Supplement for week 5
There is a lot of concern about the future course of the economy, and there are two separate worries
that are getting confused. The purpose of this post is to distinguish between the two sets of worries,
and to discuss whether the worries are justified.
The confusion comes from the failure to distinguish between the policies implemented by the Fed and
Treasury in an attempt to bailout and stabilize the banking system, and the policies passed by
Congress and signed into law by the president in an attempt to jump start the economy. Many people
think of these two separate polices as one large government bailout program, but the policies and the
worries associated with them are distinct.
The bank bailout and worries about inflation
Let's start with the policies designed to bailout the banking system. These polices, the main effort
being the Emergency Economic Stabilization Act of 2008, provided $700 billion to purchase toxic
assets from banks and allowed the Treasury to provide additional capital to banks with troubled
balance sheets. In addition to these asset purchase and capital injection programs, the Fed has
injected liquidity into the system by increasing bank reserves substantially -- massively is a better
description -- and the result is that a very large quantity of excess reserves has accumulated within
the banking system.
Reserves sitting idle within the banking system, as they are now, are not much of a problem and they
provide insurance against unexpected losses in other areas of a bank's balance sheet. But the worry is
that these reserves will become active once they economy starts to recover and cause an outbreak of
inflation. That is, the concern is that the excess reserves make loans very cheap, and once conditions
improve, the availability of cheap credit will fuel a debt driven inflationary episode.
But these worries are misplaced. With the economy still struggling to recover, we want firms to use
these funds to begin making investments. We need this type of investment activity to lead us out of
the recession, so we want lots of funds to be available at a low interest rate. As long as we are still
below full employment, then inflation -- which is driven by an excess demand for goods and services -is not much of a worry.
But what happens when the economy does recover and demand increases, won't all those excess
reserves sloshing around in the banking system looking for something to finance cause excess demand
and hence inflation? It would if these funds actually leave bank vaults and find their way into the
private sector, but there's no reason that needs to happen.
Shortly after the crisis started, the Fed began paying interest on the reserves that banks hold,
including excess reserves. This means that the Fed has the means to keep the reserves in the banking
system and avoid the inflationary consequences. For example, suppose the interest rate that banks
can earn by loaning out their excess reserves is 5 percent. If the Fed offers to pay 5.1 percent on
reserves the bank holds, the bank has the choice of making a loan to a business or consumer at 5
percent, or keeping the reserves in the vault and earning 5.1 percent. In such a case, banks would not
choose to lend to the private sector and the potential for a debt fueled inflation problem goes away.
Thus, so long as output is below full employment inflation is not much of a worry, and once conditions
improve the Fed has the means to prevent the reserves from leaving banks and becoming inflationary.
Budget deficits and worries that high interest rates will crowd out investment
The $787 billion stabilization package that congress passed and Obama signed into law, known as the
American Recovery and Reinvestment Act of 2009, is distinct from the Bush administration's bank
bailout package (because both are called bailouts, one bails out the banking system and the other
bails out the broader economy, they are often confused or incorrectly fused into a single policy). This
combination of tax cuts and government spending is an attempt to stimulate the economy out of the
recession, or, more realistically given the size of the package relative to the size of the problem, to
simply prevent conditions from being much worse than they already are.
The worry here is that government borrowing will drive up interest rates, that the increase in interest
rates will lower private investment (this is called "crowding out") and that, in turn, will cause
economic growth to be lower that it would be otherwise.
Right now, this is not a very realistic worry. When the economy is near full employment, and when
there are not bundles of cheap cash available from the excess savings in countries like China, an
increase in government borrowing adds to the competition for the available funds. The increased
competition for available savings drives up interest rates and crowds out private investment. But
when there is an excess of available funds, as there is now (this is the excess reserves described
above), and cheap loans available from foreigners (e.g. from China) -- more than the demand for
funds at the current interest rate (which is essentially zero) -- the government can borrow without
putting any upward pressure at all on the interest rate (when the supply of apples exceeds demand,
and the price is already zero and can't be lowered any further, an increase in the demand for apples
does not cause a price increase).
The long-run worries here are legitimate - if we stay on the current trajectory for the budget deficit
we will have problems in the decades ahead - but those worries are mainly due to rising health care
costs in the long-run. Relative to that problem, the stimulus package is tiny and can be handled
relatively easily. It is only when rising health care costs are piled on top of the stabilization package
that the worries become large, but this points to the need for health care reform rather than pulling
back on the stimulus package (which could be disastrous if done too soon).
I don't want to be misunderstood. It's important that, once the economy recovers, we do what is
necessary to pay for the stimulus package and when the economy is ready, I'll push as hard as anyone
to try to make that happen. Doing stabilization policy correctly requires deficit spending in bad times,
and then paying for that spending when times are better. We have been very good at running up
deficits during the bad times, but not so good at paying the bills when things improve, and that needs
to change.
But beginning to pay down the deficit too soon can endanger a recovering economy, and it's
important to be sure that the economy is on solid footing before starting to pay the bills for the
stimulus package. The day will come when it's time to do just that, but we are not there yet. (In fact,
given the poor state of the job market, I'd favor even more stimulus presently, particularly programs
that directly target jobs).
GWARTNEY – STROUP – SOBEL – MACPHERSON
Economic Fluctuations,
Unemployment, and Inflation
Full Length Text — Part: 3
Macro Only Text — Part: 3
Chapter: 8
Chapter: 8
To Accompany: “Economics: Private and Public Choice, 15th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: James Gwartney & Charles Skipton
Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part.
First page
Swings in the
Economic Pendulum
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Instability in the
Growth of Real GDP: 1960-2013
15th
edition
Gwartney-Stroup
Sobel-Macpherson
Annual Rate of Growth
in Real GDP
(long-run growth rate approximately 3%)
•Although real GDP in the
United States has grown at an
average rate of approximately
3%, the growth has been
characterized by economic
ups-and-downs.
Note: periods of recession are
indicated with shading.
8%
6%
4%
2%
0%
-2%
-4%
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2013
Source: Economic Report of the President, various issues.
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First page
15th
edition
The Hypothetical Business Cycle
•The four phases of the
hypothetical business cycle
are expansion, peak,
contraction, and recessionary
trough.
•In contrast with the business
cycle represented here, as the
previous exhibit illustrated,
real world business cycles are
characterized by expansions
and contractions of varying
duration and magnitude.
Real GDP
Business
peak
Gwartney-Stroup
Sobel-Macpherson
Trend line
Business
peak
Recessionary
trough
Recessionary
trough
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Time
First page
Economic Fluctuations
and the Labor Market
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
Labor Market Classifications
edition
Gwartney-Stroup
Sobel-Macpherson
• Employed – a person (16 years old or over) who is:
• working for pay at least one hour per week,
• self employed, or,
• working 15 hours or more each week without pay in
a family-operated enterprise.
• Unemployed – a person not currently employed who is:
• actively seeking a job, or,
• waiting to begin a job, or,
• on layoff, waiting to return to a previous job.
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First page
15th
Labor Market Classifications
edition
Gwartney-Stroup
Sobel-Macpherson
• Civilian Labor force – civilians (16 years & older) who are:
• either employed or unemployed.
• Not in the labor force – persons (16 years & older) who are:
• neither employed nor unemployed (like retirees,
students, homemakers, or disabled persons).
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First page
15th
Labor Market Indicators
edition
Gwartney-Stroup
Sobel-Macpherson
• The non-institutional civilian adult population is grouped
into two broad categories:
• Persons not in the labor force, and,
• persons in the labor force (this group includes both
the employed and unemployed).
