Price

Q

Supply

Demand

Q e

P e

Supply and Demand graphs- The Basics

The purpose of this graph is to look at markets. Free Market Price and Quantity

Price Level

Measure of

Inflation

G.D.P real

employment

Aggregate Supply (AS)

Aggregate Demand (AD)

Q e

P e

Aggregate- all together (total)

The Aggregate Market- The Basics

Long Run Aggregate Supply (LRAS)

Qy

Qy= Quantity at full employment

The purpose of this graph is to look at countries. Total supply and demand at full employment

You may find it amazing how a fairly simple graph can be interpreted in so many different ways.

Learning the basics of the graph will provide you an opportunity to learn fiscal and monetary policy in different ways.

The law of demand is the same.

There is an inverse relationship- PL up, AD down, PL down AD up

The law of supply is the same

There is a direct relationship- PL up, AS up, PL down AS down

AD= Aggregate Demand

AD= GDP= C + I G + NX

Conflicting Views

Classical Views Keynesian Views

1. Prices and Wages are flexible – markets quickly and efficiently achieve equilibrium. When applied to the resource market full employment is maintained- unemployment is not a long term problem

2. Say’s Law- supply creates it own demand- aggregate product of goods and service produces enough income to exactly purchase all output

3. Savings-investment equality-any decrease in output because of savings is offset an increase in the demand for investment

This creates a different market – the money market

Investment is demandSavings is Supply

Interest rates create equilibrium- Monetarist

1. Prices and Wages are Sticky- Prices and wages respond slowly to changes in supply and demand and this results in shortages and surplus- especially with labor.

2. Increase Aggregate Demand to increase GDP- is influenced by a host of economic decisions both public and private.- savings hurt The paradox of thrift 3. “In the Long Run we are all dead”- care more about Short run and not so much about the long run. Changes in AD have greater short run effect on real GDP and employment but not as much on price. What is true in the short run isn’t always true in the long run

4. The multiplier- increases in spending will increase consumption and increase output- which will lead to more spending

5. Steer the Market- advocated stabilization policies such as tax, government spending, laws, and regulation in order to defend against the sudden and unpredictable changes in the business cycle

Less Government

Equilibrium of market

Increase consumer or InvestmentsSAVINGS!!!!!

F.A. Hayek

Neo-ClassicalAustrianMonetaristSupply-siders

John M. Keynes More GovernmentMicro not Macro

KeynesiansNeo-Keynesians Increase Gov’tDemand-siders spending!!!!!!!!

Fiscal Policy

4. Individualism

Keynesian’s Paradox of thriftA Prisoner’s Dilemma for Savings

A Prisoners Dilemma between individuals in a society who want to save.

It is smart to save during the good times , but if everybody saves than Aggregate demand drops and GDP drops now we are in a recession.

How does the government attempt to avoid this?

Wages

Employment

(AS)

(AD)

Q

W e

AS/AD/LRAS graphs- Classical vs Keynesian models Labor Market

(AD) 1

Classical (Monetarist)- believe that when demand for employment decreases- wages will fall and the market will clear (return to equilibrium). Some people will choose not to work but most will eventually lower their wages.

W 1

Q 1

Keynesians- say- no when demand for employment falls- wages and prices are sticky. We simply get a new quantity at the same wage. This creates a surplus of supply of workers which will remain until demand increases.

Quantity demanded is less than the quantity supplied.

Q 2

P.L.

G.D.P real

(AS) much like the LRAS

(AD)

Q y

P e

The whole purpose of these graphs is to find the Price level, GDP, and unemployment

AS is vertical and at the same point of full employment

Classical economist believe that resources prices and wages are flexible

This model says that the government doesn’t need to get involved because the market will fix itself.

Aggregate Supply (The classical model)

What will happen to price as AD falls?

(AD) 1

P 1The classical model suggest that the economy fixes itself and that prices and resources price will fall to create a new equilibrium.

When Aggregate demand falls what happens to. . .

Price?

Employment?

Wage (remember wages are price)?

GDP real?

P.L.

