Course : ECON6017 - Economics Theory

Effective Period : September 2015

Long-Run Growth, Aggregate Supply in the Goods and Money Markets

Session 12

Acknowledgement
These slides have been adapted from:
Karl E. Case., Ray C. Fair., & Sharon Oster.
(2014). Principles of Economics. 11/E. Pearson
Education. -. ISBN: ISBN-10: 013302380X ISBN13:9780133023800
Chapter: 25 until 28

Learning Objectives
LO 3: Analyze the long run growth economy of
country

Contents
Aggregate Supply and the Equilibrium Price
Level
- The aggregate supply curve
- The equilibrium price level
- The long run aggregate supply curve
- Monetary and fiscal policy effects
- Causes of inflation
- The behaviour of the fed
- The labor market: Basic concepts
- The classical view of the labor market
- Explaining of unemployment

THE AGGREGATE SUPPLY

CURVE
THE AGGREGATE SUPPLY CURVE: A WARNING
aggregate supply (AS) curve A graph
that shows the relationship between
the aggregate quantity of output
supplied by all firms in an economy
and the overall price level.

AGGREGATE SUPPLY IN THE SHORT

RUN
Capacity Constraints
Even if firms are not holding excess labor and
capital, the economy may be operating below
its capacity if there is cyclical unemployment.

Output Levels and Price/Output

Responses

The Short-Run Aggregate Supply

Curve

An increase in aggregate demand when the

economy is operating at low levels of output is
likely to result in an increase in output with little
or no increase in the overall price level. That is,
the aggregate supply (price/output response)
curve is likely to be fairly flat at low levels of
aggregate output.

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

SHIFTS OF THE AGGREGATE SUPPLY

CURVE
cost shock, or supply shock A change in
costs that shifts the aggregate supply
(AS) curve.

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

SHIFTS OF THE AGGREGATE SUPPLY

CURVE

Factors That Shift the Aggregate Supply

Curve

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

THE EQUILIBRIUM PRICE LEVEL

equilibrium
price level The
price level at
which the
aggregate
demand and
aggregate
supply curves
intersect.

The Equilibrium Price

Level

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

THE LONG-RUN AGGREGATE SUPPLY

potential output, or
potential GDP The
level of aggregate
output that can be
sustained in the
long run without
inflation.

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

AGGREGATE DEMAND, AGGREGATE

SUPPLY,
AND MONETARY AND FISCAL POLICY

A Shift of the Aggregate Demand

Curve When the Economy Is on the
Nearly Flat Part of the AS Curve

A Shift of the Aggregate Demand Curve

When the Economy Is Operating at or
Near Maximum Capacity

If the AS curve is vertical in the long run, neither monetary policy nor fiscal policy has
any effect on aggregate output in the long run.

LONG-RUN AGGREGATE SUPPLY AND POLICY EFFECTS

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of

CAUSES OF INFLATION
INFLATION VERSUS SUSTAINED INFLATION: A REMINDER

inflation An increase in the overall price

level.
sustained inflation Occurs when the overall
price level continues to rise over some fairly
long period of time.
DEMAND PULL INFLATION

demand-pull inflation Inflation that is

initiated by an increase in aggregate
demand.

12 of 23

CAUSES OF INFLATION
COST-PUSH, OR SUPPLY-SIDE,
INFLATION
Cost-Push, or Supply-Side,
Inflation

cost-push, or supplyside, inflation

Inflation
caused by an
increase in costs.
stagflation Occurs
when output is
falling at the same
time that prices are
rising.
Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
13 of 23
Economics.

EXPECTATIONS AND INFLATION

Cost Shocks Are Bad News for Policy

Makers

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

CAUSES OF INFLATION
MONEY AND INFLATION

hyperinflation A
period of very rapid
increases in the price
level
Sustained Inflation from
an Initial Increase In G
and Fed Accommodation

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

THE CLASSICAL VIEW OF THE LABOR MAR

labor supply
curve is the
amount of labor
that households
want to supply at
each given wage
rate.labor demand
curve is the
amount of
labor that firms
want to employ
at each given
wage rate.

