©2004 prentice hall publishing ayers/collinge, 1/e 1 chapter 9 “short-run instability”

1 ©2004 Prentice Hall Publishing Ayers/Collinge, 1/e

Chapter 9Chapter 9“Short-Run Instability”“Short-Run Instability”

Chapter 9Chapter 9“Short-Run Instability”“Short-Run Instability”

ECONOMICS: ECONOMICS: EXPLORE & APPLYEXPLORE & APPLYby Ayers and Collingeby Ayers and Collinge

ECONOMICS: ECONOMICS: EXPLORE & APPLYEXPLORE & APPLYby Ayers and Collingeby Ayers and Collinge


Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

1.1. Explain why wages and prices might be slow to Explain why wages and prices might be slow to adjust downward, and what significance this adjust downward, and what significance this can have.can have.

2.2. Discuss how fiscal policy to stabilize the Discuss how fiscal policy to stabilize the economy is subject to lags, and how the lags economy is subject to lags, and how the lags can be overcome automatically.can be overcome automatically.

3.3. Explain how balancing the full-employment Explain how balancing the full-employment budget is consistent with a budget deficit.budget is consistent with a budget deficit.

4.4. Identify the characteristics, and significance of Identify the characteristics, and significance of short-run aggregate supply.short-run aggregate supply.

1.1. Explain why wages and prices might be slow to Explain why wages and prices might be slow to adjust downward, and what significance this adjust downward, and what significance this can have.can have.

2.2. Discuss how fiscal policy to stabilize the Discuss how fiscal policy to stabilize the economy is subject to lags, and how the lags economy is subject to lags, and how the lags can be overcome automatically.can be overcome automatically.

3.3. Explain how balancing the full-employment Explain how balancing the full-employment budget is consistent with a budget deficit.budget is consistent with a budget deficit.

4.4. Identify the characteristics, and significance of Identify the characteristics, and significance of short-run aggregate supply.short-run aggregate supply.


Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

5.5. Describe demand –pull and cost-push Describe demand –pull and cost-push inflation, and how they can be part of inflation, and how they can be part of an inflationary spiral.an inflationary spiral.

6.6. Detail the differences between classical Detail the differences between classical and Keynesian analysis.and Keynesian analysis.

7.7. (E&A) Analyze the rationale and (E&A) Analyze the rationale and limitations of deficit spending.limitations of deficit spending.

5.5. Describe demand –pull and cost-push Describe demand –pull and cost-push inflation, and how they can be part of inflation, and how they can be part of an inflationary spiral.an inflationary spiral.

6.6. Detail the differences between classical Detail the differences between classical and Keynesian analysis.and Keynesian analysis.

7.7. (E&A) Analyze the rationale and (E&A) Analyze the rationale and limitations of deficit spending.limitations of deficit spending.


9.19.1SHORT RUN STICKINES ALONG ADSHORT RUN STICKINES ALONG AD9.19.1SHORT RUN STICKINES ALONG ADSHORT RUN STICKINES ALONG ADWhenever there is an economic downturn, Whenever there is an economic downturn,

members of the press and the public call on members of the press and the public call on government to do something about it. government to do something about it.

The economic downturn of March 2001 led The economic downturn of March 2001 led President Bush and Congress to to authorize the President Bush and Congress to to authorize the refunding of some tax payments back to the refunding of some tax payments back to the taxpayer in August that year.taxpayer in August that year.There had been budget surpluses for the There had been budget surpluses for the

previous four years.previous four years.Taxpayers received up to $300 per person or Taxpayers received up to $300 per person or

$600 per couple.$600 per couple.

Whenever there is an economic downturn, Whenever there is an economic downturn, members of the press and the public call on members of the press and the public call on government to do something about it. government to do something about it.

The economic downturn of March 2001 led The economic downturn of March 2001 led President Bush and Congress to to authorize the President Bush and Congress to to authorize the refunding of some tax payments back to the refunding of some tax payments back to the taxpayer in August that year.taxpayer in August that year.There had been budget surpluses for the There had been budget surpluses for the

previous four years.previous four years.Taxpayers received up to $300 per person or Taxpayers received up to $300 per person or

$600 per couple.$600 per couple.


Because of the shock of 9/11/01, instead of Because of the shock of 9/11/01, instead of being energized, there was no discernable being energized, there was no discernable increase in consumer spending.increase in consumer spending.

