modeling demand and supply shocks using aggregate demand (ad) and aggregate supply (as) outline...
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Modeling Demand and Supply Shocks using Aggregate Demand (AD) and Aggregate Supply (AS)
Outline
•“Short-run” versus the long run.
•AD and AS Together: “Short-run” equilibrium
•Demand shocks in the short-run
•The long-run AS curve
•Adjustment to “long run” equilibrium
•Supply shocks in the short-run
•Long-run effects of supply shocks
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Professors Hall and Liebermancall the Keynesian model a “short-run” model. Why?
Because it is possible for the economy to be in equilibrium, but at the same time real GDP
can be above or below potential or full employment GDP
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450
AE
Real GDP($Trillions)
Y1 YFE Y20
AE1
AE2
AE3
E
H
K
•Point K is a short-run equilibrium since Y1 < YFE
•Point H is a short-run equilibrium since Y2 > YFE
•Point E is a long-run equilibrium since equilibrium GDP corresponds to YFE
Long-run equilibrium occurs when the economy is in equilibrium at full employment
Full employment GDP
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Short run equilibrium is a combination of price level and GDP consistent with both AS and AD curves
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PriceLevel
Real GDP($Trillions)
0
AD
AS
E
B
F
6 10 14
100
140
Why is point E a short-run equilibrium?
•At point B, the price level is 140 and AS = $14 trillion. But equilibrium GDP is equal to $6 trillion when the price level is 140—we know this from the AD curve.
•At point E, the price level is consistent with an output level of $10 along both AS and AD curves
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PriceLevel
Real GDP($Trillions)
0
AD1
AS
Effect of a Demand Shock
AD2
10 12 13.5
E
H J
100
130
Increase in government spending
Issue: Why did the economy move from point E to point H—instead of E to J?
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G GDPMultiplier Effect
AD curve shifts rightward
Unit cost P
Money Demand
Interest rate
a and IP GDP
Movement along new AD curve
Movement along AS curve
Net result: GDP increases, but by less due to the effect of an increase in the price level
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PriceLevel
Real GDP($Trillions)
0
AD2
AS
Effect of a decrease in the money supply
AD1
1086.5
EK
S
100
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M GDP
AD curve shifts Leftward
Unit cost P
Money Demand
Interest rate
a and
IP GDP
Movement along new AD curve
Movement along AS curve
Net result: GDP decreases, but by less due to the effect of an decrease in the price level
Interest
rate
a and IP
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PriceLevel
Real GDP($Trillions)
0
Long run AS curve: A vertical line indicating all possible output and price level combinations the economy could end up in the long run
Long run AS curve
YFE
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Some economists (including Hall &
Lieberman) believe the economy is “self-
correcting”—that is, forces are present that
push the economy to long-run (or full-employment)
equilibrium.
(How does it work?)
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PriceLevel
Real GDP($Trillions)
0
AD1
AS1
Long Run AS Curve
YFE Y3 Y2
AD2
AS2
P1
P3
P2
P4
E
HJ
KLet AD shift from AD1 to AD2
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Positive demand shock P and Y
Change in short-run equilibrium
Y > YFEWage
RateUnit Cost
PY until Y =YFE
Long-run adjustment process
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The following factors could shift the (short-run) aggregate supply schedule up to the left:
•An increase in the price of a basic commodity—e.g., petroleum, natural gas, wheat, soybeans.
•An increase in average money wages and benefits not restricted to just one industry or sector of the economy.
•An increase in the average markup over unit cost not restricted to just one industry or sector of the economy.
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PriceLevel
Real GDP($Trillions)
0
AD2
AS1
Effect of an increase in petroleum prices
AD1
1086.5
E
S
100
AS2
130
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Date Price ($)Jan. 1972 1.79Dec. 1973 4.68Jan. 1974 10.84
April 1979 14.55June 1979 18.00
Nov 1979 24.00
Aug. 1980 30.00Oct. 1981 34.00
Price of One Barrel of 340 crude oil
Source: The Petroleum Economist
I’d call that a shock,wouldn’t you? The story
of Joseph (see Old Testament)suggests buffer stocks
as the remedy forsupply-shock
inflation
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Productivity () means the average output of a worker
per year, or alternatively: = GDP/N
where N is total employment and Y is real GDP.
depends onthe efficiency with
which labor is employedin the production of
goods & services
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Let denote average annual compensation of employees (including benefits). Thus unit labor cost (UCL) is defined as:
ULC = /
Notice that compensationcan rise with no effect on ULC,
so long as productivitykeeps pace
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Productivity & Costs, Nonfarm Sector
-2
-1
0
1
2
3
4
5
6
year/quarter
perc
ent c
hang
e Productivity
Hourly Compensation
Unit Labor Cost
Productivity 4.1 2.7 0.6 5 5
Hourly Compensation 4.6 4.2 4.8 4.7 4
Unit Labor Cost 0.5 1.4 4.2 -0.3 -1
98.4 99.1 99.2 99.3 99.4
Source: www.dismal.com% change, annual rate
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