Embedded Files
"...what does '4-3 agg' mean?"
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"it means '...on aggregate...', which means '...in total', as the reds lost 3-0 in the first leg of this two-legged game but managed to come back and destroy Barca 4-0 in the second leg to win by 4 goals to 3 in total."
--THINK AHEAD--
"If the supply and demand diagram in microeconomics plots the output of a single good at different price levels, what do you think the aggregate demand and supply diagram ('AD/AS') in macroeconomics shows?..."
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--THE X-AXIS OF THE AD/AS--
--THE X-AXIS OF THE AD/AS--
"In the micro model, the label on the x-axis is the quantity of the particular good as measured in some uniform unit (e.g., 'per kg of rice'), but on the AD/AS model you are measuring the total output of all goods and services, so what can you use?"
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"...instead of units, we calculate 'the total $-value of all final goods and services produced domestically'...sound familiar?"
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"That's right, this is the definition of 'REAL GDP'; basically, changes in the output of all goods and services are equal to changes in real GDP."
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--THE Y-AXIS OF THE AD/AS--
--THE Y-AXIS OF THE AD/AS--
"In the AD/AS diagram you are showing how changes in average prices of all goods impact the level of overall output/income/spending, so what can we use to measure these changes in average prices?"
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"Well, if you have ever overheard your parents moaning about how 'the price of everyday staples like bread and milk has almost doubled over the past decade,' you should know what to use; go on, have a guess!"
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"Correct! Instead of price, we use changes in the inflation rate measured by something called the GDP deflator or the Consumer Price Index (CPI), which literally measures changes in the price of a fixed basket of consumer goods and services over time (with a base year)."
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--AGGREGATE DEMAND (AD)--
--AGGREGATE DEMAND (AD)--
--DEFINITION--
--DEFINITION--
"aggregate demand refers to 'the total demand for domestically produced final goods and services at each average price level'."
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"Who does the demanding?"
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--COMPONENTS OF AD--
--COMPONENTS OF AD--
+ CONSUMER DEMAND ('C')
+ CONSUMER DEMAND ('C')
'CONSUMPTION SPENDING' = 'DEMAND by DOMESTIC HOUSEHOLDS for DOMESTIC OUTPUT'. Denoted by the letter 'C'.
+ INVESTMENT (BIZ) DEMAND ('I')
+ INVESTMENT (BIZ) DEMAND ('I')
'INVESTMENT SPENDING' = 'DEMAND' by DOMESTICALLY BASED firms, for DOMESTIC OUTPUT'. Denoted by the letter 'I'.
+ GOVERNMENT DEMAND ('G')
+ GOVERNMENT DEMAND ('G')
'GOVERNMENT SPENDING' = 'DEMAND by DOMESTIC GOVERNMENT for DOMESTIC OUTPUT'. Denoted by the letter 'G'.
+ EXPORTS (FOREIGN) DEMAND ('X')
+ EXPORTS (FOREIGN) DEMAND ('X')
'EXPORT SPENDING' = 'DEMAND by FOREIGNERS for DOMESTIC OUTPUT', both of which are denoted by the letter 'X'.
- DEMAND FOR IMPORTS ('M')
- DEMAND FOR IMPORTS ('M')
'IMPORT SPENDING' = 'DEMAND by C+I+G for FOREIGN-MADE OUTPUT', both of which are denoted by the letter 'M'.
--SHIFTS IN AD--
--SHIFTS IN AD--
"What non-price-level factors would cause any of these components to increase or decrease?"
in the ad/as model an increase in income does not shift AD to the right as whenever income increases
⚠️"For this section you should use the following graphic organiser design for each component"
--HOUSEHOLD DEMAND ('C')--
--HOUSEHOLD DEMAND ('C')--
"Life is good, jobs everywhere; I am fine spending now!"
CONFIDENCE: "When households feel confident about the economic environment, future prospects, job security, etc., they tend to spend more money and vice versa."
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"Money is cheap, I am going to borrow, borrow, borrow!"
INTEREST RATES: "Interest rates are the 'cost of borrowing' money and therefore impact household spending in two ways: firstly, the higher they are, the less willing consumers are to take out loans to finance the purchase of goods and services, and secondly, if they already have existing debt, then changes in the interest rate will impact the size of their repayments, meaning their household disposable income will be reduced, which in turn impacts their ability to spend."