G.D.P real

LRAS

(AD)

Q y

P e

Aggregate Supply (The classical model)

SRAS

(AD) 1

If there is a decrease in ADThere will be a reduction in price level and higher unemployment

P 1

Q 1

SRAS 1

Q 2

According to classical economist the SRAS will eventually increase as wages decrease and the price of resources decrease

This will give you a new quantity demanded back at full employment

This will occur as long as wages can adjust. What can keep wages artificially elevated? Or in other words what can keep the market from clearing?

Unions

Min. Wage laws

Unemployment benefits

Whether or not the market will clear will also depend on the worker’s wage expectations.

Rational Expectations

Workers will revise their expectations instantaneously

Adapted Expectations

It may take workers weeks, months, or years but eventually they will adapt their wage expectations.

P.L.

G.D.P real

LRAS

(AD)

Q yfull

P e

Aggregate Supply (The Keynesian Model)

Y1

According to Keynes, it is possible for the economy to be in a recession permanently. Prices/wages won’t change and output will remain low.

When output is below full employment, the price level doesn’t fall because wages/resource prices don’t fall (wages are sticky)

(AD) 1

P.L.

G.D.P real

LRAS

Q yfull

P e

Aggregate Supply (The Keynesian Model)

Y1

According to Keynes, only with the help of the help of the government can Aggregate demand increase.

Demand side economics- focus on demand

Fiscal approach- government spending and taxationMonetarist approach is to increase investments

(AD) 1

(AD) 2 (AD) 3

Any aid past Qy- is purely inflationary

(AD) 4

(AD) 5

P.L.

G.D.P real

LRAS

Q yfull

P e

Aggregate Supply – So what Model is correct?

They Both have some valid points

Keynesian Phase

AD

When in the Keynesian Phase

Output can increase with no change in price.No increase in price level, no inflationary pressure, spare room to grow.

Intermediate Phase

AD

When in the Intermediate Phase

As AD approaches the curve

An increase in AD and decrease in unemployment

Result in a gradual increase of price and some inflationary pressure

ClassicalPhase

AD

When in the Classical Phase

The economy is operating at full employment

Any and all increase in AD will result in an increase in price and in increase in inflation

P.L.

G.D.P real

(AS)

(AD)

Q e

P e

If Aggregate Demand increases

AS/AD/LRAS graphs- how it works during Expansion

(LRAS)

Qy

(AD) 1

P 1

Q 1

Both Prices and GDP will increase.

In the long run – an increase in price will not lead to an increase in output.

Why?

Because as prices increase so does the price of resources including labor, wages, and materials.

(AS) 1

As a result the Aggregate supply will shift to the left (decrease) and we will find ourselves back at full employment.

A

B

CP 2

P.L.

G.D.P real

(AS)

(AD)

Q e

P e

If Aggregate Demand decreases.

AS/AD/LRAS graphs- how it works during Recession

(LRAS)

Qy

(AD) 1

Q 1

P 1

Both Price Level and output will decrease.

In the long-run a decrease in price will not lead to a decrease in output.

Why?

Because as prices decrease so does the price of resources including labor, wages, and materials.

As a result the Aggregate supply will shift to the right (increase) and we will find ourselves back at full employment.

(AS 1)

P 2

A

B

C

Inflationary and Recessionary Gaps- Steering the Market

Economic Activity

Time (years)

Potential GDP

Inflationary Gap

Recessionary Gap

The Government can steer the economy in different ways1. Laws and Regulations- stabilizers2. Fiscal Policy- changes in government spending or taxation to influence the economy3. Monetary policy- changes in monetary supply to influence the economy

AS/AD/LRAS graphs- Inflationary Gap

AS

AD 1

GDP real

Price Level

Q1

Fiscal Policy:

Monetary Policy:

LRAS

Q yFE

Actual GDP > Potential GDPOutput is beyond full employment

Unemployment very lowPrices very high

P1Government wants to limit inflation by reducing demand

AD 2

P2 How do they do it?

