Section 1 Macroeconomics 2.1a The circular flow

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Section 1 Macroeconomics2.1a The circular flow

• In the resource (or factor) market, businesses
  are buyers who compete for the factors of
  production to produce their goods and services.
• This generates demand for labor, capital, land
  and entrepreneurial ability.
• For these resources, they will pay wages,
  interest, rent and profits (WiRP).

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• Each payment correlates to a factor of
  production

Factor of production Payment
Labor Wages
Capital Interest
Land Rent
Entrepreneurial ability Profits
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• Sellers of resources (households) will try to
  maximize their income by selling their factors to
  the highest bidder.
• For example, a worker with scarce skills will be
  able to sell their labor for a higher wage than a
  less qualified competitor.
• With their incomes, the sellers of resources will
  turn to the product market to spend their
  earnings on goods and services.

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The circular flow

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• Circular Flow Diagrams are the simplest models
  for understanding how a macro-economy works. This
  relatively simple example shows how aggregate
  income levels are exchanged for
  resourcesincluding laborthat are bought from
  households.
• Income, in turn, gets spent on goods and
  services, repaying firms for the money spent on
  resources.

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• Sophisticated circular flow models include
  leakages and injections into the macroeconomy.
  The relative size of each leakage or injection
  can have a large impact upon the economys final
  output.
• Leakages and injections must equal each other and
  therefore can be presented as follows

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Leakages Injections

Taxes Government spending
Imports Exports
Savings Investment
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• One implication of the model is that the values
  of each flow are equal.
• Since resource expenditure is funded by consumer
  spending, they must be equal, and the total value
  of production must be the same as well.

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2.1b Measuring national income

• There are two distinct methods of measuring the
  total output of an economy.
• Gross Domestic Product (GDP)
• Gross National Product (GNP)

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• GDP is the total money value of all goods and
  services produced in an economy over a certain
  time, usually one year. GDP includes the output
  of foreign firms in a country, but does not
  include the output of domestic firms overseas.
  This figure is based on geographic boundaries.

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• GNP is the total money value of all goods and
  services produced by the citizens or firms of a
  particular country, no matter where they are
  based, but does not include the production of
  foreign firms within the country. This figure is
  based on nationality/citizenship of the owner of
  the property or labor.

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• Net Domestic Product (NDP) is Gross Domestic
  Product less depreciation, and depreciation is
  the value of capital that is used-up in
  production and must be replaced.
• GDP NDP depreciation

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• Another important distinction is that of Nominal
  GDP vs. REAL GDP.
• Nominal GDP can exaggerate the true value of
  production because it measures output at current
  prices. If there is significant inflation, any
  change in GDP will be greater than the real
  change in output.

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• REAL GDP measures output with a single years
  prices, what is called a base year.
• GDP is useful in discerning a broad picture of
  the relative size of economies and making general
  comparisons between countries.

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• Another valuable measure is called Per Capita
  GDP, which is a better measure of, on average,
  how wealthy people are in different countries.
• Per Capita GDP GDP population

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• GDP as a measurement has several shortcomings,
  one of which was just noted (income
  distribution).
• A. GDP also does not take into account
  qualitative changes in the output of goods and
  services. We know that electronics that have been
  developed recently have many more features than
  those just 5 years old. GDP does not take into
  consideration this advance in technology.

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• B. GDP does not take into account informal or
  black market activities. Consequently, the
  babysitting that you provided to your neighbor
  last weekend is not counted in the GDP. Nor are
  illegal activities such as selling stolen goods
  counted.
• C. Do it yourself activities are not counted in
  the GDP. The work of stay at home parents around
  their house nor is the shed built by your dad
  last summer included in GDP.

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• D. Used or second hand goods are not counted as
  they were already calculated in the GDP the year
  they were originally manufactured.
• E. Purely financial transactions such as stock
  market transactions or transfer payments between
  the government and citizens or family gifting of
  cash (such as at holiday or graduation time).

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• F. In developing countries, most citizens are
  engaged in informal subsistence economic
  activities, which are not in the formal economy
  and therefore not counted in the GDP figures.

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• Finally, GDP does not take into account negative
  externalities that are produced as a result of
  economic activity.
• The green GDP, which has been attempted by
  several countries, is meant to measure the output
  of goods and services while subtracting the
  bads of environmental destruction.

