Quiz 5 & Notes PDF

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Lesson 5 notes on Economic Fluctuations, Aggregate Demand and Supply for professor Carol Scotese ...

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Economic Fluctuations -

Output movements away from potential output

Recession -

Severe slowdown of output growth below the growth of potential output

Inflation -

When output growth exceeds the growth of potential output, the economy can overheat (increase in inflation)

Aggregate Supply & Demand  

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Marks potential output (vertical line) Long run equilibrium o Aggregate demand shocks  Events that change the total amount of desired spending  Primary source of potential output in the short run Short run equilibrium o Some prices are sticky in the short run o Price changes create a self-adjustment mechanism for the economy as they fully adjust to the shock and return to potential output

Short-run fluctuations: Key Ideas 1. 2. 3. 4. 5.

Output fluctuations away from potential output Aggregate supply and demand model Shocks to aggregate supply or demand will create short-run equilibrium Prices are sticky (don’t react to the shock) As prices fully adjust to the shock, economy will return to potential output

Keynesian Economics -

Prices can be slow to adjust Price adjustment may be insufficient to help return the economy to potential output quickly, and may need a boost from monetary or fiscal policy (short-run)

Classical Economics -

Prices adjust swiftly Applies to long-run

When price too high  excess supply – prices lower When price too low  excess demand – prices rise  

Prices do the work to bring economy back to sweet spot = potential output Prices can be sticky o Prices aren’t fixed, but they can react slowly and can make the return to potential output longer

Wages: price of labor    

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Especially sticky in downward direction Downward rigidity o Wages are slower to adjust downward than they are to adjust upward Truman Bewely – lowering wages will be harmful – lower morale and productivity o Maintaining wage levels are better for the firms & workers Wages also tend to be slow to adjust upwards o Implicit/explicit agreements between employer and employee o Benefits both employers and employees Wages tend to be upward sticky and downward rigid

Output Prices: price for goods and services (food & gasoline change frequently) 

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Firms don’t change prices more frequently because a business must compare the cost and benefit of a price change o Benefit  Increase revenue o Costs  Cost of implementing price change  Relabeling  Reprogramming bar codes  Changing promotional material;  Costs associated with decision making  Time and labor Prices change only when the benefits are large enough to cover the costs

Sticky Price Firms: firms who don’t change their prices right away

Aggregate Supply & Demand Model 

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Economic fluctuations are caused by demand and supply shocks o Real GDP – Y (x axis) o GDP Deflator – P (y axis) Potential output: depends on the amounts of physical & human capital, full employment level of labor and economy’s productivity (not prices) o Vertical line on graph (LRAS- long run aggregate supply curve) Short run aggregate supply curve (SRAS) o The relationship between short run production and the overall price level  When prices level rises  production rises  Upward sloping Aggregate demand curve o Shows the relationship between the overall price level and total spending  When price level rises  leads to lower spending  When price level falls  leads to higher spending  Downward sloping

Inflation Causes 1. The average growth rate of prices 2. An outcome of the balance between supply & demand pressures Aggregate supply & aggregate demand denote economy-wide forces 

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Positive relationship between aggregate demand & inflation rate o When aggregate demand rises  inflation increases o When aggregate demand falls  inflation falls Negative relationship between aggregate supply & inflation rate o When aggregate supply expands  inflation rate falls o When aggregate supply contracts  inflation rate increase Potential output – natural rate of output o When the economy is producing at its most efficient point o Inflation rate remains steady at a comfortably low rate  2% vicinity Demand-Pull Inflation o Influenced by the rise in costs that follow the aggregate demand increase along with shortages in the final goods market  Increase inflation (only if economy started @ P.O.)  If economy started below P.O  increasing production will cause little inflationary pressure Aggregate Supply Contractions o Can also drive up inflation rate – always inflationary o When price of energy goes up, production rises

When the economy is balances at P.O…  the inflation rate is modest and stable at 2%  aggregate demand expansions will be inflationary  aggregate supply contraction will always be inflationary

1. Economic fluctuations are o Output movements away from potential output 2. Output levels that remain below potential output are associated with recessions wile output levels that exceed potential output can generate inflations. 3. A long-run equilibrium occurs when aggregate demand & supply are in equilibrium at potential output.

4. If the economy begins a long-run equilibrium when a negative demand shock hits, the economy will initially go to a short-run equilibrium in a recessionary period. 5. When there is excess supply or demand in a market, prices adjust to return the economy to equilibrium.

6. John Maynard Keynes described the economy’s protracted recovery from the Great Depression as due, at least in part, to o Sluggish price adjustment 7. Classical economics is associates with flexible prices and the long run while Keynesian economics is associated with sticky prices and the short run. 8. Keynesian economics advocated the use of monetary or fiscal policy in response to a recessionary period because o When prices are sticky, the economy’s self-adjustment mechanism will be slow 9. Downward wage rigidity refers to the observation that o Wages tend to adjust downwards more slowly than they adjust upwards 10. Wages tend to be downward rigid because o Firms tend to prefer to keep worker morale high to maintain productivity o Many employees have either explicit or implicit wage contracts o Firms tend to believe that productivity will be higher if costs are cut by laying off some workers rather than lowering wages across the board 11. While some prices adjust fairly quickly, other prices then to be more sticky. Which of the reasons is a possibly explanation for sticky price adjustment o There are relabeling and reprogramming costs associated with changing prices o There are decision costs associated with price changes o The costs of adjustment outweigh the benefits of price adjustment 12. In response to an economic shock, some firms will find it profitable to change prices, but other firms find it more profitable not to change prices o True...