1. what will be the gdp?

AD105 Price Level

SRAS105

6,900 90 4,5006,600 95 4,8006,300 100 5,1006,000 105 5,4005,700 110 5,7005,400 115 6,000

1. What will be the GDP?2. Will it be long-run equilibrium?

3. What will be the relationship between the actual and natural rates of

unemployment?

AD105 Price Level

SRAS105

6,300 90 4,5006,000 95 4,8005,700 100 5,1005,400 105 5,4005,100 110 5,7004,800 115 6,000

1. What will be the GDP?2. Will it be long-run equilibrium?

3. What will be the relationship between the actual and natural rates of

unemployment?

4. Will this GDP be sustainable?

Aggregate Demandfor Goods & Services

• Aggregate demand (AD) curve: shows the various quantities of domestically produced goods & services that purchasers are willing to buy at different price levels .

• The AD curve slopes downward to the right, indicating an inverse relationship between the amount of goods & services demanded and the price level.

Output(Real GDP -- trillions of $)45º

(AE = GDP)

10.6

AE = C + I + G + NX,P1

10.6

9.4

9.410.0

10.0

Planned aggregate expenditures(trillions of $)

AE = C + I + G + NX,P2

AE = C + I + G + NX, P3

P1

P2

P3

AD10.69.4 10.0

Goods & Services(real GDP)

PriceLevel

AD

P2

Y1 Y2

P1

Aggregate Demand Curve• When the

general price level in the economy declines from P1 to P2,

• the quantity of goods and services purchased will increase from Y1 to Y2.

A reduction in the price

level will increase the quantity of goods & services demanded.

1. The Wealth Effect: A lower price level increases the purchasing power of the fixed quantity of money.

2. The Interest Rate Effect: a lower price level will reduce the demand for money and lower the real interest rate, which then stimulates additional purchases during the current period.

3. The International Trade Effect: A lower price level will make domestically produced goods less expensive relative to foreign goods.

• Each of these factors tends to increase the quantity of goods & services purchased at the lower price level.

• A lower price level will1. increase the wealth of people holding the fixed quantity of money,2. lead to lower interest rates, and 3. make domestic goods cheaper relative to foreign goods.


PriceLevel

AD

P2

Y1 Y2

P1

A reduction in the price

level will increase the quantity of goods & services demanded.


PriceLevel

AD0

AD1

AD2

a. Monetary policylowering interest rates reduces the cost of borrowing and increases consumption and investment.

b. Fiscal policychanges in government purchases shifts the aggregate demand curve by changing the G component. Changing taxes affects the C component.

a. Optimism shifts the curve rightb. Pessimism shifts the curve leftc. Stock prices, world events affect

expectations

Source: http://www.economagic.com.

Consumer Sentiment Index:A Measure of Optimism 1978-2007

• Consumer optimism and pessimism regarding the future of the economy.• Note how the index turns down prior to (or during) the recessions of the period.

Consumer Sentiment Index

100

80

60

40

20

1978 1980 1982 1984 1986 1988 1990 1992 1994 20041996 1998 2000 20020

120

2006

a. Foreign economic growth-Increased income shifts the curve right-Decreased income shifts the curve left-The large the trade sector, the larger the effect

b. Exchange rates-Appreciation shifts the curve right-Depreciation shifts the curve left

1. How will each of the following factors influence aggregate demand in the United States: (a) An increased fear of recession. (b) An increased fear of inflation.(c) The rapid growth of real income in

Canada and Western Europe.

(d) A reduction in the real interest rate.(e) A higher price level (be careful).(f) A stock market decline.

Vote a for an increase in Aggregate Demand

Vote b for a decrease in Aggregate Demand

In the long run, the level of real GDP is determined by the number of workers, the capital stock, and the available technology, none of which are affected by changes in the price level.

Changes in the price level do not affect the level of real GDP.

The level of real GDP in the long run is called potential GDP, or full-employment GDP.

PriceLevel


LRAS

YF

PriceLevel


LRAS1

YF,1

LRAS2

YF,2

a. Minimum wageb. Public policy

PriceLevel


SRAS

a. Firms are often slower to cut wages than raise them

PriceLevel


SRAS1 SRAS2

a. Expected higher reduces supply

b. Expected lower increases supply

a. If workers and firms are adjusting to prices being higher than expected the curve will shift left.

b. If they are adjusting to prices being lower than expected the curve will shift right.

An unexpected event that causes the SRAS to shift.

2. How will each of the following factors influence aggregate supply in the Short Run: (a) An increase in real wages. (b) 4 hurricanes that destroy half of the

orange crop in Florida.(c) An increase in the expected rate of

inflation.(d) An increase in the world price of oil.(e) Abundant rainfall during the growing

season.Vote a for an increase in Aggregate

SupplyVote b for a decrease in Aggregate

Supply

• Start with Equilibrium, then increase LRAS (How?).

