READ ACTIVELYREAD WITH A PEN As you read

READ ACTIVELY…READ WITH A PEN As you read, indicate the following things in the text: CODE Description * Main Ideas (underline as well) C Area of confusion ? Specific question (write it out) R Reminds me of—draw connections to course & unit content (write it out) V Visualize the content described—graph it!

AFTER READING Share main ideas, areas of confusion, questions with a partner � Revisit/Revise Predictions � Help each other to resolve confusion � Discuss course connections � Consider questions posed during reading

BUSINESS CYCLES AND ECONOMIC GROWTH

WHAT ARE BUSINESS CYCLES? Alternating periods of economic growth & contraction. Commonly called “business fluctuations” because they are not easily predicted.

Expansion §Period of recovery from a recession Peak §Point where Real GDP stops going up §Continues until a new peak is reached Recession §Period of decline in Real GDP Trough §Must decline for 2 consecutive quarters §Point where Real GDP stops doing down

A severe recession can result in a DEPRESSION Economic Conditions High unemployment and major shortages

SLOW EXPANSION (BELOW 3%) RESULTS IN GROWTH RECESSION Unemployment may not follow GDP growth Consumption fails to increase significantly Hint at when?

ESSENTIAL QUESTION: WHY ARE MARKETS UNSTABLE? WHAT TO DO? THEY ARE NOT! Classical View THEY ARE SO!! Keynesian View � Say’s Law: supply creates its own demand � If you build it, they will come… � Markets inherently UNSTABLE � Insufficient demand drags economy down Classical Response � Laissez faire � LR market self adjust Keynesian Response � Govt intervenes � SR Fiscal/Monetary Policy Keynes—In the long run, we are all dead.

CHECK FOR UNDERSTANDING… What is the business cycle?

ONE MORE CHECK Why aren’t Classical economists worried about it? Why are Keynesian economists worried about it? What is one of Mrs. Brouda’s favorite econ quotes?

GRAPHING THE CYCLE Use the GDP data provided to identify changes in the business cycle. Label periods of recession, expansion, peaks and troughs. � What do you know about U. S. history to help explain these?

BUSINESS CYCLES IN THE U. S. The Great Depression Worst and most prolonged economic downturn Marked by the stock market crash on “BLACK TUESDAY” - October 29, 1929 Between 1929 and 1933, GDP declined nearly 50%. Unemployment peaked at 24. 9% (1933). Decade long depression ended with ramp up for WWII World War II U. S. economy returned to its growth trend Spending on wartime goods helped stimulate the economy. Since then, the overall trend has been 3% growth.

A MODEL OF THE MACRO ECONOMY DETERMINANTS Internal market forces External shocks Policy levers LO 1 OUTCOMES Output Jobs MACRO ECONOMY Prices Growth International balances

MACROECONOMIC PERFORMANCE Macro outcomes include: � Output - total value of goods and services produced. � Jobs - levels of employment and unemployment. � Prices - average price of goods and services. � Growth - year-to-year expansion in production capacity. � International balances - international value of the dollar; trade and payments balances with other countries. LO 1

MACROECONOMIC PERFORMANCE Determinants of macro performance include: Internal market forces - population growth, spending behavior, intervention & innovation. External shocks - wars, natural disasters, trade disruptions, etc. Policy levers - tax policy, government policy, changes in the availability of money, credit regulation, etc. LO 1

BUSINESS CYCLE REMIX: ARE THE PRESENTERS CONCERNED ABOUT THE SR ORLR BUSINESS CYCLE? Keynes and Friends… In the long run, we’re all dead. � Therefore, focus on SR with policy changes Say and Friends… In the long run, economy will self adjust… “supply creates is own demand” � Therefore, laissez faire

AGGREGATE SUPPLY &DEMAND Behind the Macro Model

AGGREGATE DEMAND SUPPLY LO 2 Any influence on macro outcomes must be transmitted through supply or demand.

