The session previously discussed important variables such as inflation, unemployment and GDP. We also alluded to factors that cause economic growth

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1 The session previously discussed important variables such as inflation, unemployment and GDP. We also alluded to factors that cause economic growth enabling us to produce more and more to achieve higher standard of living over time. However, keeping in line the historical data on growth, we also know that economic prosperity is not consistently enjoyed in every year. Key variables such as unemployment rate, inflation and GDP fluctuate over time. Periods when GDP falls over a significant period of time is classified as recession and a depression when these economic fluctuations are more severe. Times when GDP is growing is referred to as economic boom or expansion. In order to better understand fluctuations in output and the policy instruments available to correct these we will introduce the model of aggregate demand and aggregate supply. 1

2 1) Before proceeding with the analysis of economic fluctuations, we need to master some important properties. The term used by economists to capture the notion of fluctuation in economic activity is referred to as business cycle. When the GDP is contracting, we refer to this as a downturn in the business cycle and if the fall in GDP occurs for two consecutive quarters then it is classified as a recession. During a recession many businesses experience a fall in sales and as a result downturns are related to increasing unemployment. Periods of growth in GDP are referred to as expansionary phases of the business cycle. During an expansion many business experience a rise in sales and as a result expansions are related to decreasing unemployment. Even though the term business cycle suggests that there is a predictable pattern to these changes, the truth is that business cycles are highly unpredictable. 2) In most economies around the world, real GDP is commonly used to measure economic fluctuations. Real GDP measures the value of all final goods and services produced within a given time period. However, since GDP is also equal to national income, in times of recession measures of personal income and profit also show a drop. So does consumer spending and a variety of sales figures. Investment spending is particularly prone to massive fluctuations and recessions are commonly triggered by a fall in investment 2

3 expenditure. 3) Unemployment is positively correlated with changes in output. When the economy is experiencing a recession then firms are producing a smaller quantity of goods and services and GDP declines. The firms, therefore, lay off workers. This effect is generally not immediate and there is a time lag between any downturn in economic activity and a rise in unemployment as firms will be reluctant to lay off workers immediately. Similarly when the economy recovers, firms will generally hold back on hiring unless they are confident that sales have resumed significantly. 2

4 Before explaining the fluctuations in output, we need to separate the economy into short run and long run time period. We first analyse the economy in the short run using aggregate demand (AD) and aggregate supply (AS) diagram. The model of short run fluctuations focuses on two variables- real GDP and price level. In this model we are referring to the overall price level not the price of one particular good or service. The overall price level can be measured using CPI and GDP deflator. The price level is represented on the vertical axis and the output is represented on the horizontal axis. 3

5 The aggregate demand curve shows the quantity of goods and services that consumers, firms, foreign sector and government want to buy at different price level. 4

6 The aggregate supply curve shows the quantity of goods and services and prices from the seller s perspective. As price level increases firms produce more and therefore the aggregate supply curve is upward sloping. The rate of change in price level is inflation. Some models of AD-AS sometimes use inflation instead of price level. For our purposes we will use price level. 5

7 The diagram shows the downward sloping aggregate demand curve. By now we should be able to interpret that the diagram is showing aggregate demand at different price levels and as price level reduces aggregate demand increases, holding everything else constant. Once we have interpreted the meaning of the graph, we can proceed to ask the question about why this is the case. At this point recall GDP=Y=C+I+G+NX. Each of these components contribute to the aggregate demand curve. For the moment lets assume that government expenditure is fixed by policy. 6

8 The three main effects that explain why AD curve slopes downward are: Wealth effect (C ) Interest-rate effect (I) Exchange-rate effect (NX) 7

9 The wealth effect captures the effect of changes in price level on purchasing power. As price level falls, for example, the purchasing power of consumers and businesses increases. Even though the amount of cash consumers hold has not changed, people are simply wealthier because of fall in the price level. This leads to greater expenditure- boosting consumption expenditure in particular and causing a movement along the AD curve. 8

10 A lower price level also implies that households require less money to buy the goods and services they want. This means that households have excess holdings of cash, which they can use to buy interest bearing bonds or lend the excess money by putting it in interest bearing account, which can be used by the bank to make loans. The injection of funds in the loan market leads to lower interest rates (which is essentially the price of borrowing). Lower interest rates attract greater investment by firms and thus boost aggregate demand. 9

11 A fall in price level lowers the interest rate. As interest rate reduces, this pushes exchange rate down. For example, if interest rates reduce in Australia then investment in Australia becomes less attractive pushing exchange rate down. This is because as foreign investment becomes less attractive, foreigners will demand less of Australian dollar. This will lower the exchange rate in the foreign exchange market. A lower exchange rate will boost exports as exports are relatively cheaper and reduce imports as imports are relatively more expensive and hence stimulate aggregate demand. A lower price level will also make domestic goods more attractive, therefore increasing exports and reducing imports. 10