Gov’t can decrease gov’t spending or increase tax on consumers. AD = C + I + G + NE

Federal Reserve can decrease money supply or increase interest rates. AD = C + I + G + NE

AS/AD/LRAS graphs- Recessionary Gap

AS

AD 1

GDP real

Price Level

Q1

Fiscal Policy:

Monetary Policy:

LRAS

Q yFE

Actual GDP < Potential GDPOutput is below full employment

High unemployment

P1

Government wants to limit unemployment by increasing demand

AD 2

P2

How do they do it?

Gov’t can increase gov’t spending or decrease tax on consumers. AD = C + I + G + NE

Federal Reserve can increase money supply or decrease interest rates. AD = C + I + G + NE

How Much is Too Much?

Fiscal Policy (Demand side)

Keynesians and Democrats

Keynesian economics

President sets the budget, Congress develops programs- they can tax and borrowCommerce clause – etc.

Raising Revenue- Tax or Borrow

Spending- increase of Decrease

Monetary Policy (Demand side)

Leading advocates- Monetarist

Milton Friedman showed that people’s annual consumption is a function of their “permanent income,” a term he introduced as a measure of the average income people expect over a few years.

Monetarist believe that price level depends on money supply

Friedman stated that in the long run, increased monetary growth increases prices but has little or no effect on output. In the short run, he argued, increases in money supply growth cause employment and output to increase, and decreases in money supply growth have the opposite effect.

Friedman’s solution to the problems of INFLATION and short-run fluctuations in employment and real GDP was a so-called money-supply rule. If the Federal Reserve Board were required to increase the money supply at the same rate as real GDP increased, he argued, inflation would disappear.

He argued that the Great Depression was caused by the Federal Reserves poor management of money.

To keep unemployment permanently lower, he said, would require not just a higher, but a permanently accelerating inflation rate

AD

Q

PriceInterest Rate

Supply and Demand of Money

Interest rate at supply

Q1

I1

Decreasing the supply of money will increase the interest rate

Increasing the supply of money will decrease the interest rate

I2

Q2

I3

Q3

Open Market Operations:

The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.

$$ and Treasury Securities $$ and Treasury Securities

If the Federal Reserve buys Treasury Securities from banks or market

The banks will have more in their reserves

and they will be able to lead at a lower interest rate

$$

Results:

Reserves increase

Excesses reserves increase

Loans increase

Money Supply increases

Interest rates decrease

More consumer and investment spending

If the Fed. Easy money policy

Open Market Operations:

The Fed buys and sells U.S. Treasury securities. Such buying and selling affects the amount of excess reserves that banks have available to make loans and to create money. This is the primary monetary policy tool used by the Fed. If the Fed buys Treasury securities, banks have more reserves which they use to make more loans at lower interest rates and increase the money supply. If the Fed sells Treasury securities, banks have fewer reserves which they use to make fewer loans at higher interest rates and decrease the money supply.

$$ and Treasury Securities $$ and Treasury Securities

If the Federal Reserve sell Treasury Securities to banks or market

The banks will have less in their reserves

and they will have to lead at a higher interest rate

$$

Results:

Reserves decrease

Excesses reserves decrease

Loans decrease

Money Supply decreases

Interest rates increase

Less inflation

If the Fed. Tight money policy

Discount Rate:

The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.

Easy money policy

Fed Reserve lowers discount rate (interest rate it charges banks)

Banks Borrow more reserves

There is an increase in the money supply

There is a lower interest rates because banks can compete with other banks

There is an increase in spending by consumers and investors

3.0%

3.0%3.0%3.0%

3.0%

Discount Rate:

The Fed can also adjust the interest rate that it charges banks for borrowing reserves. Higher or lower rates affect the amount of excess reserves that banks have available to make loans and create money. If the Fed lowers the discount rate, then banks can borrow more reserves, which they can use to make more loans at lower interest rates, which then increases the money supply. If the Fed raises the discount rate, then banks can borrow fewer reserves, which they use to make fewer loans at higher interest rates, which then decreases the money supply. Changes in the discount rate are most often used as a signal for monetary policy actions.