Labor Force
Participation Rate
=
Recall the Labor Force =
# in the Labor Force
Civilian population (16+)
Employed + Unemployed
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First page
U.S. Population, Employment,
and Unemployment: April 2013
245.2 million
Civilian population
16 and over
143.6 million
Labor Force
Participation Rate
Employment /
Population Ratio
Rate of
Unemployment
edition
Gwartney-Stroup
Sobel-Macpherson
155.2 million
89.9 million
Not in the
labor force
• Household workers
• Students
• Retirees
• Disabled
15th
Civilian
labor force
11.7 million
Unemployed
Employed
• Employees
• Self-employed
workers
• New entrants
• Reentrants
• Lost last job
• Quit last job
• Laid off
=
Civilian labor force
Civilian population (16+)
=
155.2
245.2
=
63.3%
=
Number employed
Civilian population (16+)
=
143.6
245.2
=
58.6%
=
Number unemployed
Civilian labor force
=
11.7
155.2
=
7.5%
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First page
Labor Force Participation Rate
of Men and Women, 1948-2012
15th
edition
Gwartney-Stroup
Sobel-Macpherson
Labor Force Participation Rate
of Men and Women
•The labor force participation
rate of women has been
steadily increasing for
several decades.
87 %
83%
78 % 76 %
70 %
57.5 % 57.7 %
46 %
•During the same period the
rate of men has been falling.
33 %
38 %
1948 1960 1975 1990 2012 1948 1960 1975 1990 2012
–––––– Women ––––––
––––––– Men –––––––
Source: www.bls.gov.
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First page
Labor Force Participation Rate and
Employment-Population Ratio: 1980-2013
•Both the labor force
participation rate and the
employment-population
ratio trended upward from
1980-2000, but have been
declining since.
•Both figures fell sharply
during the 2008-2009
recession. Each has had a
weak rebound during the
recovery phase of this
business cycle. In 2013,
both were still below their
2007 levels.
15th
edition
Gwartney-Stroup
Sobel-Macpherson
Labor Force Participation Rate
68 %
66 %
64 %
62 %
Employment-Population Ratio
60 %
58 %
56 %
1980
1985
1990
1995
2000
2005
20102013
Sources: Willem Van Zandweghe, “Interpreting the Recent Decline in Labor Force Participation,”
Federal Reserve Bank of Kansas Economic Review (Quarter 1, 2012): 5-34; and Daniel Aaronson,
Jonathan Davis, and Loujia Hu, “Explaining the Decline in the U.S. Labor Force Participation Rate,”
Chicago Fed Letter, no. 296, (March 2012):1-4.
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First page
Composition of the Unemployed
by Reason in 2013 (April)
15th
edition
Gwartney-Stroup
Sobel-Macpherson
Breakdown of Unemployed 2013 (April)
•There are various reasons why
persons were unemployed in
April of 2013.
Job leavers
7.4%
New
entrants
10.9%
•Nearly one-half (44.8%) of the
unemployed were dismissed
from their previous jobs.
•More than a third (37.8%) of
the unemployed were either
new entrants or reentrants into
the labor force.
Reentrants
26.9%
44.8%
Dismissed
from
Previous
Job
10%
On
Layoff
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First page
The Unemployment Rate
By Age and Gender: April 2013
15th
edition
Gwartney-Stroup
Sobel-Macpherson
Civilian Rates of Unemployment (April 2013)
•In 2013, the unemployment
rate for men was 7.7%,
compared to only 7.3% for
women.
•The observed differential
between male and female
workers was higher with
younger workers.
•The unemployment rate itself
was also much higher for those
under the age of 25 than for
those over the age of 25.
26.2%
22.1%
14.0%
12.3%
6.3%
16-19 20-24 25+
–– Men aged ––
7.7% 7.5% 7.3%
5.9%
All Both All
16-19 20-24 25+
men
women –– Women aged ––
Source: www.bls.gov.
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1. Classify the following as employed, unemployed, or not in labor force:
a) person who is not working but applied for a job at Target last week
b) person working part-time and searching diligently for a full-time job
c) auto worker vacationing in Florida during a layoff at a General
Motors plant who expects to be recalled in a couple of weeks
d) 17-year-old who works 6 hours per week as a throwing newspapers
e) homemaker working 70 hours a week preparing meals and
performing other household services
f) college student who spends between 50 and 60 hours per week
attending classes and studying
g) a retired Social Security recipient
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
2. The following are for the U.S. in 2011 (in millions)
Population
311.3
Civilian pop. (age 16 and over) 239.1
Employed
139.7
Unemployed
13.7
a) Calculate the unemployment rate
b) Calculate the labor force participation rate
c) Calculate the employment / population ratio
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First page
Three Types of Unemployment
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
Three Types of Unemployment
edition
Gwartney-Stroup
Sobel-Macpherson
• Frictional Unemployment:
• Caused by imperfect information.
• Occurs because:
• employers are not aware of all available workers
and their qualifications, and,
• available workers are not fully aware of all the jobs
being offered by employers.
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First page
15th
Three Types of Unemployment
edition
Gwartney-Stroup
Sobel-Macpherson
• Structural Unemployment:
• Reflects an imperfect match of employee skills
to skill requirements of the available jobs.
• Also reflects structural and demographic
characteristics of the labor market.
• Cyclical Unemployment:
• Reflects business cycle conditions
• When there is a general downturn in business activity,
cyclical unemployment increases.
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First page
Employment Fluctuations:
The Historical Record
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Unemployment and Output Are
Linked Over the Business Cycle
15th
edition
Gwartney-Stroup
Sobel-Macpherson
•The unemployment rate from
1960-2013 is illustrated here.
•As expected, unemployment
rose rapidly during each of the
eight recessions (the shaded
years indicate periods of
recession).
•In contrast, after each recession
ended, the unemployment rate
began to decline as the
economy moved into an
expansionary phase of the
business cycle.
•Note that the actual rate of
unemployment was greater
than the natural rate during and
immediately following each
recession.
Unemployment Rate (U.S) 1960 - 2013
Actual rate
of unemployment
12%
10%
8%
6%
4%
Natural rate
of unemployment
2%
0%
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2013
Sources : http://www.bls.gov/ and,
Robert J. Gordon, Macroeconomics (Boston: Addison-Wesley, 2012).
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First page
15th
The Concept of Full Employment
edition
Gwartney-Stroup
Sobel-Macpherson
• Full Employment:
Level of employment resulting when the rate of
unemployment is normal, considering both frictional and
structural factors.
• Full employment is closely related to the concept of
the natural rate of unemployment.
• Natural Rate of Unemployment:
Level of unemployment that reflects “job shopping” in an
economy of imperfect information and dynamic change.
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First page
The Concept of the
Natural Rate of Employment
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• The natural rate of unemployment is:
• neither a temporary high nor temporary low.
• a rate that is both achievable and sustainable.
• the level of unemployment accompanying an
economy’s “maximum sustainable rate of output.”
• Both demographic factors (e.g. young workers as a share
of the labor force) and public policy (e.g. the level of
unemployment benefits) influence the natural rate of
unemployment.
• Actual rate of unemployment generally rises above
natural rate during a recession and falls below the
natural rate during a boom.
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First page
Actual and Potential GDP
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
Actual and Potential GDP
edition
Gwartney-Stroup
Sobel-Macpherson
• Potential output:
Maximum sustainable output level consistent with the
economy’s resource base, given its institutional
arrangements.
• Actual and potential output will be equal when the
economy is at full employment.
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First page
15th
edition
Actual and Potential GDP, 1960-2013
Gwartney-Stroup
Sobel-Macpherson
Real GDP
(billions of 2005 $)
16,000
14,000
•Here we illustrate both
actual GDP & potential GDP.
•Note the gap between actual
and potential GDP during
periods of recession.
Actual
GDP
12,000
1990-91
recession
10,000
8,000
6,000
1970
recession
1960
recession
2008-10
recession
1982
recession
4,000
1974-75
recession
2,000
1960
2001
recession
Potential
GDP
1965
1970
1975
1980
1980
recession
1985 1990
1995
2000 2005
2013
Source: http://www.bls.gov
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1. During a recession, which of the following will be true?
a. Actual rate of unemployment will be lower than the
natural rate.
b. Actual GDP will be lower than potential GDP.
c. Actual employment will exceed what is considered as
full employment.
2. How will increased usage of the Internet by employers and
employees influence the job search process? Will it tend to
increase or decrease the natural rate of unemployment?
