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Lecture 5 AD AS phillips curve

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Lecture 8: Aggregate Demand Aggregate Supply & The Phillips curve Chapter 33, 35 Lecture Objectives Examine economic fluctuations and their features  Study the basic model of fluctuations - the aggregate demand and aggregate supply model  Analyze sources of recession  Use the AD-AS Model & Phillips curve to explain the trade-off between inflation and unemployment  Economic Fluctuations  Economic fluctuations  Negative growth:  Recession: a period of declining income and falling unemployment  Depression: a severe recession  Positive growth:  Boom Economic Growth & Fluctuations Real GDP fluctuates around the long-term growth trend every year Real GDP Long-term growth trend Business Cycles Business cycle Demonstrate short-run fluctuations  Phases of a business cycle • Expansion • Peak • Recession • Trough • Recovery  Business Cycle Real GDP Expansion Recession Recession Real GDP Peaks Recovery Troughs Time Three Key Facts About Economic Fluctuations  Irregular and unpredictable fluctuations  Simultaneous fluctuation of most macroeconomic variables  Fall in output & rise in unemployment Three Key Facts About Economic Fluctuations Economic fluctuations are irregular and unpredictable US Short-Run Economic Fluctuations (a) Real GDP Recession Billions of s 1992 Dollars $7,000 6,500 Real GDP 6,000 5,500 5,000 4,500 4,000 3,500 3,000 2,500 1965 1970 1975 1980 1985 1990 1995 Three Key Facts About Economic Fluctuations Most macroeconomic variables fluctuate together GDP falls => personal income, corporate profits, consumption, investment spending, industrial production, retail sales, auto sales, ect also fall Stagflation  Adverse shifts in aggregate supply  stagflation - a combination of recession and inflation   A fall in output A rise in the price level  cannot offset both of these adverse effects simultaneously Policy Responses to Recession  Do nothing and wait for prices and wages to adjust  Take action to increase aggregate demand by using monetary and fiscal policy Accommodating an Adverse Shift in Aggregate Supply Price Level When short-run aggregate supply falls… Long-run aggregate AS2 supply P3 P2 P1 which causes the price level to rise C A Short-run aggregate supply, AS1 …policymakers can accommodate the shift by expanding aggregate AD2 demand… …but keeps Aggregate demand, AD1 output at its natural rate Natural rate Quantity of of output Output AD-AS Model & Phillips Curve Unemployment & Inflation  AD-AS Model & Phillips Curve  Cost of reducing Inflation  Unemployment and Inflation Misery index: one measure of the “health” of the economy adding together the inflation rate and unemployment rate  A short-run tradeoff between unemployment and inflation:  expand AD  lower unemployment but only at  the cost of higher inflation  contract AD  lower inflation but at the cost of temporarily higher unemployment The Phillips Curve Inflation Rate (percent per year) B A Phillips curve Unemploymen t Rate Aggregate Demand, Aggregate Supply, and the Phillips Curve  The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve Aggregate Demand, Aggregate Supply, and the Phillips Curve  The greater aggregate demand  the greater economy’s output  the higher overall price level  the lower level of unemployment How the Phillips Curve is Related to the Model of AD and AS (a) The Model of AD and AS Price Level Short-run AS B 106 102 A 7,500 (unemploymen t is 7%) (b) The Phillips Curve Inflation Rate (percent per year) High AD B Low AD 8,000 (unemployme nt is 7%) A Phillips curve (output is 8,000) Unemployment (output Rate (percent) is 7,500) The Long-Run Phillips Curve  Friedman and Phelps: inflation and unemployment are unrelated in the long run  The long-run Phillips curve is vertical at the natural rate of unemployment  Monetary policy could be effective in the short run but not in the long run The Long-Run Phillips Curve Inflatio n Rate When the Central Bank increases the growth rate of the money supply, the rate of inflation increases… High inflation Low inflation Long-run Phillips curve B A Natural rate of unemployment … but unemploymen t remains at its natural rate in the long run Unemployme nt Rate How the Phillips Curve is Related to the Model of AD and AS (a) The Model of Aggregate Demand and Aggregate Supply Long-run aggregate Price supply Level (b) The Phillips Curve Inflation Rate P2 An increase in the money supply increases aggregate demand… P1 AD2 Long-run Phillips curve …and increases the inflation B rate… A Aggregate demand, AD1 …raises the price level… Natural rate of output Quantity of Output Natural rate of unemployment …but leaves output and unemployment at their natural rates Unemployment Rate The Cost of Reducing Inflation  To reduce inflation: pursue contractionary monetary policy  reduce the quantity of goods and services that firms produce  lead to a rise in unemployment  The sacrifice ratio: the number of percentage points of annual output that is lost in the process of reducing inflation by one percentage point  An estimate of the sacrifice ratio: five The Cost of Reducing Inflation Rational Expectations The theory of rational expectations suggests that people optimally use all the information they have, including information about government policies, when forecasting the future  Expected inflation explains why there is a tradeoff between inflation and unemployment in the short run but not in the long run SELF-STUDY  Lecture Review Economic fluctuations and business cycle  The aggregate demand and aggregate supply model  Sources of Recession  AD-AS Model and the Phillips curve  Cost of reducing inflation  ... GDP Recession Billions of s 1992 Dollars $7,000 6 ,50 0 Real GDP 6,000 5, 500 5, 000 4 ,50 0 4,000 3 ,50 0 3,000 2 ,50 0 19 65 1970 19 75 1980 19 85 1990 19 95 Three Key Facts About Economic Fluctuations Most... keeps Aggregate demand, AD1 output at its natural rate Natural rate Quantity of of output Output AD- AS Model & Phillips Curve Unemployment & Inflation  AD- AS Model & Phillips Curve  Cost of reducing... decrease in AD  A decrease/ adverse shift in SRAS A Decrease in Aggregate Demand Price Level …causes output to fall in the short run… Long-run aggregate supply Short-run aggregate supply, AS1 AS

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