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• There two primary methods of calculating GDP
• Income method adding up all of the money
  incomes generated by the owners of the factors of
  production (or WiRP) of a given economy for a
  given accounting period.
• Expenditure method compiling all of the
  expenditures on final goods and services within
  an economy for a given accounting period.

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• The income approach to GDP accounting is
  demonstrated from the data for the U.S. economy
  in the first quarter of 2012 shown below

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Category Gross value (billions USD)
Compensation of employees (wages) 8,451.5
Rents 445.5
Interest 709.6
Proprietors profits 1,130.8
Corporate profits 1,604.5
Taxes on production and imports 1,113
Adjustments to misc. income 52.6
National Income 13,507.5
Consumption of Fixed Capital 2,004.1
GDP 15,511.6
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• Note several interesting elements of the
  methodology
• Taxes on Production and Imports This is
  basically an adjustment to take into account
  indirect taxes (i.e. business property, sales and
  excise taxes) that find their way into
  transactions but are not really counted in the
  WiRP figure.

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• Consumption of Fixed Capital Essentially this is
  value of depreciated capital that has been
  replaced as a cost of production, which is not
  counted as income. As the money is not available
  for other uses, it does not show up in anybodys
  income. This category is an accounting method to
  balance the GDP in the income method with the
  expenditure method.

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• The most common method of GDP accounting though
  is the expenditure method. It is broken down as
  follows
• Consumption (C) Personal household expenditures
  on goods and services. This includes everything
  from food to utilities to rent to clothing to
  cars to school supplies. Services are things like
  hair styling, doctors, auto repair and banking.

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• Investment (I) Gross private investment in
  physical plant, machinery, construction and
  inventories. This includes replacement investment
  of worn out machinery or buildings. This figure
  does not include paper assets (stocks and bonds)
  as these are mere changes in ownership rather
  than the creation of new productive capacity.

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• Government expenditures (G) Government purchases
  includes expenditures on goods and services used
  in providing public services as well as spending
  on schools and highways which might not be used
  up in a year.

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• Net exports (X-M) Exports are goods and
  services, which are developed within an economy
  and sold abroad to consumer from other countries.
  In the expenditure method these are an injection,
  yet imports (our countrys purchases of foreign
  made goods and services) are a leakage.
  Therefore, we take the net effect of these
  transactions and include that figure in the final
  GDP figure.

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• All of this can be put together as a simple
  equation
• C I G (X M) GDP
• This equation also happens to be the equation for
  Aggregate Demand (AD) which will become a useful
  tool for you in future sections when discussing
  how different policies impact economic output.

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• Here is an example from the first quarter of 2012
  in the U.S. economy.

Category Value (billions USD)
Personal Consumption (C) 11,009.5
Gross private investment (I) 2,046.5
Government expenditures (G) 3,108.2
Net exports (X-M) - 620.1
GDP 15,454.0
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2.1c The business cycle

• Most economies experience a long run upward trend
  in economic growth partially due to the increase
  in population and improvements in productivity.

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• Potential output is represented as a trend line
  of growth. Potential output is the output of the
  economy if all factors of production are fully
  employed in their highest and best use.
• However, the actual growth of the economy is not
  always a straight line and there are often
  periods of instability or recession.

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• There are four phases most commonly referred to
  in business cycle theory.
• Peak When an economy has reached its maximum
  output with the performance being at or near full
  employment or the economys capacity. This is
  characterized by a shortage of skilled labor and
  materials, which puts upward pressure on prices.
  Companies are making solid profits and optimism
  is high.

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• Recession Indicates a period of decreasing
  total output and other measurements. A recession
  can be a point at which consumers and firms have
  exhausted their consumption or investment
  budgets. This usually lasts at least 6 months and
  is associated with contractions in employment and
  business activity. Unemployment rates usually
  rise during these periods

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• Trough The bottom of a recession. This is
  associated with high rates of unemployed labor
  and productive capacity. Corporate profits are
  low and pessimism is high.

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• Recovery Sometimes called an expansion.
  Economies cannot stay in a trough forever as
  machinery wears out and firms have to start to
  replace capital. Price levels may have fallen low
  enough to induce new investment in inventories or
  new consumption as consumers may be tired of not
  buying. GDP growth and employment increase off
  the bottom of the trough as the economy expands.

