Chapter 10 homework

• Number 4: Kyoko Yamashita

• Number 7: Harry Keyser

• Number 11: Audrey Stawecki

• Number 12: Scott Anderson

• Number 18: Michael Schwager

• Alternate: Trevor Thomas

Chapter 11

From Short-Run to Long-Run Equilibrium: The Model in Action

Curing an Underperforming or Overheating Economy

• We can use the long-run model to explain how the macroeconomy self-adjusts to two major problems: An underperforming economy (recessionary gap) An overheating economy (inflationary gap)

• Hint: it is all about SRAS…

The Underperforming Economy and Recessionary Gaps

• Symptoms of an underperforming economy: High equilibrium price level

Real GDP is below the full employment level.• Recessionary Gap

Unemployment is above the full employment level.

Figure 11.4(a) The Underperforming Economy: Identification and Elimination of the Recessionary Gap

Curing the Underperforming Economy

• Excess unemployment puts downward pressure on the nominal wage rate. Decreases costs of production.

• Falling costs increase the profit potential

• Producers respond by increasing output. The short-run aggregate supply curve shifts

to the right.

Figure 11.4(b) The Underperforming Economy: Identification and Elimination of the Recessionary Gap

Curing the Underperforming Economy

• What does the adjustment process do? increases real GDP, reduces the actual

unemployment rate, and causes the price level to fall.

• Gets us back to LR equilibrium

The Overheating Economy and Inflationary Gaps

• Symptoms of an overheating economy: Increasing incomes put upward pressure on the price

level.

Real GDP is above the full employment level.• Inflationary Gap

Unemployment is below the full employment level.

Figure 11.5(a) The Overheating Economy: Identification and Elimination of the Inflationary Gap

Curing the Overheating Economy

• An overheating economy will put upward pressure on nominal wages and resource prices. Increase firm’s costs of production.

• Higher costs reduce profits, causing firms to reduce output. The short-run aggregate supply curve shifts to

the left.

Figure 11.5(b) The Overheating Economy: Identification and Elimination of the Inflationary Gap

Curing the Overheating Economy

• What does the adjustment process do? reduces real GDP, increases unemployment and

causes the price level to rise.

• Gets us back to LR equilibrium

Can we do it? (number 15)

• In each case, identify which type of gap is being described: The full employment unemployment rate is

greater than the actual unemployment rate Full employment real GDP is greater than

actual real GDP The major economic problem is

unemployment When this gap is removed in the long run, the

price level rises and real GDP falls

Real-World Difficulties of the Long-Run Model

• Determining the length of the long-run period: Production decisions by firms are not

made immediately.

Firms and workers may initially overestimate or underestimate the necessary adjustments.

Real-World Difficulties of the Long-Run Model (cont’d)

• Estimating the full employment level of output: The full employment level of output can be a moving

target over time, increasing or decreasing with changes in resources and technology.

Different perceptions of full employment will lead to different predictions about the behavior of the economy.

• Does it seem that our government sits back and lets things happen?

Figure 11.6 Conflicting Estimates of Full Employment Real GDP

Chapter 11 Homework

• Number 1, 4, 8, and 14

Chapter 12

The Role of Aggregate Demand in the Short Run

Emergence of the Keynesian Short-Run Model

• Classical economists thought that an economy will self-adjust to any problems. Economy will always be at or near

full employment. Called the Long Run Economic Model

• The Great Depression set the stage for a new short-run economic model.

The Great Depression’s Challenge to the Long-Run Model

• Most severe economic trauma in U.S. history. From 1929 to 1933, the unemployment rate

increased from about 3% to almost 25%.

By 1933, real GDP had fallen by almost 27%.

Marriage and birth rates fell.

Participation in radical political movements increased.

Fear was fostered by not knowing what was happening or how to fix it.

The Great Depression’s Challenge to the Long-Run Model (cont’d)

• Following the long-run economic model, the belief was that the economy would eventually cure itself. However, during the1930s it didn’t seem to be

working

• The nation’s short-run suffering required immediate action.

The Keynesian Short-Run Model Emerges• John Maynard Keynes was a professor of

economics at Cambridge University in England.

The Keynesian Short-Run Model Emerges (cont’d)

• Keynes’ book, The General Theory of Employment, Interest and Money, was published in 1936. Arguably the most important

economics book of the 20th century

It challenged the accepted long-run macroeconomic model.

The Keynesian Challenge to the Long-Run Model

• The Keynesian model is a short-run model of the behavior of the macroeconomy that: Emphasizes the role of aggregate demand and

government action in the macroeconomy

Questions the validity of the long-run model as an effective guide for macroeconomic policy

The Keynesian Challenge to the Long-Run Model (cont’d)

• Compared to the Classical long-run model, the Keynesian model: Is concerned with the short run

• “In the long run, we’re all dead.”

Focuses on aggregate demand• Can be shaped by policy

Suggests that the economy could remain below full employment for prolonged periods• Because markets don’t adjust quickly

Promotes government stabilization policy

The Keynesian Model and Economic Policy

• In 1933, President Roosevelt proposed—and Congress passed—a wide variety of economic legislation designed to stabilize the economy and put people back to work. Roosevelt was unwilling for the economy to “fix

itself”.

Characteristics of the Short-Run Model

• Major belief is that full employment is the exception rather than the rule. Advocates an aggressive approach to economic

policy that attacks and cures short-run problems quickly and effectively.

