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Ke nesian Model Assumes constant Prices
What happens if prices change?
Wealth Effect: They feel poorer. They buy less.Businessmen invest less as a result.
Substitution Effect: Things are more expensivenow and in future, things may be cheaper. Theybu less now.
We export less too and we import more asimported goods are cheaper.
(1) The AE curve shifts down when the price levelrises due to wealth effect
2 e curve s ts up w en wea t ncreases
via upward shift of the consumption function.
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Keynesian Model is Demand-Driven Model
Keynesian Model
AE Higher expenditure implieshigher income, (Y)
AE
Assumes constant pricesbut what are prices? Pricesare measured in terms of
0money. What is money? What is the
rice of mone ? It is interestrate.
Along the AE line, interestrate is constant but will it
Y = GDP
Y0 Y* Y
change? Would the changeaffect the AE line?
= Income=Aggregate Expenditure
affects investment and also
consumption
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The Central Bank can change quantity of money (M)
.
M = Money Multiplier (k) . Monetary Base (MB)
= . ; = . qua on
1. Required reserve ratios; raising b will reduce
2. Discount rate; Lowering discount willencourage banks to borrow more and hence
MB and therefore M will increase3. Open market operations: Sales of bonds to
and M will fall.
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Relation between Aggregate Demand and ther ce eve
Keynesian Model
AE0(P0) = f(G0, T0)0
AE0(P1) = f(G0, T0),
AE
0 1> 0
Y=Real GDPY0(P0)Y0(P1)P
P0 H
P1 H0 Curve, AD0(G0,T0)
Y0Y1
AD0(G0,T0)
Y
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Monetary Policy and Keynesian Model
Keynesian ModelAE
H11 1 1
AE0 = a bT + I0(i 0 ) + G + bY
H0 Increase money supply (MS),
interest rate falls from i0 to i1.0
I1, shifting AE upward (Increase in MS has increased Y)
=
Y0 YY1
= Income=Aggregate Expenditure
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Relation between Aggregate Demand and thepr ce eve a ng n o accoun one ary o cy
Keynesian Model
AE0(P0) = f(G0, T0, MS0)H0
AE0(P1) = f(G0, T0, MS0)
0 P1 > P 0
Y=Real GDPY0(P0)Y0(P1)
P0 H0
P1 H0 Curve, AD0(G0, T0, MS0)
Y0Y1
AD0(G0, T0, MS0)
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Aggregate Supply and
Aggregate Demand
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GDP* is full employment output. Also known aspotential output
GDP2
Production Function
GDP
GDP* En is full employment level whenthe unemployment rate is un
Recessionary output gap = u1 >
un
Inflationary output gap = un > u2
En
Unemployment rateunu1 u2
4% 3%5%
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The ClassicalModel determinesfull employment
n
E
unEmployment
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The macroeconomic long run is a time frame that issufficiently long for the real wage rate to haveadjusted to achieve full employment:
Real GDP equals potential GDP.Unemployment is at the natural unemploymentrate.
money.
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The macroeconomic short run a period during whichsome moneyprices are sticky so that
Real GDP might be below, above, or at potential
GDP.The unemployment rate might be above, below, orat the natural unemployment rate.
.
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We have a re ate demand curve linkin a re ate
demand to prices.Where is the aggregate supply curve, linking output to
pr ces
, ,is no output!
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Production function is the factory. But we wantoutput to link with prices?
GDP2
Production Function
GDP
GDP* En is full employment level whenthe unemployment rate is un
Recessionary output gap = u1 >u
nInflationar out ut a = u > u
n
Unemployment rateunu1 u24% 3%5%
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The quantity of real GDP suppliedis the total
period. It depends on The quantity of the labor employed The quantity of physical and human capital State of technology
A re ate su l is the relationshi between thequantity of real GDP supplied and the price level.
We distinguish two time frames associated with
Long-run aggregate supply Short-run aggregate supply
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Long-run Aggregate Supply
Along the LAScurve,all prices and wagera es c ange y e
same percentage sorelative prices and thereal wage rate remainconstant. Hence, the
supplied remains atpotential GDP.
Money: Fixed output, higher
MS
higher price level
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Short-Run A re ate Su l
Short-run aggregate supply is the relationshipbetween the quantity of real GDP supplied and thepr ce eve w en e money wage ra e, e pr ces oother resources, and potential GDP remain
constant.
A rise in the price level with no change in themoney wage rate and other factor prices increases
the quantity of real GDP supplied.