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• Some of these periods are also associated with
  what are called output gaps.
•  
• If the gap is negative (Y lt Yfe), then it is
  referred to as a recessionary gap
•  
• If the gap is positive (YgtYfe), then it is
  referred to as an inflationary gap as we have
  gone beyond full employment.
•  
• Lets look at a diagram.

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• As the diagram makes clear, the inflationary gaps
  occur when the economy is peaking or growing
  faster than the trend line of growth.
•  
• The recessionary gaps are apparent when economic
  growth dips below the trend line or potential
  output of the economy.

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2.2a Aggregate Demand

• Aggregate demand (AD) is comprised of all the
  spending that comes to a domestic market.
  Aggregate demand, is a schedule, which shows the
  amounts of real GDP that buyers will collectively
  buy at given average price levels in the economy.

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• Therefore we categorize the different types of
  demand like this
• Consumer spending (C)
• Investment (I)
• Government spending (G)
• Net Exports (X M)

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• The aggregate demand curve has a negative slope.
  Essentially the AD curve is the visual
  representation of the expenditure method of GDP
  accounting.
• The price level is measured as the average price
  level of final goods and services (product) in
  the economy and is considered a measurement of
  inflation.

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• Why is the AD curve negatively sloped?
•  
• The first reason is called the real balances
  effect. As the price level rises, the purchasing
  power of the publics income or savings decreases
  so they can buy less as the price level rises.
  This factor is most closely associated with
  consumption (C).

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• Secondly, the interest rate effect influences the
  slope. As prices rise, there is an increase in
  demand for money and the cost of borrowing money
  (the interest rate) will rise as well. Lenders
  will charge a higher rate of interest for the
  public to borrow money to finance household
  consumption or for firms to invest in productive
  capacity. This effect is usually most visible in
  investment (I).

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• Finally there is the foreign purchases effect.
  When the price level rises, it makes the
  countrys exports more expensive to foreign
  buyers. This leads to a decrease in foreign
  purchases of the countrys exports. Moreover,
  rising domestic prices may make imported goods
  cheaper and result in citizens substituting
  imports for exports at higher price levels. This
  is effect is seen in net exports (X M).

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• In the diagram above, the economy is producing
  output Y at the price level P.
• Shifts in the AD curve are the result of changes
  in the components of AD or changes in the factors
  of the following equation
• C I G (X M) AD

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• Consumption The elements that affect consumer
  spending would be changes in the following
• Consumer wealth While changes in income will
  clearly change consumption, so will the wealth of
  households. If there is a change in the value of
  physical (real estate) or paper (stocks and
  bonds) assets, then consumers will feel more or
  less wealthy and adjust their spending
  accordingly.

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• Consumer expectations If consumers believe that
  their real income will change in the future, they
  will increase or reduce expenditures based upon
  their expectations.
• Personal income taxes A direct tax will affect
  disposable income which will have an impact upon
  households ability to consume.

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• Household indebtedness When households borrow
  to consume (or invest), the purchases bought with
  borrowed money will increase AD. However, when
  consumers pay back that debt, they will have to
  reduce current expenditures to pay back for
  previous consumption which will decrease AD.

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• Interest rates The cost of borrowing money will
  impact the purchase of big ticket items or
  consumer durable goods. These are goods that
  last longer than a year and are difficult for
  households to buy without borrowing moneyIf
  interest rates are low, then households would be
  willing to borrow money to buy the goods they
  desire, thereby increasing AD as noted above.

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• Investment spending Investment is the most
  volatile variable in AD because it relies upon
  future expectations of businesses and individuals
  of economic activity. The elements that affect
  business investment would be changes in the
  following

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• Real interest rates Again, the cost of
  borrowing money can induce businesses to take or
  put off investing. If the real interest rate
  increases, then businesses will hold off
  borrowing to buy new plant and equipment. If
  real interest rates decrease, then firms would
  increase investment with a corresponding increase
  in AD.

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• Expected returns If companies believe that they
  will be able to make a good return on investment,
  then they will increase their purchases and shift
  the AD curve to the right. If businesses believe
  that business conditions will improve, then they
  will invest in new projects.

