macro e conomics unit 7: the real sector: adas & classical theory economist: someone who sees...
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MACROEconomics
Unit 7: The Real Sector:ADAS & Classical Theory
Economist: Someone who sees something in practice and wonders if it would work in theory.
-- Senator Ernest “Fritz” Hollings
Created: 2007-2013 by Jim Luke.This work is licensed under the Creative Commons Attribution-NonCommercial License
MACROEconomics
Slide 2
Why Theory Matters
“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else.”
-- John Maynard Keynes
MACROEconomics
AD-AS Model illustrates & analyzes theory using shifts in 3 curves:
AD – Aggregate DemandSRAS –Short-Run Aggregate SupplyLRAS – Long Run Aggregate Supply
MACROEconomics
AD-AS Model is NOT same as micro supply-and-demand. Aggregates behave differently.
Remember the fallacy of composition?
MACROEconomicsUse AD-AS Model to show:
Level & changes in: real output (real GDP) price index How people respond to price level changes
Capacity of the economy (PPF) Economic Conditions
Inflation Recession & Unemployment Stagflation Deflation and depression
MACROEconomics
Understanding the AD-AS Model:Aggregate Demand-Aggregate Supply
(actually it’s AD-SRAS-LRAS)
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level(price index)
Graphic Space is Real Output vs. Price Level
MACROEconomics
PPrice Level(price index)
Q Real Output
(amount of real goods & services produced)
Start
Real GDP@start
Price Index @start
Economy at some starting point.
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level(price index)
start (now)
Real GDP@start
Price Index @start
after
after real growth in GDP, but no inflation or deflation
Real GDPafter
Economy Grows shifts right
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level(price index)
Start
Real GDP@start
Price Index @start
after decline in real GDPunemployment has increasedbecause fewer resources are employed
after
Real GDPafter
Economy shrinks moves left (recession)
MACROEconomics
Created:Jan 2008by Jim Luke.This work is licensed under the Creative Commons Attribution-NonCommercial License
Q Real Output
(amount of real goods & services produced)
PPrice Level(price index)
Start
Real GDP@start
Price Index @start
afterPrice Index after inflation
Inflation
Inflation shift upward
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level(price index)
Start
Real GDP@start
Price Index @start
afterPrice Index after deflation
deflation
Deflation shift downward
MACROEconomics
Real Life: both prices & real GDP change“Stagflation” shift up & left
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Start
Real GDP@start
Price Index @start
afterPrice Index after inflation
Inflation
Real GDPafter
“stagflation”
MACROEconomics
Price Index after inflation
Inflationary Growth up & right
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Start
Real GDP@start
Price Index @start
after
Inflation
Real GDPafter
MACROEconomics
2 Other Possibilities
Prices decline & real GDP increase down and to the right
Prices decline & real GDP decrease down and to left
MACROEconomics
Reactions to Changes in Prices
Two relationships (curves) show how people react to inflation/deflation: Aggregate Demand (AD)
Willingness to spend. Short-Run Aggregate Supply
(SRAS). Willingness to sell.
MACROEconomicsAD is downward sloping because
of 3 effects:
Wealth & Fixed IncomesInterest Rate & Debt PaymentsInternational Trade
MACROEconomics
Q (or Y) Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Real GDP@start
Price Index @start
AD curve shows changes in willingness to buy real Qin response to changes in price level.
AD
Start
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Start
Real GDP@start
Price Index @start
AD: Inflation reduces ability to buy
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Start
Real GDP@start
Price Index @start
Deflation increases ability to buy.
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Start
Real GDP@start
Price Index @start
AD: buyer reactions to inflation / deflation
MACROEconomics
Now: producers & sellers
Inflation: all prices increase But, inflation is not highly visible. Single-product price changes are.
Producers/sellers see price change of their product. perceive a real price increase when it is really
inflation willing to produce & sell more goods Temporary reaction SRAS, or Short-Run Aggregate Supply.
Eventually costs increase & qty returns to original
MACROEconomics
Q (or Y) Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Real GDP@start
Price Index @start
SRAS curve shows changes in desire to sell real Qin response to changes in price level.
Start
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Start
Real GDP@start
Price Index @start
SRAS: Price change “fools” producer
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Start
Real GDP@start
Price Index @start
Deflation “fools” into reduced output.