AGGREGATE DEMAND Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus. It is used to refer to the collective behavior of all buyers in the marketplace. LO 2

PRICE LEVEL (average price) AGGREGATE DEMAND Aggregate demand REAL OUTPUT (quantity per year) LO 2

AGGREGATE DEMAND Three separate reasons explain the downward slope of the aggregate demand curve: The real-balances effect. The foreign-trade effect. The interest-rate effect. LO 2

REAL-BALANCES EFFECT The real value of money is measured by how many goods and services your money will buy. Your cash balances are worth more when the price level falls so that you can buy more with them. LO 2

FOREIGN-TRADE EFFECT Consumers can buy either foreign or domestically produced goods. When the U. S. price level falls, Americans buy fewer foreign produced goods and foreigners buy more U. S produced goods. LO 2

INTEREST-RATE EFFECT With lower prices, consumers need to borrow less, the demand for loans diminishes, so interest rates drop. Lower interest rates encourages loan-financed purchases. LO 2

The Aggregate Demand curve shifts in response to changes in overall spending habits in the economy � Internal Mkt Forces � External Shocks � Policy Levers PRICE LEVEL (average price) SHIFTS IN AGGREGATE DEMAND AD 2 AD 1 REAL OUTPUT (quantity per year) Reduced Income Tax Increases Output & Price Level

CHECK FOR UNDERSTANDING 1. 2. 3. 4. 5. What does aggregate mean? What two variables interact in the market mechanism behind the macro model? What is the relationship between the two variables as it relates to the aggregate demand curve? Provide one reason for the shape (slope) of the aggregate demand curve. What is the main reason for shifts in the aggregate demand curve? 1. 2. 3. 4. 5. Total Real Output (GDP) and Price Level (measure of inflation) Indirect Relationship (As price level rises, the quantity of real output demanded falls) Real balances effect, foreign trade effect, interest rate effect Changes in overall spending

PRACTICE WITH AGGREGATE DEMAND Curve shifts as a result of changes in spending PRICE LEVEL (average price) C E A D B REAL OUTPUT (quantity per year)

AGGREGATE SUPPLY LO 2 Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.

AGGREGATE SUPPLY PRICE LEVEL (average price) Aggregate supply REAL OUTPUT (quantity per year) LO 2

AGGREGATE SUPPLY Two reasons explain the upward slope of the aggregate supply curve: The profit effect. The cost effect. LO 2

PROFIT EFFECT Changing price levels will affect the profitability of supplying goods. We expect the rate of output to increase when the price level rises. LO 2

COST EFFECT Costs go up as output expands. Producers are willing to supply additional output only if prices rise at least as far as costs. LO 2

COST EFFECT LO 2 Cost pressures are minimal at low rates of output but intensify as the economy approaches capacity.

The Aggregate Supply curve shifts in response to changes in overall cost of inputs / production � Internal Mkt Forces � External Shocks � Policy Levers PRICE LEVEL (average price) SHIFTS IN AGGREGATE SUPPLY AS 2 AS 1 REAL OUTPUT (quantity per year) Increases in Corporate Taxes Raise Price Level, Reduce Output

CHECK FOR UNDERSTANDING 1. 2. 3. 4. What is the relationship between the two variables as it relates to the aggregate supply? What is the primary reason for the shape of the AS curve? Why does the slope of the curve change as output increases? What is the main reason for shifts in the aggregate supply curve? 1. Direct Relationship (As price level rises, the quantity of real output supplied increases) 2. Profit effect 3. Cost effect 4. Changes in cost of inputs/production

MACRO EQUILIBRIUM LO 3 Macro equilibrium is the combination of price and output that is compatible with both aggregate demand aggregate supply, i. e. buyers’ and sellers’ intentions.

PRICE LEVEL (average price) MACRO EQUILIBRIUM Aggregate supply P 1 E PE Aggregate demand D 1 QE S 1 REAL OUTPUT (quantity per year) LO 3

MACRO EQ. PROBLEM SET RECAP 1. Businesses feel good about the economy and decide to increase spending. a. b. c. Shift AS or AD? Eq PL? Eq r. GDP?

MACRO EQ. PROBLEM SET RECAP 2. A sudden burst in technology makes production more efficient. a. b. c. Shift AS or AD? Eq PL? Eq r. GDP?