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• Business taxes Taxes will have a direct effect
  upon the profits that a firm expects to make from
  an investment. Consequently, a reduction in
  business taxes will increase investment and AD.
  An increase in such taxes will have the opposite
  effect.

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• Technology Improvements in technology, which
  bring with them a corresponding increase in
  productivity, will increase returns to an
  investment. Technological change incentivizes
  firms to increase their investment, which then
  leads to an increase in AD.

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• Government spending The elements that affect
  government spending would be changes in the
  following
• Changes in political priorities If a government
  decides to change spending due to a perceived
  threat or crisis then the G variable will impact
  AD. An example might be a change in defense
  expenditures.

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• Changes in economic priorities In the case of a
  recessionary environment, the government may
  increase expenditures to make up for the loss of
  AD or employment that occurs in a downturn. An
  example of this might be increasing expenditures
  on infrastructure such as roads.

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Net Export spending would be affected by the
following

• National income abroad When trade partners
  incomes rise, they have a tendency to buy more
  imports, which could mean an increase in
  purchases of our exports. The opposite is true if
  their incomes decrease.

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• Exchange rates When our countrys currency
  depreciates, it makes our exports cheaper to
  foreign buyers as it takes fewer units of their
  currency to pay for the goods or services we sell
  them. This will increase AD. Conversely, we may
  see the opposite effect if our currency
  appreciates against that of our trade partners.

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• Levels of protectionism If there is increased
  protectionism (import tariffs or quotas)
  practiced by trade partners, this can reduce
  exports and thereby AD.

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2.2b Aggregate supply

• Aggregate supply (AS) is a schedule of real
  domestic output that is produced at each possible
  price level.
• Unlike aggregate demand, aggregate supply is more
  complex in its measurement. This is due to the
  fact that producers cannot adjust quickly to
  changes in the average price level.

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• The short run is defined as the timeframe in
  which wages and input prices cannot adjust to
  changes in the average price level.
• The long run is considered to be the time in
  which wages and input prices can adjust to
  changes in the average price level.

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Movements along the SRAS curve

• Due to what we call a recognition lag, wages and
  factor input costs do not respond immediately to
  changes in the price level so it takes time for
  these prices to adjust.
• While an increase in the price level might allow
  a firm to increase its product prices, the factor
  input costs will respond much more slowly.

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• Remember that the largest cost for most firms is
  labor and so the nominal wage rate plays a
  dominant role in firms operations.
• Wage rate changes often lag changes in the price
  level in an economy as it takes time for workers
  to realize that their purchasing power has
  declined.
• When the price level rises, firms are able to
  increase their final goods prices and make larger
  profits as their wage bill remains unchanged.

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• Subsequently, a firm will increase its output
  when the price level is rising to capture more
  profits.
• Consequently, the firms increase output and can
  push the economy beyond full employment as they
  hire unemployed workers and encourage employees
  to work overtime or to move to full time work.

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• The situation is illustrated in the diagram below
  at point b in which the Y level of RGDP at the
  P price level demonstrates a rise up along the
  SRAS curve.

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• Firms respond to falls in the price level by
  lowering their final goods prices as they attempt
  to clear inventory.
• This reduction in sales revenues will reduce
  profits and put firms in a position to decrease
  production or even lay off workers. The increase
  in unemployment will correspond to a decrease in
  SRAS.
• This condition corresponds to the Y level of
  RGDP at the P price level or at point c on the
  diagram below.

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• The movements along the SRAS curve described
  above originate at point a.

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• Production costs are the primary factor in
  changes in AS. However, there are several
  determinants of AS

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• Resource costs All factor input prices will
  play a role in the final product price,
  consequently any change in resource costs will
  shift the curve. If for example, there is a
  decrease in the price of oil, then the AS curve
  will shift out to the right as we can produce
  more output with the same expenditure as before
  the price change. Conversely, a rise in wages
  will push the curve up and to the left.

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• Resource costs are not just domestic in nature.
  While labor is a domestic expense, some raw
  materials are imported. As a result, exchange
  rates and control over the supply of the needed
  resource can complicate prices firms.