MACROEconomics
Q (or Y) Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Real GDP@start
Price Index @start
SRAS curve
Start
MACROEconomics
In a short-run equilibrium, the economy is always where SRAS=AD because the quantity of Real GDP we buy
must equal the amount we sell.
PPrice Level
(price index)
Real GDP@start
Price Index @start start
SR-AS
AD
Short-Run Equilibrium:Purchases = Sales where AD intersects SRAS.
Q (or Y) Real Output
MACROEconomics
AD and SRAS curves only show Real GDP vs Price Level changes. Other changes shift the curves.
MACROEconomicsAD curves shift (move) when
changes such as…
Expectations about future More optimism shifts AD right More pessimism shifts AD left.
Growth in other countries boosts exports.
Government decisions change T or G
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
Start
Real GDP@start
Price Index @start
AD shift: more optimism or more G or lower T or more X
AD before
AD after
MACROEconomics
Next: Shifts in SRAS curve
Factors that shift SRAS: Changes in expectations about future
economic conditions. Technology improves. Cost increases: Firms realize that
resource prices have risen but they cannot pass the increase on to customers.
MACROEconomicsInput cost increases shift SRAS
left/up – but there is a lag.
SRAS: short-run reaction only “fooled” by price change
Once inflation is perceived, then SRAS curve shifts upward/left.
MACROEconomics
PPrice Level
(price index)
Real GDP@start
Price Index @start start
SR-AS start
Sellers react to inflation
Initial reaction
Price Index after inflation
Finalreaction
SR-AS after
MACROEconomics
PPrice Level
(price index)
Real GDP@start
Price Index @start
SR-AS start
Improved technology can shift SRAS also.
SR-AS after
start
MACROEconomics
PPrice Level
(price index)
Real GDP@start
Price Index @start start
SR-AS start
External input cost increases also shift SRAS - example: oil.
SR-AS after
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
LRAS:long-run aggregate supply(“capacity of economy” or “sustainable production rate” when all resources are employed)
Production Possibilities determined by available resources / technology, not prices
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
LRAS:long-run aggregate supply
any point in this region indicates the economy is not using all resources --- unemployment exists
Economy left of LRAS unemployment exists
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
LRAS:long-run aggregate supply
Amount of unemployment
Unemployment.
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
LRAS:long-run aggregate supply
attempting to produce more than capacity, only possible for short run, actually draws down inventory
What if we sell more than we can produce (SRAS > LRAS)?
reduce inventories
MACROEconomics
Q Real Output
(amount of real goods & services produced)
PPrice Level
(price index)
LRAS1
Long run growth is a shift in LRAS.
LRAS2
MACROEconomicsPutting them altogether.
We’re now ready to put all three curves together.
Short-run equilibrium is where SRAS = AD, but…
Where is that relative to LRAS?Three possibilities…….
MACROEconomics
PPrice Level(price index)
Real GDP@start
Price Index @start
start
LRAS
SR-AS
AD
Long-Run Full-Employment Equilibrium -- the goal
MACROEconomics
Recessionary Gap (also known as “contractionary gap”)
PPrice Level(price index)
Real GDP@start
Price Index @start
start
LRAS
SR-AS
AD
Real GDPif we had full employment
Gap represents amount of
unemployment
MACROEconomics
PPrice Level(price index)
Real GDP@start
Price Index @start
start
LRAS
SR-AS
AD
Inflationary Gap (also known as Expansionary Gap)
MACROEconomics
LRAS: Beneficial Supply Shocks
Abundant harvests Discovery of natural resources Technology breakthroughs Population growth & immigration
MACROEconomicsShocks cause a gaps.
“Supply shocks” New technology More people/resources Destruction of people/resources
War Natural Disaster
MACROEconomics
LRAS: Adverse Supply Shocks
Examples Drought Natural Disasters Suddenly reduced supply of any
critical resource Government instability Terrorist attacks War Any permanent reduction of
economy’s ability to produce real goods and services
MACROEconomics
Aggregate Demand Shocks
Changes in: confidence/optimism perceived wealth foreign economic events fiscal policy (G or T) monetary policy (interest rates)
MACROEconomics
Short-Run Aggregate Supply Shocks
Changes in: external input cost short-run supply restrictions uncertainty re: profits?