3. (True or false) When full employment is present the rate
of unemployment will be zero.
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
4. What is the relationship between full employment and
the natural rate of unemployment? Why might the
natural rate change?
5. Frictional unemployment is a result of:
(a) not enough jobs for everyone to be employed
(b) unemployed workers’ skills not matching those needed
for available jobs
(c) a decline in the demand for labor, such as during a
recession
(d) imperfect information & temporary periods of
unemployment while workers change jobs
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First page
The Effects of Inflation
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
Inflation
edition
Gwartney-Stroup
Sobel-Macpherson
• Inflation is a change in the general level of prices as
measured by a price index such as the GDP deflator or
the consumer price index.
• Inflation is generally measured at an annual rate.
• When inflation is high, the year-to-year changes in the
inflation rate are nearly always highly variable, making
them difficult to predict.
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First page
15th
edition
The Inflation Rate, 1956-2013
•Between 1956 and 1965, the
general price level increased
at an average annual rate of
only 1.6%.
•In contrast, the inflation rate
averaged 9.2% from 1973 to
1981, reaching double-digits
during several years.
•Since 1982, the average rate
of inflation has been lower
(2.9% from 1983-2013) and
more stable.
Gwartney-Stroup
Sobel-Macpherson
1956-1965 average
inflation rate = 1.6 %
15%
10%
1973-1981 average
inflation rate = 9.2 %
1983-2013 average
inflation rate = 2.9 %
5%
0%
-5%
1956 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
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2013
First page
Inflation Rates
Across Economies: 2006-2012
15th
edition
Gwartney-Stroup
Sobel-Macpherson
•The rate of inflation varies
widely among countries.
•For Canada, Germany,
Switzerland, and the U.S. the
annual inflation rates for the
2006-12 period were below 4%
-and- variations (year to year)
were no more than 1 or 2%.
•In contrast, both the annual
inflation rate and the change
between years was much
greater for Bolivia, Iceland,
Russia, and Venezuela.
•High rates of inflation are
almost always associated with
substantial year-to-year swings
in the inflation rate.
Annual Inflation Rates
Low Inflation (%) 2006 2007 2008 2009 2010 2011 2012
Canada
2.0 2.1 2.4 0.3 1.8 2.9 1.5
Germany
1.8
2.3
2.6
0.3
1.1
2.1
2.0
Switzerland
1.1
0.7
2.4
-0.5
0.7
0.2 -0.7
United States 3.2
2.9
3.8
-0.4
1.6
3.2
2.1
High Inflation (%)
Bolivia
6.6
4.8
7.8
5.6
6.1
5.8
3.3
Iceland
6.7
5.1 12.7 12.0
5.4
4.0
5.2
Russia
9.7
9.0 14.1 11.7
6.9
8.4
5.0
Venezuela
13.7 18.7 31.4 28.6 29.1 27.2 21.1
Source: International Monetary Fund; http://www.IMF.org
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First page
15th
Unanticipated and Anticipated Inflation
edition
Gwartney-Stroup
Sobel-Macpherson
• There are two different kinds of inflation:
• Unanticipated inflation:
An increase in the price level that comes as a surprise,
at least for most individuals.
• Anticipated inflation:
A widely expected change in the price level.
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First page
15th
Effects of Inflation
edition
Gwartney-Stroup
Sobel-Macpherson
• High and variable rates of inflation are harmful for
several reasons:
• Because unanticipated inflation alters the outcomes
of long-term projects like the purchase of a machine
or operation of a business, it will both increase the
risks and retard the level of such productive activities.
• Inflation distorts the information delivered by prices.
• People will respond to high and variable rates of
inflation by spending less time producing and more
time trying to protect their wealth and income from
the uncertainty created by inflation.
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First page
15th
What Causes Inflation?
edition
Gwartney-Stroup
Sobel-Macpherson
• Nearly all economists believe that rapid expansion in the
money supply is the primary cause of inflation.
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1. Suppose that the CPI was 150 at the end of last year and
157.5 at the end of this year. What was the inflation rate
during the year?
2. If decision makers anticipate an inflation rate of 3% at the
start of a year and prices rise by 7% during the year, this is an
example of
a. anticipated inflation.
b. an inflation rate higher than the anticipated.
c. an inflation rate lower than the anticipated.
3. (True or false) When the inflation rate is high and variable,
decision makers will generally be able to anticipate year-toyear changes in inflation quite accurately.
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
4. How would an unanticipated jump in inflation impact the
wealth of:
a. Joe, who has a 30-yr home mortgage at a fixed interest rate
b. The McCoy's, who hold most of their wealth in long-term
fixed yield bonds
c. Hanna, a retiree drawing a pension of a fixed dollar amount
d. Jose, a heavily indebted small-business owner.
e. Mike, the owner of an apartment complex with substantial
debt at a fixed interest rate
f. Tina, a worker whose wages are determined by a 3-year
union contract ratified three months ago
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
5. What impact will high and variable rates of inflation
have on the economy? How will they influence the risk
accompanying long-term contracts and related business
decisions?
6. Compared to the United States, labor markets in France,
Italy, and Spain are characterized by more generous
unemployment benefits. Other things constant, how will
this influence the unemployment rate in in these
countries compared to that in the U.S.? Explain.
Check your answers to see if your response is correct..
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First page
End of
Chapter 8
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First page
GWARTNEY – STROUP – SOBEL – MACPHERSON
An Introduction to Basic
Macroeconomic Markets
Full Length Text — Part: 3
Macro Only Text — Part: 3
Chapter: 9
Chapter: 9
To Accompany: “Economics: Private and Public Choice, 15th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: James Gwartney & Charles Skipton
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First page
Understanding Macroeconomics:
Our Game Plan
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Understanding Macroeconomics
-- Our Game Plan
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• A model is like a road map. It illustrates inter-relationships.
• We will use the circular flow of output and income
between the business and household sectors to illustrate
macro-economic inter-relationships.
• As our macroeconomic model is developed, initially, we
will assume that monetary policy (the money supply) and
fiscal policy (taxes and government expenditures) are
constant.
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First page
Four Key Markets and
the Circular Flow of Income
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Four Key Markets Coordinate
the Circular Flow of Income
•
•
•
•
15th
edition
Gwartney-Stroup
Sobel-Macpherson
Goods and Services market
Resource market
Loanable Funds market
Foreign Exchange market
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First page
15th
Four Key Markets
edition
Gwartney-Stroup
Sobel-Macpherson
• Goods and Services Market:
• Businesses supply goods & services in exchange for
sales revenue.
• Households, investors, governments, and foreigners
(net exports) demand goods.
• Resource Market:
Highly aggregated market where …
• business firms demand resources, and,
• households supply labor and other resources in
exchange for income.
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First page
15th
Four Key Markets
edition
Gwartney-Stroup
Sobel-Macpherson
• Loanable Funds Market:
Coordinates actions of borrowers and lenders.
• Foreign Exchange Market:
Coordinates the actions of Americans who …
• demand foreign currency (in order to buy things
abroad), and,
• foreigners that supply foreign currencies in exchange
for dollars (so they can buy things from Americans).
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First page
15th
The Circular Flow Diagram
edition
Gwartney-Stroup
Sobel-Macpherson
•Four key markets coordinate the
circular flow of income.
•Resource market: coordinates actions
of businesses demanding resources
and households supplying them in
exchange for income.
•Goods & services market: coordinates
the demand for and supply of domestic
production (GDP).
•Foreign exchange market brings the
purchases (imports) from foreigners
into balance with the sales (exports
plus net inflow of capital) to them.
•Loanable funds market brings net
household saving & net inflow of
foreign capital into balance with
borrowing of businesses and
governments.
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First page
Aggregate Demand
for Goods and Services
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Aggregate Demand
for Goods & Services
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• Aggregate demand (AD) curve:
indicates the various quantities of domestically produced
goods & services 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 and
services demanded and the price level.