To bring the economy out of what appeared to To bring the economy out of what appeared to be a deepening recession the President and be a deepening recession the President and Congress enacted $100 billion worth of new Congress enacted $100 billion worth of new spending and tax cuts.spending and tax cuts.

To correct To correct short-run instabilitiesshort-run instabilities, Keynesians , Keynesians argue for government action, while classical argue for government action, while classical economist emphasize that markets are capable economist emphasize that markets are capable of self-adjustment. of self-adjustment.

Because of the shock of 9/11/01, instead of Because of the shock of 9/11/01, instead of being energized, there was no discernable being energized, there was no discernable increase in consumer spending.increase in consumer spending.

To bring the economy out of what appeared to To bring the economy out of what appeared to be a deepening recession the President and be a deepening recession the President and Congress enacted $100 billion worth of new Congress enacted $100 billion worth of new spending and tax cuts.spending and tax cuts.

To correct To correct short-run instabilitiesshort-run instabilities, Keynesians , Keynesians argue for government action, while classical argue for government action, while classical economist emphasize that markets are capable economist emphasize that markets are capable of self-adjustment. of self-adjustment.

Short Run InstabilitiesShort Run InstabilitiesShort Run InstabilitiesShort Run Instabilities


The Macro Policy debateThe Macro Policy debateThe Macro Policy debateThe Macro Policy debate

ClassicalistClassicalist

Wait for a Wait for a movement along movement along

aggregate aggregate demand.demand.

The economy can The economy can self-adjust.self-adjust.

ClassicalistClassicalist

Wait for a Wait for a movement along movement along

aggregate aggregate demand.demand.

The economy can The economy can self-adjust.self-adjust.

KeynesiansKeynesians

Take action to Take action to manage aggregate manage aggregate

demand.demand.

Meaning to shift Meaning to shift the aggregate the aggregate demand curve demand curve

itself..itself..

KeynesiansKeynesians

Take action to Take action to manage aggregate manage aggregate

demand.demand.

Meaning to shift Meaning to shift the aggregate the aggregate demand curve demand curve

itself..itself..


The Classical AnalysisThe Classical AnalysisThe Classical AnalysisThe Classical Analysis

When a market is When a market is not in equilibrium, not in equilibrium, the forces of supply the forces of supply and demand will and demand will cause price to cause price to change until the change until the equilibrium comes equilibrium comes about.about.

When a market is When a market is not in equilibrium, not in equilibrium, the forces of supply the forces of supply and demand will and demand will cause price to cause price to change until the change until the equilibrium comes equilibrium comes about.about.

1.1. Wage and price Wage and price adjustments will lead adjustments will lead to a long-run macro to a long-run macro equilibrium.equilibrium.

2.2. The new long-run The new long-run equilibrium is equilibrium is characterized by both characterized by both full employment, and full employment, and an associated full an associated full employment output.employment output.

1.1. Wage and price Wage and price adjustments will lead adjustments will lead to a long-run macro to a long-run macro equilibrium.equilibrium.

2.2. The new long-run The new long-run equilibrium is equilibrium is characterized by both characterized by both full employment, and full employment, and an associated full an associated full employment output.employment output.


The Keynesian AnalysisThe Keynesian AnalysisThe Keynesian AnalysisThe Keynesian Analysis

Keynesians dismiss Keynesians dismiss the classicalist the classicalist analysis as irrelevant analysis as irrelevant in the short run.in the short run.

Their rationale is the Their rationale is the existence of existence of downwardly downwardly sticky sticky wages and sticky wages and sticky prices.prices.

Keynesians dismiss Keynesians dismiss the classicalist the classicalist analysis as irrelevant analysis as irrelevant in the short run.in the short run.

Their rationale is the Their rationale is the existence of existence of downwardly downwardly sticky sticky wages and sticky wages and sticky prices.prices.

1.1. Sticky refers to an Sticky refers to an inflexibility that makes inflexibility that makes it difficult for wages it difficult for wages and prices to falland prices to fall

2.2. The stickiness can be The stickiness can be due to labor contracts due to labor contracts or human psychology.or human psychology.

3.3. RigiditiesRigidities exist in both exist in both labor markets and labor markets and output markets.output markets.

1.1. Sticky refers to an Sticky refers to an inflexibility that makes inflexibility that makes it difficult for wages it difficult for wages and prices to falland prices to fall

2.2. The stickiness can be The stickiness can be due to labor contracts due to labor contracts or human psychology.or human psychology.