MACRO EQ. PROBLEM SET RECAP 3. The cost of oil, a major input, increases. a. b. c. Shift AS or AD? Eq PL? Eq r. GDP?

MACRO EQ. PROBLEM SET RECAP 4. The government decides to increase personal income taxes. a. b. c. Shift AS or AD? Eq PL? Eq r. GDP?

MACRO EQ. PROBLEM SET RECAP 5. The stock market collapses and investors lose billions. a. b. c. Shift AS or AD? Eq PL? Eq r. GDP?

MACRO FAILURES There are two potential problems with macro equilibrium: � Undesirability - the equilibrium price or output level may not satisfy our macroeconomic goals. � Instability – even if the designated macro equilibrium is optimal, it may not last long. LO 3

UNDESIRABILITY Full-employment GDP is the total market value of final goods and services that could be produced in a given time period at full employment. It represents potential GDP. LO 3

UNDESIRABILITY Recessionary Gap: If macro equilibrium is below full-employment GDP, then we have failed to achieve the full employment goal. LO 3

PRICE LEVEL (average price) AN UNDESIRED EQUILIBRIUM Aggregate demand Aggregate supply E PE F P* Equilibrium output Full-employment output QE LO 3 QF

UNDESIRABILITY Inflationary Gap: Similar problems may arise when the equilibrium price level is inflationary. � Inflation is an increase in the average level of prices of goods and services. LO 3

PRICE LEVEL (average price) AN UNDESIRED EQUILIBRIUM Aggregate demand PE Aggregate supply E Desired price level F P* Equilibrium output QE LO 3 QF

INSTABILITY Macroeconomic equilibrium changes whenever the aggregate supply and/or demand curves shift. � Macro Model Determinants: Policy Levers External Shocks Internal Market Forces � Short LO 3 Run vs. Long Question Revisited…

EXAMPLE OF INSTABILITY… Government Shutdown!

CHECK FOR UNDERSTANDING 1. 2. 3. When does Macro Equilibrium occur? What two major policy goals might Macro Equilibrium conflict with? Is Macro Equilibrium stable? Why or why not? 1. When AD/AS intersect 2. Full Employment (Potential Full Employment Output) & Preferred Price Level SR-no, AD or AS can shift LR-perhaps…but in the long run… 3.

COMPETING THEORIES OF SHORT-RUN INSTABILITY Economists AGREE to DISAGREE � What is the shape of AD/AS curve? Horizontal Vertical Steeply/gently sloped � Do LO 3 policy options exist to shift either curve?

DEMAND-SIDE THEORIES Keynesian and Monetary theories are the two basic demand-side theories. � Both theories emphasize the potential of AD shifts to alter macro outcomes LO 3

DEMAND-SIDE THEORIES AS P* E 1 E 0 AD 1 QF REAL OUTPUT (quantity per year) LO 3 (b) Excessive demand PRICE LEVEL (average price) (a) Inadequate demand AS 0 P 2 P* E 2 E 0 AD 2 AD 0 QF Q 2 REAL OUTPUT (quantity per year)

KEYNESIAN THEORY Inadequate demand Problem: deficiency of spending Effect: depress economy (high unemployment) LO 3 Solution: Government spending substitute for consumers AS PRICE LEVEL (average price) P* E 1 E 2 AD 1 QF REAL OUTPUT (quantity per year)

MONETARY THEORIES Money and credit affect the ability and willingness of people to buy goods and services. � Problem: TIGHT MONEY (high interest rates) � Effect: Consumers cut purchases/businesses cut investment � Solution: Manage money supply carefully (“Goldilocks” interest rates) LO 3

PRICE LEVEL (average price) SUPPLY-SIDE THEORIES Decrease in AS 2 AS 1 E 2 P 3 Increases in AS Closer to P* & FE E 1 P* Suppliers impacted by taxes, regulations, etc. AD 0 Q 3 QF REAL OUTPUT (quantity per year) LO 3 Increase Inflation & UE

CHECK FOR UNDERSTANDING 1. 2. 3. 4. What two theories explain shifts of the AD that cause Macro failures? What do Keynsians consider the cause of Macro failures? What do Monetarists consider the cause of Macro failures? What problems might cause a supply side Macro failure? 1. Keynesian theory & Monetary theory 2. Inadequate Demand 3. Tight Money (reducing investment or spending) 4. High taxes, onerous regulations

LONG-RUN SELF ADJUSTMENT FOCUS=INSTITUTIONAL CONSTRAINTS NOT FLUCTUATIONS Monetarists focus: institutional constraints limit LR output � Short Run profit effect dominate with increases in output � Long Run cost effect minimizes increase in output LO 3 Shape: Vertical AS means shifting AD impacts prices but NOT output in LR.