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First page
15th
edition
Aggregate Demand Curve
Gwartney-Stroup
Sobel-Macpherson
Price
Level
•As illustrated here, 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.
P1
P2
AD
Y1
Y2
Goods & Services
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(real GDP)
First page
15th
edition
Aggregate Demand Curve
•Other things constant, a lower
price level will increase the
wealth of people holding the
fixed quantity of money, lead
to lower interest rates, and make
domestically produced goods
cheaper relative to
foreign goods.
•Each of these factors tends to
increase the quantity of goods
and services purchased at the
lower price level.
Gwartney-Stroup
Sobel-Macpherson
Price
Level
A reduction in the price
level will increase the
quantity of goods &
services demanded.
P1
P2
AD
Y1
Y2
Goods & Services
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(real GDP)
First page
Why Does the Aggregate
Demand Curve Slope Downward?
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• A lower price level increases the purchasing power of
the fixed quantity of money.
• 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.
• Other things constant, a lower price level will make
domestically produced goods less expensive relative to
foreign goods.
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First page
Aggregate Supply
of Goods and Services
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Aggregate Supply
of Goods & Services
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• When considering the Aggregate Supply curve, it is important to
distinguish between the short-run and the long-run.
• Short-run:
• A period of time during which some prices, particularly those
in resource markets, are set by prior contracts and
agreements.
• Therefore, in the short-run, households and businesses are
unable to adjust these prices when unexpected changes
occur, including unexpected changes in the price level.
• Long-run:
• A period of sufficient time, that people have the opportunity
to modify their behavior in response to price changes.
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First page
15th
Short-Run Aggregate Supply (SRAS)
edition
Gwartney-Stroup
Sobel-Macpherson
• The Short-run Aggregate Supply Curve (SRAS) indicates
the various quantities of goods and services that domestic
firms will supply in response to changing demand
conditions that alter the level of prices in the goods and
services market.
• The SRAS curve slopes upward to the right.
• The upward slope reflects the fact that in the short run
an unanticipated increase in the price level will improve
the profitability of firms.
• Firms respond to this increase in the price level with an
expansion in output.
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First page
15th
edition
Short-Run Aggregate Supply Curve
•The SRAS shows the relationship
between the price level and the
quantity supplied of goods &
services by producers.
•In the short-run, firms will
expand output as the price level
increases because higher prices
improve profit margins since
many components of costs will
be temporarily fixed as the result
of prior long-term commitments.
Price
Level
Gwartney-Stroup
Sobel-Macpherson
SRAS (P
100)
P105
An increase in the
price level will increase
the quantity supplied
in the short run.
P100
P95
Y1
Y2
Y3
Goods & Services
(real GDP)
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First page
15th
Long-Run Aggregate Supply (LRAS)
edition
Gwartney-Stroup
Sobel-Macpherson
• LRAS indicates the relationship between the price level and
quantity of output after decision makers have had sufficient
time to adjust their prior commitments where possible.
• LRAS is related to the economy's production possibilities
constraint.
• A higher price level does not loosen the constraints
imposed by the economy's resource base, level of
technology, and the efficiency of its institutional
arrangements.
• Therefore, an increase in the price level will not lead to
a sustainable expansion in output.
• Thus, the LRAS curve is vertical.
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First page
15th
edition
Long-Run Aggregate Supply Curve
•In the long-run, a higher price
level will not expand an
economy’s rate of output.
Price
Level
Gwartney-Stroup
Sobel-Macpherson
LRAS
Change in price level
does not affect quantity
supplied in the long run.
•Once people have time to adjust
their long-term commitments,
resource markets (and costs) will
adjust to the higher levels of
prices and thereby remove the
incentive of firms to continue to
supply a larger output.
Potential GDP
YF
(full employment
rate of output)
Goods & Services
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(real GDP)
First page
15th
edition
Long-Run Aggregate Supply Curve
•An economy’s full employment
rate of output (YF), the largest
output rate that is sustainable,
is determined by the supply of
resources, level of technology,
and the structure of the
institutions. These factors that
are insensitive to changes in the
price level.
Price
Level
Gwartney-Stroup
Sobel-Macpherson
LRAS
Change in price level
does not affect quantity
supplied in the long run.
Potential GDP
•Hence the vertical LRAS curve.
YF
(full employment
rate of output)
Goods & Services
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(real GDP)
First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1. What is the circular flow of income? What are the
four key markets of the circular flow model?
2. Why is the aggregate demand curve for goods & services
inversely related to the price level? What does this
inverse relationship indicate?
3. What are the major factors that influence the quantity
of goods & services a group of people can produce in
the long run?
Why is the long run aggregate supply curve (LRAS)
vertical? What does the vertical nature of the curve
indicate?
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
4. Why does the short run aggregate supply (SRAS) curve
slope upward to the right? What does the upward slope
indicate?
5. If the prices of both (a) resources and (b) goods and
services increase proportionally will business firms have
a greater incentive to expand output? Why or why not?
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First page
Equilibrium in the
Goods & Services Market
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Short-run Equilibrium
in the Goods & Services Market
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• Short-run Equilibrium:
• Short-run equilibrium is present in the goods & services
market at the price level P where the aggregate
quantity demanded is equal to the aggregate quantity
supplied.
• This occurs (graphically) at the output rate where the
AD and SRAS curves intersect.
• At this market clearing price P, the amount that buyers
want to purchase is just equal to the quantity that sellers
are willing to supply during the current period.
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First page
Short-run Equilibrium
in the Goods & Services Market
•Short-run equilibrium in the
goods and services market
occurs at the price level P
where AD & SRAS intersect.
•If the price were lower than P,
general excess demand in the
goods and services market
would push prices upward.
•Conversely, if the price level
were higher than P, excess
supply would result in falling
prices.
Price
Level
15th
edition
Gwartney-Stroup
Sobel-Macpherson
SRAS
(P100)
Intersection of
AD and SRAS
determines output.
P
AD
Y
Goods & Services
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(real GDP)
First page
Long-run Equilibrium
in the Goods & Services Market
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• Long-run Equilibrium:
• Long-run equilibrium requires that decision makers,
who agreed to long-term contracts influencing
current prices and costs, correctly anticipated the
current price level at the time they arrived at the
agreements.
• If this is not the case, buyers and sellers will want
to modify the agreements when the long-term
contracts expire.
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First page
Long-run Equilibrium
in the Goods & Services Market
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• When long-run equilibrium is present:
• Potential GDP is equal to the economy’s maximum
sustainable output consistent with its resource base,
current technology, and institutional structure.
• The Economy is operating at full employment.
• Actual rate of unemployment equals the natural rate
of unemployment.
• Occurs (graphically) at the output rate where the
AD, SRAS, & LRAS curves intersect.
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First page
Long-run Equilibrium
in the Goods & Services Market
•The subscripts on SRAS and AD
indicate that buyers and sellers
alike anticipated the price level
P100 (where 100 represents an
index of prices during an earlier
base year).
•When the anticipated price
level is attained, output YF will
be equal to potential GDP and
full employment will be
present.
Price
Level
15th
edition
Gwartney-Stroup
Sobel-Macpherson
LRAS
SRAS
(P100)
Note, at this point, the
quantity demanded just
equals quantity supplied.
P100
AD
YF
(full employment
rate of output)
Goods & Services
(real GDP)
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First page
Disequilibrium in the
Goods and Services Market
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• Disequilibrium:
Adjustments that occur when output differs from longrun potential.
• An unexpected change in the price level (rate of
inflation) will alter the rate of output in the short-run.
• An unexpected increase in the price level will
improve the profit margins of firms and thereby
induce them to expand output and employment in
the short-run.
• An unexpected decline in the price level will reduce
profitability, which will cause firms to cut back on
output and employment.
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1. If the price level in the current period is higher than
what buyers and sellers anticipated, what will tend to
happen to real wages and the level of employment?
How will the profit margins of business firms be
affected? How will the actual rate of unemployment
compare with the natural rate of unemployment? Will
the current rate of output be sustainable in the future?