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"My stocks and property price are up, I feel like spending...!"
WEALTH: "Not to be confused with income, this term refers to the estimated value of assets that a household owns, for example, real estate and shares. If these were to increase in value, then the household will feel more wealthy and, as a result, more willing to spend money."
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"I've got more money after-tax, I have to spend it...!"
INCOME TAX: "The amount of income a person has remaining to spend after tax is referred to as 'disposable income'; therefore, the income tax rate directly impacts the level of consumer spending."
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"I'm debt-free, baby! I feel free to spend...!"
INDEBTEDNESS: "Clearly the level of debt impacts the amount of disposable income that a household has to spend."
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"F.O.M.O.—I have to spend NOW...!"
EXPECTATION: "When future prices are expected to rise, people often rush to spend in the present, and vice versa."
--FIRM'S DEMAND ('I')--
--FIRM'S DEMAND ('I')--
"The malls and restaurants are all full; Let's expand!"
CONFIDENCE: "When businesses feel confident about the economic environment, future demand, price stability, etc., they tend to spend more money on expanding their operations and vice versa."
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"..the cost of borrowing is low, time to invest!"
INTEREST RATES: "Interest rates are in effect the 'cost of borrowing' money, and therefore impact business spending in two ways, firstly the higher they are the less willing firms are to take out loans to finance the purchase of capital goods and services, and secondly if they already have existing debt then changes in the interest rate will impact the size of their repayments, meaning their profits will be directly impacted, which in turn impacts their ability to spend."
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"We need an e-commerce site to compete; I am investing now!"
TECHNOLOGY: "When new technology is introduced, firms cannot afford to be left behind by their rivals; therefore, they need to update their operations."
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"We can keep more profits yay, I am investing now!"
CORPORATION TAX: "The amount of disposable profit a business has to spend on capital goods and services depends directly on the level of corporation tax."
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"We are debt-free, so I am ready to invest!"
INDEBTEDNESS: "Clearly the level of debt impacts the amount of disposable profit that a firm has to spend."
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"The bank's are practically begging me to borrow, I am investing now!"
ACCESS TO CREDIT: "The correlation between access to credit and the ability of firms to engage in investment spending is obvious. During economic downturns, banks may be unwilling to lend money, and if they do, they may attach very high interest rates.
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"I am 100% confident that any profits I make won;t be stolen!"
PPR PROTECTION: "Private Property Rights (PPR) are taken for granted in most developed nations; however, in less developed countries in which the rule of law is not enforced, lack of protection of PPRs can mean entrepreneurs are reluctant to engage in investment activity in fear that their gains will be taken from them."
--GOVERNMENT'S DEMAND ('G')--
--GOVERNMENT'S DEMAND ('G')--
"Yikes, too much demand and not enough supply, prices are skyrocketing, let's reduce our public spending, shhhhhhhh!"
BOOM: A boom is a period of rapid economic expansion resulting in higher GDP, lower unemployment, a higher inflation rate, and rising asset prices. Booms usually suggest the economy is overheating with demand greater than the potential creating a positive output gap and inflationary pressures, hence the government use policies such as contractionary fiscal policy (Less Gov’t spending) to reduce demand. (‘See Lawson Boom UK’)
"OMG, no-one's spending we need to kickstart some economic activity, fire up the printing press, let's spend some money!"
TROUGH: A trough is the stage of the economy's business cycle that marks the end of a period of declining business activity and the transition to expansion. The government can help in the recovery bY stimulating demand via expansionary fiscal policy (More gov’t spending)
--FOREIGN DEMAND ('X-M' or 'NX')--
--FOREIGN DEMAND ('X-M' or 'NX')--
"Our curency has dropped in value against other countries, no wonder we have so many tourists buying our stuff!"
Δ EXCHANGE RATE: The exchange rate refers to the price of one currency in terms of another currency. Clearly, if the price of your currency falls in terms of another, your currency can buy less of the other currency; hence, the prices of imports are more expensive in your currency; however, your exports are now cheaper in terms of their currency.
"Brazilians, Russians, Indians, and Chinese, are all generating higher incomes, and of course this means more demand for our stuff!"
Δ FOREIGN INCOME: Demand for exports is very much dependent on the income and economic situation within your trading partners. If they are in an expansionary phase, then the demand for your exports should be growing.