3.3. RigiditiesRigidities exist in both exist in both labor markets and labor markets and output markets.output markets.


Long-Run Macro EquilibriumLong-Run Macro EquilibriumLong-Run Macro EquilibriumLong-Run Macro Equilibrium

Real GDP

Pri

ce L

evel

Long-Run Aggregate Supply

Full-Employment GDP

Aggregate Demand

Actual Output

Full-employment price level

Actual price level

AWages and prices may be downwardly sticky preventingthe economy from rapidly moving to a full-employmentequilibrium.


Long-Run Macro EquilibriumLong-Run Macro EquilibriumLong-Run Macro EquilibriumLong-Run Macro Equilibrium

Real GDP

Pri

ce L

evel


Full-Employment GDP

Aggregate Demand

Actual Output

Full-employment price level

Actual price level

AIn the long-run prices will fall from point A to the full-employment output, but wage and price rigidity might prevent it from doing so in the short-run.


9.29.2FISCAL POLICY TO STABILIZE FISCAL POLICY TO STABILIZE THE BUSINESS CYCLETHE BUSINESS CYCLE

9.29.2FISCAL POLICY TO STABILIZE FISCAL POLICY TO STABILIZE THE BUSINESS CYCLETHE BUSINESS CYCLEFiscal policyFiscal policy refers to the government’s policy refers to the government’s policy

toward taxing and spending.toward taxing and spending.Keynesians commonly advocate using Keynesians commonly advocate using

expansionary fiscal policy (increased expansionary fiscal policy (increased government spending or reduced taxation) to government spending or reduced taxation) to stimulate (shift) aggregate demand.stimulate (shift) aggregate demand.

Shifting aggregate demand can also be Shifting aggregate demand can also be accomplished through accomplished through monetary policymonetary policyMonetary policy involves varying the quantity of Monetary policy involves varying the quantity of

money available to spend.money available to spend.

Fiscal policyFiscal policy refers to the government’s policy refers to the government’s policy toward taxing and spending.toward taxing and spending.

Keynesians commonly advocate using Keynesians commonly advocate using expansionary fiscal policy (increased expansionary fiscal policy (increased government spending or reduced taxation) to government spending or reduced taxation) to stimulate (shift) aggregate demand.stimulate (shift) aggregate demand.

Shifting aggregate demand can also be Shifting aggregate demand can also be accomplished through accomplished through monetary policymonetary policyMonetary policy involves varying the quantity of Monetary policy involves varying the quantity of

money available to spend.money available to spend.


Aggregate demandAggregate demandAggregate demandAggregate demand

Real GDP

Pri

ce L

evel


Starting Aggregate Demand

Fiscal Stimulus increases aggregateDemand.Current

sticky price level.

The economy startsThe economy startsat an unemploymentat an unemploymentequilibriumequilibrium

Expansionary fiscal Expansionary fiscal policypolicy is increased is increased

government spendinggovernment spendingor reduced taxesor reduced taxesto stimulate AD.to stimulate AD.


When the economy overheats – growing When the economy overheats – growing so fast that inflation threatens – so fast that inflation threatens – government can use government can use contractionary fiscal contractionary fiscal policy.policy.

Both expansionary and contractionary Both expansionary and contractionary fiscal policy are examples of fiscal policy are examples of discretionary discretionary policypolicy.. Public Policy which is adjusted at the Public Policy which is adjusted at the

discretion of lawmakers.discretion of lawmakers.

When the economy overheats – growing When the economy overheats – growing so fast that inflation threatens – so fast that inflation threatens – government can use government can use contractionary fiscal contractionary fiscal policy.policy.

Both expansionary and contractionary Both expansionary and contractionary fiscal policy are examples of fiscal policy are examples of discretionary discretionary policypolicy.. Public Policy which is adjusted at the Public Policy which is adjusted at the

discretion of lawmakers.discretion of lawmakers.

Keynesians and Fiscal PolicyKeynesians and Fiscal PolicyKeynesians and Fiscal PolicyKeynesians and Fiscal Policy


Fiscal Policy LagsFiscal Policy LagsFiscal Policy LagsFiscal Policy Lags

Recognition Lag:Recognition Lag: It takes time to know It takes time to know that a recession is at hand.that a recession is at hand.