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-
CSB version Price
From a to b, pricesdo not rise as output
d
(Keynesian range)
From b to c, prices
SAS
start to rise. Oncereal output exceedsGDP* rices rise
a bc
significantlyY=Real GDP
GDP*
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Short-run Aggregate Supply The SAScurve is
upward-sloping because:
A rise in the price level
with no change in costsinduces firms to bear ahigher marginal cost
and increase
A fall in the price levelwith no change in costs
induces firms todecrease production to
.
Real GDP suppliedincreases if P increases
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Aggregate Supply
Movements Along theLASand SASCurves
A change in the pricelevel with an equalpercentage c ange nthe money wage
causes a movementalong the LAScurve.
No change in the
money wage means amovement along theSAScurve.
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Aggregate Supply
ven money wage rate,at P = 115, SAScutsLAScurve at otential
GDP. Given the money wage,,
real GDP supplied
decreases along thecurve.
With the given moneywage rate, as P rises
above 115, real GDPsupplied increases
. Real GDP exceeds
potential GDP.
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A re ate Su l
Aggregate supply changes if an influence onproduction plans other than the price levelchanges.
These influences include a change in: Potential GDP
Money wage rate and other factor prices
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Changes in Aggregate Supply
en potent a ncreases, ot t e an
SAScurves shift rightward.
, :
The full-employment quantity of labor
The quantity of capital (physical or human)changes
Technology advances
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An increase in
potent a s ts
the LAScurve and theSAScurve shifts alonwith the LAScurve.
CSB version: the shiftof SAS is notpermanent.
ence, c ange nwill not cause SAS toshift
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Aggregate Supply
Suppose unions askfor higher wages
A rise in the moneywage rate decreasess or -run aggrega esupply and shifts
the SAScurveleftward.
It has no effect on
long-run aggregatesupply.
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From Lecture 10: Relation between Aggregate
eman an e r ce eve
Keynesian Model
AE0(P0) = f(G0, T0)0
AE0(P1) = f(G0, T0),
AE
0 1> 0
Y=Real GDPY0(P0)Y0(P1)P
P0 H
P1 H0
Curve, AD0(G0,T0)
Y0Y1
AD0(G0,T0)
Y
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The ADcurve slopesdownward for tworeasons:
wea e ec
Substitution effect
Y
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Wealth Effect
A rise in the price level, other things remaining thesame, decreases the quantity of real wealth (money,stoc s, etc. .
To restore their real wealth, people increase saving.
The quantity of real GDP demanded decreases.
Similarly, a fall in the price level, other thingsremaining the same, increases the quantity of real
demanded increases.
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Substitution Effects
Intertemporal substitution effect: A rise in the rice level other thin s remainin the
same, decreases the real value of money andraises the interest rate.
en e n eres ra e r ses, peop e orrow anspend less so the quantity of real GDP demandeddecreases.
Similarly, a fall in the price level increases the realvalue of money and lowers the interest rate.
When the interest rate falls, people borrow and
spend more so the quantity of real GDP demandedincreases.
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A rise in the price level, other things remaining thesame, increases the rice of domestic oodsrelative to foreign goods.
So imports increase and exports decrease, which.
Similarly, a fall in the price level, other thingsremainin the same increases the uantit of real
GDP demanded.
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Short-Run Macroeconomic Equilibrium
Short-run macroeconomic equilibrium occurs
the quantity of real GDP supplied at the point of
intersection of the ADcurve and the SAScurve.
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Macroeconomic Equilibrium
SR macroeconomicequilibrium occurs when realGDP demanded = real GDP
of ADand SAS When price is 105, AD > AS:
inventory down, firmsincrease production and
raise prices
When price is 125, AD< AS,inventory up, firms decrease
These changes bring amovement alon the SAScurve towards equilibrium.
Y* not shown here
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Long-Run Macroeconomic Equilibrium Long-run macroeconomic equilibrium occurs when
real GDP equals potential GDPwhen the economyis on its LAScurve.
-the ADand LAScurves.
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A is the long-run
e uilibrium wherethree lines meet.
Long-run equilibriumoccurs when themoney wage has
ad usted to ut the A
SAScurve throughthe long-run
.
GDP*
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Fluctuations in
Aggregate Demand
We start at A.
Now, an increase inaggregate demandshifts the ADcurve
B
.
Firms increaseroduction and the
price level rises inthe short run at B
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Macroeconomic Equilibrium
At the short-runequilibrium at B,there is an
inflationary gap.
C
e money wage ra ebegins to rise and
the SAScurve starts
B
to shift leftward.
B moves up until the
economy hasreturned to full-em lo ment at C.
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Recessionary Output Gap-
A is SR point. Y0 is belowY*.
