  • Shifts in the aggregate demand curve may arise
    because of changes in
  • Private behaviour Changes in spending plans by
    consumers or firms.
  • Public policy Changes in fiscal or monetary
    policy.
  • Anything that causes buyers to want to purchase
    more or less than before will cause the aggregate
    demand curve to shift.

24
Shifts in the Aggregate Demand Curve
P1
D2
0
Y1
Y2
25
The Aggregate Supply Curve
  • In the long run, the aggregate-supply curve is
    vertical.
  • In the short run, the aggregate-supply curve is
    upward sloping.

26
The Long-Run Aggregate Supply Curve
  • The long-run aggregate supply depends on the
    economys resources and level of technology.
  • The price level does not affect these variables
    in the long run.
  • The long-run aggregate supply curve is vertical
    at the natural rate of output.

27
The Long-Run Aggregate Supply Curve
Price Level
P1
P2
2. Does not change the natural rate of output in
the long run
1. A Change in the Price Level
0
28
Shifts in the Long-Run Aggregate Supply Curve
  • Any change in the factors that determine the
    long-run aggregate supply will cause the curve to
    shift.
  • An event that reduces the economys potential
    output shifts the curve to the left.
  • Any event that increases the economys potential
    output shifts the curve to the right.

29
The Short-Run Aggregate Supply Curve
  • In the short run, an increase in the overall
    level of prices in the economy tends to raise the
    quantity of goods and services supplied.
  • A decrease in the level of prices tends to reduce
    the quantity of goods and services supplied.

30
The Short-Run Aggregate Supply Curve
Price Level
P0
1. A decrease in the price level
2. Causes the level of output supplied to fall in
the short run
P1
Y1
Y0
0
31
Explaining the Positive Slope of the Short-Run
Aggregate Supply Curve
  • New classical misperceptions theory
  • The Keynesian sticky-wage theory
  • The new Keynesian sticky-price theory

32
The New Classical Misperceptions Theory
  • Changes in the overall price level temporarily
    mislead suppliers about what is happening in the
    markets in which they sell their output.
  • A lower price level causes misperceptions about
    relative prices.
  • These misperceptions induce suppliers to decrease
    the quantity of goods and services supplied.

33
The Keynesian Sticky-Wage Theory
  • Nominal wages are slow to adjust, or are sticky
    in the short run.
  • Wages do not adjust immediately to a fall in the
    price level.
  • A lower price level makes employment and
    production less profitable.
  • This induces firms to reduce production.

34
The New Keynesian Sticky-Price Theory
  • Prices of some goods and services adjust
    sluggishly in response to changing economic
    conditions.
  • An unexpected fall in the price level leaves some
    firms with higher-than-desired prices.
  • This depresses sales, which induces firms to
    reduce the quantity of goods and services they
    produce.

35
Why the Aggregate Supply Curve Might Shift
  • Changes in factor (input) prices
  • Changes in productivity
  • Legal-institutional environment
  • Expectations about the price level

36
Shifts in the Aggregate Supply Curve
S3
Price Level
Short-run aggregate supply, S1
S2
P1
0
Y0
Y1
Y2
37
Changes in Resource Prices
  • Changes in the prices of domestic or imported
    resources change firms cost of production.
  • An increase in input prices shifts the aggregate
    supply curve to the left.
  • A decrease in input prices shifts the aggregate
    supply curve to the right.

38
Changes in Productivity
  • An improvement in factor productivity allows
    firms to produce more at a lower cost.
  • New technologies can increase the output per unit
    of labour or capital.
  • The resulting decrease in production costs shifts
    the aggregate supply curve to the right.

39
Legal-Institutional Environment
  • Taxes and government regulations can increase
    production costs and discourage firms from
    producing.
  • The resulting increase in production costs shifts
    the aggregate supply curve to the left.

40
Expectations About the Price Level
  • Current wages and prices often depend on
    expectations of the price level.
  • A higher expected price level shifts the
    short-run aggregate supply curve to the left.
  • A lower expected price level shifts the short-run
    aggregate supply curve to the right.

41
AD-AS and Long Run Equilibrium
42
Long-Run Equilibrium
  • The intersection of the aggregate demand curve
    and the long-run aggregate supply curve
    determines the economys equilibrium output and
    price level.
  • Output is at its natural rate.
  • The short-run aggregate supply curve passes
    through the point of intersection.

43
Long-Run Equilibrium
44
AD-AS and Economic Fluctuations
  • Recession

45
Recession
  • A recession in the economy may have two causes.
  • A decrease in aggregate demand.
  • A decrease in aggregate supply.

46
A Decrease in Aggregate Demand
  • A decrease in one of the determinants of
    aggregate demand shifts the curve to the left.
  • Output falls below the natural rate of
    employment.
  • Unemployment rises.
  • The price level falls.

47
A Decrease in Aggregate Demand
3. But over time the SRAS curve shifts and output
returns to its normal rate
2. Causes output to decline
AS2
A
P1
1. A decrease in aggregate demand
B
P2
P3
C
0
Y1
Y2
48
A Decrease in Aggregate Supply
  • A decrease in one of the determinants of
    aggregate supply shifts the curve to the left.
  • Output falls below the natural rate of
    employment.
  • Unemployment rises.
  • The price level rises.

49
A decrease in aggregate supply
Long-run aggregate supply
AS2
Short-run aggregate supply, AS1
B
P2
A
P1
Aggregate demand
0
Y1
Y2
50
Possible Responses to Recession
51
Stagflation
  • Adverse shifts in aggregate supply cause
    stagflationa combination of recession and
    inflation.
  • Output falls and prices rise.
  • Policymakers who can influence aggregate demand
    cannot offset both of these adverse effects
    simultaneously.

52
Policy Response
  • Policymakers may respond to a recession in one of
    the following ways
  • Do nothing and wait for prices and wages to
    adjust.
  • Take action to increase aggregate demand by using
    monetary and fiscal policy.

53
Accommodate the Negative AS Shift
Long-run aggregate supply
AS2
Short-run aggregate supply, AS1
C
P3
B
P2
A
P1
AD2
Aggregate demand
0
Y1
Y2
54
Concluding Remarks
  • The AD-AS model is a popular model used to
    explain and analyse economic fluctuations.
  • The effects of shocks to the economic system can
    be modelled.
  • We can also (next week) use the ADAS model to
    show the impact that government policies have on
    the system.

55
In Light of the Objectives of Todays Lecture
  • We now know about
  • Economic fluctuations
  • Short run and long run fluctuations
  • How to build the AD-AS model
  • How to use the AD-AS model to show the effects of
    various changes

56
Next Week
  • Material Covered Module Eight, Parts One and Two
  • Reading Chapters 17, 18 and 19
  • Topics Monetary and Fiscal Policy and the
    Associated Debates
  • This will be the last lecture of content.
  • Lecture Twelve will be REVISION

57
THE END
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