Action Lag:Action Lag: Tax and spending bills are Tax and spending bills are not passed overnight.not passed overnight.

Implementation LagImplementation Lag: : Planning Planning government spending takes time. It also government spending takes time. It also takes time before tax changes can take takes time before tax changes can take effect.effect.

Recognition Lag:Recognition Lag: It takes time to know It takes time to know that a recession is at hand.that a recession is at hand.

Action Lag:Action Lag: Tax and spending bills are Tax and spending bills are not passed overnight.not passed overnight.

Implementation LagImplementation Lag: : Planning Planning government spending takes time. It also government spending takes time. It also takes time before tax changes can take takes time before tax changes can take effect.effect.


o Instead of discretionary policy, lawmakers can Instead of discretionary policy, lawmakers can rely on rely on automatic stabilizersautomatic stabilizers..

o Automatic stabilizers are components of Automatic stabilizers are components of existing fiscal policies that stimulate the existing fiscal policies that stimulate the economy when it is sluggish, and act as a drag economy when it is sluggish, and act as a drag when it overheats.when it overheats.

o The U.S. has automatic stabilizers embedded The U.S. has automatic stabilizers embedded within its system of of taxation and spending.within its system of of taxation and spending.

o Instead of discretionary policy, lawmakers can Instead of discretionary policy, lawmakers can rely on rely on automatic stabilizersautomatic stabilizers..

o Automatic stabilizers are components of Automatic stabilizers are components of existing fiscal policies that stimulate the existing fiscal policies that stimulate the economy when it is sluggish, and act as a drag economy when it is sluggish, and act as a drag when it overheats.when it overheats.

o The U.S. has automatic stabilizers embedded The U.S. has automatic stabilizers embedded within its system of of taxation and spending.within its system of of taxation and spending.

Keynesians and Fiscal PolicyKeynesians and Fiscal PolicyKeynesians and Fiscal PolicyKeynesians and Fiscal Policy


Automatic StabilizersAutomatic Stabilizers

On the tax side..On the tax side.. Personal and corporate Personal and corporate

incomes fall during incomes fall during recession and so do U.S. recession and so do U.S. personal and corporate personal and corporate income taxes.income taxes.

Alternatively, if the Alternatively, if the economy is booming, economy is booming, income taxes collect income taxes collect more revenue.more revenue.

No policy action is No policy action is necessary.necessary.

On the tax side..On the tax side.. Personal and corporate Personal and corporate

incomes fall during incomes fall during recession and so do U.S. recession and so do U.S. personal and corporate personal and corporate income taxes.income taxes.

Alternatively, if the Alternatively, if the economy is booming, economy is booming, income taxes collect income taxes collect more revenue.more revenue.

No policy action is No policy action is necessary.necessary.

On the spending side..On the spending side.. Payments for welfare, Payments for welfare,

unemployment, and unemployment, and other social programs other social programs rise when the economy rise when the economy slows, and provides a slows, and provides a safety net for people.safety net for people.

Conversely, this spending Conversely, this spending falls when the economy falls when the economy heats up.heats up.

Again no policy action is Again no policy action is necessary.necessary.

On the spending side..On the spending side.. Payments for welfare, Payments for welfare,

unemployment, and unemployment, and other social programs other social programs rise when the economy rise when the economy slows, and provides a slows, and provides a safety net for people.safety net for people.

Conversely, this spending Conversely, this spending falls when the economy falls when the economy heats up.heats up.

Again no policy action is Again no policy action is necessary.necessary.


Balancing the BudgetBalancing the BudgetBalancing the BudgetBalancing the Budget

If the economy is at full employment, fiscal If the economy is at full employment, fiscal policy should be neutral. policy should be neutral.

The neutral fiscal policy could generate a The neutral fiscal policy could generate a balanced budget (federal).balanced budget (federal).

When the economy is overheating the When the economy is overheating the government would run a government would run a budget surplus.budget surplus.

When economic health is poor, the government When economic health is poor, the government would choose a would choose a budget deficit.budget deficit.

If the economy is at full employment, fiscal If the economy is at full employment, fiscal policy should be neutral. policy should be neutral.

The neutral fiscal policy could generate a The neutral fiscal policy could generate a balanced budget (federal).balanced budget (federal).

When the economy is overheating the When the economy is overheating the government would run a government would run a budget surplus.budget surplus.

When economic health is poor, the government When economic health is poor, the government would choose a would choose a budget deficit.budget deficit.


