ec4004 lecture 19 last time - stephen...

EC4004 LECTURE 19

Aggregate Supply & Supply crises

Stephen [email protected]

LAST TIMEAggregate Demand:

AD = C + I + G + X-M

TODAY.Aggregate Supply & Aggregate Demand (Cht 20)

NEWS.

China, US, EU out of recession thanks to stimulus programmes.Read www.irisheconomy.ie, Philip Lane’s posts; Read Ronanlyons.com. Live Register decreased from 425,500 in September to 422,500 in October, a fall of 3,000.. 1st fall since Jan. 2007, when the total was 156,600, and may reflect a rise in emigration.

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FROM LAST TIMEAggregate Demand:

AD = C + I + G + X-M

Increase in C,I, G, (X-M)

Increase in the aggregate demand curve

SHIFTS IN THE AGGREGATE DEMAND CURVE

Inflation

Real National Income

AD

2.0%

Y1U = 5%

Shifts in AD will be caused by changes in

factors affecting C, I, G and (X-M) (exogenous

factors) e.g. increasing income

tax rates affect consumption

AD2

Y2U = 2%

Any exogenous factor causing C,

I or G to rise, or a trade surplus

causes a shift to the right in AD

This would cause a rise in national

income (economic growth) and lead to

a fall in unemployment (U = 2%) (and vice versa)

CHANGES IN AD: CONSUMPTION

Exogenous factors affecting consumption:Tax rates

Incomes – short term and expected income over lifetimeWage increasesCreditInterest ratesWealth

PropertySharesSavingsBonds

CHANGES IN AD: INVESTMENT

Spending on:

Machinery

Equipment

Buildings

Infrastructure

Influenced by:

Expected rates of return

Interest rates

Expectations of future sales

Expectations of future inflation rates

CHANGES IN AD: GOVERNMENT

Defence

Health

Social Welfare

Education

Foreign Aid

Regions

Industry

Law and Order

KEY VARIABLES

(Write these down)

Inflation

Growth

Unemployment

Balance of Payments (X-M)

KEY POLICIES

Monetary Policy

Don’t have one. (ECB)

Fiscal Policy

Government spending & government income (taxes & borrowing)

Supply-Side Policy

Aggregate supply. Next lecture!

NOW. AGGREGATE SUPPLY

AS: CAPACITY OF THE ECONOMY

Depends on

Costs of Production

Technology

Education and Training

Incentives

Tax regime

Capital stock

Productivity

Labour Market

AGGREGATE SUPPLYInflation


The shape of the AScurve is important in

determining the outcome in the economy

AS

Yf

This shape reflects a Keynesian view of the AS curve.

Yf represents ‘Full Employment Output’ –

at this point the economy is working to full capacity and cannot

produce any more.

Y1

An output level of Y1 would suggest the

economy is working below full capacity and

there would be widespread

unemployment.Economy starts to overheat

Between Y1 and Yf, increases in capacity are possible but the nearer the economy gets to Yf,

the more problems are experienced with acquiring

resources to boost production (production bottlenecks) especially labour skills

shortages.



AS1 AS2

Yf1 Yf2

Increases in capacity can occur

as a result of a shift in AS (akin to a shift outwards of

the Production Possibility Frontier)

(PPF)



SRAS

Short run aggregate supply (SRAS)

assumes firms only able to increase output at higher

costs (e.g. overtime payments) thereby pushing up price

level

SRAS 1

SRAS 2

SRAS assumes costs such as

overall wage rate remain fixed,

changes in such costs cause a shift in the SRAS curve

(exogenous shocks – input

costs)



LRASClassical

economists assume the long run

aggregate supply curve (LRAS) is

vertical (perfectly inelastic).

This is because they believe that in the long

run, there will be no unemployment of resources because

markets will clear, thus whatever the rate of

inflation, firms will supply the maximum capacity of

the economy.

Yf

AGGREGATE SUPPLY

For our analysis, we will assume the AS

curve looks like this!