Tight money policy

Fed Reserve increases discount rate (interest rate it charges banks)

Banks Borrow less reserves

There is an decrease in the money supply

There is a higher interest rate

There is an decrease in spending which will slow down inflation

11.0%

11.0%11.0%11.0%

11.0%

Reserve Requirements:

The Fed can further adjust the proportion of reserves that banks must keep to back outstanding deposits (the reserve ratio). Higher and lower rates affect the deposit multiplier and the amount of deposits banks can create with a given amount of reserves. If the Fed lowers reserve requirements, then banks can use existing reserves to make more loans and thus increase the money supply. If the Fed raises reserve requirements, then banks can use existing reserves to fewer more loans and thus decrease the money supply. This tool is seldom used as a means of controlling the money supply.

A depository institution's reserve requirements vary by the dollar amount of net transaction accounts held at that institution. Effective December 30, 2010, institutions with net transactions accounts:

Of less than $10.7 million have no minimum reserve requirement;Between $10.7 million and $58.8 million must have a liquidity ratio of 3%;Exceeding $58.8 million must have a liquidity ratio of 10%.

Monetary Policy (Demand side)

Who- the Federal ReserveWhat- increasing or decreasing the amount of money in circulationGoal- full employment, stability, and growth

Easy Money Supply- increasing money supply and decreasing interest rates

Open Market Operations- buy securitiesDiscount Rates- lower discount rateReserve Requirements- lessen requirements

Decrease interest rates

Tight Money Supply – decreasing the money supply and increasing interest rates

Open Market operations- sell securitiesDiscount Rates- increase discount ratesReserve Requirements- increase requirements

Prisoner’s Dilemma between Monetary and Fiscal Policy.

Normally, high expenditures and is a dominate strategy for Congress and tight money for the Fed. When each selects its preferred strategy will be deficit spending with tight money.

It is important that both the Fed and Congress aligned their ideas, but they are independent of each other and have different goals. The goal’s of the Fed can vary but the goals representatives in Congress is the same- get reelected.

If the Fed and Congress oppose follow their dominate strategies they will find themselves in a prisoner’s dilemma- this happen a lot in the 1980’s

Congress

The Fed.

Payoffs (Utility) 1-10

1 being least desirable10 being most desirable

High Expenditures

Low Expenditures

Easy Money

Tight Money 10, 0

0, 10

4, 4

6, 6

Supply-side theory in AS/AD/LRAS

v v v

LRAS 1 LRAS 2 LRAS 3

Supply side economics

1. Supports any action by the government that enables business to lower cost, boost efficiency, and competitiveness.

2. This increases potential output

3. There are a number of methodsa. Increase labor market flexibility- Lower min. wage, Weaken trade unions, Reduce unemployment

benefitsb. Invest in educationc. Lower income tax and capital gains tax- eliminate progressive tax (marginal tax rates)d. Lower corporate tax ratese. Invest in infrastructure

4. Eliminate safety nets and allow for profit and loss

How to fix the economy? According to . . .

Fiscal Policy Monetary Policy Supply Side Policy

During aRecession

With high unemployment

During Expansion

With high inflation

Increase Government Spending

Decrease Taxes

Buy Securities from banks or dealers

Decrease Discount Rate

Reduce Reserve requirements

All ideas intended to lower interest rate

Cut tax on Business

Reduce Regulation

Give business a chance to expand and hire

Decrease Government Spending

Increase Tax

Sell securities to banks

Increase Discount Rate

Increase Reserve Requirements

All ideas intended to increase interest rates

Eliminate tax cuts

No capital gains tax or marginal (progressive income tax)

Increase regulation and oversight

Expand minimum wage and unemployment benefits

Capital gain tax

The Problem with Lag.

Knowledge lag- knowledge and recognition lag, it takes time to recognize and correctly understand the problem.

Procedure or Action Lag- In the United States our legislative process can take long and there can be many hold ups.

Change or impact Lag- By the time change has taken place or the impacts are felt we may have been past the initial phase of the business cycle

Progressive Tax

Laffer Curve

http://econstories.tv/

http://www.econedlink.org/lessons/index.php?lid=593&type=educator