Continued. Explain, using a diagram, why the short-run aggregate supply curve (SRAS curve) is upward sloping.

Transcription

1 Aggregate Supply

2 Continued Describe the term aggregate supply. Explain, using a diagram, why the short-run aggregate supply curve (SRAS curve) is upward sloping. Explain, using a diagram, how the AS curve in the short run (SRAS) can shift due to factors including changes in resource prices, changes in business taxes and subsidies and supply shocks. Explain, using a diagram, that the monetarist/new classical model of the long- run aggregate supply curve (LRAS) is vertical at the level of potential output (full employment output) because aggregate supply in the long run is independent of the price level. Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three sections because of wage/price downward inflexibility and different levels of spare capacity in the economy.

3 Continued Explain, using the two models above, how factors leading to changes in the quantity and/or quality of factors of production (including improvements in efficiency, new technology, reductions in unemployment, and institutional changes) can shift the aggregate supply curve over the long term. Equilibrium: Explain, using a diagram, the determination of shortrun equilibrium, using the SRAS curve. Examine, using diagrams, the impacts of changes in short- run equilibrium.

4 Continued Explain, using a diagram, the determination of long-run equilibrium, indicating that long-run equilibrium occurs at the full employment level of output. Explain why, in the monetarist/new classical approach, while there may be short-term fluctuations in output, the economy will always return to the full employment level of output in the long run. Examine, using diagrams, the impacts of changes in the long-run equilibrium.

5 Continued Explain, using the Keynesian AD/AS diagram, that the economy may be in equilibrium at any level of real output where AD intersects AS. Explain, using a diagram, that if the economy is in equilibrium at a level of real output below the full employment level of output, then there is a deflationary (recessionary) gap. Discuss why, in contrast to the monetarist/new classical model, the economy can remain stuck in a deflationary (recessionary) gap in the Keynesian model. Explain, using a diagram, that if AD increases in the vertical section of the AS curve, then there is an inflationary gap. Discuss why, in contrast to the monetarist/new classical model, increases in aggregate demand in the Keynesian AD/AS model need not be inflationary, unless the economy is operating close to, or at, the level of full employment.

6 Continued HL Only Explain, with reference to the concepts of leakages (withdrawals) and injections, the nature and importance of the Keynesian multiplier. Calculate the multiplier using either of the following formulae. 1/(1- MPC) 1 /(MPS + MPT + MPM) Use the multiplier to calculate the effect on GDP of a change in an injection in investment, government spending or exports. Draw a Keynesian AD/AS diagram to show the impact of the multiplier.

7 Links to Theory of Knowledge The Keynesian and Monetarist positions differ on the shape of the AS curve. What is needed to settle this question: empirical evidence (if so, what should be measured?), strength of theoretical argument, or factors external to economics such as political conviction?

8 Introduction to Aggregate Supply

9 As we studied before, AD is the total output produced in a nation. AD=C+I+G+(X-M) This will affect households, firms and governments budget An increase in output will lead to an outward shift in the AD curve and vise versa

10 Definition: Aggregate Supply: The total output produced by the firms in a nation at a range of price levels in a given period of time.

11 Similarities to Microeconomics Increase in price levels= increase in output Decrease in price levels= decrease in output

12 The Aggregate Supply Curve The aggregate supply curve is generally upward sloping. For our analysis, we will consider the short-run aggregate supply curve and the long-run aggregate supply curve. PL LRAS SRAS real GDP Y fe

13 Short-run aggregate supply (SRAS): Illustrates the relationship between the price level of a nation s output and the level of output produces in the fixed-wage and price period, which is the period of time following a change in aggregate demand over which

14 Long-run aggregate supply (LRAS): Illustrates the relationship between the price level and the level of output in the flexible-wage and price period, which is the period of time following a change in aggregate demand over which all

15 Test Your Knowledge In your groups, Answer the following questions Post on edmodo Refer to googledocs for appropriate answer Describe the term aggregate supply. Explain, using a diagram, why the short-run aggregate supply curve (SRAS curve) is upward sloping. Explain, using a diagram, how the AS curve in the short run (SRAS) can shift due to factors including changes in resource prices, changes in business taxes and subsidies and supply shocks.

