session-13.pdf

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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.

75


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A C T I V E L E A R N I N G 2 : Answers

76

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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