Economics principles tools and applications 9th by sullivan sheffrin perez chapter 15

15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK Returning to Full Employment from a Recession If the economy is operating below full employment, as shown in Panel A, pric

NINTH EDITION

Chapter 15

Modern Macroeconomics: From

Insert Cover Picture

15.1 Describe the key difference between the short run and long run in macroeconomics

15.2 Demonstrate graphically how the economy can return to full employment.

15.3 Analyze monetary neutrality and crowding out using graphs

15.4 Assess how classical economic doctrines relate to modern macroeconomics

15.1 LINKING THE SHORT RUN AND THE LONG RUN (1 of 2)

The Difference between the Short and Long Run

● Short run in macroeconomics

The period of time in which prices do not change or do not change very much

● Long run in macroeconomics

The period of time in which prices have fully adjusted to any economic changes

Should economic policy be guided by what we expect to happen in the short run, as Keynes thought, or what we expect to happen in the long run, as Friedman thought? To answer this question, we need to know two things:

1 How does what happens in the short run determine what happens in the long run?

2 How long is the short run?

Wages and Prices and Their Adjustment over Time

REAL - NOMINAL PRINCIPLE

What matters to people is the real value of money or income—its purchasing

power—not its “face” value

● Wage–price spiral

The process by which changes in wages and prices cause further changes in wages and prices

TABLE 15.1 Unemployment, Output, and Wage and Price Changes

When unemployment is below the natural rate … When unemployment is above the natural

rate …

He believes that easy credit fuelled a stock market boom n the late 1990s and later the housing boom in the 2000s and that is the only reason we have had sufficient demand

in the last few decades

•

Critics say the economy has grown consistently since the last recession and the unemployment rate in 2015 was at or near full employment Although infrastructure

spending is a good idea, it is not necessary to achieve full employment

Aggregate demand curve

A curve that shows the relationship between the level of prices and the quantity of real GDP demanded

2 Aggregate supply.

•

Short-run aggregate supply curve

A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand

•

Long-run aggregate supply curve

A vertical aggregate supply curve that reflects the idea that in the long run, output is determined solely by the factors of production and technology

15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK

Returning to Full Employment from a Recession

If the economy is operating below full employment, as shown in

Panel A, prices will fall, shifting down the short-run aggregate

supply curve, as shown in Panel B

This will return output to its full-employment level

TO FULL EMPLOYMENT (3 of 6)

Returning to Full Employment from a Boom

If the economy is operating above full employment, as shown in

Panel A, prices will rise, shifting the short-run aggregate supply

curve upward, as shown in Panel B

This will return output to its

full-employment level

15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK

TO FULL EMPLOYMENT (5 of 6)

Economic Policy and the Speed of Adjustment

Rather than letting the economy naturally return to full employment at point b,

economic policies could be implemented to increase aggregate demand from

AD0 to AD1 to bring the economy to full employment at point c

The price level within the economy, however, would be higher

15.2 HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK

Liquidity Traps or Zero Lower Bound

● Liquidity trap

A situation in which nominal interest rates are so low, they can no longer fall

Political Business Cycles

● Political business cycle

The effects on the economy of using monetary or fiscal policy to stimulate the economy before an election to improve re election prospects

ELECTIONS, POLITICAL PARTIES, AND VOTER EXPECTATIONS

APPLYING THE CONCEPTS #2: What are the links between presidential elections and macroeconomic performance?

The original political business cycle theories focused on incumbent presidents trying to manipulate the economy in their favour to gain re election Subsequent research began to incorporate other, more realistic factors

15.3 THE ECONOMICS BEHIND THE ADJUSTMENT PROCESS (1 of 7)

REAL - NOMINAL PRINCIPLE

What matters to people is the real value of money or income—its purchasing

power—not its “face” value.

With the economy initially below full employment, the price

level falls, as shown in Panel A, stimulating output

In Panel B, the lower price level decreases the demand for

money and leads to lower interest rates at point d

In Panel C, lower interest rates lead to higher investment

spending at point f

As the economy moves down the aggregate demand curve

from point a toward full employment at point b in Panel A,

investment spending increases along the aggregate

demand curve

15.3 THE ECONOMICS BEHIND THE ADJUSTMENT PROCESS (3 of 7)

Why changes in wages and prices restore the economy to full employment:

(1) Changes in wages and prices change the demand for money

(2) This changes interest rates, which then affect aggregate demand for goods and services and ultimately GDP

The Long-Run Neutrality of Money

As the Fed increases the supply of money, the aggregate demand

curve shifts from AD0 to AD1 and the economy moves to point a

In the long run, the economy moves to point b

15.3 THE ECONOMICS BEHINE THE ADJUSTMENT PROCESS (5 of 7) The Long-Run Neutrality of Money

Starting at full employment, an increase in the supply of money from

Ms0 to M s 1 will initially reduce interest rates from rF to r0 (from point

a to point b) and raise investment spending from IF to I0 (point c to

point d) We show these changes with the red arrows.

The blue arrows show that as the price level increases, the demand

for money increases, restoring interest rates and investment to their

prior levels—rF and IF, respectively Both money supplied and

money demanded will remain at a higher level, though, at point e.

The Long-Run Neutrality of Money

● Long-run neutrality of money

A change in the supply of money has no effect on real interest rates, investment, or output in the long run

15.3 THE ECONOMICS BEHIND THE ADJUSTMENT PROCESS (7 of 7)

Crowding Out in the Long Run

Starting at full employment, an increase in government spending

raises output above full employment As wages and prices increase,

the demand for money increases, as shown in Panel A, raising interest

rates from r0 to r1 (point a to point b) and reducing investment from I0

to I1 (point c to point d )

The economy returns to full employment, but at a higher level of

interest rates and a lower level of investment spending

INCREASING HEALTH-CARE EXPENDITURES AND CROWDING OUT

APPLYING THE CONCEPTS #3: Will increases in health-care expenditures crowd out consumption or investment spending?

• In 1950, health-care expenditures in the United States were 5.2 percent of GDP; by 2000, this share had risen to 15.4 percent

• Since 1950, the average life span has increased by 1.7 years per decade

• Two economists, Charles I Jones and Robert E Hall, go further and suggest normal increases in economic growth will propel health-care expenditures to approximately 30 percent of GDP by mid-century

• Their argument is that as societies grow wealthier, individuals face the tradeoff of buying more goods (automobiles or cars) to enjoy their current life span or spending more

on health care to extend their lives

• Assuming this argument is correct and health-care expenditures increase, what other component of GDP will fall?

• If investment is crowded out, living standards would fall in the long run, reducing the ability to consume both health and non-health goods

• Spending on health would then come at the expense of spending on consumer durables or larger houses That would be the preferred outcome

15.4 CLASSICAL ECONOMICS IN HISTORICAL PERSPECTIVE

Say’s Law

Classical economics is often associated with Say’s law, the doctrine that “supply creates its own demand.”

Keynes argued that there could be situations in which total demand fell short of total production in the economy for extended periods of time

Keynesian and Classical Debates

If wages and prices are not fully flexible, then Keynes’s view that demand could fall short of production is more likely to hold true

However, over longer periods of time, wages and prices do adjust and the insights of the classical model are restored

Aggregate demand curve

Liquidity trap

Long-run aggregate supply curve

Long run in macroeconomics

Long-run neutrality of money

Political business cycle

Short-run aggregate supply curve

Short run in macroeconomics