LAS
Pricelevel
gap at A.
wage (price) level will SAS.
This will cause SAS to shiftto SAS to reach B, LR
ASAS
.
A to B will take a while asthe economy is self-correcting.
BAD
The government can usefiscal or monetary policy toshift AD to AD.
AD
The LR point is C, back tofull employment but at ahigher price level.
Y0 Y*
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AD-AS Model A is SR point. Y0 is
*
LASPricelevel
SAS.
a inflationary outputgap at A.
SAS
C will rise.
This will cause SAS to
shift to SAS to reach C,A
po nt. The government can
use fiscal or monetaryolic to shift AD to
D
AD. The new LR point is D,back to full employment
ADAD
level. Y0Y* Y
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Case 1: Increase in Y* A is LR point.
The LAScurve shifts
rightward because ofhigher productive
SAS0
capacity
A is now SR point. It has
a recessionar out ut
A
gap. Wages (prices) willfall.
SAS1
meet AD at LAS1
Higher output and lower
B
pr ce eve rom oY*Y*
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Case 1: Increase in Y*
From A to B is a longprocess. The
0
C
AD to AD and the LR
point is C.A SAS1
Back to fullemployment outputfaster but the rice
AD
level is higher. A to C is unlikely
B
ecause t s s a
case of higher Y*
Y*Y*
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Macroeconomic E uilibrium
Case 2: Shift in AD
An increase in aggregateSAS1
demand shifts the ADcurve
rightward.
C
,output gap. Wages (prices)will rise shifting SAS0 to
SAS A
C is the LR point.
A to B, output and prices
rise. From B to C, higherprice level.
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Case 2: Shift in AD
demand shifts the ADcurve rightward.
The best way to counterthe unexpected rise in
aggregate demand is to Apolicy to shift AD1 back toAD0.
Hence, there is no Cand the economy willmove from B to A.
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Macroeconomic Equilibrium
Workers demand
higher wages, shiftingSAS0 to SAS1.
Real GDP and P . B From A to B, the
economy experiences
sta flation. A
B is a SR point, arecessionary outputgap.
Wages will fall
SAS1 back to SAS0,
from B to A, back to
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Case 3: Rise in oil
prices
From B to A is a
long process.Unemployment B
C
level is notacceptable.
Most overnments Awill use fiscal ormonetary policy toshift AD to AD1. AD1
C is the LR point.Same output but
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schools of thought: Classical
Keynesian
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The Classical View
c ass ca macroeconom st e eves t at t e
economy is self-regulating and always at fullem lo ment.
The term classical derives from the name of the
founding school of economics that includes AdamSmith, David Ricardo, and John Stuart Mill.
A new classical view is that business cycleuc ua ons are e e c en responses o a we -
functioning market economy that is bombarded byshocks that arise from the uneven ace oftechnological change.
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The Keynesian View
eynes an macroeconom s e eves a e
alone, the economy would rarely operate at fullemployment and that to achieve and maintain fullemployment, active help using fiscal policy andmonetary policy is required.
The term Keynesian derives from the name of oneof the twentieth centurys most famous economists,John Ma nard Ke nes.
A new Keynesian view holds that not only is themoney wage rate sticky but the prices of goods arealso sticky.
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The Monetarist View
A monetarist is a macroeconomist who believesthat the economy is self-regulating and that it willnorma y operate at u emp oyment, prov ethat monetary policy is not erratic and that the
ace of mone rowth is ke t stead .
The term monetarist was coined by anoutstanding twentieth-century economist, Karl
Brunner, to describe his own views and those ofMilton Friedman.
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U.S. Inflation, Unemployment,
and Business Cycle
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In the 1970s, when inflation was raging at a double-
digit rate, Arthur M. Okun proposed a Misery Indexthe inflation rate plus the unemployment rate.
At its peak, in 1980, the misery index hit 22.
At its lowest, in 1953, the misery index was 3.
Inflation raises our cost of living.
Unemployment hits us directly or it scares us intothinking that we might lose our jobs.
We want low inflation and low unemployment.
Can we have both together? Or do we face a tradeoffbetween them?
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Starting from full
C
,increase in aggregatedemand moves us to
B
The price level rises, A
higher wages, thismoves us from B to
C. AD will shift up
pers s en y
Inflation Cycles
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Inflation Cycles
Process
A demand-pull inflationspiral goes from A to B to C
to D to E. D
increasing and the process
just described repeatsB
C
indefinitely.
Although any of several
A
aggregate demand to starta demand-pull inflation,on y an ongo ng ncrease nthe quantity of money can
sustain it.
