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Time horizons in macroeconomics
Long run:Prices are flexible, respond to changes in supplyor demand.
Short run:Many prices are sticky at some predeterminedlevel.
The econ om y behaves mu chdifferent ly w hen p r ices are s t ick y.
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Short Run Aggregate Supply ( SRAS )
The SRAS curveis upward sloping:
Over the periodof 1-2 years,an increase in P
P
Y
SRAS
causes anincrease in thequantity of g & ssupplied.
Y 2
P 1
Y 1
P 2
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Why the Slope of SRAS Matters
If AS is vertical,fluctuations in ADdo not causefluctuations in outputor employment.
P
Y
AD 1
SRAS
LRAS
AD hi
AD loY 1
If AS slopes up,then shifts in AD
do affect outputand employment.
P lo
Y lo
P hi
Y hi
P hi
P lo
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Three Theories of SRAS
In each, some type of market imperfection result:
Outp ut d eviates f rom i ts natura l ratew hen th e ac tu al pr ice level devia tesf rom the pr ice level people exp ected.
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1. The Sticky-Wage Theory
Imperfection:Nominal wages are sticky in the short run,they adjust sluggishly. Due to labor contracts, social norms.
Firms and workers set the nominal wage inadvance based on P E, the price level theyexpect to prevail.
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1. The Sticky-Wage Theory
If P > P E,revenue is higher, but labor cost is not.Production is more profitable,so firms increase output and employment.
Hence, higher P causes higher Y ,so the SRAS curv e s lop es upw ard .
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2. The Sticky-Price Theory
Imperfection:Many prices are sticky in the short run. Due to menu costs , the costs of adjusting
prices.
Examples: cost of printing new menus,the time required to change price tags.
Firms set sticky prices in advance basedon P
E.
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2. The Sticky-Price Theory
Suppose the Fed increases the money supplyunexpectedly. In the long run, P will rise. In the short run, firms without menu costs can
raise their prices immediately. Firms with menu costs wait to raise prices.
Meantime, their prices are relatively low,which increases demand for their products,
so they increase output and employment. Hence, higher P is associated with higher Y ,
so the SRAS curv e s lop es upw ard .
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3. The Misperceptions Theory
Imperfection:Firms may confuse changes in P with changesin the relative price of the products they sell.
If P rises above P E, a firm sees its price risebefore realizing all prices are rising.The firm may believe its relative price is rising,and may increase output and employment.
So, an increase in P can cause an increase inY ,making the SRAS c urve up w ard-s lop ing .
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What the 3 Theories Have in Common:
In all 3 theories, Y deviates from Y N whenP deviates from P E.
Y = Y N + a (P P E)
OutputNatural rate
of output(long-run)
a > 0,measures
how much Y responds tounexpected
changes in P
Actualprice level
Expectedprice level
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What the 3 Theories Have in Common:
P
Y
SRAS
Y N
When P > P E
Y > Y N
When P < P E
Y < Y N
P Ethe expected
price level
Y = Y N + a (P P E)Y = Y N + a (P P E)
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SRAS and LRAS
The imperfections in these theories aretemporary. Over time, sticky wages and prices become flexible misperceptions are corrected
In the LR, P E = P AS curve is vertical
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LRAS
SRAS and LRAS
P
Y
SRAS
P E
Y N
In the long run,P E = P
and
Y = Y N.
Y = Y N + a (P P E)Y = Y N + a (P P E)
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Why the SRAS Curve Might Shift
Everything that shiftsLRAS shifts SRAS , too.
Also, P E shifts SRAS :
If P E
rises,workers & firms sethigher wages.
At each P ,
production is lessprofitable, Y falls,SRAS shifts left.
LRASP
Y
SRAS
P E
Y N
SRAS
P E
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The Long-Run Equilibrium
In the long-runequilibrium,
P E = P ,
Y = Y N ,and unemploymentis at its natural rate.
