Dynamic AS AD Model Outline The Dynamic Aggregate Demand Curve The Solow Growth Curve Real Shocks Aggregate Demand Shocks and the Short Run Aggregate Supply Curve Shocks to the Components of Aggregate Demand Understanding the Great Depression Aggregate Demand Shocks and Real Shocks Introduction Real GDP grew at an average rate of 3 3 over the past 50 years Growth is not a smooth process USA growth 8 RGDP growth 6 4 2 0 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 2 4 Year Introduction Business fluctuations fluctuations in the growth rate of real GDP around its trend growth rate Recession a significant widespread decline in real income and employment Introduction Dynamic Aggregate Demand Dynamic aggregate demand curve shows all the combinations of inflation and real growth that are consistent with a specified rate of spending growth Recall the quantity theory in dynamic form M P YR Inflation Real Growth The AD curve gives combinations of inflation and real growth consistent with a given rate of spending growth Dynamic Aggregate Demand Shifting AD Solow Growth Curve Solow growth rate is an economy s potential growth rate the rate of economic growth that would occur given the flexible prices and existing real factors of production Important point If markets are working well and prices are perfectly flexible the economy will grow at the potential growth rate Solow Growth Curve Shifting Solow Growth Curve Real shock also called a productivity shock is any shock that increases or decreases the potential growth rate Positive real shock shifts the Solow growth curve to the right higher real growth Negative real shock shifts the Solow growth curve to the left lower real growth Shifting Solow Growth Curve Combining the Two Curves Real Shocks Changes in economic conditions that increase or decrease the productivity of capital and labor We will take a closer look at different kinds of real shocks Weather Oil shocks Other shocks including wars terrorist attacks major new regulations mass strikes tax changes and new technologies Real Shocks Weather Economies that depend heavily on agriculture are most effected by weather India is a good example Let s look at the next diagram and see what we can learn about weather on the overall economy Real Shocks Weather Panal A changes in rainfall have a large impact on agricultural output Panal B Prior to 1980 changes in the growth rate of real GDP are closer Related to changes in rainfall than after 1980 Why Real Shocks Oil Economy with a large manufacturing sector a reduction in oil supply is like a decrease in rainfall in an agricultural economy First oil shock 1973 Oil embargo Price of oil more than tripled higher gas prices Higher gas prices reduced the demand for larger cars costly changes in the auto industry Real Shocks Oil Sharp increases in oil prices adversely affects many industries including Those industries that convert oil into products such as plastics and textiles Transport of goods Industries that depend on people traveling to destinations e g the hospitality industry resorts and hotels airlines The cumulative effect of these impacts can result in recessions Real Shocks Oil Real Shocks Oil It is more difficult to eyeball the effect of smaller oil shocks Statistical analysis can disentangle the effect of oil shocks from other shocks that occur at the same time The following graph shows that the impact of a 10 increase in the price of oil can impact real GDP growth for two and a half years Real Shocks Oil Other Shocks Economies are continually hit by many small shocks Typical year good shocks outweigh the bad and the economy grows Bad year A recession results when Economy is hit by a large bad shock or More small shocks are negative than positive Real Shocks Short Run vs Long Run John Maynard Keynes 1883 1946 The General Theory of Employment Interest and Money 1936 Wrote in the context of the Great Depression Explained that when prices are not perfectly flexible sticky deficiencies in aggregate demand could cause recessions Aggregate Demand Shocks Aggregate demand shock a rapid and unexpected shift in the AD curve spending growth Short run Increase in AD is split between increases in inflation and increases in real growth Long run Increase in AD results only in higher inflation Essence of the short run aggregate supply curve the short run increase in output resulting from sticky prices and wages Short Run Aggregate Supply SRAS shows the positive relationship between the inflation rate and real growth when prices and wages are sticky Upward sloping increase in AD will increase both inflation and real growth Each SRAS curve is associated with a particular rate of expected inflation E p Let s put everything together to see what happens if the money supply increases unexpectedly Equilibrium Aggregate Demand Shift Increase Spending Increase Growth Increase in spending higher prices Higher prices encourage producers to increase output Increased output overtime and higher hourly wages Workers are eager to work longer for overtime wages How Long Does It Last Eventually workers realize they are working more for lower real wages and demand higher regular wages Nominal wage confusion Occurs when workers respond to their nominal wage instead of their real wage Prices don t always change quickly due to menu costs Menu costs costs of changing prices Readjustment to Equilibrium Readjustment to Equilibrium Why does the SRAS shift up In the long run unexpected inflation becomes expected inflation An increase in AD higher expected inflation Higher expected inflation causes producers and workers to raise prices and wages in order to hold real incomes and wages constant The SRAS shifts up so that the actual inflation rate equals the expected inflation rate Problems Preview of some dilemmas in policy Once c is reached policy makers may try to increase growth by increasing the expected rate of inflation even higher above 7 and may get trapped in an inflationary spiral Lowering the inflation rate by reducing the growth rate of money may cause a recession due to prices being more sticky downward Solution Shocks to Components of AD Changes in are the same as changes in the spending rate holding M constant If increases the growth rate of C I G or NX must increase We will look at changes in each of these components as a change in we will Changes in
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