2. Why is an unanticipated increase in the price level likely
to expand output in the short run, but not in the long
run?
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First page
Resource Market
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
Resource Market
edition
Gwartney-Stroup
Sobel-Macpherson
• Demand for Resources:
Business firms demand resources because they contribute
to the production of goods the firm expects to sell at a profit.
• The demand curve for resources slopes down and to
the right.
• Supply of Resources:
Households supply resources in exchange for income.
• Higher prices increase the incentive to supply resources;
thus, the supply curve slopes up and to the right.
• Equilibrium price:
Known as the market clearing price, equilibrium price brings
the resources demanded by firms into balance with those
supplied by resource owners.
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First page
15th
edition
Equilibrium in the Resource Market
•As resource prices increase,
the amount demanded by
producers declines and the
amount supplied by resource
owners expands.
•In equilibrium, the resource
price brings quantity demanded
into equality with the quantity
supplied.
•The labor market is a large part
of the resource market.
Real
resource
price
(wage)
Gwartney-Stroup
Sobel-Macpherson
Households supply
resources in
exchange for income
Resource
market
S
Businesses demand
resources to produce
goods & services
PR
D
Q
Quantity
Employment
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First page
Loanable Funds Market
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
Loanable Funds Market
edition
Gwartney-Stroup
Sobel-Macpherson
• The interest rate coordinates the actions of borrowers
and lenders.
• From the borrower's viewpoint, interest is the cost
paid for earlier availability.
• From the lender’s viewpoint, interest is a premium
received for waiting, for delaying possible current
expenditures into the future.
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First page
15th
The Money and Real Interest Rates
edition
Gwartney-Stroup
Sobel-Macpherson
• The money interest rate is the nominal price of loanable funds.
• When inflation is anticipated, lenders will demand
(and borrowers will pay) a higher money interest rate
to compensate for the expected decline in the purchasing
power of the dollar.
• The real interest rate is the real price of loanable funds.
• The difference between the money rate and real interest rate
is the inflationary premium.
• This premium reflects the expected decline in the purchasing
power of the dollar during the period the loan is outstanding.
Real
interest rate
=
Money
interest rate
–
Inflationary
premium
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First page
15th
edition
Inflation and Interest Rates
•Suppose that when people
expect the general level of prices
to remain stable (zero inflation),
a 6% interest rate brings
equilibrium in the loanable
funds market.
•Under these conditions, the
money and real interest rates
will be equal (here 6%).
Gwartney-Stroup
Sobel-Macpherson
Loanable Funds
market
Interest
Rate
S (stable prices expected)
i = r i== .06
Here, the money
and real interest
rates are equal
D(stable prices expected)
Q
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Quantity
of funds
First page
15th
edition
Inflation and Interest Rates
Gwartney-Stroup
Sobel-Macpherson
Interest
Rate
•When people expect prices to
rise at a 5% rate, the money
interest rate (i) will rise to 11%
even though the real interest
rate (r) remains constant at 6%.
S
Loanable Funds
market
(5% inflation expected)
S (stable prices expected)
i = .11
D
i = .06
(5% inflation expected)
D(stable prices expected)
Inflationary premium
equals expected
rate of inflation
Q
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Quantity
of funds
First page
15th
Does Inflation Help Borrowers?
edition
Gwartney-Stroup
Sobel-Macpherson
• When inflation occurs, borrowers will be able to repay
their loans with dollars that have less purchasing power.
• If the actual rate of inflation is greater than the
expected, borrowers will gain at the expense of
lenders.
• If the actual rate of inflation is less than the expected,
lenders will gain at the expense of borrowers.
• When the rate of inflation is accurately anticipated, the
inflationary premium built into the nominal interest rate
will fully compensate lenders for the reduction in the
purchasing power of the dollar as the loan is repaid.
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First page
Interest Rates and
the Inflow / Outflow of Capital
edition
Gwartney-Stroup
Sobel-Macpherson
Loanable Funds
market
•The demand and supply in the
loanable funds market will
determine the interest rate.
Interest
Rate
•When demand for loanable
funds is strong (D2), real
interest rates will be high (r2)
and there will be a inflow of
capital.
r2
•In contrast, weak demand (D1)
and low interest rates (r1) will
lead to capital outflow.
15th
Capital
inflow
r0
r1
D2
D1
Capital
outflow
Supply of
loanable
funds
Domestic
saving
Q1
Q0
D0
Q2
Quantity
of funds
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First page
Foreign Exchange Market
15th
edition
Gwartney-Stroup
Sobel-Macpherson
Copyright ©2015 Cengage Learning. All rights reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible web site, in whole or in part.
First page
15th
Foreign Exchange Market
edition
Gwartney-Stroup
Sobel-Macpherson
• When Americans buy from foreigners and make
investments abroad (outflow of capital), their actions
generate a demand for foreign currency in the foreign
exchange market.
• On the other hand, when Americans sell products and
assets (including bonds) to foreigners, their transactions
will generate a supply of foreign currency (in exchange
for dollars) in the foreign exchange market.
• The exchange rate will bring the quantity of foreign
exchange demanded into equality with the quantity
supplied.
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First page
15th
edition
Foreign Exchange Market
•Americans demand foreign
currencies to import goods and
services and make investments
abroad.
Gwartney-Stroup
Sobel-Macpherson
Foreign Exchange
market
Dollar price
(of foreign currency)
Depreciation
•Foreigners supply their
of dollar
currency in exchange for dollars
to purchase American exports
and undertake investments in
P1
the United States.
•The exchange rate brings
quantity demanded into
Appreciation
of dollar
balance with the quantity
supplied and will bring (imports
+ capital outflow) into equality
with (exports + capital inflow).
S (exports + capital inflow)
[Sales to Foreigners]
D (imports + capital outflow)
[Purchases from Foreigners]
Q
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Quantity
of currency
First page
15th
edition
Capital Flows and Trade Flows
Gwartney-Stroup
Sobel-Macpherson
• When equilibrium is present in the foreign exchange market,
the following relation exists:
Imports
+
Capital
Outflow
=
Exports
+
Capital
Inflow
Capital
Inflow
-
Capital
Outflow
• This relation can be re-written as:
Imports
–
Exports
=
• The right side of this equation (capital inflow - capital outflow)
is called net capital inflow.
• Net capital inflow may be:
• positive, reflecting a net inflow of capital, or,
• negative, reflecting a net outflow of capital.
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First page
15th
edition
Capital Flows and Trade Flows
Imports
–
Capital
Outflow
=
Exports
Gwartney-Stroup
Sobel-Macpherson
+
Capital
Inflow
• The left side of the equation above is called the trade balance.
• When imports exceed exports, a trade deficit occurs.
• If, instead, exports exceed imports, a trade surplus is present.
• When the exchange rate is determined by market forces, trade
deficits will be closely linked with a net inflow of capital.
• (See the following exhibit for evidence on this point.)
• Conversely, trade surpluses will be closely linked with a net
outflow of capital.
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First page
U.S. Capital Flows and
Trade Flows: 1978-2012
Net Capital Inflow as a share of GDP th
edition
15
6%
Gwartney-Stroup
Sobel-Macpherson
5%
4%
3%
• When a country’s exchange rate is
determined by market forces, the
size of the net inflow of capital and
trade deficit will be closely linked.
• Notice (to the right) that when the
United States has experienced an
increase in net capital inflow, its
trade deficit has increased by a
similar magnitude.
2%
1%
0%
1978
1983
1988
1993
1998
2003
2008 2012
Exports – Imports as a share of GDP
1978
0%
1983
1988
1993
1998
2003
2008 2012
-1%
-2%
-3%
-4%
15th
edition
Gwartney-Stroup
Sobel-Macpherson
-5%
-6%
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First page
15th
Are Trade Deficits Bad?
edition
Gwartney-Stroup
Sobel-Macpherson
• A trade deficit reflects an inflow of capital (borrowing
financial capital from foreigners).
• Are trade deficits bad?