9.39.3THE SHORT-RUN ADKUSTMENT THE SHORT-RUN ADKUSTMENT PROCESSPROCESS

9.39.3THE SHORT-RUN ADKUSTMENT THE SHORT-RUN ADKUSTMENT PROCESSPROCESS

In the long-run aggregate supply is unaffected by In the long-run aggregate supply is unaffected by the price causing it to be vertical. the price causing it to be vertical.

Short-run aggregate supplyShort-run aggregate supply,, the amount of output the amount of output the economy has to offer in the short-run will slope the economy has to offer in the short-run will slope upward. upward. In the short-run the amount of output can exceed full In the short-run the amount of output can exceed full

employment GDP as workers offer to work overtime, or employment GDP as workers offer to work overtime, or seek out extra jobs.seek out extra jobs.

Conversely, if workers expect more inflation than Conversely, if workers expect more inflation than actually occurs the work they would offer at the actual actually occurs the work they would offer at the actual price level would be less than the full employment GDP.`price level would be less than the full employment GDP.`

In the long-run aggregate supply is unaffected by In the long-run aggregate supply is unaffected by the price causing it to be vertical. the price causing it to be vertical.

Short-run aggregate supplyShort-run aggregate supply,, the amount of output the amount of output the economy has to offer in the short-run will slope the economy has to offer in the short-run will slope upward. upward. In the short-run the amount of output can exceed full In the short-run the amount of output can exceed full

employment GDP as workers offer to work overtime, or employment GDP as workers offer to work overtime, or seek out extra jobs.seek out extra jobs.

Conversely, if workers expect more inflation than Conversely, if workers expect more inflation than actually occurs the work they would offer at the actual actually occurs the work they would offer at the actual price level would be less than the full employment GDP.`price level would be less than the full employment GDP.`


Real GDP

Pri

ce L

evel

Aggregate Demand

Full-employment GDP

Short-Run Aggregate Supply slopes upwardintersecting LRAS at the expected price level.Expected

and Actual Price Level


The Short-Run Aggregate SupplyThe Short-Run Aggregate SupplyThe Short-Run Aggregate SupplyThe Short-Run Aggregate Supply


Structural rigiditiesStructural rigidities are are one reason for the one reason for the upward sloping SRAS upward sloping SRAS curve.curve.

As new spending power As new spending power is added to the economy, is added to the economy, it tends to raise wages it tends to raise wages and prices where it first and prices where it first hits, before eventually hits, before eventually diffusing throughout the diffusing throughout the economy.economy.

Structural rigiditiesStructural rigidities are are one reason for the one reason for the upward sloping SRAS upward sloping SRAS curve.curve.

As new spending power As new spending power is added to the economy, is added to the economy, it tends to raise wages it tends to raise wages and prices where it first and prices where it first hits, before eventually hits, before eventually diffusing throughout the diffusing throughout the economy.economy.

The production effectThe production effect is is the second reason for the second reason for the upward sloping the upward sloping SRAS curve.SRAS curve.

When the price level When the price level rises and labor supply rises and labor supply curves remain curves remain unchanged, firms can unchanged, firms can profit by increasing profit by increasing output and employmentoutput and employment

The production effectThe production effect is is the second reason for the second reason for the upward sloping the upward sloping SRAS curve.SRAS curve.

When the price level When the price level rises and labor supply rises and labor supply curves remain curves remain unchanged, firms can unchanged, firms can profit by increasing profit by increasing output and employmentoutput and employment



Real GDP

Pri

ce L

evel

Aggregate Demand

Full-employment GDP

Expected Price Level

Short-Run Aggregate Supply slopes upward



Actual Price Level

Short_run Short_run unemploymentunemploymentequilibriumequilibrium

Long-Run equilibriumLong-Run equilibrium

Actual GDP


Types of InflationTypes of InflationTypes of InflationTypes of Inflation

Demand-pull inflation:Demand-pull inflation: When a rightward When a rightward shift in aggregate demand moves the shift in aggregate demand moves the economy to both a higher output and a economy to both a higher output and a higher price level.higher price level.

Cost-push inflation:Cost-push inflation: When firms adjust When firms adjust their inflationary expectations downward, their inflationary expectations downward, it may cause the economy to move up the it may cause the economy to move up the aggregate demand curve to a point with aggregate demand curve to a point with higher prices and lower output.higher prices and lower output.