16 Competing Views of Aggregate Supply

17 The neo- classical View of Aggregate Supply: The ver'cal, LRAS curve reflects the theories of a school of economic thought known as the new (or neo)- classical school of economics. Click Here to read on the neo- classical views In the new- classical view, the aggregate supply curve is always VERTICAL PL LRAS real GDP Y fe

18 Read The Classical view of Aggregate Supply: During the boom era of the Industrial Revolu'ons in Europe, Britain and the United States, governments played a rela'vely small role in na'on s economies. Economic growth was fueled by private investment and consump'on, which were lee largely unregulated and unchecked by government. When labor unions were weak and minimum wages and unemployment benefits were unheard of, wages fluctuated depending on market demand for labor. When spending in the economy was strong, wages were driven up and firms restricted their output in response to higher costs, keeping output near the full employment level. When spending in the economy was weak, firms lowered workers' wages without fear of repercussions from unions or government requiring minimum wages. Flexible wages meant labor markets were responsive to changing macroeconomic condi'ons, and economies tended to correct themselves in 'mes of excessively weak or strong aggregate demand. The Classical view of aggregate supply held that lee unregulated, a week or over- hea'ng economy would "self- correct" and return to the full- employment level of output due to the flexibility of wages and prices. When demand was weak, wages and prices would adjust downwards, allowing firms to maintain their output. When demand was strong, wages and prices would adjust upwards, and output would be maintained at the full- employment level as firms cut back in response to higher costs.

19 The Keynesian View of Aggregate Supply: The upwards sloping, SRAS curve reflects the theories of a school of economic thought known as the Keynesian school. Click here to read on the Keynesian view In the Keynesian view, AS is horizontal below fullemployment and vertical beyond full employment! PL SRAS real GDP Y fe

20 Read The Keynesian View of Aggregate Supply: John Maynard Keynes was an English economist who represented the Bri'sh at the Versailles treaty talks at the end of WWI. During the Great Depression, Keynes no'ced that, in contrast to what the neo- classical economists thought should happen, the world s economies were not self- correcfng. Keynes believed that during a 'me of weak spending (AD), an economy would be unable to return to the full- employment level of output on its own due to the downwardly inflexible nature of wages and prices. Since workers would be unwilling to accept lower nominal wages, and because of the role unions and the government played in protec'ng worker rights, the only thing firms could due when demand was weak was decrease output and lay off workers. As a result, a fall in aggregate demand below the full- employment level results in high unemployment and a large fall in output. To avoid deep recession and rising unemployment aeer a fall in private spending (C, I, Xn), a government must fill the "recessionary gap" by increasing government spending. The economy will NOT "self- correct" due to "s'cky wages and prices", meaning there should be an ac've role for government in maintaining full- employment output.

21 AS Curves PL The Keynesian view AS PL The Classical view AS real GDP Y fe Y fe real GDP

22 In reality, neither view is totally correct. Keynes was right in the short-run, because wages and prices tend not to adjust quickly to changes in the level of demand. The new-classicals are rights in the long-run, because over time, following a decrease or an increase in AD, wages and prices tend to rise or fall accordingly. causing output in the nation to return to a relatively constant, full-employment level, regardless of the level of AD.

23 Discussion: Discuss with your partner and answer the following question: Why does the SRAS curve slopes upward? Why does the LRAS curve is vertical? Post your answer on Edmodo

24 Test Your Knowledge In your groups, answer the following questions Post your answers on edmodo Refer to googledocs for appropriate answers Explain, using a diagram, that the monetarist/new classical model of the long- run aggregate supply curve (LRAS) is vertical at the level of potential output (full employment output) because aggregate supply in the long run is independent of the price level. Explain, using a diagram, that the Keynesian model of the aggregate supply curve has three sections because of wage/price downward inflexibility and different levels of spare capacity in the economy.

25 Short-run Aggregate Supply

26 The Keynesian theory of rela'vely inflexible wages and prices is reflected in the short- run aggregate supply curve which is rela'vely flat below full employment (Yfe) and rela'vely steep beyond full employment.

27 Explanation for the shape of SRAS Slopes upwards because at higher prices, firms respond by producing a greater quantity of output As price level falls, firms respond by reducing output At low levels of output (when unemployment is high), firms are able to attract new workers without paying higher wages, so prices rise gradually as output increases

28 At high levels of output, when resources in the economy are fully employed, firms find it costly to increase output as they must pay higher wages and other costs. Increases in output are accompanied by greater and greater levels of inflation as an economy approaches and passes full employment See the graph in the next slide

29 PL SRAS P 4 P fe P 3 P 2 P 1 Y 1 Y 2 Y 3 Y 4 real GDP Y fe

30 Long-run Aggregate Supply

31 The new- classical view of AS is reflected in the ver'cal, long- run AS curve, which shows that output will always occur at the full employment level (Yfe).