• This depends on how the funds are used:
• If the borrowing is channeled into productive
investments, it will increase the productivity of
Americans and lead to higher future income.
• However, if borrowing from foreigners is used either in
an unproductive fashion or in order to increase
current consumption, it will reduce future income.
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First page
15th
Are Trade Deficits Bad?
edition
Gwartney-Stroup
Sobel-Macpherson
• Recently, a large portion of the capital inflow to the has
been used to finance federal budget deficits.
• This borrowing has facilitated high levels of federal
spending without having to levy equivalent taxes.
• As a result, current consumption has been higher, and
investment lower, than would otherwise have been.
• Borrowing of this type reduces the rate of capital formation
and slows growth.
• A family with financial problems cannot solve them by
borrowing more in order to maintain its current level
of consumption.
• Neither can a nation.
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First page
Long-Run Equilibrium
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
Long-Run Equilibrium
edition
Gwartney-Stroup
Sobel-Macpherson
• When the macro-economy is in long-run equilibrium:
• The interrelationships among the 4 key markets must
be in harmony.
• Resource prices, interest rates, exchange rates, and
product prices will be such that, on average, firms will
be just able to cover their costs of production,
including a competitive return on their investment.
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1.If the inflation rate increases and the higher rate is
sustained over an extended period of time, what will
happen to the nominal interest rate? What will happen
to the real interest rate?
2. “When the U.S. dollar appreciates against the Euro,
fewer dollars will be required to purchase a Euro.”
Is this true? If the dollar appreciates, how will this affect
net exports?
3.Can output rates beyond the economy’s long run
potential be achieved? Can they be sustained? Why or
why not?
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
4. When the economy is in long-run equilibrium, which
of the following will be true?
a. The actual price level will be equal to the price level
anticipated by decision makers.
b. The actual unemployment rate will be equal to the
natural rate of unemployment.
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
5. (a) What is the difference between the real interest rate
and the money interest rate?
(b) Suppose that you purchased a $5,000 bond that pays
7% interest annually and matures in five years. If the
inflation rate in recent years has been steady at 3%
annually, what is the estimated real rate of interest? If
the inflation rate during the next five years rises to 8%,
what real rate of return will you earn?
6. How is a nation’s trade balance related to its net inflow
of foreign capital? If the inflow of foreign capital is used
to finance the federal deficit, how will the well-being of
future generations be affected?
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First page
End of
Chapter 9
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First page
GWARTNEY – STROUP – SOBEL – MACPHERSON
Dynamic Change, Economic
Fluctuations, and the AD-AS Model
Full Length Text — Part: 3
Macro Only Text — Part: 3
Chapter: 10
Chapter: 10
To Accompany: “Economics: Private and Public Choice, 15th ed.”
James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson
Slides authored and animated by: James Gwartney & Charles Skipton
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First page
Anticipated and
Unanticipated Changes
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Understanding Macroeconomics
-- Our Game Plan
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• Anticipated changes are fully expected by economic
participants.
• Decision makers have time to adjust to them before
they occur.
• Unanticipated changes catch people by surprise.
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First page
Factors That Shift
Aggregate Demand
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
Shifts in Aggregate Demand
edition
Gwartney-Stroup
Sobel-Macpherson
• The aggregate demand (AD) curve indicates the quantity
of goods & services that will be demanded at alternative
price levels.
• An increase in aggregate demand (a shift of the AD
curve to the right) indicates that decision makers will
purchase a larger quantity of goods and services at
each different price level.
• A decrease in aggregate demand (a shift of the AD
curve to the left) indicates that decision makers will
purchase a smaller quantity of goods and services at
each different price level.
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First page
15th
Factors that Shift Aggregate Demand
edition
Gwartney-Stroup
Sobel-Macpherson
• The following factors will cause a shift in aggregate
demand outward (inward):
• an increase (decrease) in real wealth
• a decrease (increase) in the real interest rate
• an increase in the optimism (pessimism) of businesses
and consumers about future economic conditions
• an increase (decline) in the expected rate of inflation
• higher (lower) real incomes abroad
• a reduction (increase) in the exchange rate value of
the nation’s currency
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First page
15th
edition
Shifts in Aggregate Demand
•An increase in real wealth, such
as would result from a stock
market boom, would increase
aggregate demand, shifting the
entire curve to the right (from
AD0 to AD1).
•In contrast, a reduction in real
wealth decreases aggregate
demand, shifting AD left (from
AD0 to AD2).
Gwartney-Stroup
Sobel-Macpherson
Price
Level
AD1
AD0
AD2
Goods & Services
(real GDP)
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First page
Aggregate Demand and
Consumer Optimism / Pessimism
15th
edition
Gwartney-Stroup
Sobel-Macpherson
•Below is the consumer
sentiment index for 1978-2012.
•This measure attempts to
capture consumers’ optimism
and pessimism regarding the
future of the economy.
•Moves toward optimism tend to
increase AD, while moves
toward pessimism tend to
decrease AD.
•Note how the consumer
sentiment index turns down
prior to or during recessions
(shaded time periods).
Consumer Sentiment Index 1978-2012
120
100
80
60
40
20
1980
1984
1988
1992
1996
2000
2004
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2008
2012
First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1. Explain how and why each of the following factors would
influence current 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 decline in housing prices
(f) a higher price level (be careful)
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First page
Shifts in Aggregate Supply
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
Long- and Short-Run Aggregate Supply
edition
Gwartney-Stroup
Sobel-Macpherson
• When considering shifts in aggregate supply, it is important
to distinguish between the long run and short run.
• Shifts in LRAS:
A long run change in aggregate supply indicates that it will
be possible to achieve and sustain a larger rate of output.
• A shift in the long run aggregate supply curve (LRAS)
will cause the short run aggregate supply (SRAS) curve
to shift in the same direction.
• Shifts in LRAS are an alternative way of indicating there
has been a shift in the economy’s production possibilities
curve.
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First page
15th
Long- and Short-Run Aggregate Supply
edition
Gwartney-Stroup
Sobel-Macpherson
• Shifts in SRAS:
Changes that temporarily alter the productive capability
of an economy will shift the SRAS curve, but not the LRAS
curve.
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First page
15th
Shifts in Aggregate Supply
edition
Gwartney-Stroup
Sobel-Macpherson
• Factors that increase (decrease) LRAS:
• increase (decrease) in the supply of resources
• improvement (deterioration) in technology and productivity
• institutional changes that increase (reduce) efficiency of
resource use
• Factors that increase (decrease) SRAS:
• a decrease (increase) in resource prices — hence,
production costs
• a reduction (increase) in expected inflation
• favorable (unfavorable) supply shocks, such as good (bad)
weather or a reduction (increase) in the world price of key
imported resource
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First page
15th
Price
Level
Shifts in LRAS & SRAS
• Such factors as an increase in the stock
of capital or an improvement in
technology will expand an economy’s
potential output and shift LRAS to the
right (note that when the LRAS curve
shifts, so too does SRAS).
• Such factors as a reduction in resource
prices or favorable weather would shift
SRAS to the right (note that here the
LRAS curve will remain constant).
Price
Level
edition
LRAS1
LRAS2
YF1
YF2
Gwartney-Stroup
Sobel-Macpherson
Goods & Services
(real GDP)
SRAS1
SRAS2
15th
edition
Gwartney-Stroup
Sobel-Macpherson
Goods & Services
(real GDP)
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1. Which of the following would be most likely to shift the
long-run aggregate supply curve (LRAS) to the left?
a. unfavorable weather conditions that reduced the size
of this year’s grain harvest
b. an increase in labor productivity as the result of
improved computer technology and expansion in
the Internet
c. an increase in the cost of security as the result of
terrorist activities
2. How would an increase in the economy’s production
possibilities influence the LRAS?
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First page
Steady Economic Growth and
Anticipated Changes in
Long-Run Aggregate Supply
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
The Impact of
Steady Economic Growth
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• Expansions in the productive capacity of the economy, like
those resulting from capital formation or improvements in
technology, shifts an economy's LRAS curve to the right.
