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Economics

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Unemployment Rates

After reading chapters 8, 9, and 10, write a 2-page paper describing how the published unemployment rate is derived.

What is the relationship between the labor participation rate and the unemployment rate?

How can the published unemployment rate actually be misleading vis-a-vis economic conditions?



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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 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 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. 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 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 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. Time First page Economic Fluctuations and the Labor 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 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. 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 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). 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 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 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 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% 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 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. 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 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. 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 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 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 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. 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 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 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 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 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 Three Types of Unemployment 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 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. 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 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. 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 Employment Fluctuations: The Historical Record 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 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). 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 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. 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 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. 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 Actual and Potential GDP 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 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. 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 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 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 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. 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 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 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 The Effects of Inflation 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 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. 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 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 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. 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 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 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. 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 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. 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 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. 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 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. 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 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 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 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.. 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 End of Chapter 8 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 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 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 Understanding Macroeconomics: Our Game Plan 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 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. 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 Four Key Markets and the Circular Flow of Income 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 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 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 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. 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 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). 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 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. 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 Aggregate Demand for Goods and Services 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 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. 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 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 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. (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 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. (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. 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 Aggregate Supply of Goods and Services 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 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. 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 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. 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 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) 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 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. 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 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 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. (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 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. (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? 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 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? 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 Equilibrium in the Goods & Services 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 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. 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 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 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. (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. 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 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. 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 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) 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 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. 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 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? 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 Resource 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 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. 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 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 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 Loanable Funds 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 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. 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 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 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 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 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. 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 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. 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. 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 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 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 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. 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 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 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. 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. 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 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. 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 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% 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 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. 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 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. 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 Long-Run Equilibrium 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 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. 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 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? 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 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. 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 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? 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 End of Chapter 9 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 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 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 Anticipated and Unanticipated Changes 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 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. 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 Factors That Shift Aggregate Demand 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 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. 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 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 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 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) 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 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 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. 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) 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 Shifts in Aggregate Supply 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 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. 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 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. 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 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 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 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) 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 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? 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 Steady Economic Growth and Anticipated Changes in Long-Run Aggregate Supply 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 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. 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 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 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. (real GDP) First page Unanticipated Changes and Market Adjustments 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 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. 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 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. 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 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) 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 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) 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 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. 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 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) 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 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) 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 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. 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 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. 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 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 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. (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). 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 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 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 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 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. (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 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. (real GDP) First page The Price Level, Inflation, and the AD-AS Model 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 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. 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 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. 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 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. 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 Unanticipated Changes, Recessions, and Booms 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 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. 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 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. 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 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. 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 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 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. (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 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. (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? 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 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 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 Expansions and Recessions: The Historical Record 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 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. 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 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 ? ? 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 Using the AD-AS Model to Think about the Business Cycle and the Great Recession of 2008-2009 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 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. 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 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. 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 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 ––– 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 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 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 End of Chapter 10 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
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