Lecture 10 Flashcards

Objectives

• Define and explain the influences on aggregate supply.

• Define and explain the influences on aggregate demand.

• Understand how fluctuations in aggregate demand and aggregate supply affect economic growth and inflation.

• Learn about the Aggregate Expenditure model.

• Understand the significance of the expenditure multiplier.

Outline of Lecture

• Aggregate supply

• Aggregate demand

• Explaining economic trends and fluctuations

• Inflation cycles: Demand-pull and Cost-push

• Aggregate Expenditure model

• Expenditure Multiplier

Aggregate Supply and Aggregate Demand

Aggregate Supply-Aggregate Demand Model Purpose

• To explain how real GDP (RGDP) and price level are determined and how they interact.

• To explain business cycle fluctuations in RGDP and the price level.

• Show the relationship between unemployment rate and full employment and the AS-AD model and the long-run aggregate supply.

Long-Run and Short-Run Aggregate Supply

• Short-run aggregate supply (SAS) or aggregate supply (AS) is the relationship between the quantity of real GDP supplied and the price level when the money wage rate, the prices of other resources, and potential GDP remain constant.

• Long-run aggregate supply is the relationship between the quantity of real GDP supplied and the price level when the money wage rate changes in step with the price level to maintain full employment.

• In the long-run, the quantity of real GDP supplied at full employment equals potential GDP, and this quantity is the same regardless of the price level.

Aggregate Supply Curve

• Why the AS curve is upward sloping:

  • When the price level rises and nominal wages stay constant, real wages fall (w/↑p).

  • It becomes more profitable to hire more workers to produce more for less (in real terms).

  • Hiring more workers increases output.

Aggregate Supply Changes

• Aggregate supply (AS) changes (i.e., shifts) when:

  • Potential GDP changes, such as:

    • Quantity of inputs

    • Capital stock

    • Technology change

  • Input price change (i.e., cost of production), such as:

    • The money wage rate changes.

    • The money prices of other resources change.

Shift in Aggregate Supply Curve

• Assume economy is at full-employment (point c).

• An increase in potential GDP (e.g., due to improvement in technology) shifts the potential GDP line rightward.

• The aggregate supply curve shifts rightward from AS0 to AS1.

• Assume economy is at full-employment (point c).

• A rise in an input price (e.g., crude oil price) decreases aggregate supply and the aggregate supply curve shifts leftward from AS0 to AS2.

• A rise in the crude oil price does not change potential GDP.

Aggregate Demand

• Aggregate demand (AD) is the relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same.

• AD = C + I + G + X - M

Why the AD Curve is Downward Sloping

• The buying power of money

• The real interest rate

• The real prices of exports and imports

Buying Power of Money

• Fall in domestic price level ⇒ Real value of firms and households' money balance (wealth) increases.

• Consumption expenditure (C) increases ⇒ AD increases.

Real Interest Rate

• Suppose domestic prices rise (inflation):

  • The Central Bank raises the interest rate.

  • Consumption falls (also means savings increase) and investment falls.

  • AD falls.

Real Prices of Exports and Imports

• Fall in prices of domestically produced goods:

  • Exports become cheaper, so export (X) rises.

  • Imports are now relatively more expensive, so import (M) falls.

  • Net exports (NX) rise, and AD increases.

Factors That Can Change Aggregate Demand

• Expectations about the future

• Fiscal policy and monetary policy

• The state of the world economy

Expectations About the Future

• Future income

• Future inflation

• Future profit

Fiscal and Monetary Policy

• Fiscal policy: Changing taxes, cash transfers from the government, and government expenditure on goods and services.

• Monetary policy: Changing the quantity of money and the interest rate.

The State of the World Economy

• Value of $A against foreign currencies.

• Economic conditions (e.g., inflation) in other countries.

Explaining Economic Trends and Fluctuations

• The purpose of the AS-AD model is to explain business cycle fluctuations in RGDP and the price level.

• Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied (AS = AD).

Three Types of Macroeconomic Equilibrium Scenarios

• Full-employment equilibrium

• Recessionary gap

• Inflationary gap

Full-Employment Equilibrium

• When equilibrium real GDP equals potential GDP.

• AS = AD = potential GDP.

Recessionary Gap

• A gap that exists when potential GDP exceeds real GDP and that brings a falling price level.

• Indicates a surplus of labor, and firms can hire new workers by lowering the nominal wage rate.

• As the nominal wage rate falls, the AS curve shifts to the right.

Inflationary Gap

• A gap that exists when real GDP exceeds potential GDP and that brings a rising price level.

• Indicates excess demand.

• Firms increase production and raise prices (movement along AS).

• Workers demand higher wages due to falling real wages (from higher prices).

• As the nominal wage rate rises, the AS curve shifts to the left.

Inflation Cycles

Demand-Pull Inflation

• An inflation that starts because aggregate demand increases.

• Accommodative fiscal and monetary policy can result in high inflation.

Cost-Push Inflation

• When AS falls, the AS curve shifts leftward, and the price increases.

• Examples: The 1973 Oil price surge or an increase in the cost of resources or supply chain issues.

Why is Inflation Currently So High?

• A combination of factors:

  • Supply problems (e.g., labor shortages, war (surge in gas and oil prices), lack of vacant properties) kept inflation high.

  • Fiscal and monetary support underpinned a strong recovery in demand, putting further pressure on prices.

  • Monetary policy is only effective in curbing demand-side factors.

Aggregate Expenditure Multiplier

• Only Sections 12.1 to 12.3 are covered.

Aggregate Expenditure and The Multiplier

• The Aggregate Expenditure model and the Multiplier is simplified for EFB231.

Expenditure Plans and Real GDP

• Aggregate Expenditure (AE) model is also known as the Keynesian model.