• When growth of the economy is steady and predictable, it
will be anticipated by decision makers.
• Anticipated increases in output (LRAS) need not disrupt
macroeconomic equilibrium.
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First page
15th
edition
Shifts in Long Run Aggregate Supply
•Consider the impact of capital
formation or a technological
advancement on the economy.
Price
Level
LRAS1
Gwartney-Stroup
Sobel-Macpherson
LRAS2
SRAS1
SRAS2
•Both LRAS and SRAS increase
(to LRAS2 and SRAS2).
•Full employment output
expands from YF1 to YF2.
P100
P95
•A sustainable, higher level of
real output is the result.
AD
YF1 YF2
Goods & Services
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(real GDP)
First page
Unanticipated Changes
and Market Adjustments
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Unanticipated Changes
in Aggregate Demand
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• In the short-run, output will deviate from full employment
capacity as prices in the goods and services market
deviate from the price level that people expected.
• Unanticipated changes in aggregate demand often lead
to such deviations.
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First page
Unanticipated Increase
in Aggregate Demand
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• Impact of unanticipated increase in AD:
• Initially, the strong demand and higher price level in the
goods & services market will temporarily improve profit
margins.
• Output will increase, the rate of unemployment will drop
below the natural rate, and output will temporarily
exceed the economy's long-run potential.
• With time, however, contracts will be modified and
resource prices will rise and return to their competitive
position relative to product prices.
• Once this happens, output will recede to the economy's
long-run potential.
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First page
Unanticipated Increase
in AD: Short Run
Price
Level
•In response to an unanticipated
increase in AD for goods and
services (shifting AD from AD1
to AD2), prices rise to P105
and output will increase to Y2,
temporarily exceeding fullemployment capacity.
15th
edition
Gwartney-Stroup
Sobel-Macpherson
LRAS
SRAS1
Short-run effects of
an unanticipated
increase in AD
P105
P100
AD2
AD1
YF
Y2
Goods & Services
(real GDP)
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First page
Unanticipated Increase
in AD: Long Run
•With time, resource market
prices, including labor, rise due
to the strong demand. Higher
costs reduce SRAS1 to SRAS2.
•In the long-run, a new
equilibrium at a higher price
level, P110 , and output
consistent with long-run
potential will occur.
•So, the increase in demand only
temporarily expands output.
Price
Level
15th
edition
Gwartney-Stroup
Sobel-Macpherson
SRAS2
LRAS
SRAS1
P110
Long-run effects of
an unanticipated
increase in AD
P105
P100
AD2
AD1
YYF
Y2
Goods & Services
(real GDP)
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First page
Unanticipated Decrease
in Aggregate Demand
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• Impact of unanticipated reduction in AD:
• Weak demand and lower prices in the goods & services
market will reduce profit margins. Many firms will incur
losses.
• Firms will reduce output, the unemployment rate will rise
above the natural rate, and output will temporarily fall
short of the economy's long-run potential.
• With time, long-term contracts will be modified.
• Eventually, lower resource prices and lower real interest
rates will direct the economy back to long-run equilibrium,
but this may be a lengthy and painful process.
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First page
Unanticipated Decrease
in AD: Short Run
Price
Level
15th
edition
Gwartney-Stroup
Sobel-Macpherson
LRAS
SRAS1
•The short-run impact of an
unanticipated reduction in AD
(a shift from AD1 to AD2) will
be a decline in output (to Y2),
and a lower price level (P95).
•Temporarily, profit margins
decline, output falls, and
unemployment rises above its
natural rate.
Short-run effects of
an unanticipated
reduction in AD
P100
P95
AD2
Y2 YF
AD1
Goods & Services
(real GDP)
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First page
Unanticipated Decrease
in AD: Long Run
•In the long-run, both weak
demand and excess supply
in the resource market lead
to lower resource prices
(including labor) resulting in
an expansion in SRAS (shifting
it from SRAS1 to SRAS2).
•A new equilibrium at a lower
price level, P90, and an output
consistent with long-run
potential will result.
Price
Level
15th
edition
Gwartney-Stroup
Sobel-Macpherson
LRAS
SRAS1
SRAS2
P100
Long-run effects of
an unanticipated
reduction in AD
P95
P90
AD2
Y2 YF
AD1
Goods & Services
(real GDP)
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First page
Unanticipated Changes in
Short-Run Aggregate Supply
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• Unanticipated changes in short-run aggregate supply
(SRAS) can catch people by surprise.
• Thus, they are often referred to as supply shocks.
• A supply shock is an unexpected event that temporarily
increases or decreases aggregate supply.
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First page
Impact of Unanticipated
Increase in SRAS
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• SRAS shifts to the right
– output temporarily exceeds the economy's
long-run potential.
• Since the temporarily favorable supply conditions cannot
be counted on in the future, the economy’s long-term
production capacity will not be altered.
• If individuals recognize that they will be unable to
maintain their current high level of income, they will
increase their saving. Lower interest rates, and additional
capital formation may result.
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First page
15th
edition
Unanticipated Increase in SRAS
•Consider an unanticipated,
temporary, increase in SRAS,
such as may result from a
bumper crop from good
weather.
•The increase in aggregate supply
(to SRAS2) would lead to a lower
price level P95 and an increase in
current GDP to Y2.
•As the supply conditions are
temporary, LRAS persists.
Price
Level
Gwartney-Stroup
Sobel-Macpherson
LRAS
SRAS1
SRAS2
P100
P95
AD1
YF
Y2
Goods & Services
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(real GDP)
First page
Impact of Unanticipated
Decrease in SRAS
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• SRAS shifts to the left
– output falls short of economy's long-run potential
temporarily.
• If an unfavorable supply shock is expected to be
temporary, long-run aggregate supply will be unaffected.
• Households may reduce their current saving (dip into past
savings).
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First page
15th
edition
Supply Shock: Resource Market
•Suppose there is an adverse
supply shock, perhaps as the
result of a crop failure or a sharp
increase in the world price of a
major resource, such as oil.
•Here we show the impact in the
resource market: prices rise from
Pr1 to Pr2.
Gwartney-Stroup
Sobel-Macpherson
Resource
market
Real
resource
price
S2
S1
Pr2
Pr1
D
Q2
Q1
Quantity
Employment
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First page
15th
edition
Supply Shock: Product Market
•As shown here, the higher
resource prices shift SRAS to
the left in the product market;
in the short-run, 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.
Price
Level
LRAS
Gwartney-Stroup
Sobel-Macpherson
SRAS2 (Pr2 )
SRAS1 (Pr1 )
P110
P100
AD1
Y2 YF
Goods & Services
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(real GDP)
First page
15th
edition
Effects of Adverse Supply Shock
•If the adverse supply shock is
temporary, resource prices will
eventually fall in the future,
shifting SRAS2 back to SRAS1,
returning equilibrium to (A).
•If the adverse supply factor is
permanent, the productive
potential of the economy will
shrink (LRAS shifts left and Y2
becomes YF2) and (B) will
become the long-run
equilibrium.
Price
Level
P110
Gwartney-Stroup
Sobel-Macpherson
SRAS2 (Pr2 )
SRAS1 (Pr1 )
LRAS
B
A
P100
AD1
Y2 YF
Goods & Services
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(real GDP)
First page
The Price Level, Inflation,
and the AD-AS Model
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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Price Level, Inflation,
and the AD-AS Model
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• The basic AD-AS model focuses on how the general level
of prices influences the choices of business decision
makers.
• If the price level in the product market changes, this
indicates that this price has changed relative to other
markets.
• This structure implicitly assumes that the actual and
expected rates of inflation are initially zero.
• When inflation is present this model can be recast in a
dynamic setting.
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First page
When Actual and Expected
Rates of Inflation are Equal
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• When the actual and expected rates of inflation are equal:
• Inflation will be built into long term contracts.
• Prices will rise in both resource and product markets, but
the relative price between the two will be unchanged.