PRICE LEVEL (average price) THE “NATURAL” RATE OF OUTPUT AS P 2 P 1 AD 2 AD 1 QN REAL OUTPUT(quantity per year) LO 3

SHORT VS. LONG-RUN PERSPECTIVES The long-run aggregate supply curve is likely to be vertical. The short-run aggregate supply curve is likely to be upward-sloping. LO 3 COMPROMISE: 3 Part aggregate supply curve

TAMING THE CYCLE The real challenge for macro theory is to determine which curves or shifts best represents reality.

THREE BASIC POLICY STRATEGIES Shift aggregate demand curve – find and use policy tools that stimulate or restrain total spending. Shift the aggregate supply curve – find and implement policy levers that reduce the costs of production or otherwise stimulate more output at every price level. Laissez-faire – Don’t interfere with the market; let markets self adjust. LO 3

SPECIFIC POLICY OPTIONS There a host of policy tools for any given AS/AD strategy: � Classical laissez faire. � Fiscal policy. � Monetary policy. � Supply-side policy. � Trade policy. LO 3

CHECK FOR UNDERSTANDING 1. 2. 3. 4. What group focuses primarily on long run perspectives? How does the profit effect govern the AS in the short run? How does the cost effect govern the AS in the long run? What three policies strategies exist to manage the business cycle? 1. Monetarists 2. Short Run increases in production 3. Long run production cannot be increased 4. Shift AS, shift AD or do nothing (laissez-faire)

MACRO EQ. ADDITIONAL PROBLEMS 1. OPEC lowers the price of oil. a. b. c. d. Shift AS or AD? Eq PL? Eq r. GDP? Unemployment?

MACRO EQ. ADDITIONAL PROBLEMS 2. The “Buy American” movement gains increased power in the US. a. b. c. d. Shift AS or AD? Eq PL? Eq r. GDP? Unemployment?

MACRO EQ. ADDITIONAL PROBLEMS 3. The government increases taxes to pay down our national debt. a. b. c. d. Shift AS or AD? Eq PL? Eq r. GDP? Unemployment?

MACRO EQ. ADDITIONAL PROBLEMS 4. Consumers choose to increase their savings rate. a. b. c. d. Shift AS or AD? Eq PL? Eq r. GDP? Unemployment

ADDITIONAL QUESTIONS… The horizontal range of the AS curve reflects: An overheated economy b) An economy that is experiencing high levels of inflation c) An economy that is near capacity d) An economy with fairly high levels unemployment a) Say’s law argues that: Cyclical instability requires government intervention b) In the long run we’re all dead c) Consumers will never increase spending during periods of recession d) Unsold goods will eventually sell at lower prices via the market mechanism a)

ADDITIONAL QUESTIONS… The shape of the AD curve is influenced by all but which of the following: Real balances effects b) Cost effects c) Interest rate effects d) Foreign trade effects a) Recessions are characterized by: Increases in real GDP b) Low levels of unemployment c) Two quarters of declining real GDP d) High levels of inflation a)

AP MACRO COOK OFF LAYERS OF SPENDING… Cook Off Rules Groups of 2 � Due Fri, October 11 th � Creatively Depict AE p. 186 -191 � 1 paragraph typed design explanation � Must Be Edible � 2 points for participation � 4 points for winner! � Class Vote Based on • Accuracy • Creativity • Taste

FRIEDRICH HAYEK (1899 -1992) Prominent classical (or Neoliberal) economist Winner of the 1974 Nobel in Economics Argued for recovery from Great Depression with increased PRIVATE investment NOT government spending