P
Y
AD
SRAS
P E
LRAS
Y N
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Changes in Short-Run Aggregate Supply
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Short-Run Equilibrium
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Changes in Short-Run Equilibrium inthe Economy
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How a Factor Affects the Price Level, Real GDP,and the Unemployment Rate in the Short Run
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How to Study the Impact ofEconomic Fluctuations
Caused by events that shift the AD and/or AS curves.
Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS .2. Determine whether curve shifts left or right.
3. Use AD - AS diagram to see how the shiftchanges Y and P in the short run.
4. Use AD - AS diagram to see how economymoves from new SR eqm to new LR eqm.
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LRAS
Y N
The Effects of a Shift in A D
Event: stock market crash
1. affects C , AD curve
2. C falls, so AD shifts left
3. SR eqm at B.P and Y lower,unemp higher
4. Over time, P E falls,SRAS shifts right,until LR eqm at C.Y and unemp backat initial levels.
P
Y
AD 1
SRAS 1
AD 2
SRAS 2P 1 A
P 2
Y 2
B
P 3 C
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Two Big A D Shifts:1. The Great Depression
From 1929-1933, money supply fell
28% due to problems
in banking system stock prices fell 90%,reducing C and I
Y fell 27%
P fell 22% u-rate rose
from 3% to 25%
550
600
650
700
750800
850
900
1 9 2 9
1 9 3 0
1 9 3 1
1 9 3 2
1 9 3 3
1 9 3 4
U.S. Real GDP ,billions of 2000 dollars
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Two Big A D Shifts:2. The World War II Boom
From 1939-1944,
govt outlays rosefrom $9.1 billion
to $91.3 billion Y rose 90% P rose 20%
unemp fellfrom 17% to 1% 8001,000
1,200
1,400
1,600
1,800
2,000
1 9 3 9
1 9 4 0
1 9 4 1
1 9 4 2
1 9 4 3
1 9 4 4
U.S. Real GDP ,billions of 2000 dollars
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A C T I V E L E A R N I N G 2 :Exercise Draw the AD -SRAS -LRAS diagram
for the U.S. economy,starting in a long-run equilibrium.
A boom occurs in Canada.Use your diagram to determinethe SR and LR effects on U.S. GDP,the price level, and unemployment.
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A C T I V E L E A R N I N G 2 : Answers
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LRAS
Y N
P
Y
AD 2
SRAS 2
AD 1
SRAS 1
P 1
P 3 C
P 2
Y 2
B
A
Event: boom in Canada
1. affects NX , AD curve
2. shifts AD right
3. SR eqm at point B.P and Y higher,unemp lower
4. Over time, P E rises,SRAS shifts left,until LR eqm at C.Y and unemp backat initial levels.
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LRAS
Y N
The Effects of a Shift in SRAS Event: oil prices rise1. increases costs,
shifts SRAS(assume LRAS constant)
2. SRAS shifts left3. SR eqm at point B.
P higher, Y lower,unemp higher From A to B,
stagflation ,a period offalling outputand rising prices.
P
Y AD 1
SRAS 1
SRAS 2
P 1 A
P 2
Y 2
B
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LRAS
Y N
Accommodating an Adverse Shift in SRAS If policymakers do nothing,4. Low employment
causes wages to fall,SRAS shifts right,until LR eqm at A.
P
Y AD 1
SRAS 1
SRAS 2
P 1 A
P 2
Y 2
B
AD 2
P 3 C
Or, policymakers coulduse fiscal or monetarypolicy to increase ADand accommodate the
AS shift:Y back to Y N, butP permanently higher.
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The 1970s Oil Shocks and Their Effects
# of unemployedpersons
Real GDP
CPI
+ 1.4million
+ 2.9%
+ 26%
+ 99%
+ 3.5million
0.7%
+ 21%
+ 138%Real oil prices
1978-801973-75
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Supply Shocks
Supply shocks areexternal events that shiftthe aggregate supply
curve. Adverse supply shocks can
cause a recession (a fall inoutput) with increasingprices. This phenomenonis known as stagflation .
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