"We have signed a Free trade agreement with the US, so our stuff is much cheaper!"
TRADE BARRIERS: A trade barrier is designed to reduce the demand for imports in order to protect domestic producers from competition.
🤔--THINK AHEAD--🤔
"In the micro-model we simply assume that profit maximising producers will produce 'more' when price rises, assuming that 'spare productive resources' are readily available, right?" "They can hire more staff, get more inputs, and so on to satisfy any shortages, but surely there must be some limit, think about the PPC model with its 'production boundary.'" "How would you produce more units if all the required new resources were already employed elsewhere?"
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"In the micro-model, if the price of, say, Coca-Cola rises, it has no impact on the real income of anyone, well maybe this guy...
"...but what if 'all-prices' rise? Surely that will have an impact on your purchasing power, so what are you likely to do, and when will you actually realise this is happening?"
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"...but what if all prices fall? "Will you do the same?"
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--AGGREGATE SUPPLY (AS)--
--AGGREGATE SUPPLY (AS)--
"With these ideas in mind, we see an interesting dichotomy of perspectives regarding the relationship between changes in the average price level and firms' willingness to alter production (real GDP), a relationship that depends critically on whether we are in the short run or long run, how much spare capacity the economy possesses, and whether prices have risen or fallen."
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"Let's do some defining!"
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--SHORT-RUN & LONG-RUN--
--SHORT-RUN & LONG-RUN--
-SHORT-RUN-
-SHORT-RUN-
--LONG-RUN--
--LONG-RUN--
--DEFINITION--
--DEFINITION--
In the MACRO-SENSE the SHORT-RUN refers to a TIME-PERIOD in which FACTOR PRICES, such as wages, are INFLEXIBLE and DON'T CHANGE when the AVERAGE PRICE LEVEL CHANGES.
--DEFINITION--
--DEFINITION--
In the MACRO-SENSE the LONG-RUN refers to a TIME-PERIOD in which FACTOR PRICES, such as wages are FLEXIBLE, and ADJUST TO CHANGES IN THE AVERAGE PRICE LEVEL CHANGE.
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"Now that we know the difference between the short and long run, we can show
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"Now that we know the difference between the short and long run, we can show namely the link between the average price level and the willingness and ability to supply, we need to assume the economy is currently at its capacity, let's imagine that foreign demand has increased considerably in the form of a large increase in tourist numbers. What do you think would now happen in the 'short-term'?"
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"That's right, with reference to our micro models, as a profit maximiser, you would likely follow the 'law of supply' and react by raising your prices and increasing output by asking staff to work longer hours and staying open as long as possible, meaning you would see the average price level rise as well as more real GDP, giving an upward-sloping supply curve, right?"
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"⚠️This law specifically mentioned a condition called ceterus paribus, do you remember?" "It referred to the condition that 'all other factors stay constant or 'fixed' to preserve the positive relationship between price and output, right?" "What would have happened to output if prices and input costs increased at the same time?"
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"Well, with a rightward shift in demand matched by a leftward shift in supply, then the answer is 'Nothing would happen to output.'"
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"Fortunately for firms, price levels and input costs rarely change at the same time, as we can see in the diagram below how, despite moving in the same general direction, prices and wages exhibit time lags.
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Scenario # 1:
An increase in AD @ full employment
Scenario # 2:
A decrease in AD @ full employment
Scenario # 3:
An increase in SRAS @ full employment
Scenario # 4:
A decrease in SRAS @ full employment
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"So we can
This fact gives rise to TWO distinct relationships between the price level and the level of REAL GDP an economy produces."
and if they all did it you would see the average price level rise as well as more real GDP, giving an upward-sloping supply curve, right?
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"⚠️ Note, however, that we have just assumed that profit maximising producers will produce 'more' when price rises, which assumes that 'spare productive resources' are readily available right!, we can hire more staff, get more inputs, and so on to satisfy any shortages, but surely there must be some limit." "How would you produce more bubble teas if all the required new resources were already employed elsewhere?"
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"I suppose we could ask existing staff to work extra hours, or open for longer hours, and run our machines faster and so on, but getting new staff that are employed elsewhere will require offering a higher wage as an incentive, or a new shop will require a higher bid than previously; costs are rising."
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"...what's that unlike the micro model, we are not dealing with the increase in the price of one single good, we are dealing with the increase in the average price level right, so if all prices start to rise won't that reduce the purchasing power of the current wages offered to your staff?"
