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WY2013 Econ IV

aggregate supply and demand, short-run and long-run fluctuations
by

JY Tang

on 22 May 2013

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Transcript of WY2013 Econ IV

Background photo by t.shigesa Aggregate supply and demand, short-run and long-run Short-Run
Economic Fluctuations vs recession

expansion

business cycle economy grows slower than long-run trend

economy grows faster than long-run trend


alternation between expansion and recession depression severe/prolonged recession rule of thumb:
a recession is when real GDP declines for two consecutive quarters National Bureau of Economic Research (NBER) Great Depression 43-month decline starting August 1929
GDP fell more than 25% -since the Great Depression, recessions have been short and mild in GDP decline
-expansions lasted longer than recessions
-upward trend of real GDP Characteristic of
Short-run Fluctuations fluctuations in economy's aggregate growth unemployment
inflation recessions = rising unemployment
= slow rate of inflation
expansion = high rate of inflation Potential Output, the Output Gap,
and the Natural Rate of Unemployment actual level of GDP consists of: -potential output: quantity of goods and services a country can produce with its resources at normal rates

-output gap = Y - Y * or actual output - potential output when output potential output,

actual output potential output is < resources are not completely utilized unemployment = natural rate of unemployment level of unemployment due to frictional and structural causes Okun's Law every 1% that the unemployment rate differed from from the natural rate was associated with a two percent deviation in the output gap
if cyclical unemployment increased 1% to 2%, then the output gap would rise from 2% to 4%. Explaining Short-Run Fluctation in Output rate of growth of potential output depends on growth rate of population
capital stock increase rate
pace of technological advances short-run fluctuations are influenced by divergence between actual and potential output many market prices do not adjust immediately differences in demand because firms initially adjust production, not prices aggregate demand: total $ everyone actually wants to spend in the economy desired level demand production demand firms raise prices
inflation accelerates firms lower prices
inflation slows John Keynes and the Keynesian model aggregate demand (AD)
aggregate supply (AS ) SR Y=Y * output=potential output Aggregate Demand Curve negative relationship between aggregate demand and aggregate price level Three reasons: Wealth effects: when aggregate price level declines, people can purchase more with same amount of $$

M * V= P * Y Interest rate effects: at a lower price level, people are holding more $$ than they want, so they save it

increased saving lower interest rates encourages people to borrow more funds and increase spending Foreign exchange effects: at a lower domestic price level, people will buy less imports
and foreign consumers will buy more domestic products net exports increase influences for increased investment and consumption
changes in consumer sentiment
changes in government spending or taxes increase in gov. spending shifts AD curve right
reduce in taxes shifts shifts AD curve right Aggregate Supply Curve positive relationship between aggregate supply and aggregate price level -position of the curve depends on the economy's long-run potential output and on the expected aggregate price level
-passes through the vertical line at Y* at a price level equal to the prevailing expectation about aggregate prices
-resources fully employed, and aggregate supply equal to its long-run potential output (Y*) when aggregate price level is equal to the anticipated level two reasons for the short-run curve to shift:
1. changes in expected price level



2. aggregate supply shocks since AS is equal to Y* at the expected aggregate price level, an increase in the expected price level will cause the aggregate supply curve to shift upward The Keynesian Model of Short-Run Fluctuations implies that the economy's aggregate production and price level are determined by the intersection of AD and AS AD AS SR Inflation in the Keynesian Model SR Using Fiscal and Monetary Policy to Stabilize the Economy fiscal policy: use of taxes and spending to influence aggregate demand and through it level of overall economic activity

-expansion fiscal policy to offset a recession and restore full employment
-can also be used to increased spending through a tax cut SR equilibrium level of output: no cyclical unemployment
resources fully employed -when aggregate demand rises faster than aggregate supply, inflation rises
-lagging aggregate demand is a sign of an economic recession C is Y*
B is lower than Y* -- economy is in a recession
when B is above Y* -- inflation accelerates In general: expansionary policies shifts the aggregate demand curve to the right while contractionary policies shifts the aggregate demand curve to the left full employment equilibrium at any anticipated level of inflation
increased government spending causes output to increase Federal Reserve can control the amount of money in the economy and thus the interest rate problems with using monetary or fiscal policies to stabilize the economy
-what is the economy's potential output?
-practicality of effectively carrying out the policies
-information about the aggregate economy takes time to collect
-effects of actions take time to be felt
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