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• If one particular trade partner has inordinate
  market power over a commodity, then it can
  increase the price and thereby impact our AS due
  to our use of the input in our production.
  Furthermore, if our exchange rate depreciates, we
  will have to pay more for imports of a critical
  factor input.

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• Productivity Improvements in productivity will
  increase output at all price levels and push the
  AS out and to the right.
• By improving the quality of factor inputs, either
  in the case of new machines or increasing the
  skill level of workers, we can produce more
  output at current prices and shift out the AS
  curve.

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• Business Environment This addresses many
  variables such as
• Business taxes Higher direct and indirect taxes
  increase costs in the short run and can lead to a
  reduction in output at every price level with a
  corresponding leftward shift in the AS curve.

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• Subsidies Payments by the government to firms
  to encourage the production of specific goods can
  lower production costs and encourage companies to
  expand their output.
• Regulation - The costs associated with complying
  with government regulations can divert funds from
  production and decrease output for firms. An
  increase in government regulation may shift the
  AS curve to the left.

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2.2c Controversy over aggregate supply

• Aggregate supply is a source of debate among
  different schools of economic thought. Most
  economists agree that the long run AS (LRAS)
  curve is vertical and that it represents the full
  employment/potential level of output.

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• Neo- Classical economists (Friedrich Hayek and
  Milton Friedman) argue that production levels are
  determined through the efficient operation of
  markets. Therefore, there is no SRAS as the
  economy is always just at full employment
  operating on or near the LRAS curve.

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• If there is a temporary downturn, then laid off
  workers will quickly adjust their wage demands or
  change their location and be reemployed very
  soon. There is no need for the government to
  intervene
• Neo-classical economists believe that any policy
  to address instability in the economy will
  interfere with the self-correcting mechanism of
  markets and result in price distortions
  (inflation).

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• In essence, the neo-classical perspective
  believes that AS in the long run is independent
  of prices as markets will act to push the economy
  back towards equilibrium.

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• The neo-classical school is often associated with
  non-interventionist and market based policies. By
  reducing the role of government in the economy
  and regulating the rate of growth in the money
  supply (more on this later), markets will
  self-correct and the economy will grow more
  effectively.

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• Consequently, neo-classical economists focus on
  the long run and as a result they will push for
  supply-side policies which reduce impediments to
  competition as well as reduce government
  intervention in the economy.

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• Neo-classical attitudes are connected to mostly
  right leaning political parties. Policies
  promoted in Ireland in the period after the 2009
  financial crisis which reduced government
  spending and encouraged austerity in general,
  could be considered to be neo-classical in
  nature.

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• However, Keynesian economists believe that
  markets are imperfect and that macroeconomic
  instability is the result of different forms of
  market failure.
• Consequently, the Keynesians believe in the AS
  curve which has three regions.

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• They believe that output can fall at such as rate
  that it falls into the horizontal range of the AS
  curve. This means that there could be a decrease
  in output with no change in the price level.
• This is due to the belief that resource costs and
  final product prices are sticky downwards.
  This perspective is rooted in the belief that
  workers do not adjust their wage demands as
  rapidly as they will attempt to find employment
  at their previous income.

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• Moreover, from this perspective, producers do not
  adjust their product prices until absolutely
  necessary to clear inventory.
• When both of these scenarios are in play, there
  is plenty of spare capacity for the economy to
  put back to work without putting upward pressure
  on the price level.

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• Horizontal range this is substantially below
  full employment implies that the economy is in
  recession or worse, a depression. There are
  plenty of unemployed resources and there is
  upward pressure on prices. This is characterized
  by a flat portion of the AS curve.

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• Intermediate range as the economy starts to
  grow, there is increased demand for labor and
  other resources. This results in upward pressure
  on factor input prices and requires firms to
  increase their product prices to maintain
  profitability. There will begin to be shortages
  of resources, which will further drive up prices.
  This region is where most of the short run
  analysis is done and is upward sloping.

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• Vertical range when the economy reaches its
  potential output or full employment, the curve
  becomes vertical. This is because the economy is
  at full capacity. Any efforts by firms to
  increase output will only bid resources away from
  other firms and drive up prices in the process.
  This is due to the finite resources in the
  economy.

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• Keynesian economists believe that markets are
  imperfect and that macroeconomic instability is
  the result of different forms of market failure.
• They believe that output can fall at such as rate
  that it falls into the horizontal range of the AS
  curve. This means that there could be a decrease
  in output with no change in the price level.