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"What would happen to the average price level and real GDP if both demand and the costs of production increased by 10%?"
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"What's the link between wages and prices?"
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"Looking at the graph below what can be concluded?"
--DEFINITION--
--DEFINITION--
AGGREGATE SUPPLY refers to the total quantity of goods and services domestically produced in an economy at all given price levels in a given period of time, as measured by REAL GDP.
However, due to the fact that the 'produtive capacity' of an economy is limited the relationship between AVERAGE PRICE LEVEL and REAL GDP differs between the SHORT-RUN and the LONG-RUN, creating two distinct curves.
--THINK AHEAD--
--THINK AHEAD--
"So your unit costs of production are fixed (e.g., staff wages fixed at $10 p/h), and all of a sudden you notice demand for your bubble tea has started to boom, and you are literally turning away customers ('shortage'). What would a profit-maximizing producer do?"
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"That's right! They would raise prices and produce more."
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--SRAS CURVE--
--SRAS CURVE--
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"So the SRAS should be an upward sloping curve similar to the microeconomic supply curve, reflecting the 'law of supply', stating that producers are willing to supply more at higher prices ceterus paribus."
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of "But unlike the micro model, we are not dealing with the increase in the price of one single good, we are dealing with the increase in the average price level right, so if all prices start to rise won;t that reduce the purchasing power of factor owners such as labour?"
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"Yes but there is a
--WHY ARE WAGES INFLEXIBLE IN THE SR?--
--WHY ARE WAGES INFLEXIBLE IN THE SR?--
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"All of a sudden the demand for int'l schools in HK increases, as a result, your school has a shortage of places. In order to satisfy this, they raise the admission fees and enlarge the class size, earning a lot of extra profits. Do you think I will get a share of this via a raise?"
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"Firstly, why would I ask for one?"
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"Secondly, I have a contract with a fixed wage, so I can't really expect to get it changed just yet, can I?"
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"Now, what if the demand for int'l schools in HK actually decreases and the school has a surplus of places? In order to fill this, they lower the admission fees. Do you think I will accept a lower wage as a result?"
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"Firstly, why would they ask me too?"
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"Secondly, I have a contract with a fixed wage, so I can't really expect to get it changed just yet, can I?."
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--WHY ARE WAGES INFLEXIBLE IN THE SR?--
--WHY ARE WAGES INFLEXIBLE IN THE SR?--
Wages are usually CONTRACTUALLY FIXED, in addition, government regulations such as the MINIMUM WAGE will prevent wages from falling, whilst TRADE UNIONS will threaten to go on strike to prevent this from happening. Finally, firms will be reluctant to offer lower wages (even though the real value is the same) out of fear that it will DEMOTIVATE THEIR WORKERS.
--WHY IS THIS SIGNIFICANT?--
--WHY IS THIS SIGNIFICANT?--
--...If AD and the PRICE LEVEL RISES--
--...If AD and the PRICE LEVEL RISES--
If AD rises and the APL RISES in the SR the wage that a worker receives ('The NOMINAL WAGE') LOSES 'REAL' VALUE in terms of its purchasing power, in other words, THE REAL WAGE FALLS WHEN THE APL RISES.
Workers are initially unaware of this fall in value, plus they tend to have contracts that have fixed wages and this inability to increase wages and restore their real values means 'REAL COSTS DECREASE' while the prices that firm's can charge rises so firms will have A PROFIT INCENTIVE TO PRODUCE MORE, in this time period.
However, In the LR working contracts will eventually end and WORKERS having noticed that their real wage have fallen will SEEK HIGHER NOMINAL WAGES in order for their 'REAL WAGES' to regain their purchasing power, in other words, THE REAL WAGE IS RESTORED. This rise in costs for the firm makes the original profit motive disappear.
--...If AD and the PRICE LEVEL FALLS--
--...If AD and the PRICE LEVEL FALLS--
When the APL FALLS in the SR the fixed wage that a worker receives ('THE NOMINAL WAGE') GAINS 'REAL' VALUE in terms of its purchasing power, in other words, THE REAL WAGE RISES WHEN THE APL FALLS.
This inability to reduce wages and restore their real values means 'REAL COSTS INCREASE' and firms will have NO CHOICE but to REDUCE PRICE and OUTPUT, hence the SLOPE of the SRAS curve.
