Macro_Chapter05

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Chapter 5 Output, Business Cycles, and Employment:

Macro economics by Curtis, Irvine, and Begg Second Canadian Edition McGraw-Hill Ryerson, © 2010 1 Chapter 5 Output, Business Cycles, and Employment

Learning Outcomes:

Learning Outcomes ©2010 McGraw-Hill Ryerson Ltd. Chapter 5 2 This chapter explains: Short-run aggregate demand and supply Equilibrium output and potential output Business cycles and output gaps Okun’s Law: output gaps & unemployment Adjustments to output gaps The role of macroeconomic policy

A Short-Run AD/AS Model:

A Short-Run AD/AS Model ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 3 An introduction to the AD/AS model developed in detail in the chapters that follow Short run assumptions : Constant factor-prices esp. money wage rates Fixed supply of labour, stock of capital, & technology As a result: ∆output  ∆employment & ∆capital utilization

The AD/S Model in a Diagram:

The AD/S Model in a Diagram ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 4 AD = (C+I+G+X-Z) at different P levels. AS = P at different rates of real output AS reflects unit costs of production [(W+BI)/Y] at constant input prices P = GDP deflator P Y Real GDP GDP deflator AS 2008 AD 2008 1326 120.9

Aggregate Demand (AD):

Aggregate Demand (AD) ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 5 Downward sloping AD from three effects of ∆P: Interest rate effect ↑ P  ↑ i  ↑ finance cost  ↓ Expenditure Substitution effect ↑ P  ↑ P CAN /P US  ↓ X + ↑ Z  ↓ Expenditure Wealth effect ↑ P  ↓ (Nominal Wealth)/P  ↓ Expenditure

Aggregate Demand:

Aggregate Demand 6 The AD curve: Shows ∆expenditure caused by ∆ P Assumes all determinants of expenditure except price are constant Slope of AD = ─ ∆P/∆Y Position of AD: factors other than P that affect expenditure ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1

The Aggregate Demand Curve:

The Aggregate Demand Curve ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 7 The AD curve: Planned aggregate expenditure: (C+I+G+X-Z) at different prices, ceteris paribus ∆ P  i effect + Substitution effect + Wealth effect  ∆Y/∆P < 0 P Y AD P 0 Y 0 P 1 Y 1 A B

Aggregate Supply (AS):

Aggregate Supply (AS) ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 8 Upward sloping AS curve: From national accounts: Price = unit cost : ∆Y  ∆(Y/N)  ∆(W/Y) (Y/N ≡ labour productivity) ↑ Y  ↓ (Y/N)  ↑ unit labour cost  ↑ P

Aggregate Supply:

Aggregate Supply The AS Curve : Shows relationship between ∆Output & ∆P Assumes money wage rates & other input prices are constant Slope of AS = ∆P/∆Y > 0 Position of AS : input prices & other production conditions ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 9

The Aggregate Supply Curve:

The Aggregate Supply Curve ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 The AS curve shows output (Y) businesses would produce at different prices (P) ↑ Y  ↑ unit costs  ↑ P ∆P/∆Y > 0 P Y Real GDP & Income GDP Deflator AS Y 2 Y 3 P 2 P 3 10

Equilibrium Real GDP and Price:

Equilibrium Real GDP and Price ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 11 Equilibrium: AD = AS At P 0 ,Y 0 : AD = AS Planned expenditure on current output = business sector current production At P 1 : AD < AS Y 1 < Y 2  unplanned ↑ inventory  ↓ Y P Y AS AD A C B P 0 P 1 Y 0 Y 1 Y 2 Unplanned ↑ in inventories

Stability of AD/AS Equilibrium:

Stability of AD/AS Equilibrium ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 12 Equilibrium AD = AS Planned expenditure buys current output Business revenues = costs including profit No ∆Y Disequilibrium AD ≠ AS Unplanned ∆ in inventories Business revenues ≠ costs including profit ∆Y  AD = AS  Equilibrium

Equilibrium Real GDP and Price:

Equilibrium Real GDP and Price ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.1 13 A Numerical Example: AD: Y = 1000 – 2P AS Y = -200 + 10P In Equilibrium AD = AS 1000 – 2P = - 200 + 10P 12P = 1200 P = 100 Y = 800

Equilibrium Output vs Potential Output:

Equilibrium Output vs Potential Output ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.2 14 Y e ≡ equilibrium Y from AD = AS Y P ≡ Potential output Y P = ‘full employment’ of labour & capital Y P = Benchmark for macro performance Y e = Y P is a policy target

Potential GDP:

Potential GDP ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.2 15 Potential GDP is determined by the economy’s: Labour force, Capital stock & Technology. ∆Y P / ∆P = 0 P P 1 P 0 Y P Y P Y

Potential and Actual GDP, Canada 1975-2007:

Potential and Actual GDP, Canada 1975-2007 ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.2 16 The deviation of actual real GDP from the potential GDP can be seen in following plot Note: A recessionary gap starting in 1981. A recovery and boom from 1983 to 1989. A recession and recovery of the 1990s.