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• This is due to the belief that resource costs and
  final product prices are sticky downwards.
  This perspective is rooted in the belief that
  workers do not adjust their wage demands as
  rapidly as they will attempt to find employment
  at their previous income.

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• Moreover, producers do not adjust their product
  prices until absolutely necessary to clear
  inventory.
• When both of these scenarios are in play, there
  is plenty of spare capacity for the economy to
  put back to work without putting upward pressure
  on the price level.

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• Keynesian policies to address economic
  instability are often a mix of fiscal (government
  driven) and monetary (central bank directed)
  policies. These policies often affect the economy
  through the demand or AD side.
• These tactics can be interventionist as in
  increasing government spending to make up for a
  decrease in AD or cutting taxes to increase
  investment. Or the central bank could increase
  the money supply to lower interest rates to
  promote investment.

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• Unfortunately, both of these policies often
  result in inflation, which we will discuss in
  more detail in the future.
• An example of such Keynesian government driven
  policies was the 819 billion stimulus package of
  increased spending and continuation of tax cuts
  passed by Congress in the U.S. in 2009.

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2.2d Long run aggregate supply

• Despite their differences, both Keynesians and
  neo-classical economists agree on the LRAS being
  vertical at the potential output of the economy
  and the goal of shifting the LRAS to the right.
• The LRAS corresponds to the full-employment
  output (Yfe) of the economy. This is basically
  when the economy is operating at its potential.

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• Another way of saying this is that the economy is
  operating at the natural rate of unemployment
  (NRU). This point occurs when the number of job
  applicants is equal to the number of vacancies.
• The economy can operate below the NRU or at time
  beyond the NRU. How the economy adjusts to these
  two conditions is the subject of much controversy
  and we will discuss this dispute in more detail
  in section 2.3.

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• Shifting the LRAS is another way of demonstrating
  economic growth through expanding the potential
  or full employment output of the economy.
• In this case it is very similar to the how the
  PPC operates.

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• Notice how the PPC is pushed out demonstrating
  economic growth and how this matches the increase
  from Yfe to Yfe in the LRAS on the AD/AS model
  on the right.

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• Two sources of expansion of the LRAS are
  increasing the quantity and quality of factor
  inputs.
• If there is an increase in the factors of
  production we can shift the potential of full
  employment output.

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• For example, we can add more to our labor force
  via population growth or increase labor force
  participation. By having formerly unemployed
  workers or more women enter the labor force, we
  have increased our potential output.

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• If we increase our stock of physical capital
  through investment, we have pushed out our
  potential. When firms put in place more
  machinery, it will increase the productivity of
  labor and consequently potential output.

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• A new natural resources discovery will push the
  LRAS to the right reflecting an increase in land
  as a factor of production. An example of this
  might be Brazils oil discovery in 2006, which
  added to its potential GDP.

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• By improving the quality of inputs, we can push
  the LRAS outward as well. This is usually
  associated with improvements in training and
  education for labor to increase productivity.
  Highly trained labor can be more capable of
  suggesting cost saving ideas to increase output.

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• Technological advances associated with capital
  equipment will make labor more productive and
  thereby push the LRAS out as well. For example,
  new machines in a metal fabrication plant, which
  use raw materials more efficiently, will increase
  potential output.

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• Finally, we can improve our allocative efficiency
  by more effectively organizing our productive
  resources. Companies endeavor to do this by
  continually examining production processes to
  decrease wasted movements or procedures.

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2.2e SRAS/AD equilibrium

• Similar to equilibrium in microeconomics,
  macroeconomic equilibrium occurs when AD and the
  SRAS behave in a manner to move towards
  equilibrium in which
• P level AD SRAS

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Real Output Demanded (AD) Price level (Index Number) Real Output Supplied (AS)
440 110 453
443 105 450
447 100 447
450 95 444
453 90 441
The table makes evident that macroeconomic
equilibrium will occur at a price level of 100
with a real output of 447 billion. Lets look
at a diagram.
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As the diagram makes clear, the equilibrium level
of output is at 447 billion at the price index
of 100.
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• Arriving at a new equilibrium in the short run
  can be achieved through the demand side or the
  supply side. Lets examine the demand side
  first.
• Whenever one of the determinants of aggregate
  demand (CIG(X-M)) changes, the result will be
  a shift in the AD curve.