In the LR working contracts will end and FIRMS will OFFER LOWER NOMINAL WAGES in order for their 'REAL WAGES/COSTS' to regain their real purchasing power, in other words, THE REAL WAGE IS RESTORED.
--SHIFTS IN THE SRAS --
--SHIFTS IN THE SRAS --
THE REASONS FOR A SHIFT IN THE SRAS ARE SIMILAR TO THE REASONS FOR A SHIFT IN THE SUPPLY CURVE FOR A SPECIFIC GOOD IN THE MICRO MODEL.
CHANGES IN WAGES: If wages INCREASE, with the price level constant, firms’ costs of production rise, resulting in a LEFTWARD shift in the SRAS curve and vice versa.
CHANGES IN OTHER RESOURCE PRICES: Changes in the price of non-labour resources, such as the price of oil, equipment, capital goods, land inputs, and so on affect the SRAS curve in the same way as changes in wages.
CHANGES IN BUSINESS TAXES: Business taxes are taxes on firms’ profits, and are treated by firms like costs of production. Therefore, HIGHER taxes on profits are like INCREASES in production costs, which shifts the SRAS to the LEFT.
CHANGES IN SUBSIDIES offered to businesses. Subsidies have the opposite effect to taxes, as they involve money transferred from the government to firms. If they DECREASE, the SRAS curve shifts to the LEFT; and vice versa.
SUPPLY SHOCKS: Supply shocks are events that have a sudden and strong impact on short-run aggregate supply. Some supply shocks directly affect aggregate supply. For example, a war or violent conflict can result in destruction of physical capital and disruption of the economy, leading to lower output produced and a LEFTWARD shift in the SRAS curve. Unfavourable weather conditions can cause a fall in agricultural output, also shifting the SRAS curve to the left. For example supply-chain issues following COVID, UKRAINE-RUSSIA conflict etc...
--LONG-TERM ADJUSTMENTS--
--INCREASE IN AD--
--IN THE SR--
--IN THE SR--
In the SR, factor prices such as wages are fixed, therefore if AD increases, (EXPANSIONARY GAP) real wages falls meaning it is profitable for firms to raise prices and increase output.
Even though the firm is at full employment they can increase production by asking existing workers to do overtime, hiring unemployed workers, or running machines more intensively.
This is unsustainable, but possible in the short run because wages and contracts haven’t yet adjusted.
--IN THE LR--
--IN THE LR--
In the LR people realise that the cost of living has increased, but eventually in the long-run this loss of purchasing power is fully recognised and factor prices (wages) are renegotiated back to their real values, which increases the costs of production for the firms (Shifting the SRAS curve to the left), meaning the original profit incentive (available with fixed factor prices) has gone and so they reduce output and make the extra workers redundant as well as eliminate overtime hours reverting back to the original potential output.
--DECREASE IN AD--
--IN THE SR--
--IN THE SR--
In the SR, factor prices such as wages are fixed, therefore if AD decreases, (CONTRACTIONARY GAP) real wages rise, meaning the costs of production rise, forcing then to reduce output.
Even though the firm is at full employment they can increase production by asking existing workers to do overtime, hiring unemployed workers, or running machines more intensively.
This is unsustainable, but possible in the short run because wages and contracts haven’t yet adjusted.
--IN THE LR--
--IN THE LR--
As mentioned above, the quantity supplied decreases as factor payments are fixed and therefore the real costs of the firm has increased, while the price it can sell at has fallen hence they produce less and make staff redundant meaning they are above the NRU.
However in the long-run this gain of purchasing power is fully recognised and factor prices (wages) are renegotiated downwards to their real values, workers who don't accept will be replaced by those who were made redundant before (Don't forget the real wage has returned to normal now, just at a lower nominal rate) which decreases the costs of production for the firms, so they revert back to the original potential output level and the NRU returns to 3%.
So we can say that in the long run, factor prices adjust to the change in prices back to their real values, and output returns to the full-employment level at an NRU of 3%.
--INCREASE IN SRAS--
--IN THE SR--
--IN THE SR--
In the short-run aggregate supply (SRAS) curve shifts to the right. This could be due to falling wages, lower raw material costs, technological improvements, or higher productivity.
The new intersection with the aggregate demand (AD) curve occurs at a lower average price level (P↓).