Demand-pull inflation:Demand-pull inflation: When a rightward When a rightward shift in aggregate demand moves the shift in aggregate demand moves the economy to both a higher output and a economy to both a higher output and a higher price level.higher price level.

Cost-push inflation:Cost-push inflation: When firms adjust When firms adjust their inflationary expectations downward, their inflationary expectations downward, it may cause the economy to move up the it may cause the economy to move up the aggregate demand curve to a point with aggregate demand curve to a point with higher prices and lower output.higher prices and lower output.


Stimulative Fiscal PolicyStimulative Fiscal PolicyStimulative Fiscal PolicyStimulative Fiscal Policy

Real GDP

Pri

ce L

evel

Aggregate Demand

Short-Run Aggregate Supply

Output Increases

The result is an increasein output along with demand-pull inflation.

Inflation


Fiscal or Monetary StimulusFiscal or Monetary StimulusFiscal or Monetary StimulusFiscal or Monetary Stimulus

Real GDP

Pri

ce L

evel


Full-Employment Output

Starting Aggregate Demand

Aggregate Demand after Stimulus

1. Output increases, but by less than was intended.

2. Moving to full-employment equilibrium without causing inflation.

3. Stimulus in spending causes demand-pull inflation.


Cost–Push InflationCost–Push Inflation Cost–Push InflationCost–Push Inflation

Inflation could also arise from an upward shift in Inflation could also arise from an upward shift in the short-run supply curve.the short-run supply curve.

Because the short-run aggregate supply curve Because the short-run aggregate supply curve intersects long-run aggregate supply at the intersects long-run aggregate supply at the expected price level, a change in the expected price expected price level, a change in the expected price level will shift the short-run aggregate supply level will shift the short-run aggregate supply upward.upward.

If the expected price level increases, short-run If the expected price level increases, short-run supply shifts vertically upward.supply shifts vertically upward.

Likewise if the expected price level decreases , Likewise if the expected price level decreases , short-run supply shifts downward.short-run supply shifts downward.

Inflation could also arise from an upward shift in Inflation could also arise from an upward shift in the short-run supply curve.the short-run supply curve.

Because the short-run aggregate supply curve Because the short-run aggregate supply curve intersects long-run aggregate supply at the intersects long-run aggregate supply at the expected price level, a change in the expected price expected price level, a change in the expected price level will shift the short-run aggregate supply level will shift the short-run aggregate supply upward.upward.

If the expected price level increases, short-run If the expected price level increases, short-run supply shifts vertically upward.supply shifts vertically upward.

Likewise if the expected price level decreases , Likewise if the expected price level decreases , short-run supply shifts downward.short-run supply shifts downward.


Cost Push InflationCost Push InflationCost Push InflationCost Push Inflation

Real GDP

Pri

ce L

evel

Full-employment GDP

Alternativeexpected

price levels

Short-Run Aggregate Supply


Whatever the expectedprice level may be that is where the short-run aggregate supply and LRASintersect and long-runequilibrium occur.


o When aggregate supply shifts up, the When aggregate supply shifts up, the economy moves up the aggregate demand economy moves up the aggregate demand curve to a point of higher prices and curve to a point of higher prices and lower output. lower output.

o Inflation that is caused this way is called Inflation that is caused this way is called cost-push inflationcost-push inflation..

o Cost push inflation reduces output and Cost push inflation reduces output and increases the price level.increases the price level.

o When aggregate supply shifts up, the When aggregate supply shifts up, the economy moves up the aggregate demand economy moves up the aggregate demand curve to a point of higher prices and curve to a point of higher prices and lower output. lower output.

o Inflation that is caused this way is called Inflation that is caused this way is called cost-push inflationcost-push inflation..

o Cost push inflation reduces output and Cost push inflation reduces output and increases the price level.increases the price level.

Cost Push InflationCost Push InflationCost Push InflationCost Push Inflation


9.49.4SHORT-RUN PATHS TO LONG-RUN SHORT-RUN PATHS TO LONG-RUN STABILITYSTABILITY

9.49.4SHORT-RUN PATHS TO LONG-RUN SHORT-RUN PATHS TO LONG-RUN STABILITYSTABILITY

When stimulative government policy When stimulative government policy increases aggregate demand, the result increases aggregate demand, the result can be an can be an inflationary spiral.inflationary spiral.