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• The increase in investment described above will
  lead to an increase in aggregate demand from AD
  to AD. This results in a new equilibrium level
  of output Y at a higher price level of P.
• While the economy experiences higher output, the
  challenge here is that there is a rise in the
  price level, which is associated with demand pull
  inflation.

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• Suffice it to say, if we see a decline in any of
  the AD variables, the new equilibrium would be at
  a lower output and a lower price level (all
  things being equal).
• Drops in various components of AD may be the
  result of higher interest rates resulting in
  businesses reducing Investment or Consumers
  income stagnating so they buy fewer goods and
  services.

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• One final note here is that a natural or man-made
  event can reduce Consumption (as well as
  Investment) due to the disruption in peoples
  lives. An example of this might be the terrorist
  attacks in Spain in 2004 and in England in 2005
  leading to less train travel by citizens or a
  decline in consumption due to the earthquake in
  Haiti in 2010.
• Do you think that you can draw the correct
  diagram for a decline in AD?

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• Decreases in SRAS are usually associated with
  supply shocks. These events are often the result
  of the disruption of a segment in the supply
  chain due to a natural or man-made disaster.
• The 2011 earthquake and tsunami in Japan lead to
  a decrease in the SRAS in Japan as well as
  impacting the supply chain of firms in other
  countries.

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• The classic explanation of a supply shock is an
  increase in oil prices that is so dramatic as to
  make every unit of output that much more
  expensive to produce that the economy creates
  less output at a higher price.
• In the 1970s when oil prices tripled in a very
  short period of time, the U.S. economy in
  particular, production costs soared and the
  result was what is called cost push inflation.

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The lower output was at a higher price and the
diagram below illustrates the conundrum.
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• With an increase in factor input costs (such as
  oil in this case), producers can make fewer goods
  and services for a given budget.
• The scenario leads to a shift in the SRAS curve
  to SRAS.
• This results in a decrease in output form Y to
  Y, yet with prices increasing from P to P
  accounting for the corresponding increase of
  resource costs.

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• There are occasions when the both AD increases
  and the SRAS curve shifts out as well. This
  results in low inflation and strong economic
  growth.
• Unfortunately, this sort of benign environment
  is not always seen in the real economythe U.S.
  experienced this scenario between 1996 and 2000.
• The diagram below will illustrate this favorable
  environment.

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• As the diagram makes evident, the growing economy
  shows a shift in the AD curve from AD to AD.
  The new equilibrium shows a corresponding output
  of Y at the price level P.
• However, as a result of increased worker
  productivity, the SRAS curve shifts out to SRAS.
  The shift in the SRAS curve increases output
  even further to Y at a lower price level of P.

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2.2f LRAS-SRAS-AD equilibrium

• Short run and long run equilibrium can come
  together at full employment.
• Remember that the full employment level of output
  corresponds to the LRAS. This is because nominal
  wages adjust in response to changes in the price
  level over time.

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• In the long run, the SRAS goes through a series
  of adjustments to changes in the price level.
• As we will see shortly, these adjustments can
  lead to a recessionary or inflationary gap in the
  short run.
• Corrections can result in AD-SRAS-LRAS
  equilibrium, as demonstrated by the diagram
  below.

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• In the scenario above, the economy starts in a
  recessionary environment at Y output at the P
  price level. Now suppose that prices have fallen
  far enough to induce firms to invest in new
  machinery and hire workers to operate the
  machinery.
• The increase in I, leads to a shift in the AD
  curve to AD at the P price level and Yfe level
  of output. This happened to be in long run
  equilibrium for the economy.

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• The neo-classical school believes that the
  economy always self-corrects, so therefore we
  only need to worry about policies that push out
  the LRAS.
• The neo-classical analysis shown below starts at
  full employment output (Yfe) at the price level Y
  or point a.

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• If there is an unanticipated increase in
  aggregate demand shown by the shift in the AD
  curve from AD to AD, then this will push
  equilibrium beyond the full employment level of
  output corresponding to Y at point b.