Characteristics of the Short-Run Model (cont’d)

• Three pillars of the model Each is a contradiction of a characteristic of the long-

run model.

• Challenges: Say’s Law The loanable funds market Flexible prices and wages

Challenge to Say’s Law

• Say’s Law = “supply creates its own demand.”

• Keynes taught that demand creates its own supply. Aggregate demand motivates firms

•Produce a good only if there is a demand for it.

If something is wrong with the economy, it’s due to a problem with aggregate demand.

Challenge to the Loanable Funds Market

• Long-run model interest rate adjusted so that the quantity supplied of funds equals the quantity demanded of funds.

Saving was channeled into investment spending.

• Short-run model no mechanism converts saving to investment spending.

• Factors other than the interest rate can also influence saving and investment:

Disposable income has a major impact on saving. Expected return on investment affects the decision to invest.

Challenge to Price and Wage Flexibility

• Long-run model freely adjusting prices and wages. Based on an economy comprised of small,

competitive firms, workers negotiating their own wages, and minimal government.

• Short-run model prices and wages are “sticky downward.” Based on an economy characterized by:

• Large firms with some control over the prices they charge

• Workers represented by strong unions with the power to negotiate wages and other benefits

Price Inflexibility

• Long-run model AD decline leads to lower prices as the short-run aggregate supply curve shifts to the right. Firms are not required to reduce output

or employment.

• Short-run model little pressure for firms to cut prices. AD declines firms cut output and employment. Unless and until prices adjust, the economy will

remain below full employment.

Wage Inflexibility

• long-run model decline AD workers accept lower nominal wages to keep their jobs.

• short-run model workers resist accepting lower wages. Wage stickiness doesn’t allow the economy to self-

adjust to a decline in aggregate demand.

• Employers will ultimately have to lay off some workers.

The Importance of Aggregate Demand in the Short Run

• The long-run model aggregate supply runs the economy and cures for any economic problems.

• Keynesian short-run model aggregate demand causes and cures economic problems.

Figure 12.1(a) Impact of Changing Aggregate Demand on Short-Run Equilibrium

Figure 12.1(b) Impact of Changing Aggregate Demand on Short-Run Equilibrium

Changes in Aggregate Demand

• Changes in aggregate demand can result from Consumption Investment Government Spending Net Exports C+I+G+(X-M)

The Role of Consumption

• Consumption Is the largest component of aggregate

demand in the United States

Represents about 70% of total GDP

Is very stable and difficult to change

The Role of Consumption

• Factors that can affect consumption: Household wealth and debt Consumers’ optimism or pessimism about

the future The level of real interest rates The overall price level Households current stock of durable goods

Consumption and Income

• Most important determinant is disposable income. Income that remains after all taxes

are paid

•As disposable income increases, households generally spend more dollars.

•But…they spend a smaller percentage of each additional dollar of disposable income.

MPC

Change in Consumption

Change in Disposable Income

CDI

Consumption and Income (cont’d)

• The marginal propensity to consume (MPC) is the fraction of additional income that is spent on consumption:

Example: Suppose a family receives a $600 tax cut, of which it spends $400 on consumption goods.

The MPC is then $400/$600 = .67

MPS

Change in Saving

Change in Disposable Income

SDI

Consumption and Income (cont’d)

• The marginal propensity to save (MPS) is the fraction of additional income that is saved:

Example: Suppose a family receives a $600 tax cut, of which it saves $200.

The MPS is then $200/$600 = .33

Consumption and Income (cont’d)

• The value of the MPC plus the value of the MPS must equal 100%

• Disposable income can only be consumed or saved.

Can we do it? (number 4)

• Based on the following information calculate the MPC

What is the MPS for this sample household?

If the income increases to $12,900 and the MPC remains the same what will be the amount of consumption at the new level of income?

Income Consumption

$12,000 $12,100

$12,300 $12,350

$12,600 $12,600

Answer anyone??• The MPC and MPS for this household

are:

83.0300

250

IncomeinChange

CinChangeMPC

17.083.011 MPCMPS

1284924912600

249

)1260012900(83.0

C

C

CI

CMPC

The Role of Investment

• Unlike consumption, investment can and does easily change.

• Depends on: Business expectations about economic

performance Interest rates Tax policies

The Role of Investment

• Can be easily but not reliably changed. Not a good candidate for policy makers who

want to change aggregate demand.

The Role of Net Exports

• The amount of net exports is determined by: The value of the dollar

• If the dollar appreciates, U.S. imports would increase and U.S. exports would decrease.

•But value is determined in a huge market, policy makers can’t do much to affect its value.

The economic health of other nations•Cannot be influenced by U.S. policy makers

The Role of Government

• So…it is hard to use consumption, investment or net exports to alter aggregate demand.

• So…Keynes concluded that it was up to the government to use its own spending and taxes to change aggregate demand.

• The government could: Be the spender of last resort, or Cut taxes to encourage consumption.

Summary

• The long-run model predicts that real-world economies will adjust to equilibrium at the full employment level of real GDP. The Great Depression demonstrated the

shortcomings of the long-run model.

The Keynesian short-run model emerged as an explanation of and a cure for macroeconomic problems.

Chapter 12 homework

• Numbers 5, 10, 13, and 15