(End of Semester
Beginning of Semester)
-Short-run equilibrium P & Real GDP are found at the intersection of AD and (short run) AS.
- If SHORT-RUN
equilibrium price level (P) is higher than expected, the real wage will be lower than expected, and Real GDP will exceed Q
in the SHORT RUN. (By the same token, if short-run equilibrium
price level (P) is lower than expected, the real wage will be higher than expected, and Real GDP will be less than Q
in the SHORT RUN.)
- In the LONG RUN,
price expectations will adjust to reality, which will change nominal wages and SHIFT THE SHORT RUN AS CURVE
, moving equilibrium output to Q
in the LONG RUN.
- Therefore, long run equilibrium will occur at the intersection of AS, AD, and LRAS
- Business cycles
can be driven by AD shifts (in which case the inflation rate will fall during recessions and increase during booms) or by AS shifts (in which case the inflation rate will rise during recessions and fall
- Most recessions (including the Great Recession of 2008-2009 and the Great Depression of 1929-39) appear to be AD driven: Great Depression: 25% unemployment, 33% drop in Real GDP, 22% drop in P.
Great Recession: 10% unemployment, 3% drop in Real GDP, inflation fell to 0.
- Proximate causes of the Great Depression: Panic plus ↓M of 28% causing ↓Investment; Stock prices fell 90%, causing ↓C. Also, protectionism contributed to ↓AD.
- Proximate causes of the Great Recession: Panic caused ↓Investment; Housing and stock prices fell, causing ↓C.
- On the other hand, the Stagflation of 1974 was AS–driven (due to oil price increases): Stagflation: 9% Unemployment, 2.5% drop in Real GDP, inflation rose to 12%.
- The recessions of 1980-82 were caused by an AD-shift, deliberately driven by monetary policy of the Federal Reserve Chairman Paul Volcker, with backing of Carter and Reagan. Volcker Recession: 11%
Unemployment, 2.5% drop in Real GDP, inflation fell from 15% to 4% and has remained below that level ever since.
- Monetary policy
, which is done by the Federal Reserve, consists of the manipulation of the money supply to affect the business cycle.
- Fiscal policy
, done by Congress usually under Presidential leadership, consists of taxing and spending decisions designed to affect the business cycle.
- Ability of monetary policy to affect Real GDP is explained by Keynes' Theory of Liquidity Preference,
which states that people choose to hold more of their wealth as money if interest rates fall (therefore MD slopes
down if the interest rate r is on the vertical axis).
-Expansionary Monetary Policy
: ↑ M
↑ ( C + I + G + NX)
↑ P, ↑ GDP, ↓ U in the short run. ( In the long run, P may rise even more as GDP and U move back to QNAT & UNAT )
-Contractionary Monetary Policy
: ↓ M
↓ ( C + I + G + NX)
↓ P, ↓ GDP, ↑ U in the short run. ( In the long run, P may fall even more as GDP and U move back to QNAT & UNAT )