32 Explanation for the shape of LRAS AS is vertical at the full-employment level of output (Yfe), implying that whatever the level of AD, the economy will always produce at full employment. When AD is very low, wages and prices fall so that firms can continue to employ the same number of workers and produce the same output. Output will not decrease when AD decreases

33 When AD is very high, firms will see wages rising and therefore they will NOT hire more workers, and will just pass their higher costs onto buyers as higher prices. Output will not increase when AD increases Wages and prices must be completely flexible in the long-run for Yfe to always prevail

34 PL LRAS SRAS P 4 P fe P 3 P 2 P 1 Y 1 Y 2 Y 3 Y 4 real GDP Y fe

35 Discussion With your partner, distinguish between the SRAS and LRAS

36 The Determinants of Aggregate Supply A change in AD is not the only factor that can lead to a change in an economy s short- run equilibrium level of output. AS can also shie, if one of the determinants of aggregate supply changes.

37 IMPOETANT (test question) The Determinants of Aggregate Supply: When any of the following change, aggregate supply will either decrease and shie inwards (or up, graphically) or decrease and shie outwards (or down, graphically).

38 Wage rates: The cost of labor. Higher wages cause SRAS to decrease, lower wages cause SRAS to increase Resource costs: Rents for land, interest on capital; as these rise and fall, so does AS Energy and transportabon costs: Higher oil or energy prices will cause SRAS to decrease. If costs fall, SRAS increases Government regulabon: Regula'ons impose costs on firms that can cause SRAS to decrease

39 Business taxes: Taxes are a monetary cost imposed on firms by the government, and higher taxes will cause SRAS to decrease Exchange rates: If a country s producers use lots of imported raw materials, then a weaker currency will cause these to become more expensive, reducing SRAS. A stronger currency can make raw materials cheaper and increase AS.

40 Short-run Equilibrium in the AD/AS Model Full Employment By considering both the aggregate supply AND the aggregate demand in a na'on, we can analyze the levels of output, employment and prices in an economy at any par'cular period of 'me PL LRAS SRAS P fe AD 1 real GDP Y fe

41 Consider the economy shown here: When equilibrium occurs at full-employment: The total demand for the nation s output is just high enough for the economy to produce at its full employment level in the short-run. Nearly everyone who wants a job has a job and the nation s capital and land are being fully utilized. Unemployment is at its Natural Rate (the NRU)

42 Since the economy is at full-employment, we can assume that the macroeconomic objectives are being met: Ø Price level stability, Ø Full employment Ø Economic growth. PL LRAS SRAS P fe See graph AD 1 real GDP Y fe

43 What happens if the AD falls?

44 Short-run Equilibrium in the AD/AS Model AD decreases On the previous slide we say an economy that was producing at its full employment level, e.g. a strong, healthy economy. But what if something changed, and AD fell due to a fall in consumpfon, net exports, investment or government spending?

45 Explaining the graph (test) At AD2: A fall in expenditures has caused AD to decrease to AD2 PL LRAS SRAS In the short-run, firms will fire workers and reduce output to Y2. Price level fall, but only slightly, to P2 P fe The economy is no longer at full employment, and is in a demand-deficient recession at Y2. Ø Price level has fallen slightly Ø Employment has decreased Ø National output has decreased, there is a recessionary gap equal to the difference between actual output and full-employment output P 2 Y 2 Y fe Recessionary Gap AD 1 AD 2 real GDP

46 What happens when the AD decreases in the LR equilibrium?

47 Long-run Equilibrium in the AD/AS Model: AD decreases When AD decreases, output will decrease in the short- run because firms will have to lay workers off to cut costs and lower their prices. However, in the long- run, wages and prices are flexible, so output will return to its full employment level.

48 At AD2 in the long-run: Over time, unemployed workers will begin accepting lower wages, which will reduce production costs for firms At lower wage rates, SRAS increases to SRAS1, firms begin hiring back the workers they fired when AD first fell Output will return to Yfe, and prices will fall to P fe1. The economy self-corrects in the long-run Ø Output returns to full employment Ø Wages are lower, but prices are too Ø The economy recovers on its own from the recession in the long-run PL P 2 P fe 1 Y 2 real GDP LRAS SRAS SRAS 1 AD 1 AD 2 Y fe

49 What happens when the AD increases in the SR equilibrium?

50 Short-run Equilibrium in the AD/AS Model AD increases Assume that either consumpfon, investment, net exports or government spending increased, causing the AD curve to shie from AD1 to AD3 PL LRAS SRAS P 3 P fe AD 3 AD 1 real GDP Y fe Y 3 Inflationary Gap