Real GDP/output increases (Y↑) in the short run.
The economy experiences growth without inflationary pressure — sometimes called “supply-side growth”.
In the short run: Firms are able to supply more at each price level due to lower costs or efficiency gains. Households and businesses benefit: consumers enjoy lower prices, firms may expand output and employment rises.
--IN THE LR--
--IN THE LR--
In the long run, factor markets adjust as wages and other input prices eventually catch up with the lower costs and the higher output levels.
Once these costs adjust, the initial “windfall” to firms disappears.
The long-run aggregate supply (LRAS) remains fixed at FE
The economy settles back at the full employment output, but with a lower long-run price level.
So, in the long run:
--DECREASE IN SRAS--
--IN THE SR--
--IN THE SR--
If we imagine the economy is at its potential output level and (at full employment with say an NRU of 3%), and then it enters a CONTRACTIONARY PHASE with low demand, causing the average price level to fall, how will producers react?
They will initially think that the price decreases are specific to their industry and given that factor costs are all fixed, they will need to reduce their staff in order to cut costs and reduce the quantity they supply.
So, we can say that in the SR as the APL FALLS so too does the quantity supplied, with the equilibrium moving from 'A' to 'B', hence the slope of the SRAS.
Furthermore, we can say that in the SR as the APL falls following a decrease in AD, so too does the quantity supplied, moving from the 'full employment level of Real GDP, 'Yfe' to level 'Y1', this deviation below 'Yfe' is referred to as a 'DEFLATIONARY GAP'
But this scenario won't last forever?
--IN THE LR--
--IN THE LR--
As mentioned above, the quantity supplied decreases as factor payments are fixed and therefore the real costs of the firm has increased, while the price it can sell at has fallen hence they produce less and make staff redundant meaning they are above the NRU.
However in the long-run this gain of purchasing power is fully recognised and factor prices (wages) are renegotiated downwards to their real values, workers who don't accept will be replaced by those who were made redundant before (Don't forget the real wage has returned to normal now, just at a lower nominal rate) which decreases the costs of production for the firms, so they revert back to the original potential output level and the NRU returns to 3%.
So we can say that in the long run, factor prices adjust to the change in prices back to their real values, and output returns to the full-employment level at an NRU of 3%.
--LRAS--
--LRAS--
--LONG RUN AGGREGATE SUPPLY CURVE--
--LONG RUN AGGREGATE SUPPLY CURVE--
If we look at the two diagrams below, what can you infer about where the level of output lies once the factor prices adjust? That's right, it always returns to the full-employment level of output, and the only thing that changes is the price level.
So, if we were to draw the long-run level of output we would end up with a vertical line stationed at the full employment level of output.
--AD/AS & THE BUSINESS CYCLE--
--AD/AS & THE BUSINESS CYCLE--
So far we know this...
The LRAS curve represents the level of REAL GDP at full employment.at any one moment in time.
The Long term trendline in the business cycle represents the level of REAL GDP at full employment over time.
Therefore, the level of REAL GDP at the LRAS curve = a point on the Long term trendline
Therefore...
The INFLATIONARY/EXPANSIONRY GAP on the ADAS diagram caused by either a rise in demand or supply corresponds to expansionary periods of time on the business cycle when actual GDP is MORE THAN potential GDP.
The DEFLATIONARY/STAGFLATIONARY GAP on the ADAS diagram can be caused by either a fall in demand or supply and corresponds to contractionary periods of time on the business cycle when actual GDP is LESS THAN potential GDP.
When there is NO GAP on the ADAS diagram it corresponds to a period of time on the business cycle when actual GDP EQUALS potential GDP.
--CLASSICAL PERSPECTIVE--
--CLASSICAL PERSPECTIVE--
--NEW-CLASSICAL VIEW--
--NEW-CLASSICAL VIEW--
So far we have assumed that in the short-run during an expansionary phase the economy produces beyond its NRU, and as a result, prices and output will rise at the same time, and that eventually IN THE LONG RUN FACTOR PRICES WILL ADJUST UPWARDS and real values will be restored, meaning only prices will rise and output will return to its full-employment level.
Similarly, we have also assumed that in the short-run during a contractionary phase the economy produces below its NRU, and as a result, prices and output will fall at the same time, and that eventually IN THE LONG RUN FACTOR PRICES WILL ADJUST DOWNWARDS and real values will be restored, meaning only prices will fall and output will return to its full-employment level.