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First page
When Actual and Expected
Rates of Inflation Differ
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• An actual rate of inflation that is less than anticipated is
the equivalent of a reduction in the price level. As a
result, firms will incur losses and reduce output.
• An actual rate of inflation that is greater than anticipated
is the equivalent of an increase in the price level. Profits
will be enhanced and firms will expand output.
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First page
Unanticipated Changes,
Recessions, and Booms
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
The AD-AS Model and Instability
edition
Gwartney-Stroup
Sobel-Macpherson
• The AD-AS model indicates that unanticipated changes will
disrupt macro equilibrium and result in economic instability.
• Recessions occur because prices in the goods and services
market are low relative to the costs of production and
resource prices.
• The two causes of recessions are:
• unanticipated reductions in AD, and,
• unfavorable supply shocks.
• An unsustainable boom occurs when prices in the goods
and services market are high relative to resource prices
and other costs.
• The two causes of booms are:
• unanticipated increases in AD, and,
• favorable supply shocks.
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Two Forces Directing the
Economy Back to Equilibrium
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• The AD-AS model indicates that there are two forces that
will help direct an economy back to long-run equilibrium:
• Changes in real resource prices:
• During a recession, real resource prices will tend to
fall because the demand for resources will be weak
and the rate of unemployment high.
• During a boom, real resource prices will tend to rise
as demand for resources will be strong and the
unemployment rate low.
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First page
Two Forces Directing the
Economy Back to Equilibrium
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• The AD-AS model indicates that there are two forces that
will help direct an economy back to long-run equilibrium:
• Changes in real interest rates:
• During a recession, real interest rates will tend to
decline because of the weak demand for investment.
The lower interest rates will stimulate AD and help
direct the economy back to full employment.
• During a boom, real interest rates will tend to rise
because of the strong demand for investment. The
higher rates will retard AD and help direct the
economy back to full employment.
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First page
15th
edition
The Macro-Adjustment Process
•If output is temporarily less than
long-run potential YF … falling
interest rates will shift AD (from
AD1 to AD2) … while lower resource
prices decrease production costs
and thereby increase SRAS (from
SRAS1 to SRAS2) … and so direct
output toward its full-employment
potential (YF).
Output may exceed or fall
short of the economy’s
full-employment capacity
(YF) in the short-run.
Price
Level
LRAS
Gwartney-Stroup
Sobel-Macpherson
Lower resource
prices increase SRAS
SRAS1
SRAS2
P100
Lower real interest
rates increase AD
AD2
AD1
Y1
YF
Goods & Services
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(real GDP)
First page
15th
edition
The Macro-Adjustment Process
•If output is temporarily greater
than long-run potential YF …
higher interest rates will reduce AD
(from AD1 to AD2) … while higher
resource prices increase production
costs and thereby reduce SRAS
(from SRAS1 to SRAS2) …
directing output toward its
full-employment potential (YF).
Output may exceed or fall
short of the economy’s
full-employment capacity
(YF) in the short-run.
Gwartney-Stroup
Sobel-Macpherson
Price
Level
Higher resource
prices reduce SRAS
LRAS
SRAS2
SRAS1
Higher real interest
rates reduce AD
P100
AD1
AD2
YF
Y1
Goods & Services
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(real GDP)
First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1. Suppose consumers and investors suddenly become
more pessimistic about the future and therefore decide
to reduce their consumption and investment spending.
How will a market economy adjust to this increase in
pessimism?
2. “If the general level of prices is higher than business
decision makers anticipated when they entered into
long-term contracts for raw materials and other
resources, profit margins will be abnormally low and
the economy will fall into a recession.”
– Is this statement true?
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
3. Which of the following would be most likely to throw the
U.S. economy into a recession?
(a) a reduction in transaction costs as the result of the
growth and development of the Internet
(b) an unanticipated reduction in the world price of oil
(c) an unanticipated reduction in AD as the result of a
sharp decline in consumer confidence
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First page
Expansions and Recessions:
The Historical Record
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
Expansions and Recessions:
the Historical Record
15th
edition
Gwartney-Stroup
Sobel-Macpherson
• During the past six decades, economic expansions have
been far more lengthy than recessions.
• The depth and severity of the recession that started in
December 2007 highlights the issue of economic
instability and recovery from a recession.
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First page
Expansions and Recessions:
1950-2012
Period of Expansion
Length
(in Months) Period of Recession
15th
edition
Gwartney-Stroup
Sobel-Macpherson
Length
(in Months)
Oct ‘49 to Jul ’53
44
Jul ‘53 to May ’54
10
May ‘54 to Aug ’57
39
Aug ‘57 to Apr ’58
9
Apr ‘58 to Apr ’60
24
Apr ‘60 to Feb ’61
10
Feb ‘61 to Dec ’69
105
Dec ‘69 to Nov ’70
10
Nov ‘70 to Nov ‘73
36
Nov ‘73 to Mar ’75
16
Mar ‘75 to Jan ’80
58
Jan ‘80 to Jul ’80
6
Jul ‘80 to Jul ’81
12
Jul ‘81 to Nov ’82
16
Nov ‘82 to Jul ’90
92
Jul ‘90 Mar ’91
9
Mar ‘91 to Mar ’01
120
Mar ‘01 to Nov ’01
8
Nov ‘01 to Nov ’07
73
Dec ‘07 to June ‘09
19
July ’09 to ?
?
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First page
Using the AD-AS Model to Think
about the Business Cycle and the
Great Recession of 2008-2009
15th
edition
Gwartney-Stroup
Sobel-Macpherson
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First page
15th
The Great Recession of 2008-2009
edition
Gwartney-Stroup
Sobel-Macpherson
• What caused boom of 2003-07 and the bust of 2008-09?
• Between 2002 and mid-year 2006, housing prices rose by
almost 90%. Stock prices also rose rapidly. As a result,
wealth expanded and AD increased, leading to an
economic boom.
• But the situation changed in the second half of 2006.
Housing prices began to fall. Both mortgage default and
housing foreclosure rates increased. This reduced AD.
• Stock prices began to decline in October 2007 and they
plunged during 2008. This also reduced wealth and AD.
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First page
15th
The Great Recession of 2008-2009
edition
Gwartney-Stroup
Sobel-Macpherson
• What caused boom and bust?
• During 2007 and the first half of 2008, crude oil and
other energy prices soared, and this generated an
unanticipated reduction in SRAS.
• These forces led to a sharp reduction in consumer and
investor confidence, further reducing AD.
• The reductions in both AD and SRAS reduced output and
employment just as the AD-AS model implies.
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First page
Changes in Stock and Housing Prices
During Expansions
•Both stock & housing prices
generally rise prior to and during
expansions.
•This leads to increases in AD.
•In contrast, stock and housing prices
generally fall prior to and during
recessions, and this reduces AD.
•The wealth effects associated with
the swings in stock and housing
prices are a contributing factor to
the ups and downs of the business
cycle.
•Note: the reduction in housing
prices for the 2008-2009 recession
were far greater than other
recessions. Stock price reductions
were also substantial.
•These price reductions increased
the severity of the recent downturn.
% Change
15th
edition
Gwartney-Stroup
Sobel-Macpherson
––– Expansion –––
50%
40%
30%
20%
10%
0%
1970-72 1975-77 1980-81 1982-84 1991-93 2002-04
Stock Prices
1969-70 1973-75
1980
2010--
Home Prices
1981-82 1990-91
2001
2008-09
0%
-10%
-20%
-30%
-40%
-50%
% Change
––– Recession –––
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First page
15th
Questions for Thought:
edition
Gwartney-Stroup
Sobel-Macpherson
1. During the first half of 2008, the world price of oil soared
while stock and housing prices plunged. Within the
framework of the AD-AS model, how would these two
changes influence the U.S. economy? Explain the expected
impact on output & price level.
2. When actual output is less than the economy’s full
employment level of output, how will real resource prices
and real interest rates adjust?
3. Build the AD, SRAS, & LRAS curves for an economy
experiencing:
(a) full employment equilibrium
(b) an economic boom
(c) a recession
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End of
Chapter 10
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