51 The Graph At AD3: An increase in demand led to firms wanting to produce more output, which increases to Y3. Wages are relatively inflexible in the shortrun, so firms can hire more workers, and the economy produces beyond its full employment level. The economy experiences demand-pull inflation Ø Price level has risen due to greater demand for the nation s output Ø Employment has increased Ø The economy is beginning to overheat, and there is an inflationary gap equal to the difference between actual output and fullemployment output PL P 3 P fe real GDP LRAS SRAS AD 3 AD 1 Y fe Y 3 Inflationary Gap

52 What happens when the AD increases in the LR equilibrium?

53 Long-run Equilibrium in the AD/AS Model AD increases In the long- run, wages and prices will adjust to the level of aggregate demand in the economy. When AD grows beyond the full employment level, this means wages will rise in the long- run leading producers to reduce employment and output back to the full- employment level

54 The Graph At AD3 in the long-run: Demand for resources has driven up their costs (wages, rents, interest have all risen) Facing rising costs of production, firms begin reducing employment and output, and passing higher costs onto consumers as higher prices. Output returns to Yfe, and price level rises to P fe3 Ø The economy has self-corrected from the rising AD Ø Output is back at its full-employment level Ø There is more inflation in the economy (higher price levels) PL P fe 3 P 3 real GDP LRAS SRAS 1 Y fe SRAS AD 1 AD 3

55 More stuff on AS Almost done, I promise

56 Negative Supply Shocks -Stagflation- Assume that a determinant of AS changes which causes the short- run aggregate supply curve to decrease, and shie to the lee. What results is a situa'on known as stagfla&on DEFENIITON: Stagflation, An increase in the average price level combined with a decrease in output, caused by a negative supply shock. Stagnant growth and inflation together make stagflation

57 The Graph Assume higher energy costs caused SRAS to decrease to SRAS 2. To off-set higher energy costs, firms must lay off workers, reducing employment. Higher costs must be passed onto consumer as higher prices, causing inflation. An economy facing stagflation will only self-correct if resources costs fall in the long-run, which may occur if wages fall due to a large increase in unemployment. PL P 2 P fe Y 2 real GDP LRAS SRAS 2 Y fe SRAS 1 AD

58 Positive Supply Shock -Economic Growth- While a nega've supply shock can be disastrous for an economy, a posi've supply shock has very beneficial effects on employment, output and the price level. Assume,for example, a na'on signs a free trade agreement and now lots of new resources can be imported at very low costs.

59 The Graph LRAS SRAS increases to SRAS 3 : Cheaper resource costs allow firms to produce more output with the same amount of workers and capital. Lower costs are passed onto consumers as lower prices, Pfe falls to P3 Output increases to Y3, indicating shortrun economic growth has occurred. If the lower costs remain permanent, then eventually LRAS will increase and Y3 will become the new full-employment level of output, indicating long-run economic growth PL P fe P 3 real GDP Y fe Y 3 SRAS 1 SRAS 3 AD

60 Long-run Economic Growth in the AD/AS Model So far we have illustrated demand- deficient recessions, demand- pull inflafon, negafve and posifve supply shocks. But real, long- run economic growth requires that not only AS or AD increase, rather that both AS AND AD increase.

61 The Graph Long-run Economic Growth: For national output to grow in the long-run, AD, SRAS and LRAS must all shift outward. This can be cause by an improvement in the production possibilities of the nation, combined with growing demand for the nation s output. The quality and/or quantity of resources must increase: Ø Better technology, Ø Larger population, Ø Better educated workforce, Ø More natural resources, and so on. PL P fe LRAS 1 Y fe1 real GDP LRAS 2 SRAS 1 SRAS 2 AD 1 AD 2 Y fe2

62 Video Watch the Video and answer the following questions on edmodo Refer to googledocs for appropreate answer

63 Test Your Knowledge Explain, using a diagram, the determination of short-run equilibrium, using the SRAS curve. Examine, using diagrams, the impacts of changes in short- run equilibrium. Explain, using a diagram, the determination of long-run equilibrium, indicating that long-run equilibrium occurs at the full employment level of output. Explain why, in the monetarist/new classical approach, while there may be short-term fluctuations in output, the economy will always return to the full employment level of output in the long run. Examine, using diagrams, the impacts of changes in the long-run equilibrium.

64 Practice questions: HWK.. Test Prep IB Econ, Jason Welker Page 284

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