12 To summarise the AD curve is inversely related to the price level. A fall in price level, will increase AD and an increase in price level will reduce AD. The main reasons for the downward slope of AD curve is due to the wealth effect, interest rate effect and exchange rate effect. 11

13 The graph on the slide above shows the inverse relationship between AD and price level. A fall in the price level from P 1 to P 2 increases the quantity of goods and services demanded from Y 1 to Y 2. There are three reasons for this negative relationship. As the price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. These effects stimulate spending on consumption, investment, and net exports. Increased spending on any or all of these components of output means a larger quantity of goods and services demanded. 12

14 The inverse relationship between price level and AD is based on ceteris paribus assumption which means that the AD curve s relationship with price level is drawn holding everything else constant. However, many other factors cause a shift in the AD curve. Some of these include: Changes in consumption, C Changes in investment, I Changes in government purchases, G Changes in net exports, NX 13

15 Change in consumption pattern is one of the most important variable impacting the AD curve. Any factor that changes how much people want to consume at a given price level, shifts AD curve. Note that we have already discussed the changes in consumption due to changes in price level in the previous slides. A change in consumption pattern due changes in price level results in the movement of AD curve, not a shift. Suppose people for some reason become pessimistic about the future, then they will reduce consumption at each and every price level causing AD to shift to the left. Similarly a stock market boom will boost people s confidence levels about the future and thus increase consumption at all price levels. So AD shifts to the right. Changing government policy, such as taxes can also have profound effects on the AD curve. For example a cut in taxes will mean that people will have more to spend and therefore AD will shift to the right. The opposite will occur is there is an increase in taxes. 14

16 Any event that changes how much firms want to invest at a given price level also shifts the aggregate demand curve. Firm s primary motive for investment is profit. Anything, other than the price, that changes firms relationship between investment and profits will cause a shift in investment demand. Suppose the advent of faster broadband network makes firms want to invest in new high-tech industries because the availability of new technology opens the possibility of new product development and hence greater profits in the future. This will cause AD to shift to the right. Entrepreneurs expectations form another important factor in investment demand. If the firms are pessimistic about the future then they are unlikely to invest, shifting the AD curve to the left. Similarly, higher tax rate may make investment less profitable and therefore investment may go down causing AD to shift to the left. A more complex relationship exists between interest rate and investment expenditure. As discussed earlier if there is a change in price level then this causes a change in the interest rate and therefore investment and is represented by a movement along the AD curve. But if the central bank changes the stock of money supply which also influences aggregate demand then this shifts the AD curve. This is represented as a shift in the AD curve because for the given price level the relationship between firms investment demand and hence AD has changed. An increase in the money supply lowers 15

17 the interest rate in the short run. This makes borrowing less costly, which stimulates investment spending and thereby shifts the aggregate demand curve to the right. Conversely, a decrease in the money supply raises the interest rate, discourages investment spending, and thereby shifts the aggregate demand curve to the left. 15

18 If policy makers change government spending at the given price level then AD demand shifts. Some examples of government policies that can shift the aggregate demand to the right include increased spending on roads, hospitals, education, salaries of public servants etc. 16

19 Any event that changes the level of net exports for a given price level also shifts aggregate demand. For example, a recession in China causes a decline in demand of Australian resources. This will lead to a decline in AD as exports go down. At the same time Australians increase their demand for foreign goods then AD shifts to the left as well because imports increase. A movement in exchange rate, for a given price level, will also shift the AD curve. A rise in the value of Australian dollar, for example, makes Australian exports less attractive and imports more attractive causing a shift in the AD curve to the left as NX falls. 17

20 We now move to aggregate supply side of the equation. The aggregate supply captures the total amount of goods and services being produced in the economy. Unlike the aggregate demand curve, the aggregate supply analysis depends on the time horizon. We will look at the aggregate supply for two time horizons- short term and long term. 18

21 The long run aggregate supply curve (LRAS) of the economy is vertical. In the long run, the quantity of output supplied depends on the economy s quantities of labor, capital, and natural resources and on the technology for turning these inputs into output. Because the quantity supplied does not depend on the overall price level, the long-run aggregate-supply curve is vertical at the natural level of output. Another way to think of long run aggregate supply curve is that this is the level of output at which the economy is employing all its resources- land, labor, capital and technology at a normal rate. At the long run level of output, unemployment is at its natural rate. It is the point where the economy is fully realizing its potential and therefore LRAS also represents potential output. To summarise LRAS represents the level of output when the economy is employing all its resources fully and the level of unemployment is at its natural rate. Thus, the level of output in the long run is also known as full employment output, natural rate of output and potential output. 19

22 The LRAS will shift if there is any change in the productive capacity of the economy. The shift in LRAS normally arises from changes in labor, capital, natural resources and technology. 20

