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04/17/2007 Econ 201: Principles of Economics Hakan TASCI

1. What we have done so far? • Demand Side Equilibrium • Total Expenditure and its determinants

• Shifts in Aggregate Demand

• Multiplier Analysis

2. Today’s Outline • Aggregate Supply • Equilibrium Supply=Demand • Inflationary and Recessionary Gap • Inflation and the Multiplier • Multiplier

3. Aggregate Supply

Aggregate Supply: shows for each possible price level, the quantity of goods and services that all the nation’s businesses are willing to and able to produce in a given specified time holding all other determinants constant. It slopes upward. Normally firms can purchase labor and other inputs at prices that are fixed for some period of time. So selling with higher price will increase profits and make production more attractive. Why the Aggregate Supply Curve Slopes Upward

• Firms normally can purchase labor and other inputs at prices that are fixed for some period of time.

• Higher prices, thus, mean higher profits and more incentive to produce. Shifts of Aggregate Supply Curve: Shifts of the Aggregate Supply Curve

• Costs of production are constant along the AS curve. • ∆ costs of production ⇒ shifts in the AS curve

1. The money wage rate 2. Prices of other inputs 3. Technology and productivity 4. Available supplies of labor and capital

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1. The Money wage rate 2. Prices of Other Inputs

3. Technology and Productivity 4. Available Supplies of Labor and Capital

4. Equilibrium Price level is a crucial determinant of whether equilibrium GDP is below or above potential GDP level. Prices cannot be determined by only looking at demand side equilibrium. And so is the GDP level. These are determined by aggregate demand and aggregate supply together. And equilibrium is where aggregate demand is equal to the aggregate supply.

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5. Recessionary and Inflationary Gaps Recessionary Gap Inflationary Gap

Adjusting to a Recessionary Gap: Unemployment or Deflation? Unemployment => wage rate falls => AS <-- This adjustment is to slow and painful. So many people believe that government intervention should help to speed the process. There are several possible reasons why wages are so sticky in the downward direction:

• Institutional rigidities • Psychological resistance • Reduced severity of business cycles • Competition for the best workers

Adjusting to an Inflationary Gap: Inflation Super tight labor market produces inflation, eventually inflation eliminates inflationary gap. (1999, internet bubble in United States) When GDP > full employment

♦ Price level rises ♦ Labor is in short supply

Both forces ⇒ ↑ money wages ♦ AS curve shifts inward ♦ Employment falls ♦ Eventually eliminates the inflationary gap

During this process, both prices and unemployment are increasing. Stagflation = inflation that occurs while the economy is growing slowly or having a recession. In an inflationary gap, prices and wages rise because of excess demand. Rising wages are a symptom, not a cause, of the underlying problem. A period of stagflation is part of the normal aftermath of a period of excessive aggregate demand.

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6. Inflation and the Multiplier Inflation reduces the size of the multiplier. One person’s spending becomes other person’s income, which leads to further spending by second person and so on. But this is only demand side reasoning. This additional demand will be produced by firms but now they charge higher price and this mechanism will reduce the size of the multiplier.

● Inflation ⇒ ↓ size of the multiplier ● As long as the aggregate supply curve is

upward sloping, ↑ AD ⇒ ↑ price level ● This, in turn, drains off some of the

higher real demand. ♦ ↓ purchasing power of consumer

wealth ♦ ↓ net exports

5. Fiscal Policy

Fiscal policy: is the government’s plan for spending and taxation. It is designed to steer aggregate demand in some desired direction. Three policy types that government can employ:

1) Government Spending 2) Taxation 3) Transfer payments

Expansionary and Contractionary Fiscal Policies:

6. Multiple Choice Questions:

1. Economists generally assume that there is a short-run trade-off between a. output and employment. b. inflation and employment. c. deflation and unemployment. d. inflation and unemployment. e. output and growth.

2. “Stagflation” refers to the unwelcome combination of a. inflation and rising prices. b. deflation and unemployment. c. inflation and unemployment. d. inflation and expansion.

