Econ 1202 1st Edition Lecture 17Outline of Last Lecture I. Interest Rate EffectII. International Trade EffectIII. What Constitutes Aggregate Demand?IV. Shifts in Aggregate DemandV. What Causes the Components of Aggregate Demand to Change?VI. Why Do We Care About It?VII. AD Shifts: Changes in Foreign VariablesVIII. “Strong Dollar Slams Profits”IX. A Big Shift in Aggregate Demand: The Great DepressionX. Shifts in the AD Curve vs. Movements Along ItXI. Aggregate SupplyXII. Long-Run Aggregate Supply Curve (LRAS)XIII. QuestionsXIV. LRAS ShiftsOutline of Current Lecture I. What about the Short Run?II. Why does Short Run AS “look” the way is does?III. The short run the Aggregate Supply is Driven ByIV. Focus of AttentionV. Sticky-Wage TheoryVI. Long Term Labor ContractVII. Long Term Requirements ContractVIII. Misperceptions TheoryIX. Sticky-Price Theory X. Why aren’t we doe yet?XI. “Things” that Cause the SRAS to shift/changeXII. Big IdeaXIII. Cliff Notes: AD-AS ModelXIV. Natural Rate of UnemploymentXV. QuestionsXVI. Macroeconomics “starts” with KeynesCurrent LectureFramework of Aggregate Demand and Supply (continued)I. What about the Short Run?a. The short-run aggregate supply curve describes the relationship between the price level and the quantity of goods and services firms are willing to supply, holding constant all other variables that affect the willingness of firms to supply goods and servicesb. In the short-run:i. Increase in overall level of [prices in the economy1. Tends to raise the quantity of goods and services suppliedii. Decrease in level of prices1. Tends to reduce quantity of goods and services suppliedc. In the short-run, a fall in the price level from P1 to P2 reduces the quantity output supplied from Y1 to Y2i. Why does this happen?1. Sticky wages, sticky prices, or misperceptions2. Over time, wages, prices, and perceptions adjust, so this positive relationship is only in the short run, but the short run could become long run.II. Why does Short Run AS “look” the way is does?a. Reviewi. Long Run AS: “real” factors (potential GDP)ii. Short Run AS: “real” factors (potential GDP+ factors that cause fluctuations around a nation’s potential output)b. Inflexible/Rigid Structure of Nominal Prices and CostsStructure of Production Costsc. Economic ShocksIII. The short run the Aggregate Supply is Driven Bya. The “real” factors (potential GDP) in the economy (just like long run) plus:i. Inflexible/Rigid Structure of Nominal Prices and Costs that can cause fluctuations around a nation’s potential output arising from changes in the overall price level and structure of productionii. Economic shocks that cause fluctuations around a nation’s potential output through price effectsIV. Focus of Attentiona. Theories that explain why the AS curve slopes upward in short-run (that is, why there can be fluctuations around a nation’s potential output caused solely around changes in prices):i. Sticky-wage Theoryii. Stick-price Theoryiii. Misperceptions Theory V. Sticky-Wage Theorya. Nominal wages-slow to adjust to changing economic conditionsi. Long-term contracts: workers and firmsii. Institutional constraintsiii. Notions of fairness-influence wage settingb. Nominal wages-based on expected pricesi. Don’t respond immediately when actual price level is different from what was expectedc. Applies to other input contractsi. Businesses have incentives to enter into long term requirements and other contracts: Alcoa and Bauxited. If price level>expectedi. Firms-incentive to produce more outpute. If price level<expectedi. Firms-incentive to produce less outputVI. Long Term Labor Contracta. Inflation expectations are embedded in long term contractsb. Example:i. Long term contract:1. Assume expected annual inflation is 1%2. Expected real annual increase is 2%a. 2015: $20/hourb. 2016: $20.60/hourc. 2017: $21.22/hourd. 2018: $21.85/hour3. But what if actual annual inflation is 10%?VII. Long Term Requirements Contracta. Inflation expectations are embedded in long term contractsb. Example:i. Alcoa signs a contract with an Australian bauxite miner for the delivery of bauxite over a 4 year period at a set priceii. Long term contract:1. Assume expected annual inflation is 1%2. Expected real annual increase is 2%a. 2015: $20/tonb. 2016: $20.60/tonc. 2017: $21.22/tond. 2018: $21.85/ton3. But what if actual annual inflation is 10%?c. Overall prices rising 10%d. Wages/input costs rising 3%e. Real wage=nominal wages/price leveli. Real wages falling, real cost is fallingii. Expectations regarding businessVIII. Misperceptions Theorya. Changes in the overall price leveli. Can temporarily mislead suppliers1. About changes in individual markets2. Changes in relative pricesii. Suppliers-respond to changes in level of prices1. Change-quantity supplied of goods and servicesIX. Sticky-Price Theory a. Prices of some goods and servicesi. Slow to adjust to changing economic conditionsii. Menu costs1. Costs to adjusting pricesX. Why aren’t we done yet?a. There are a couple of reasons why, but first and foremost, it is because the movement from P1, Y1 to P2, Y2 is occurring in the short runb. There is also a long run adjustment that is reflected in a shifting of the SRASc. LRAS acts as a “economic magnet” or “gravitational force” that pulls the SRAS toward it (through an “equilibrating” process)d. That is, all things being equal, there are economic forces driving that economy toward the long run aggregate supply that are “graphically” reflected in a shifting of the SRASXI. “Things” that Cause the SRAS to Shift/Changea. Changes in the “real” side of the economyi. The same factors that can cause the LRAS to shift will also cause the SRAS to shiftb. Changes in the structure of production costsi. Factors that are unique to the short run1. These are tied to economic shocks (such as a rapid increase in the price of critical resources such as oil) or as parties adjust their contracts to align their expectations (ofinflation) with the actual level of inflation2. Often this occurs when parties attempt to “catch up” lost economic ground when overall prices increase or decrease at rates not expectedXII. Big Ideaa. Embedded in the SRAS are workers and firms expectations of pricesi. They are “hardwired” into contracts.1. That is why as overall prices change, output is changing because the real production costs are falling or rising: the nominal wages or