PriceLevel

LRAS1

YF1

P100


AD

SRAS1

YF2

LRAS2

P95

SRAS2

• Both LRAS and SRAS increase full employment output expands from YF1 to YF2.• A sustainable, higher level of real output is the result.

• Prices are high relative to production costs• Unanticipated increase in AD.• Supply shock

• Increased output is unsustainable

PriceLevel

LRAS

YF Y2

P100

AD2


AD1

Short-run effects of an unanticipatedincrease in AD

SRAS1

P105

• Improves profits.

• Output increases

• Unemployment drops below the natural rate,

AD2AD1

PriceLevel

P105

YF Y2

P105


Long-run effects of an unanticipatedincrease in AD

SRAS2

P110

YF

LRAS SRAS1

•Resource prices will rise. (SRAS shifts)

•Output will recede to the long-run potential.

• Prices are low relative to production costs• Unanticipated decrease in AD.• Supply shock

• Causes losses, so production decreases

PriceLevel

LRAS

YFY2

P100


AD1

Short-run effects of an unanticipatedreduction in AD

SRAS1

AD2

P95

• Profits fall.• Output decreases• Unemployment

rises,

AD2AD1

PriceLevel

LRAS

YFY2

P100


Long-run effects of an unanticipatedreduction in AD

SRAS1

P95

SRAS2

P90

YF

•Resource prices adjust down. (SRAS shifts)

•Output will recede to the long-run potential.

• Prices fall• Output increases• But conditions return to normal SRAS

shifts back

Due to some favorable supply shock

PriceLevel

LRAS

YF Y2

P100


AD

SRAS1

SRAS2

P95

Quantity of resourcesQ2

D

Pr2

Q1

S1

ResourceMarket

Pr1

S2

• An adverse supply shock, (crop failure or oil price increase)

Decrease in SRAS

• prices rise from Pr1 to Pr2.

PriceLevel

AD

PriceLevel

YFY2

P100


P110

• The higher resource prices shift SRAS to the left• the price level rises to P110 and output falls to Y2.• What happens in the long-run depends on whether the supply

shock is temporary or permanent.

LRASSRAS1 (Pr1 )

SRAS2 (Pr2 )

Decrease in SRAS

PriceLevel LRAS

YFY2

P100


AD

SRAS1 (Pr1 )SRAS2 (Pr2 )

P110

• If temporary, resource prices fall in the future, shifting SRAS2 back to SRAS1, returning equilibrium to (A).• If permanent, the productive potential of

the economy will shrink (LRAS shifts left and Y2 becomes YF2) and (B) will become the long-run equilibrium.

A

B

Decrease in SRAS

How Long Does It Take to Return to Potential GDP? Economic Forecasts Following the

Recession of 2007–2009

Price Level, Inflation, and the AD-AS ModelThe actual price level will also differ from the

level people anticipated when the rate of inflation differs from what is expected.When the inflation rate is greater than

anticipated, profit margins will be attractive and business firms will respond with an expansion in output.

When the inflation rate is less than anticipated, profit margins will be unattractive and businesses

will reduce their output.

A. A widespread fear of depression on the part of consumers.B. A large purchase of American wheat by Russia.

E. A 10 percent reduction in personal income taxes.

D. The complete disintegration of OPEC, causing oil prices to fall by one-half.

C. A cut in Federal spending for health care.

F. An increase in labor productivity.G. Depreciation in the international value of the

dollar.H. A decline in the percentage of the American labor force which is unionized.

Which way will the AS or AD curves move after:

LRAS


Price level

Y F

SRAS

Y F

AD

PPrice level

Employment

GDP

A. A widespread fear of depression on the part of consumers.B. A large purchase of American wheat by Russia.E. A 10 percent reduction in personal income taxes.

D. The complete disintegration of OPEC, causing oil prices to fall by one-half.C. A cut in Federal spending for health

care.F. An increase in labor productivity.

G. Depreciation in the international value of the dollar.

H. A decline in the percentage of the American labor force which is unionized.

Recessions:

Source: Derived from computerized data supplied by FAME Economics.

• Expansion and contraction in the U.S. economy since 1960.

• Reductions in real GDP in the top graph relate with increases in the rate of unemployment above the natural rate (bottom graph).