3. The major cost of production in the economy is a. interest expense. b. capital costs. c. rents. d. profits. e. wages.

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4. The aggregate supply curve normally a. slopes downward and to the right due to higher resource prices. b. has a horizontal slope equal to zero. c. is very steep in the lower portion and flatter in the upper portion. d. slopes upward to the right due to short-run fixed costs of production.

5. As a result of the war in Afghanistan, the population of Afghanistan as well as their capital stock was reduced. This can be illustrated by aggregate supply curve

a. shifting outward. b. becoming flatter. c. shifting inward. d. becoming more elastic.

6. An increase in wages will cause the aggregate supply curve to a. shift outward. b. shift inward. c. become flatter. d. become steeper.

7. If the price level rises, what will happen to aggregate supply? a. It will shift outward. b. It will shift inward. c. Nothing. d. It will get steeper. e. It will get flatter.

8. The aggregate supply curve shows the relationship between __________ and _____________, holding all other factors constant.

a. price level, quantity of real GDP supplied b. price level, supply of nominal GDP c. nominal GDP, price level of real GDP d. price level, amount of nominal GDP supplied e. price level, quantity of nominal GDP demanded

9. If scientific research produces a technological breakthrough in the production of computer memory, then

a. business costs will increase, profits will fall, and production will decrease. b. business costs will fall, but profits will also fall, and production will decrease. c. business costs will fall, profits will improve, and production will increase. d. profits will increase, allowing businesses to cut back production.

10. An increase in the money wage rate will cause the aggregate supply curve to shift a. outward, which means the quantity supplied at any price level decreases. b. outward, which means the quantity supplied at any price level increases. c. inward, which means the quantity supplied at any price level increases. d. inward, which means the quantity supplied at any price level decreases.

11. Educational reforms that result in improved reading and math skills of high school graduates as they enter the labor force would do what to the aggregate supply curve?

a. Shift it outward. b. Shift it inward. c. Move the economy up along the curve. d. Move the economy down along the curve.

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12. The aggregate demand and aggregate supply curve intersect a. at potential GDP. b. below potential GDP. c. above potential GDP. d. at a point which may or may not be equal to potential GDP.

13. How is it possible for the economy to have an inflationary gap? a. Equilibrium is at a GDP level below full employment. b. Equilibrium is at a GDP level equal to full employment. c. Equilibrium is at a GDP level above full employment. d. GDP is rising at full employment. e. GDP is falling at full employment.

14. What is the principal reason that economists give for the existence of deflationary and inflationary gaps?

a. Wages are flexible in the short run. b. Wages are flexible in the long run. c. Wages are fixed in the long run. d. Wages are fixed in the short run. Table 1 Aggregate Quantity Aggregate Quantity Demanded Supplied Price

(billions) (billions) Level $3,500 65 $2,900 3,400 75 3,000 3,350 90 3,150 3,250 110 3,250 3,100 130 3,400

15. In Table 1, what is the equilibrium level of real output and the equilibrium price? a. $3,100 real output and a price of 75 b. $3,250 real output and a price of 110 c. $3,350 real output and a price of 90 d. $3,400 real output and a price of 75

16. In Table 1, if full employment occurs at $3,100 billion, then a. the economy experiences a recessionary gap of $150 billion. b. the economy experiences a recessionary gap of $250 billion. c. the economy experiences an inflationary gap of $150 billion. d. the economy experiences an inflationary gap of $250 billion.

17. In Table 1, if full employment occurs at $3,400 billion, then a. the economy experiences a recessionary gap of $150 billion. b. the economy experiences a recessionary gap of $250 billion. c. the economy experiences an inflationary gap of $150 billion. d. the economy experiences an inflationary gap of $250 billion.

18. The principal way in which an economy self-corrects from an inflationary gap is through a. deflation, which increases purchasing power. b. inflation, which reduces purchasing power. c. disinflation, which maintains purchasing power. d. price level decreases, which stimulate production.

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19. An economic boom that creates an inflationary gap is usually followed by a. falling prices. b. a period of stagflation. c. an increase of potential GDP. d. an increase in aggregate supply.