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“ 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 KeynesThe 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 GDPPotential 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 $)
1970recession
1974-75recession
1980recession
1982recession
1990-91recession
2001recession
1960recession
8,000
6,000
4,000
2,000
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
10,000
PotentialGDP
12,000
ActualGDP
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.
PriceLevel
Goods & Services(real GDP)
LRAS
YF
PriceLevel
Goods & Services(real GDP)
LRAS1
YF,1
LRAS2
YF,2
a. Minimum wageb. Public policy
PriceLevel
Goods & Services(real GDP)
SRAS
a. Firms are often slower to cut wages than raise them
PriceLevel
Goods & Services(real GDP)
SRAS1 SRAS2
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 Demandfor 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)
PriceLevel
AD
P2
Y1 Y2
P1
Aggregate Demand Curve• When the
general price level in the economy declines from P1 to P2,
• the quantity of goods and services purchased will increase from Y1 to Y2.
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 will1. 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)
PriceLevel
AD
P2
Y1 Y2
P1
A reduction in the price
level will increase the quantity of goods & services demanded.
Goods & Services(real GDP)
PriceLevel
AD0
AD1
AD2
a. Monetary policylowering interest rates
reduces the cost of borrowing and increases consumption and investment.
b. Fiscal policychanges in government purchases
shifts the aggregate demand curve by changing the G component. Changing taxes affects the C component.
a. Optimism shifts the curve rightb. Pessimism shifts the curve leftc. Stock prices, world events affect
expectations
Source: http://www.economagic.com.
Consumer Sentiment Index:A Measure of Optimism 1978-2007
• 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
100
80
60
40
20
1978 1980 1982 1984 1986 1988 1990 1992 1994 20041996 1998 2000 20020
120
2006
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
AD105 Price Level
SRAS105
6,900 90 4,5006,600 95 4,8006,300 100 5,1006,000 105 5,4005,700 110 5,7005,400 115 6,000
1. 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?
AD105 Price Level
SRAS105
6,300 90 4,5006,000 95 4,8005,700 100 5,1005,400 105 5,4005,100 110 5,7004,800 115 6,000
1. 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?).
PriceLevel
LRAS1
YF1
P100
Goods & Services(real GDP)
AD
SRAS1
YF2
LRAS2
P95
SRAS2
• Both LRAS and SRAS increase full employment output expands from YF1 to YF2.• 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
PriceLevel
LRAS
YF Y2
P100
AD2
Goods & Services(real GDP)
AD1
Short-run effects of an unanticipatedincrease in AD
SRAS1
P105
• Improves profits.
• Output increases
• Unemployment drops below the natural rate,
AD2AD1
PriceLevel
P105
YF Y2
P105
Goods & Services(real GDP)
Long-run effects of an unanticipatedincrease in AD
SRAS2
P110
YF
LRAS SRAS1
• 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
PriceLevel
LRAS
YFY2
P100
Goods & Services(real GDP)
AD1
Short-run effects of an unanticipatedreduction in AD
SRAS1
AD2
P95
• Profits fall.• Output decreases
• Unemployment rises,
AD2AD1
PriceLevel
LRAS
YFY2
P100
Goods & Services(real GDP)
Long-run effects of an unanticipatedreduction in AD
SRAS1
P95
SRAS2
P90
YF
• 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
PriceLevel
LRAS
YF Y2
P100
Goods & Services(real GDP)
AD
SRAS1
SRAS2
P95
Quantity of resourcesQ2
D
Pr2
Q1
S1
ResourceMarket
Pr1
S2
• An adverse supply shock, (crop failure or oil price increase)
Decrease in SRAS
• prices rise from Pr1 to Pr2.
PriceLevel
AD
PriceLevel
YFY2
P100
Goods & Services(real GDP)
P110
• The higher resource prices shift SRAS to the left• the price level rises to P110 and output falls to Y2.• What happens in the long-run depends on whether the supply
shock is temporary or permanent.
LRASSRAS1 (Pr1 )
SRAS2 (Pr2 )
Decrease in SRAS
PriceLevel
LRAS
YFY2
P100
Goods & Services(real GDP)
AD
SRAS1 (Pr1 )SRAS2 (Pr2 )
P110
• If temporary, resource prices fall in the future, shifting SRAS2 back to SRAS1, returning equilibrium to (A).• If permanent, the productive potential of
the economy will shrink (LRAS shifts left and Y2 becomes YF2) 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 ModelThe 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
Goods & Services(real GDP)
Price level
Y F
SRAS
Y F
AD
PPrice 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 1960.
• Reductions in real GDP in the top graph relate with increases in the rate of unemployment above the natural rate (bottom graph).
1960 1965 1970 1975 1980 1985 1990 1995 2000
2,000
4,000
6,000
8,000
9,000
19601970
1974-751980198219902001
1960 1965 1970 1975 1980 1985 1990 1995 2000
2 %4 %6 %8 %
10 %
% Labor force unemployed
Real GDP (billions of 1996 $)
Actual rate ofunemployment
Natural rate ofunemployment
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 recessionb. an increase in the real interest ratec. sharp increase in the value of stocks owned by Americansd. 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 outputb. an increase in unemploymentc. a decrease in real GDPd. 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 experiencea. 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 inflationb. a decrease in unemploymentc. an increase in the general level of pricesd. an increase in the natural rate of
unemployment5. 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 ratec. higher real interest ratesd. 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 boomb. highly attractive profit marginsc. output less than the economy’s long-run
potentiald. 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 unemploymentb. reductions in real interest rates and real
resource pricesc. a sharp increase in importsd. 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.