• It is the sum of:

  • planned consumption expenditure,

  • planned investment,

  • planned government expenditure,

  • planned exports minus planned imports.

• AE is related to, but different from AD.

• AD is the whole range of expenditures over a range of price levels.

• AE are expenditures at a given price level.

Aggregate Expenditure

• Modeling the spending behaviors:

  • Consumption

  • Investment

  • Government Expenditure

  • Exports

  • Imports

• The 45° line serves as a reference for comparing consumption expenditure and disposable income.

• Points on the 45° line indicate that consumption expenditure equals disposable income (Yd).

• C = Yd

Consumption Function

• Consumption function is the relationship between consumption expenditure and disposable income, other things remaining the same.

• At point A, if you had zero income, C = 0.4. This is autonomous consumption.

• C = a + Yd, where a is autonomous expenditure.

• As disposable income increases, consumption expenditure increases—induced consumption.

Marginal Propensity to Consume (MPC)

• MPC is the fraction of a change in disposable income that is spent on consumption.

• C = a + bYd, where b = MPC

• MPC = \frac{\Delta \text{ in consumption expenditure}}{\Delta \text{ in disposable income}}

Disposable Income and Taxes

• If there was no government tax on income, disposable income equals aggregate income: Yd = Y

• With government tax on income, Yd is aggregate income minus net taxes (assuming government handouts are zero).

• For a proportional income tax (t): Yd = (1 – t)Y

• C = a + bYd

• C = a + b(1 – t)Y

• b(1 - t) is the tax-adjusted MPC.

Investment, Government, and Exports

• Investment (I) function is assumed to be autonomous of RGDP (Y) because I is dependent on the interest rate.

• Government (G) function is autonomous of Y (depends on government policies).

• Exports (X) depend on other countries’ GDP, not the GDP of Australia. Hence, X is autonomous of Australia’s GDP.

Imports

• Imports (M) is a function of Australian GDP.

• An increase in Australian RGDP brings an increase in Australian imports.

• M = m0 + mY

• Where m0 is the autonomous import and m is the marginal propensity to import.

• Marginal propensity to import (m) is the fraction of an increase in real GDP that is spent on imports.

• m = \frac{\Delta \text{ in imports}}{\Delta \text{ in real GDP}}

Calculating Equilibrium RGDP

• Numerical Example:

  • C = 20 + 0.8Yd

  • G = 30

  • t = 25\%

  • I = 20

  • X = 20

  • M = 10 + 0.1Y

  • AE function: \text{AE} = C + I + G + (X – M)

  • \text{AE} = 20 + 0.8(1 – t)Y + 30 + 20 + 20 – (10 + 0.1Y)

  • \text{AE} = 90 + 0.8(1 – 0.25)Y – 10 – 0.1Y

  • \text{AE} = 80 + 0.6Y – 0.1Y

  • \text{AE} = 80 + 0.5Y

• Calculate the economy’s equilibrium RGDP.

  • \text{AE} = 80 + 0.5Y

  • Equilibrium: Y = \text{AE}

  • Y = 80 + 0.5Y

  • Y – 0.5Y = 80

  • 0.5Y = 80

  • Y = \frac{80}{0.5} = 160

Expenditure Multiplier

• The multiplier is the amount by which a change in autonomous expenditure is multiplied to determine the change in equilibrium expenditure that it generates.

• \text{Multiplier} = \frac{\Delta \text{ in equilibrium expenditure}}{\Delta \text{ in autonomous expenditure}} = \frac{\Delta Y}{\Delta A}

Expenditure Multiplier: A Numerical Example

• Scenario (a):

  • C = 20 + 0.8Yd

  • G = 30

  • t = 25\%

  • I = 20

  • X = 20

  • M = 10 + 0.1 Y

• Scenario (b):

  • C = 20 + 0.8Yd

  • G = 50

  • t = 25\%

  • I = 20

  • X = 20

  • M = 10 + 0.1 Y

• Calculate the Y_e for scenarios (a) and (b).

• Scenario (a):

  • \text{AE} = C + I + G + X – M

  • \text{AE} = 20 + 0.8(1 – t)Y + 30 + 20 + 20 – (10 + 0.1Y)

  • \text{AE} = 90 + 0.8(1 – 0.25)Y – 10 – 0.1Y

  • \text{AE} = 80 + 0.6Y – 0.1Y

  • \text{AE} = 80 + 0.5Y

  • Market equilibrium: Y = \text{AE} = 80 + 0.5Y

  • Y = 80 + 0.5Y

  • Y – 0.5Y = 80

  • 0.5Y = 80

  • Y = \frac{80}{0.5} = 160

• Scenario (b):

  • \text{AE} = C + I + G + X – M

  • \text{AE} = 20 + 0.8(1 – t)Y + 50 + 20 + 20 – (10 + 0.1Y)

  • \text{AE} = 110 + 0.8(1 – 0.25)Y – 10 – 0.1Y

  • \text{AE} = 100 + 0.6Y – 0.1Y

  • \text{AE} = 100 + 0.5Y

  • Market equilibrium: Y = \text{AE} = 100 + 0.5Y

  • Y = 100 + 0.5Y

  • Y – 0.5Y = 100

  • 0.5Y = 100

  • Y = \frac{100}{0.5} = 200

Expenditure Multiplier Calculation

• \text{Multiplier} = \frac{\Delta Y}{\Delta A} = \frac{40}{20} = 2.0

• The general formula for the multiplier is:

  • \Delta Y = \text{Multiplier} \times \Delta A

  • \text{Multiplier} = \frac{1}{1 – \text{Slope of AE}}

  • \text{Multiplier} = \frac{\Delta Y}{\Delta A} = \frac{1}{1 – 0.5} = 2.0