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Cost-Push Inflation
An inflation that starts with an increase in costs iscalled cost- ush inflation.
There are two main sources of increased costs:
. 2. An increase in the money price of raw materials,
such as oil.
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The initial increase in costs creates a one-timerisein the price level, not inflation.
To create inflation, aggregate demand must
increase. That is, the Fed must increase the quantity of
money persistently.
Inflation Cycles
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Inflation Cycles
We are at A.
A rise in the price of oilcauses increase the cost
of living and workersdemand hi her wa es, B
C
the SAScurve shifts up,we move from A to B
t , recess onary gap
Suppose that the Fed
demand. This moves theeconomy from B to C.
Real GDP and P again
A Cost-Push Inflation Process
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A Cost Push Inflation Process
At D, workers againask for higher wages
E
responds byincreasing the MS (D
D
to E),
The combination of B
a r s ng pr ce eveand a decreasingreal GDP is called
A
stagflation (A to Band C to D).
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Fiscal Policy
PP.731-735
The Supply Side Effects of
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The Supply-Side Effects of
Fiscal Policy
Fiscal policy has important effects employment,
potential GDP, and aggregate supplycalled- .
An income tax changes full employment and
otential GDP.
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Fiscal policy actions that seek to stabilize theus ness cyc e wor y c ang ng aggrega e
demand.
Automatic
Discretionar fiscal olic is a olic action that isinitiated by an act of Congress.
Automatic fiscal policy is a change in fiscal policy
triggered by the state of the economy.
Stabilizin the Business C cle
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Stabilizin the Business C cle
Limitations of Discretionary Fiscal Policy
The use of discretionary fiscal policy is seriously
hampered by three time lags:
Recognition lagthe time it takes to figure outthat fiscal policy action is needed.
- pass the laws needed to change taxes orspending.
Impact lagthe time it takes from passing a tax orspending change to its effect on real GDP being.
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Automatic Stabilizers
real GDP without explicit action by the government.
Induced taxes and needs-tested spending areautomatic stabilizers.
Taxes that vary with real GDP are called inducedaxes.
When real GDP increases in an expansion, wages and,
taxesrise.
profits fall, so the induced taxes on these incomes fall.
Stabilizing the Business Cycle
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Stabilizing the Business Cycle
The spending on programs that pay benefits tosuitably qualified people and businesses is callednee s-teste spen ng.
When the economy is in a recession, unemployment-
unemployment benefits and food stamps increases.
When the econom ex ands unem lo ment fallsand needs-tested spending decreases.
Induced taxes and needs-tested spending decrease
the multiplier effects of changes in autonomousexpenditure.
and make real GDP more stable.
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Discretionary FiscalExpansionary Fiscal Policy
Fiscal policy mightclose a recessionary
.
An increase in
expenditure or a taxcut increases
The multiplier processincreases aggregate
eman urt er.
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A Reality Check
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y
Budget Deficit Over theBusiness Cycle
Figure (b) shows the
business cycle from1980 to 2005.
highlighted.
During a recession,the budget deficit
increases.
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Stabilizing the Business Cycle
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g y
This figureillustrates thedistinction between
a structural andc clical sur lus anddeficit.
In part (a), potentialGDP is $12 trillion.
As real GDPfluctuates aroundpotential GDP, ac clical deficit orcyclical surplus
arises.
Stabilizing the Business Cycle
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g y
Singapores position A B C
where there has been
budget surplus at full.
Some countries such
represented by Awhere at fullemp oymen , ere s
still budget deficit.
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Monetary Policy
Fight Recession with Monetary Policy
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A represents recession. Increase MS increasessupply of loanable funds in the short-term. Results
MS0Interestrate
SASLASMS1
A
B
AD MSMD
1
MY
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Loose Links and Long and Variable Lags
Long-term nterest rates t at n uence spen ng
plans are linked loosely to the federal funds rate.-
change in the nominal rate depends on how
inflation expectations change. The response of expenditure plans to changes in
the real interest rate depends on many factors thatma e t e response ar to pre ct.
The monetary policy transmission process is long
same way.
Monetary Policy Transmission
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A Reality Check When the Fed
ushes thefederal funds rate
abovethe long-term bond rate,e rea
growth rate slowsin the following
. When the Fed
lowers the federal
the long-termbond rate, the
rate speedsup inthe next year.
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Production function is the factor
But we want the aggregate supply curve
AD-AS model
Demand-pull inflation
Cost-push inflation
Budget deficits: Cyclical and structural
Which is better: fiscal or monetary?
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