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• However, owners of resources/factor inputs are
  quick to realize that the price level has
  increased and they will demand higher prices or
  wages to restore lost purchasing power.

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• As per unit production costs increase, aggregate
  supply will decrease leading to a shift in the
  curve from AS to AS. Hence the economy
  self-corrects to point c back at the full
  employment output (Yfe) but at a higher price
  level (P).

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• Neo-classical economists believe that people
  behave rationally and therefore take action
  rapidly to protect their self-interest.
• Even though the economy will slip out of long run
  equilibrium, individuals and firms interacting in
  the market place will automatically push it back
  to Yfe.
• For these reasons, there is no need for the
  government to invoke any changes in fiscal policy
  or for the central bank to take monetary
  actionlet the markets work.

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• Keynesian economists have a different perspective
  on how an economy falls into, and for how long
  the economy can be in, disequilibrium.
• The basic belief here is that the economy is in
  equilibrium wherever AS ADwhether at full
  employment or not.

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• The Keynesian school of thought focuses on the
  role that aggregate demand plays in economic
  instability.
• Rapid changes in any of the variables of AD will
  lead to the economy reaching a new equilibrium
  often above or below full employment.

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• Remember that another key to the Keynes
  perspective is that individuals and firms take a
  longer time to recognize and adjust their wage
  and price demands.
• For example, a dramatic drop in Consumption in an
  economy where consumption plays a large role can
  push the economy into recession.

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• However, the most destabilizing variable is wide
  swings in Investment.
• Due to investment relying upon real interest
  rates and expected rates of return, optimism (or
  pessimism) can lead to big booms (or busts) in
  investment.

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2.2g Keynesian perspective on equilibrium.

• A recessionary gap is defined as a level of
  macroeconomic equilibrium below the full
  employment level of output as show in the diagram
  of the Malaysian economy below.
• This gap corresponds to the point when actual
  economic growth falls below potential economic
  growth in the business cycle.

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• The result of this decline is unemployed
  resources whether it be labor or capital in the
  form of plant and machinery being idle.
• In the Keynesian system, the economy can
  experience long periods of recession due to the
  downward rigidity in wages and prices. In this
  view, individuals do not adjust their wage
  demands as rapidly as they will attempt to find
  employment at their previous income.

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• As noted earlier, from this perspective,
  producers do not adjust their product prices
  until absolutely necessary to clear inventory.
• An equation for this might be
• AD AS lt LRAS/Yfe

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• This diagram of the Malaysian economy shows a
  recessionary gap where equilibrium is reached at
  a price level of 100 equaling a RGDP of 447
  billion.
• However, this point is below the full employment
  level of potential output at 450 billion.

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• This model also allows for an inflationary gap to
  occur in which the economy reaches equilibrium
  beyond full employment.
• In this case, we might be able to write this as
  an equation
• AD SRAS gt LRAS/Yfe

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• If an economy starts to grow rapidly and
  overheat, there can be a reduction in spare
  manufacturing capacity and very tight labor
  markets.
• Wage rates will be bid up as firms try to secure
  scarce labor to meet the growing demand for their
  output.

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• Natural resource and other factor input prices
  will increase as firms continue to compete for
  scarce resources as most producers of natural
  resources cannot quickly increase supply to meet
  growing demand.
• These input price increases will lead to higher
  final goods and services prices as shown below.

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• In this scenario it is evident that the Malaysian
  economy is overheating reaching equilibrium at a
  price level of 105 with RGDP beyond full
  employment at 453 billion.

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• Finally, unlike neo-classical economists, Keynes
  did not believe that increases in AD had to be
  inflationary.
• It is a core belief of the Keynesians that the
  economy can operate for long periods of time in
  the horizontal range of the Keynesian AS curve.

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• Because of the large amount of unused resources
  (labor, capital or natural resources), there are
  plenty of factor inputs available for production.
• These unemployed resources can be engaged without
  worry for bottlenecks or shortages leading to
  wage and price increases.
• Therefore, increases in AD can result in growth
  and output can be increased with little or no
  upward pressure on the overall price level.

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• In the economy above, equilibrium is deep in the
  horizontal zone of the AS curve and there is
  enough excess capacity and surplus labor that AD
  can increase to AD with no impact upon the
  overall price level as RGDP moves from Y to Y.