Zara Mahmood Nov 14 2013 EC102 Lecture 14 Macroeconomic Equilibrium and Business Cycle Overview of the Financial System Financial System The system of financial markets and financial intermediaries through which firms acquire funds from households Financial Markets Markets where financial securities such as stocks and bonds are bought and sold Financial Intermediaries Firms banks insurance companies that borrow funds from savers and lend them to borrowers Long Run Macroeconomic Equilibrium Where LRAS SRAS and AD slopes meet o E long run macroeconomic equilibrium Level of unemployment will always be tending towards unemployment rate Inflationary Gap r then C I NX and AD G T then AD Ye then C I then AD NX then AD o YSR is greater than YLR Recessionary Gap r then C I NX and AD G T then AD Ye then C I then AD NX then AD o YSR is greater than YLR Supply Shock The Short Run Effect of a Supply Shock Oil prices increase substantially o Negative Supply shock will increase firms costs and cause SRAS to shift left Price level is higher and real GDP is lower o Positive Supply shock will decrease firms costs and cause SRAS to shift right Price level is lower and real GDP is higher Stagflation Unpleasant combination of inflation and recession Zara Mahmood Nov 14 2013 EC102 Adjustment Back to Potential GDP in the Long Run Recession caused by a supply shock increase unemployment and reduces output o Workers willing to accept lower wages o Firms willing to accept lower prices Short run Aggregate supply shifts right not instant Economy back to potential GDP and original price level Relationship Between Inflation and Unemployment Recessionary Gap YACTUAL YPOTENTIAL Price Level goes down Unemployment Natural Rate Inflationary Gap YACTUAL YPOTENTIAL Price Level goes up Unemployment Natural Rate Phillips Curve A curve showing the short run relationship between inflation rate and unemployment rate inverse relationship Vertical Long Run Phillips Curve 1968 Milton Friedman and Edmund Phelps argued that the tradeoff was temporary o Hypothesis The claim that unemployment eventually returns to its normal or natural rate regardless of the inflation rate o Based on the vertical LRAS o If the LRAS is vertical then in the long run the PC is vertical In the long run government policies designed to shift AD to the right only cause faster inflation Reconciling Theory and Evidence In the short run PC can slope downward rate o People expect the same of inflation in short run Actual inflation is lower In the long run PC is vertical Shifts in the SR Phillips Curve People s expectations for inflation rate change o Shift the SRPC Peoples inflation expectations change o Higher inflation shift right Zara Mahmood Nov 14 2013 EC102 o Lower Inflation shift left When LRPC and SRPC intersect actual inflation expected inflation The Phillips Curve Equation Short Run o Monetary policy can reduce unemployment rate below the natural unemployment rate Makes inflation greater than expected Long Run o Expectations catch up to reality Unemployment rate goes back to natural rate whether inflation is high or low How Expected Inflation Shifts the PC NAIRU Natural Rate of Unemployment called NAIRU Nonaccelerating Inflation Rate of Unemployment
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