This readjustment mechanism, due entirely to market forces outlines the school of thought held by the 'NEW CLASSICAL' economists who overwhelmingly trust in these forces to solve most misallocations.
-KEYNESIAN PERSPECTIVE-
-KEYNESIAN PERSPECTIVE-
--KEYNESIAN VIEW--
--KEYNESIAN VIEW--
Whilst most economists agree, regarding the upward adjustment of prices during expansionary phases there exists some disagreement regarding the downward adjustment of factor prices (in particular the price of labour 'wages') during contractionary phases.
These economists come from the 'KEYNESIAN' school of thought, which cites real-world examples of wages not adjusting downwards during times of economic contraction, in particular during 'The Great Depression' in the US between 1929 – 1939.
It was observed that factor prices (wages) as well as product prices did not adjust downwards and were in fact 'STICKY' in the downward direction, meaning the economy gets 'stuck in the short run' and cannot return to the Long run full employment level, meaning output levels will remain low, while unemployment will stay above the NRU.
--WHY ARE WAGES & PRICES STICKY?--
--WHY ARE WAGES & PRICES STICKY?--
WAGES do not fall easily, even over long periods of time, because of a variety of factors such as labour contracts, minimum wage legislation; worker and union resistance to wage cuts.
PRICES do not fall easily either as the stickiness of wages means firms will avoid lowering their prices because that would reduce their profits. Furthermore, large oligopolistic firms may fear price wars; if one firm lowers its price, then others may lower theirs more aggressively in an effort to capture market shares, and then all the firms will be worse off. Such factors, it is argued, make prices unlikely to fall even in a recession.
--HOW DO STICKY PRICES IMPACT THE AS CURVE?--
--HOW DO STICKY PRICES IMPACT THE AS CURVE?--
We can see from the diagrams below that in the Keynesian diagram when AD falls from AD1 to AD2 prices do not fall and readjust like in the classical diagram. Therefore, the economy gets stuck at point 'd', in the SR and hence is 'Unable to move into the LR'.
--KEYNESIAN AS CURVE & SPARE CAPACITY--
--KEYNESIAN AS CURVE & SPARE CAPACITY--
The KEYNESIAN AS curve consists of three separate sections, which illustrate the relationship between output and price level as before, approaching and at the full employment level of output.
SECTION 1: CHANGE IN OUTPUT & NO CHANGE IN PRICE. Within this range of output, there exists an abundance of 'Spare capacity' in terms of unemployed factor resources therefore as output rises, there is no upward pressure on factor costs.
SECTION 2: CHANGE IN OUTPUT & CHANGE IN PRICE. Within this range of output, the availability of resources is running out and firms need to compete for these scarce factors by offering higher payments, which inevitably means they will charge higher prices.
SECTION 3: NO CHANGE IN OUTPUT & CHANGE IN PRICE. Within this range of output level, the economy has reached full employment, and beyond to a level of output that represents an NRU of 0%. as such only prices can rise while output is fixed.
--EQUILIBRIUM IN THE KEYNESIAN MODEL--
--EQUILIBRIUM IN THE KEYNESIAN MODEL--
We can use the Keynesian model to show basically the same scenarios as in the classical model, however, the main differences are as follows:
Factor costs won't automatically adjust downwards, and the economy can become stuck in a recessionary stage.
Unlike in the classical model, increases in AD will not always raise prices when in section 1.
--LRAS--
--LRAS--
--WHAT CAUSES THE LRAS TO SHIFT?--
--WHAT CAUSES THE LRAS TO SHIFT?--
The LRAS curve is stationed at a level of REAL GDP that is termed the 'full employment level of output', and this level is just a single point on the long-term trend on the business cycle, which as we know is upward sloping over time. This suggests that the LRAS curve regularly SHIFTS to the RIGHT, but what would cause this to happen? To answer this we need to consider those factors which 'PERMANENTLY' impact the productive capacity of the economy.
Increases in the QUANTITY of the factors of production: For example a growing population, Increases in net migration, the discovery of new mineral reserves, all increase the level of resources available.
Increases in the QUALITY of the factor of production: For example Improvements in education and training, a healthier workforce, all lead to greater productivity and output.