An inflationary spiral is an ongoing An inflationary spiral is an ongoing sequence of demand-pull inflation, sequence of demand-pull inflation, followed by cost-push inflation, as short-followed by cost-push inflation, as short-run aggregate supply shifts to reflect run aggregate supply shifts to reflect higher expectations of inflation.higher expectations of inflation.

When stimulative government policy When stimulative government policy increases aggregate demand, the result increases aggregate demand, the result can be an can be an inflationary spiral.inflationary spiral.

An inflationary spiral is an ongoing An inflationary spiral is an ongoing sequence of demand-pull inflation, sequence of demand-pull inflation, followed by cost-push inflation, as short-followed by cost-push inflation, as short-run aggregate supply shifts to reflect run aggregate supply shifts to reflect higher expectations of inflation.higher expectations of inflation.


Inflationary SpiralInflationary SpiralInflationary SpiralInflationary Spiral

Real GDP

Pri

ce L

evel Long-Run Aggregate

Supply

Fluctuating Output

Expanding Aggregate Demand

The Inflationary Spiral

Inflation


SUMMARY OF CLASSICAL SUMMARY OF CLASSICAL AND KEYNESIAN VIEWSAND KEYNESIAN VIEWS


The focus is on the long run.

The focus is on the short run.

CLASSICAL KEYNESIAN




Prices and wages will adjust upwardor downward as needed to reacha full employment equilibrium.

Prices and wages adjust upward without difficulty, but are downwardly sticky and thus unable to lead the economy from an unemployment equilibrium to full employment.

CLASSICAL KEYNESIAN




Government should not attempt tomanage aggregate demand.

Government should actively adjust taxesand spending in order to manageaggregate demand.

CLASSICAL KEYNESIAN




Shortcoming: Remedying unemploymentrequires patience.

Shortcoming: Remedying unemploymentcan lead to demand-pull inflation andpossibly an inflationary spiral.

CLASSICAL KEYNESIAN


9.5 EXPLORE & APPLY9.5 EXPLORE & APPLYDeficits and DebtDeficits and Debt9.5 EXPLORE & APPLY9.5 EXPLORE & APPLYDeficits and DebtDeficits and Debt

Per capita debt for each U.S. citizen is Per capita debt for each U.S. citizen is over $21,000.over $21,000.In 2002 the In 2002 the budget deficitbudget deficit was $106 billion, was $106 billion, and the and the gross national debtgross national debt stood at $6.14 stood at $6.14 trillion.trillion.The national debt can be thought of as the The national debt can be thought of as the stockstock or inventory of past accumulated or inventory of past accumulated debt, while deficit can be thought of as a debt, while deficit can be thought of as a flow flow that adds to that debt.that adds to that debt.

Per capita debt for each U.S. citizen is Per capita debt for each U.S. citizen is over $21,000.over $21,000.In 2002 the In 2002 the budget deficitbudget deficit was $106 billion, was $106 billion, and the and the gross national debtgross national debt stood at $6.14 stood at $6.14 trillion.trillion.The national debt can be thought of as the The national debt can be thought of as the stockstock or inventory of past accumulated or inventory of past accumulated debt, while deficit can be thought of as a debt, while deficit can be thought of as a flow flow that adds to that debt.that adds to that debt.


Terms along the WayTerms along the WayTerms along the WayTerms along the Way

sticky wages sticky wages sticky wages and sticky wages and

pricesprices unemployment unemployment

equilibriumequilibrium fiscal policyfiscal policy expansionary fiscal expansionary fiscal

policy (fiscal policy (fiscal stimulus)stimulus)

sticky wages sticky wages sticky wages and sticky wages and

pricesprices unemployment unemployment

equilibriumequilibrium fiscal policyfiscal policy expansionary fiscal expansionary fiscal

policy (fiscal policy (fiscal stimulus)stimulus)

contractionary fiscal contractionary fiscal policy (fiscal drag)policy (fiscal drag)

discretionary policydiscretionary policy recognition lagrecognition lag action lagaction lag implementation lagimplementation lag automatic stabilizersautomatic stabilizers balanced budgetbalanced budget

contractionary fiscal contractionary fiscal policy (fiscal drag)policy (fiscal drag)

discretionary policydiscretionary policy recognition lagrecognition lag action lagaction lag implementation lagimplementation lag automatic stabilizersautomatic stabilizers balanced budgetbalanced budget