23 Suppose due to immigration the quantity of labour increases in the economy. As a result the capacity of the economy to produce goods and services increases and LRAS shifts to the right. A change in the natural rate of unemployment can also shift LRAS. Suppose due to technological innovations the natural rate of unemployment reduces, this causes LRAS to shift to the right. Or a rise in unemployment benefits will increase the natural rate of unemployment and hence, LRAS will shift to the left. Changes in capital stock will also change the productive capacity of the economy. This applies to both physical and human capital. An increase in the number of educated people increases the economy s productive capacity and so does investment in capital goods, shifting LRAS to the right. 21

24 An economy s production capacity depends on the level of resources available. Any changes in the level of natural resources available will have an impact on LRAS. For example, discovery of new oil resources will shift LRAS to the right. Severe weather events that reduce the economy s natural resources will shift LRAS to the left. 22

25 Technological innovation has been one of the most important factors impacting the LRAS in the last few decades. The advent of computers and internet, for example, shifted the LRAS curve to the right. Although not directly related to the technology, other factors such as international trade and government regulation can also impact the LRAS. 23

26 Most economies have experienced both an increase in output and price level over time. This can be represented by Aggregate demand and LRAS curve. As the economy becomes better able to produce goods and services over time, primarily because of technological progress, the long-run aggregate-supply curve shifts to the right. At the same time, as the central bank increases the money supply, the aggregate-demand curve also shifts to the right. In this figure, output grows from Y 1990 to Y 2000 and then to Y 2010, and the price level rises from P 1990 to P 2000 and then to P Thus, the model of aggregate demand and aggregate supply offers a new way to describe the classical analysis of growth and inflation. 24

27 What we have seen so far is the long run behaviour of the economy. In the short run the aggregate supply behaves slightly differently. In the short-run: Increase in overall level of prices in economy Tends to raise the quantity of goods and services supplied Decrease in level of prices Tends to reduce quantity of goods and services supplied 25

28 In the short run, a fall in the price level from P 1 to P 2 reduces the quantity of output supplied from Y 1 to Y 2. This positive relationship could be due to sticky wages, sticky prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary. 26

29 The upward sloping aggregate supply curve is partly a response to sticky wages. The sticky wage theory argues that nominal wages are slow to adjust. Wages are normally agreed to in advance and so if the price level fall and nominal wages remain the same, this in effect implies that real wages have increased. Because wages are a large part of the firms costs, an increase in real wages reduces firms profitability and therefore firms respond to this by reducing production and employment. 27

30 Sticky price theory argues that like wages, some firms may be slow to reduce the prices. This may due to costs with adjusting prices, referred to as menu costs. As general price level falls some firms may be able to respond immediately, others may lag behind and may not be able to cut prices. Too high prices relative to other firms in the economy, makes the goods of the firms with high price less attractive. The firms with higher prices, therefore, may lose customer base forcing a cut in production and employment. 28

31 Changes in the overall price level can temporarily mislead suppliers. Suppliers may view the change in price level as a fall in their product demand and hence, may cut production. Note that the change in overall price level may be difficult to interpret by individual producers, leading to an inappropriate response. If the suppliers had correctly interpreted that the overall price level had fallen then there would not have necessarily been a need to cut production as a drop in overall price level also implies a reduction in costs for individual producers. 29

32 The short-run AS curve might shift: Changes in labor, capital, natural resources, or technological knowledge Expected price level increases Aggregate-supply curve: shifts left 30

33 31

34 We can now bring all three curves together to analyse the output level in the economy. The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. As a result, the shortrun aggregate-supply curve crosses this point as well. 32

35 The model of aggregate demand and supply can also be used to analyze the short run economic fluctuations. The short run economic fluctuations are caused due to changes in aggregate demand or supply. Unless otherwise specified, the starting point is the equilibrium. After an initial change, the following can be used to find the new equilibrium point. 1. Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve (or perhaps both). 2. Decide the direction in which the curve shifts. 3. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run. 4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its long-run equilibrium. 33

36 Suppose that the economy is at the long run equilibrium point and firms experience an increase in production costs. This will shift the SRAS curve to the left. 34

37 When some event increases firms costs, the short-run aggregate-supply curve shifts to the left from AS 1 to AS 2. The economy moves from point A to point B. The result is stagflation: Output falls from Y 1 to Y 2, and the price level rises from P 1 to P 2. If AD is constant then the AS curve shifts back to the original point and equilibrium is restored at point A. This is because an increase in costs will put pressure on the firms leading to reduction in output and increase in price. A reduction in output will also lead to a fall in employment. Rising unemployment will lead to adjustments in labor market, in prices and perceptions; eventually shifting the AS curve back to the original point. 35

38 However, the adjustment process mentioned above assumes no intervention by the government or central bank. 36

39 Faced with an adverse shift in aggregate supply from AS 1 to AS 2, policymakers who can influence aggregate demand might try to shift the aggregate-demand curve to the right from AD 1 to AD 2. For example, the government can increase government expenditure. Remember here government expenditure is part of AD. The economy would move from point A to point C. This policy would prevent the supply shift from reducing output in the short run, but the price level would permanently rise from P 1 to P 3. 37

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