1 Review people to buy more a Expansionary AD shocks ie increase in consumer confidence anything that causes i Keynesian model boom with no inflation economy can stay at Y Y indefinitely ii AD AS model AD shifts out 1 Short run economy moves from AD to B boom plus higher pi 2 Long run self correction mechanism kicks in a Tight labor market workers are scares wages increase AS shifts left Y returns to Y and pi increases economy moves to point C b Contractionary AD shocks ie stock market crash bank failures anything that causes people to stop buying things i Keynesian model recession with no change in inflation Y can stay Y indefinitely ii AD AS model AD shifts left 1 Short run moves from A to B 2 Long run self correction kicks in a Slack labor market jobs are scarce wage growth fails AS shifts right pi fails Y returns to Y at point C 2 Expansionary AD shocks lead to inflation overheating output is too high and unemployment is too low so there is much inflation a Examples i WWII ii Late 60s after Vietnam war leads to 70s inflation 3 Contractionary AD shocks lead to wage undercutting unemployed workers tend to put downward pressure on wages a Examples i Great depression ii Great Recession iii Volker disinflation of 80s 4 Contractionary adverse AS shocks ie oil price increase bad weather a AS shifts up left i Short run economy moves to point B Y decreases and pi increases 1 Stagflation ie 1974 1975 1979 1980 recession inflation ii Long run depends on whether adverse shocks reduces Y 1 2 If Y falls to Y some lower level then the economy could stay at point B indefinitely with no self correction If Y is unchanged then self correction will kick in starting at point B a Y Y UR UR slack labor market wages decrease AS shifts back to original position Y and pi return to initial levels 5 Expansionary AS shock oil price decrease or development of technology a AS shifts down right i Short run economy moves from point A to point B where there is a boom and ii Long run if Y rises too then we can stay at point B indefinitely with no self disinflation correction iii If Y unchanged self correction occurs and causes tight labor market where wages grow b Examples c 90s internet d 80s oil price decrease 6 Stabilization policy in AS AS model what should government do a Scenario 1 booming economy Y0 Y point A i Option one do nothing and let the economy self correct 1 Outcome will be inflationary overheating AS will gradually shift up as wages grow quickly and in the long run we will move to point B with higher inflation graph 5 ii Option two wage and price controls 1 Government prohibits wages and prices from rising faster than some rate 2 Keep the economy frozen at point A keep a boom but with no accelerating inflation a Examples i WWII 1941 45 ii 1972 Nixon 3 Problem Cant keep wage and price controls forever lead to inefficiency by preventing relative wage and price change a Once you life the controls the result is very quick overheating 1946 and 73 b Not a permanent solution iii Option three contractionary fiscal and monetary policies to cool off overheating economy 1 Fiscal decrease G decrease TR increase t austerity 2 Monetary shift credit supply curve in which increases r and decreases I tight monetary policy 3 Goal of policies shift AD left which will eliminate overheating pressure and return Y to Y with lower inflation Graph 6 a Move from point A to point C instead of point B 4 Issue who should tighten fiscal or monetary authorities a Fiscal austerity may be unpopular with voters so the president may b One value of having an independent central bank is that they can do be reluctant to adopt it unpopular things b Scenario 2 recession Y0 Y at point A i Option one do nothing let self correction work 1 Eventually wages will stagnate and the economy will return to full employment Y will lower inflation point B ii Option two expansionary fiscal or monetary policy 1 Shift AD out and return the economy to full employment with higher inflation point C Graph 7 iii Neo Keynesian versus monetarists 1 Neo Keynesians option 2 self correction is too slow and expansionary policies will work more quickly 2 Monetarists option 1 self correction is not too slow and self correction will work better if the government stays out and lets the market work a Governments will generally mess things up if they try to adopt expansionary policy wont always be the right amount
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