MacroEcomonics principles, application, and tools 7th edition by sullivan chapter 15

Using aggregate demand and aggregate supply, we can illustrate graphically how changing prices and wages help move the economy from the short to the long run.. Returning to Full Employme

Modern Macroeconomics:

From the Short Run to the Long Run

P R E P A R E D B Y

Just prior to the start of the December 2007 recession, unemployment stood at

4.7 percent It rose to over 10 percent in 2009.

15

Avoiding a Liquidity Trap

What are the links between presidential elections andmacroeconomic performance?

Elections, Political Parties, and Voter Expectations

Will increases in health-care expenditures crowd out consumption or investment spending?

Increasing Health-Care Expenditures and Crowding Out

3

A P P L Y I N G T H E C O N C E P T S

Long Run

● short run in macroeconomics

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

LONG RUN

The Difference between the Short and Long Run

● 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?

R E A L - N O M I N A L P R I N C I P L E

What matters to people is the real value of money or income—its purchasing power—not its “face” value.

From the Short Run to the

● aggregate demand curve

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

Using aggregate demand and aggregate supply, we can illustrate graphically how changing prices and wages help move the economy from the short to the long run

1 Aggregate demand.

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

Returning to Full Employment from a Recession

 FIGURE 15.1

How the Economy Recovers from a Downturn

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

From the Short Run to the

Long Run

Returning to Full Employment from a Boom

 FIGURE 15.2

How the Economy Returns 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.

EMPLOYMENT (cont’d)

15.2

• If output is less than full employment, prices will fall

as the economy returns to full employment.

• If output exceeds full employment, prices will rise and output will fall back to full employment.

HOW WAGE AND PRICE CHANGES MOVE THE ECONOMY NATURALLY BACK TO FULL EMPLOYMENT (cont’d)

15.2

From the Short Run to the

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

EMPLOYMENT (cont’d)

15.2

maintaining low interest rates, so this is not an ideal policy.

•Instead, the Fed began paying interest rates on bank reserves Since banks could

earn a minimum interest rate with deposits, this effectively put a floor on interest rates

AVOIDING A LIQUIDITY TRAP

APPLYING THE CONCEPTS #1: What steps can policymakers take to deal with a possible liquidity trap?

A P P L I C A T I O N 1

From the Short Run to the

● political business cycle

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

Political Business Cycles

EMPLOYMENT (cont’d)

15.2

The original political business cycle theories focused on incumbent presidents trying to

manipulate the economy in their favor to gain reelection Subsequent research began to incorporate other, more realistic factors

• The first innovation was to recognize that political parties could have different goals or preferences

•Republicans historically have been more concerned about fighting inflation, whereas Democrats have placed more weight on reducing unemployment

• The second major innovation was to recognize that the public would anticipate that politicians will try to manipulate the economy

•If the public is not sure who will win the election, the outcome will be a surprise to them—a contractionary surprise if Republicans win and an expansionary surprise if Democrats win

•This suggests that economic growth should be less if Republicans win and greater if Democrats win The postwar U.S evidence is generally supportive of this theory

ELECTIONS, POLITICAL PARTIES, AND VOTER EXPECTATIONS

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

A P P L I C A T I O N 2

How the Changing Price Level Restores the Economy to Full Employment

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.

UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS

15.3

Long Run

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 ADJUSTMENT PROCESS (cont’d) 15.3

Monetary Policy in the Short

Run and the Long Run

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

UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS (cont’d) 15.3

Long Run

The Long-Run Neutrality of Money

 FIGURE 15.6

The Neutrality of Money

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

0 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—r and I , respectively Both money supplied and

THE ADJUSTMENT PROCESS (cont’d) 15.3

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

UNDERSTANDING THE ECONOMICS OF THE ADJUSTMENT PROCESS (cont’d) 15.3

Long Run

Crowding Out in the Long Run

 FIGURE 15.7

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

THE ADJUSTMENT PROCESS (cont’d) 15.3

•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

INCREASING HEALTH-CARE EXPENDITURES AND CROWDING OUT

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

A P P L I C A T I O N 3

Long Run

HISTORICAL PERSPECTIVE 15.4

Say’s Law

Keynesian and Classical Debates

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

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

short-run aggregate supply curve short run in macroeconomics wage–price spiral

K E Y T E R M S