Improved TECHNOLOGY => PRODUCTIVITY of production: For example, workers who work with improved machines and equipment that have been produced as a result of technological innovations will be able to produce more output in the same amount of time.
Increases in EFFICIENCY: When an economy increases its efficiency in production, it makes better use of its scarce resources, and can as a result produce a greater quantity of output. Therefore, potential output increases, and the AS curves shift to the right. (Decreases in efficiency would shift the LRAS and AS curves to the left.)
INSTITUTIONAL changes: This point is related to efficiency in resource use because changes in institutions can sometimes have important effects on how efficiently scarce resources are used, and therefore on the quantity of output produced. For example, the degree of private ownership as opposed to public ownership of resources, the degree of competition in the economy, the degree and quality of government regulation of private sector activities, and the amount of bureaucracy can each affect the quantity of output produced.
Reductions in the NRU: Yes, you can actually decrease this for example by reducing the time it takes for people between jobs to find new jobs. Therefore, potential output increases, and the AS curves shift to the right. (An increase in the natural rate of unemployment would result in a leftward shift in the LRAS and Keynesian AS curves.)
--LINK BETWEEN SRAS & LRAS & AD--
--LINK BETWEEN SRAS & LRAS & AD--
SHIFTS IN LRAS WILL ALSO SHIFT THE SRAS: Any permanent increase in the productive capacity of the economy will also help firms in the SR to lower the cost of production, hence the SRAS will shift with any changes in LRAS.
NOT ALL SHIFTS IN SRAS WILL SHIFT THE LRAS: As already shown changes in the costs of production such as wages have only a temporary impact on output in the SR, but not in the LR.
SHIFTS IN LRAS WILL ALSO SHIFT AD: As we know output = income = spending, therefore we can assume that with greater output comes greater spending and aggregate demand, for example a larger labour force will make more goods and equally demand more goods.
--15-MARKER P1
--15-MARKER P1
Why do we study these two perspectives? Basically, so you can answer this very common P1 Macro question.
--SHIFTS IN THE AD CURVE--
--SHIFTS IN THE AD CURVE--
Every AD curve is based on a level of SPENDING GROWTH that is consistent along the entire curve, for example, say the amount of spending in $-terms increased by 5%.
But what did this extra 5% spending go on? Is it the purchasing of greater amounts of output (SPENDING GROWTH = REAL GDP GROWTH), is it simply the same quantity of goods with higher prices (SPENDING GROWTH = PRICE LEVEL GROWTH) or is it a combination of both (SPENDING GROWTH = REAL GDP GROWTH + PRICE LEVEL GROWTH)?
For example, with a SPENDING GROWTH of 5% we could have any of the following REAL GDP GROWTH & PRICE LEVEL GROWTH rate combinations
Therefore we can say THE AD CURVE REPRESENTS THE COMBINATIONS OF OUTPUT & PRICE LEVEL GROWTH ASSOCIATED WITH A CERTAIN LEVEL OF SPENDING GROWTH.
Obviously when spending growth rises the AD curve shifts right and vice versa.
--SLOPE OF THE AD CURVE--
--SLOPE OF THE AD CURVE--
As mentioned above the level of aggregate demand corresponds to the LEVEL OF SPENDING in the economy. This level of spending is directly correlated to the average price level:
THE WEALTH EFFECT wealth effect (wealth = value of all assets owned, including property, savings, stocks, bonds, etc); If the price level increases then the real value of wealth falls and people feel poorer and thus spend less.
THE INTEREST RATE EFFECT If the price level increases then consumers and firms need more money for their transactions =? demand for money 1l' =? interest rate 1l' =} cost of borrowing 1l' =? consumer and firm spending U due to lower borrowing =? there is an upward movement along the AD curve, from a to b on AD,
THE INTERNATIONAL TRADE EFFECT trade effect If the price level increases=} exports become more expensive to foreigners =? quantity of exports (X) demanded by foreigners U. Also imports (M) become relatively cheaper to domestic residents =? quantity of imports 1l' =? (X - M) U =? there is an upward movement along the AD curve, from a to b on AD,
Therefore we can say THE AD CURVE REPRESENTS THE COMBINATIONS OF OUTPUT & PRICE LEVEL GROWTH ASSOCIATED WITH A CERTAIN LEVEL OF SPENDING GROWTH.
Obviously when spending growth rises the AD curve shifts right and vice versa.
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