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

THE CLASSICAL LABOR

MARKET AND THE
AGGREGATE SUPPLY CURVE
The classical idea that wages adjust to clear the
labor market is consistent with the view that wages
respond quickly to price changes. This means that
the AS curve is vertical.
When the AS curve is vertical, monetary and fiscal
policy cannot affect the level of output and
in the
Theemployment
unemployment
rateeconomy.
is not necessarily an accurate
indicator of whether the labor market is working properly.
The measured unemployment rate may
sometimes seem high even though the labor
market is working well.

THE EXISTENCE OF
UNEMPLOYMENT
STICKY WAGES
sticky wages The downward
rigidity of wages as an
explanation for the existence of
unemployment.
Source : Karl E. Case.,
Ray C. Fair., & Sharon
Oster. (2014).
Principles of
Economics.
Sticky
W
a
g
e
s

THE SHORT-RUN RELATIONSHIP

BETWEEN
THE UNEMPLOYMENT RATE AND
INFLATION

The Aggregate
Supply
Curve

This curve represents

the positive relationship
between Y and the
overall price level (P).
In the short run, the
unemployment rate
(U) and aggregate
output (income) (Y)
are negatively related.
When Y rises, the
unemployment rate falls, and
when Y falls, the
unemployment rate rises.

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

THE SHORT-RUN RELATIONSHIP BE

THE UNEMPLOYMENT RATE AND IN
There is a negative relationship between the
unemployment rate and the price level. As
the unemployment rate declines in response
to the economys moving closer and closer
to capacity output, the overall price level
rises more and more
The Relationship
Between
the Price Level
and
the
Unemployment
The Phillips Curve
Rate

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

THE PHILLIPS CURVE: A

HISTORICAL PERSPECTIVE

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

THE LONG-RUN AGGREGATE

SUPPLY CURVE, POTENTIAL GDP,
AND THE NATURAL RATE OF
UNEMPLOYMENT

he Long-Run Phillips Curve: The Natural Rate of Unemployment

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

STABILIZATION: THE FOOL IN THE

SHOWER
stabilization policy
describes both
monetary and fiscal
policy, the goals of
which are to smooth out
fluctuations
in output and
employment and to
time
lags
keep prices as
stable
as
Delays
in
possible.

the economy
response to
stabilization
policies.

The Fool in the ShowerHow Government Policy Can Make

Matters Worse

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

IMPLEMENTATION LAGS
implementation lag The time it
takes to put the desired policy into
effect once
economists and policy makers
recognize that the economy is in a
recognition lag The time it takes
boom or a slump.
for policy makers to recognize the
existence of a boom or a slump.
The implementation lag for monetary policy is generally much
shorter than for fiscal policy.

MONETARY POLICY
THE FEDS RESPONSE TO
THE STATE OF THE
ECONOMY
The Feds Response
to Low
Output/Low
Inflation
The Fed is likely to lower the
interest rate (and thus
increase the money supply)
during times of low output
and low inflation.

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

MONETARY POLICY
The Feds Response
to High
Output/High Inflation
The Fed is likely to
increase the interest rate
(and thus decrease
the money supply) during
times of high output and
high inflation.

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

MONETARY
POLICY
INFLATION TARGETING
inflation targeting When a monetary
authority chooses its interest rate values with
the aim of keeping the inflation rate within
some specified band over some specified
horizon.

FISCAL POLICY: DEFICIT TARGE

ECONOMIC STABILITY AND DEFICIT
REDUCTION
negative demand shock Something that
causes a negative shift in consumption or
investment schedules or that leads to a
decrease in U.S. exports.
automatic stabilizers Revenue and
expenditure items in the federal budget that
automatically change with the
economy in such a way as to stabilize GDP.
automatic destabilizers Revenue and
expenditure items in the federal budget that
automatically change with the
economy in such a way as to destabilize GDP.

FISCAL POLICY: DEFICIT TARGETING

Deficit Targeting as an Automatic

Destabilizer

Source : Karl E. Case., Ray C. Fair., & Sharon Oster. (2014). Principles of
Economics.

Referrence
Principles of Economics, Case, Fair
& Oster (2014). Chapter 27-28
http://catalog.flatworldknowledge.co
m/bookhub/23?e=rittenmacroch10_s02

Thank You