1960 1965 1970 1975 1980 1985 1990 1995 2000

2,000

4,000

6,000

8,000

9,000

19601970

1974-751980198219902001

1960 1965 1970 1975 1980 1985 1990 1995 2000

2 %4 %6 %8 %

10 %% Labor force unemployed

Real GDP (billions of 1996 $)

Actual rate ofunemployment

Natural rate ofunemployment

1. The end of the housing bubble. A speculative bubble contributed to the rapidly rising housing prices between 2002 and 2005 before deflating in 2006, as both new home sales

and existing home values began to decline. The growth of aggregate demand slowed as spending on

residential construction fell more than 60 percent over the next four years.

The Recession of 2007-2009

2. The financial crisis. The financial crisis led to a “credit crunch” that made it difficult for many households and firms to obtain the loans they needed to finance their spending, which

contributed to declines in consumption spending and investment spending.

3. The rapid increase in oil prices during 2008. Although rising oil prices can result in a supply shock that causes the

short-run aggregate supply curve to shift to the left, it did not shift as far to the left during 2008 as it had from the increases

in oil prices 30 years earlier because many firms had since switched to less oil-dependent production processes.

The Beginning of the Recession of 2007–2009

2007 - 2008, the AD curve shifted to the right, but not by nearly enough to offset the shift to the right of the LRAS curve, which represented the increase in potential real GDP from $13.20 trillion to $13.51 trillion.Because of a sharp increase in oil prices, short-run aggregate supply shifted to the left, from SRAS2007 to SRAS2008. Real GDP decreased from $13.21 trillion in 2007 to $13.16 trillion in 2008, which was far below the potential real GDP, shown by LRAS2008. As a result, the unemployment rate rose from 4.6 percent in 2007 to 5.8 percent in 2008. Because the increase in aggregate demand was small, the price level increased only from 106.2 in 2007 to 108.6 in 2008, so the inflation rate for 2008 was only 2.3 percent.

1. Which of the following would be most likely to cause an increase in current aggregate demand in the United States?a. increased fear that the U.S. economy was going into a recessionb. an increase in the real interest ratec. sharp increase in the value of stocks owned by Americansd. a recession in Canada, Mexico, and Western Europe2. Which of the following will most likely accompany an unanticipated increase in aggregate demand?a. an increase in real outputb. an increase in unemploymentc. a decrease in real GDPd. a decrease in the demand for resources3. In the aggregate demand/aggregate supply model, when the output of an economy is less than its long-run potential, the economy will experiencea. declining real wages and interest rates that will stimulate employment and real output.b. rising interest rates that will stimulate aggregate demand and restore full employment.c. a budget surplus that will stimulate demand and, thereby, help restore full employment.d. rising real wages and real interest rates that will restore equilibrium at a higher price level.

4. Which of the following will most likely result from an unanticipated decrease in aggregate supply due to unfavorable weather conditions in agricultural areas?

a. a decrease in inflationb. a decrease in unemploymentc. an increase in the general level of pricesd. an increase in the natural rate of

unemployment5. Which of the following will most likely increase aggregate supply in the long run?

a. unfavorable weather conditions in agricultural areas

b. an increase in the expected inflation ratec. higher real interest ratesd. an increase in the rate of capital formation

6. Within the AD/AS model, an unanticipated increase in short-run aggregate supply will cause real output to

a. increase and the general level of prices to fall.b. decrease and the general level of prices to rise.c. increase and the general level of prices to rise.d. decrease and the general level of prices to fall.

7. An increase in the long-run aggregate supply curve indicates that

a. the natural rate of unemployment has increased.

b. unemployment has increased.c. the general level of prices has increased.d. potential real GDP has increased.

8. If the general level of prices is lower than business decision makers anticipated when they entered into long-term contracts for raw materials and other resources, which of the following is most likely to occur?

a. an economic boomb. highly attractive profit marginsc. output less than the economy’s long-run

potentiald. a sharp increase in imports

9. When output is less than the economy’s long-run capacity, which of the following is most likely to occur?

a. an abnormally low rate of unemploymentb. reductions in real interest rates and real

resource pricesc. a sharp increase in importsd. a government budget surplus

10. Suppose there was a sharp reduction in stock prices and a sharp increase in the world price of crude oil. Within the framework of the AD/AS model, how would these two changes influence the U.S. economy?

a. The lower stock prices would increase SRAS, and the higher crude oil prices would reduce AD; as a result, there would be downward pressure on the general level of prices.

b. The lower stock prices would reduce SRAS, and the higher crude oil prices would increase AD; as a result, there would be upward pressure on the general level of prices.

c. The lower stock prices would increase AD, and the higher crude oil prices would increase SRAS; as a result, output would tend to increase.

d. The lower stock prices would reduce AD, and the higher crude oil prices would reduce SRAS; as a result, output would tend to decline.

1. what will be the gdp?

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