Inflation


AS

PUTTING AD AND AS TOGETHER

Inflation


AS

Yf

AD

2.0%

Y1

In this situation, the economy would be

operating at less than capacity, there would be unemployment and the

economy might be growing only slowly.

AD 1

Y2

2.5%

A shift in the AD curve to AD1 as a result of a

change in any or all of the factors affecting AD would increase growth, reduce unemployment but at a cost of higher inflation (a trade-off)

Putting AD and AS togetherInflation


AS

Yf

AD

2.0%

Y1

AD1

Y2

2.5%AD2

3.5%

Further increases in AD would lead to

successively smaller increases in growth

and employment at the cost of ever higher

inflation.

Y3

SUSTAINED GROWTH

Inflation


AD

AS

2.0%

Y1

AS1

Y2

AD2

Sustained growth (not to be confused

with sustainable economic growth)

occurs when AS and AD rise at similar rates – national income can rise

without effects on inflation

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HOW FISCAL POLICY INFLUENCES AGGREGATE DEMAND

!Fiscal policy refers to the government’s choices regarding the overall level of government purchases or taxes.

!Fiscal policy influences saving, investment, and growth in the long run.

!In the short run, fiscal policy primarily affects the aggregate demand.

!Fiscal policy can be used to alter government purchases or to change taxes.

CHANGES IN GOVERNMENT PURCHASES

!There are two macroeconomic effects from the change in government purchases: !

!The multiplier effect

!The crowding-out effect

THE MULTIPLIER EFFECT

Aggregate demand, AD1

Quantityof Output

0

PriceLevel

AD2 1. An increase in government

purchases of !20 billion initially increases aggregate demand

by !20 billion…

!20 billion

AD3

2. …but the multiplier effect can amplify the shift in aggregate demand.

THE CROWDING-OUT EFFECT

Fiscal policy may not affect the economy as strongly as predicted by the multiplier.

An increase in government purchases causes the interest rate to rise.

A higher interest rate reduces investment spending.

THE CROWDING-OUT EFFECT

When the government increases its purchases by "20 billion, the aggregate demand for goods and services could rise by more or less than "20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

AUTOMATIC STABILIZERS

Automatic stabilizers are changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action.

Automatic stabilizers include the tax system and some forms of government spending.

FINALLY.

FROM WWW.PROGRESSIVE-ECONOMY.IE:SOME HOME TRUTHS

SOME HOME TRUTHS• Ireland’s bloated public sector: Before the current

recession Ireland’s government spending as a proportion of GDP was the lowest of any economy in the Euro Area, 33.6% in the years 2002-2006, compared to a Euro Area average of 47.4% . France, Belgium and Austria, have a public sector which is proportionately 1# times greater than Ireland, at over 50% of GDP.

• There is no scope to raise taxes: In the same 2002-2006 period Ireland’s tax take was also the lowest of any Euro Area economy, at 34.9% of GDP compared to Euro Area average of 44.9% of GDP.

• Ireland has a uniquely high level of public debt:

• Ireland’s public debt level will rise to 96.2% of GDP in 2011, compared to 135.4% for Greece, 117.8% for Italy, 104% for Belgium and a Euro Area average of 88.2%.

• There’s no scope for fiscal stimulus: Ireland’s output gap relative to potential GDP is expected to be up to 8.5% of GDP in 2009 and will still be as high as 5.4% of GDP in 2011, the largest in the Euro Area and compared to averages for the Euro Area as a whole of 3.6% this year and 2.5% in 2011.

• Ireland has become uncompetitive internationally: 2002-2006, price deflator for Ireland’s exports fell at an annual average rate of 2.7% and the price deflator for imports fell at an annual average rate of 2.3%, compared to Euro Area average rises of 0.5% and 0.7%. Ireland’s growth of per capita labour productivity was an annual average 2.2% compared to just 1.2% for the Euro Area, and 1.6% for Britain and 2.1% for the US

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WRITE DOWN2 THINGS YOU

REMEMBER FROM TODAY.

SUMMARY

Aggregate Demand

& Aggregate Supply

Fiscal Policy

Some home truths from TASC Blog.

ec4004 lecture 19 last time - stephen...

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