Terms along the WayTerms along the WayTerms along the WayTerms along the Way

budget deficitbudget deficit budget surplusbudget surplus full-employment full-employment

budgetbudget national debtnational debt short-run aggregate short-run aggregate

supplysupply structural rigiditiesstructural rigidities

budget deficitbudget deficit budget surplusbudget surplus full-employment full-employment

budgetbudget national debtnational debt short-run aggregate short-run aggregate

supplysupply structural rigiditiesstructural rigidities

the production effectthe production effect short-run short-run

macroeconomic macroeconomic equilibriumequilibrium

demand-pull inflationdemand-pull inflation cost-push inflationcost-push inflation inflationary spiralinflationary spiral

the production effectthe production effect short-run short-run

macroeconomic macroeconomic equilibriumequilibrium

demand-pull inflationdemand-pull inflation cost-push inflationcost-push inflation inflationary spiralinflationary spiral


Test YourselfTest YourselfTest YourselfTest Yourself

1.1. When wages and prices are described When wages and prices are described as being sticky it is meant that they as being sticky it is meant that they

a.a. adjust quickly.adjust quickly.

b.b. adjust slowly.adjust slowly.

c.c. never adjust.never adjust.

d.d. do not need to be adjusted.do not need to be adjusted.

1.1. When wages and prices are described When wages and prices are described as being sticky it is meant that they as being sticky it is meant that they

a.a. adjust quickly.adjust quickly.

b.b. adjust slowly.adjust slowly.

c.c. never adjust.never adjust.

d.d. do not need to be adjusted.do not need to be adjusted.



2.2. An example of an automatic stabilizer is An example of an automatic stabilizer is

a.a. the U.S. income tax system.the U.S. income tax system.

b.b. the Internet.the Internet.

c.c. sticky wages.sticky wages.

d.d. the full-employment equilibrium.the full-employment equilibrium.

2.2. An example of an automatic stabilizer is An example of an automatic stabilizer is

a.a. the U.S. income tax system.the U.S. income tax system.

b.b. the Internet.the Internet.

c.c. sticky wages.sticky wages.

d.d. the full-employment equilibrium.the full-employment equilibrium.



3.3. The federal budget deficitThe federal budget deficita.a. has not existed since 1997.has not existed since 1997.b.b. is the accumulation of all federal debts.is the accumulation of all federal debts.c.c. equals the national debt minus the equals the national debt minus the

budget surplus.budget surplus.d.d. is the amount by which government is the amount by which government

spending exceeds its revenue over the spending exceeds its revenue over the course of a year.course of a year.

3.3. The federal budget deficitThe federal budget deficita.a. has not existed since 1997.has not existed since 1997.b.b. is the accumulation of all federal debts.is the accumulation of all federal debts.c.c. equals the national debt minus the equals the national debt minus the

budget surplus.budget surplus.d.d. is the amount by which government is the amount by which government

spending exceeds its revenue over the spending exceeds its revenue over the course of a year.course of a year.



4.4. Short-run aggregate supply always Short-run aggregate supply always intersects long-run aggregate supply atintersects long-run aggregate supply at

a.a. the expected price level.the expected price level.

b.b. the actual price level.the actual price level.

c.c. the long-run equilibrium price level.the long-run equilibrium price level.

d.d. an unemployment equilibrium.an unemployment equilibrium.

4.4. Short-run aggregate supply always Short-run aggregate supply always intersects long-run aggregate supply atintersects long-run aggregate supply at

a.a. the expected price level.the expected price level.

b.b. the actual price level.the actual price level.

c.c. the long-run equilibrium price level.the long-run equilibrium price level.

d.d. an unemployment equilibrium.an unemployment equilibrium.



5.5. In an inflationary spiral, outputIn an inflationary spiral, output

a.a. always rises.always rises.

b.b. always falls.always falls.

c.c. alternatively rises and falls..alternatively rises and falls..

d.d. remains constant.remains constant.

5.5. In an inflationary spiral, outputIn an inflationary spiral, output

a.a. always rises.always rises.

b.b. always falls.always falls.

c.c. alternatively rises and falls..alternatively rises and falls..

d.d. remains constant.remains constant.


The End!The End!Next Chapter 10Next Chapter 10

““Aggregate Aggregate Expenditures"Expenditures"

©2004 prentice hall publishing ayers/collinge, 1/e 1 chapter 9 “short-run instability”

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