Potential and Actual GDP in Canada 1975-2007:

Potential and Actual GDP in Canada 1975-2007 ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.2 17 In the 1975-2007 period actual Y fluctuated around Y P In recession years actual Y < Y P  ↑ unemployment rates In boom years Y>Y P  inflationary pressure

Business Cycles and Output Gaps:

Business Cycles and Output Gaps Business cycles ≡ fluctuations in Y growth Business cycles  Y ≠ Y P  output gaps Output Gap ≡ Y – Y P , or in a growing economy: ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.3 18

Business Cycles and Output Gaps:

Business Cycles and Output Gaps ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.3 19 Output gaps indicate macro performance Y – Y P < 0  recessionary gap High unemployment, low inflation pressure Y – Y P > 0  inflationary gap Low unemployment, inflationary pressure Y =Y P : ‘full employment’, stable inflation

The Output Gap in Canada, 1982-2008:

The Output Gap in Canada, 1982-2008 ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.3 20 Output Gap %

Output Gaps:

Output Gaps ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.4 21 Y P P AS 0 P 1 P 0 AD 1 AD 0 Y 0 Y P Y 1 Y Recessionary gap Inflationary gap Assume Y P and AS 0 Recessionary gap: AD 0  P 0 Y 0 , Y 0 < Y P Inflationary gap: AD 1 > AD 0  P 1 Y 1 Y 1 >Y P

Output Gaps & Unemployment Rates:

Output Gaps & Unemployment Rates ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.4 22 Okun’s law: links unemployment to GDP growth & output gaps Unemployment rate, u: ∆Y  ∆employment with the result that : e.g. ∆Y/Y = 2.0% & ∆Y P /Y P = 0  ∆u = – 1.5%

Okun’s Law:

Okun’s Law ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.4 Growth of Y, Y P Change in Unemployment Rate ∆u < 0 0 ∆u > 0 ∆u = - ½ ( gY – gY P ) gY P gY 1 gY 2 23

Empirical Test of Okun’s Law in Canada :

Empirical Test of Okun’s Law in Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.4 24

Adjustment to Recessionary Gap:

Adjustment to Recessionary Gap 25 P P 0 Y P AS 0 AS 1 ∆w AD Y 0 Y P Y Recessionary gap = Y 0 – Y P < 0 High unemployment  ↓ money wage, w  ↓ unit labour costs  ↓ shift in AS  AS 1 Equil with Y = Y P gap P 1 Chapter 5.5 ©2010 McGraw-Hill Ryerson Ltd.

Adjustment to Inflationary Gap:

Adjustment to Inflationary Gap 26 P Y P AS 4 ∆w AS 3 AD gap Y P Y 3 Y P 3 P 4 Inflationary gap Y 3 > Y P > 0 Low unemployment  ↑ money wage  ↑ unit labour costs  ↑ shift in AS, AS 3  AS 4  Equil with Y = Y P ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.5

The Role for Macroeconomic Policy:

The Role for Macroeconomic Policy ©2010 McGraw-Hill Ryerson Ltd. Chapter 5.6 27 Why are recessionary gaps persistent? Wage and prices adjust slowly Pessimism re future employ, incomes & markets etc. depresses demand recovery Macroeconomic policy Fiscal p olicy & monetary policy Manage AD  Y = Y P & π = π *

Chapter Summary:

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter 5 28 The Aggregate and Supply model explains determination of equilibrium Y and P. Potential output (Y P ) is the economy’s output at full employment level Business Cycles are short-run fluctuations of actual real GDP around its potential

Chapter Summary:

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter 5 29 Output Gaps : Y e ≠ Y P Inflationary Gaps and Recessionary Gaps : Y > Y P & Y < Y P Okun’s Law links output gaps & unemployment Factor price flexibility  Adjustments to gaps Fiscal and Monetary policy  AD management Adjust Y  Y P & π  π *

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