Study Session 5

Just some quick notes:

MRP = the amount of $ you make from the extra stuff you sell because you hired one more guy. This in turn determines demand for labour (or any other productive input). Therefore, MRP equilibrium will always equal the cost of the input (e.g. wage for the worker day) because any more and you would make a loss.

Physical capital is actual stuff you spend money on which helps you make products. The demand for physical capital is also determined by the MRP of that input (e.g. bulldozer) except that the difference here is that your return on investment in physical capital is seen over many periods. The PV of the MRP's derived from investing in that bulldozer determines the value of investing in that item and determines demand. Kind of like IRR for projects?

SAS vs LAS - Short Run Aggregate Supply and Long Run Aggregate Supply
Aggregate supply is the amt of goods and services produced by an economy and is a function of price level (higher prices increase supply).

General Rules

• This is all about regression to the mean. The mean in this case is the level of GDP at full employment.

The swings back and forth are cause by the usual suspects:

• higher prices of goods and services cause more supply
• higher price of inputs (inc. labour) causes marginal cost to rise, supply to fall
• oversupply of labour will cause wages to fall and demand for labour to increase to equilibrium
• oversupply of goods/services will cause prices to fall and demand for goods/services to increase to equilibrium
• if workers' fears of inflation do not (yet) match actual inflation, we temporarily move along the SAS curve and out of equilibrium until workers' expectations are equal with actual inflation i.e. when workers' fear future inflation, they demand higher wages which increases marginal cost of producing and suppliers will produce less at the same price. Fewer workers employed causes downward pressure on wages as more people compete for fewer jobs and with lower wages come lower marginal cost/higher employment/more supply of product and we return to equilibrium

NB note difference between things that cause a move along a curve and things that cause the whole curve to shift.

SAS is the short term fluctuation either side of the equilibrium supply level (LAS). Movements along this curve are caused by worker expectations about inflation as seen above. Shape of the SAS curve comes from supply at different price levels. Supply increases as price rises so curve is upward sloping.

LAS is level of supply of goods and services when economy is operating at full employment (i.e. only structural and frictional unemployment). This is the natural rate of unemployment and produces the real level of GDP (output). Assumes that workers' view of inflation is in line with reality.

Potential output is positively related to (1) the quantity of labour (2) the quantity of capital and (3) the technology that the economy possesses

In the short run, we are holding money wages (and prices of all inputs) and potential GDP constant.

If the wage rate or prices of other productive inputs increases, the SAS curve will shift to the left, a decrease of aggregate supply in the short run.

Two factors influence change in money wage rates (and cause shift in SAS):

1. unemployment
2. inflation expectations

LOS 23b: Explain the components of and the factors that affect real GDP demand, describe the aggregate demand curve and why it slopes downward, and explain the factors that can change aggregate demand.

AD curve shows the relationship between the price level and the real quantity of final goods and services (real GDP) demanded and is made up of:

CIGX = Consumption + Investment + Government Spending + Net eXports

AD is downward sloping as expected because at high price levels, consumption, business investment, and exports will decrease due to the following effects:

1. when price level rises, real wealth declines so people spend less (wealth effect)
2. when price level rises, interest rates rise which decrease investment as well as consumption because borrowing cost is higher; consumers delaying purchases in this case is an intertemporal substitution as consumers substitute consumption later (when it is relatively cheaper) for consumption now (which is relatively expensive)

What shifts the AD curve?

1. Expectations about future incomes, inflation, and profits
   Expectations of inflation will cause current spending to increase (inexpensive compared to future); expectations of higher incomes will increase consumption; increase in expected profits will increase investment
2. Fiscal and monetary policy Gov spending increases G component of demand; decrease in taxes or increase in transfer payments (e.g. Soc Security) will increase demand through increase in consumption (more money in pockets); increase in money supply tends to decrease interest rates and increase consumption and investment
3. world economy - FX rates and countries' incomes affect their ability to consume other countries' goods and services.

LOS 23c. Differentiate between short-run and long-run macroeconomic equilibrium and explain how economic growth, inflation, and changes in aggregate demand and supply influence the macroeconomic equilibrium

• If equilibrium is price = 100 everything is good, full employment, equilibrium output of GDP
• At 115, there is excess supply since aggregate supply has outstripped aggregate demand. This is a recessionary gap and will cause downward pressure on prices as suppliers restrict supply and try to shed excess inventory and will move the price back to equilibrium.
• At 90, aggregate demand has outpaced aggregate supply = upward pressure on prices and increase of supply - the inflationary gap - as businesses experience unanticipated shortages. return to equilibrium price.

As the price level changes, we move back and forth along the AD curve, regressing toward equilibrium.

Shifts in the short run AS curve are part of the process of moving toward equilibrium i.e. the economy can be in short run equilibrium above or below long term equlibrium.

Economic expansion shift in AD/AS curves = AD outpaces LAS = above full employment = upward pressure on prices. Inflation causes real wages to decline which causes workers to demand more $. More demand for workers (we are above full employment) also causes wages to rise. This increases marginal cost of production which decreases demand for workers (pushing employment back to equilibrium) and decreases supply at the current price (since production is more expensive due to wage increase and fewer employed workers means lower AD) which returns supply to equilibrium.

increase in any input/resource price will cause supply of resulting product to decrease at each price level and causes SAS to decrease.

Recession shift in AD and AS curves = AD is less than equilibrium so fewer workers are employed (less than full employment = structural + frictional + cyclical) and output (GDP) is lower than equilibrium = excess supply of labour = wages/input prices fall = marginal cost falls = increase in SAS of goods and services (now cheaper to produce at same price level) = greater supply in short term = lower prices = increase in demand = more demand for labour = return to equilibrium

LOS 23d: Compare and contrast the classical, Keynesian, and monetarist schools of macroeconomic

All are trying to explain deviations from equilibrium.

Classical economists = shifts in both AD and AS driven by changes in technology over time and that economy has a strong tendency toward full employment equilibrium as either recession or over-full employment lead to decreases or increases in the money wage rate. Taxes are impediment and cause inefficiencies in this process.

Keynesian = shifts in AD due to change in expectations and that wages were "downward sticky" (i.e. they refuse to fall at the rate they should) reducing the ability of a decrease in money wages to increase SAS and move econo0my from recession (or depression) back toward full-employment. Keynesians think this can be nudged by increasing money supply (monetary policy) and/or increasing gov spending, decreasing taxes or both (fiscal policy).

Monetarists believe that monetary policy is the key influence over boom and bust i.e. recessions are cause by inappropriate decreases in the money supply so keep the money supply steady with predictable increases.

Monetarists share the Keynesian belief in downward sticky wages and input prices and share the classical view that taxes cause inefficiencies.

LOS 24h: Explain interest rate determination and the short run and long run effects of money on real GDP

• In the short run
  If the Fed increases the money supply (by buying back treasuries and other securities on the open market), this will decrease the interest rate because there is more cash in the hands of banks who compete to supply this now more abundant cash. Multiplier effect as people spend and more people have cash which banks can then lend again.
• Decreased interest rates encourage Investment and Consumption (which increase AD aggregate demand).
• Low interest rates cause foreigners to move money out of the country to places where it can earn more which lowers the FX rate for that currency which makes eXports cheaper and increases net eXports.
• Long run effect = higher price level, same GDP
  Increased demand for goods and services pushes up the price level (inflation) which increases wages and increases MC causing a decrease in SAS to equilibrium GDP of LAS with the price settling at a higher equilibrium price and interest rate returning to equilibrium (because people want to spend less because prices were higher, demand for money is lower).
• contractions in the money supply (by Fed selling securities) would have the opposite effect.