Welcome to Day 14

1. Welcome to Day 14 Principles of Macroeconomics

2. What we did last class:1) Understanding the AD curve2) Understanding LRAS and SRAS3) AS/AD equilibrium

3. Goals For Today1) Using the AD/AS model to predict the effect of different events.2) Introduction to Keynesian economics.

4. What does it doto the the U.S. economy if there is a war in the Middle East and the price of world oil goes sky high?

5. The Short-Run Effect of a Rise In Oil Prices SRAS2 P SRAS1 P2 P1 AD Q Q1 Q2

6. Breaking it down step-by-step1) Oil prices rise making production more expensive.2) Businesses are now losing money on some items, so they stop making these.3) There is a shortage of these things, so their prices rise.4) In response to higher prices, businesses make more and customers buy less so the shortage goes away.

7. Price rises from P1 to P2. What price is this?Output falls from Q1 to Q2 – into a recession.Unemployment is not on our graph. Do we know what happens to unemployment?

8. Output and unemployment always go in the opposite direction in the short-run.

9. Both inflation and unemployment rising at the same time has a name. We call it stagflation.

10. Year Oil P. Inflat. Unemp.1973 $4.75 6.1% 5.1%1974 $9.35 11.0% 8.1%1979 $25.10 11.2% 6.3%1980 $37.4 2 13.6% 7.5%2014 $85.60 1.62% 5.7%2015 $41.85 0.12 % 4.9%

11. Short-Run Effect of an Increase in Government Hiring P SRAS P2 P1 AD2 AD1 Q Q2 Q1

12. Vietnam War Buying and “Hiring”Year Inf. Unemp1967 3.04% 3.7%1968 4.72% 3.4%

13. So what causes inflation? 1) Increase in AD – people trying to buy more than there is.2) Decrease in SRAS – making less than before.How do you know which it is? Output goes up too, it is #1. Output goes down, it is number #2.

14. And what causes recessions?1) Decrease in AD – people buying less there is.2) Decrease in SRAS – making less than before. How do you know which it is? Prices go down, it is #1. Prices goes up, it is number #2.

15. Let’s talk about what the government can do to fight recessions and inflation. This is moving us into chapter 12.

16. The area to the left of QN on the AS/AD diagram is called the recessionary gap.The area to the right of QN on the AS/AD diagram is called the inflationary gap.

17. Keynesianism is built on a belief in two building blocks. 1) Sticky wages.2) Unstable aggregate demand.

18. Why should aggregate demand be so unstable?Keynes said our income goes up and down, we spend more or less on consumption goods. How much more we spend with each additional dollar is our marginal propensity to consume = MPC.

19. If you get a $100 dollar raise, spend $70 at the store, and put $30 in the cookie jar, your MPC = .70 Your marginal propensity to save = MPS = .30

20. What changes our desire to spend?1) Changes in wealth.2) Changes in confidence in the future. 3) Changes in interest rates.

21. Imagine that the President of Ford comes to work in the morning and is feeling good about things. Maybe he had a good dream or a great breakfast. Keynes used the term “animal spirits”.

22. For whatever reason, the President of Ford thinks next year is going to be better than this year. He orders a tool shed built behind the main factory to hold the tools of the overtime workers he anticipates hiring next year.

23. Start with an increase of $100 in investment and MPC = 0.8  I  C  GDPRound 1 $100 $0 $100Round 2 $0 $80 $80 Round 3 $0 $64 $64Round 4 $0 $52 $52More Rounds … … …Total $100 $400 $500

24. Someone is hired to build the tool shed and is paid the $100. He spends $80, and remember, what is expense for someone is income for someone else. That person has an income of $80 and spends $64, and so on.

25. This process is called the Keynesian multiplier. An initial increase in spending of $100 causes GDP to go up $500.

26. What if the President of Ford’s animal spirits are low, so he thinks next year will be worse than this year. Last year they build a tool shed, this year they don’t.

27. Everything is the same but with negative signs  I  C  GDPRound 1 -$100 -$0 -$100Round 2 -$0 -$80 -$80 Round 3 -$0 -$64 -$64Round 4 -$0 -$52 -$52More Rounds … … …Total -$100 -$400 -$500

28. Now the economy is going down as the multiplier causes a cascade of lay-offs. Keynes was a great believer in the self-fulfilling prophecy. When people thought things would be good, they would be good … and when they thought things would be bad, they would go bad.

29. How do you now how much to multiply the initial change in spending to get the end change in GDP?m = 1/(1-MPC)m = 5 when mpc = 0.8The $100 change in investment causes a $100 x 5 = $500 change in GDP.

30. Keynes believed the main cause of the Great Depression was the simultaneous end of a lot of investment projects at the end of the 1920’s and drop in confidence that the 1930’s would be as good as the roaring 20’s.

31. Let’s translate the table to the AD/AS diagram. $500 SRAS AD0 ADF AD1 AD2 QF Q2 Q1 Q0 $80 $100

32. And viola, we are into the recessionary gap.It is easy to imagine that as the economy tanks, confidence drops further and there are more drops in investment to restart the cycle.

33. This concept is called the multiplier.

34. We saw this prediction before on an earlier slide, but now we realize there is more to it than just a drop in G. Shutdown Would Shave U.S. Growth as Much as 1.4 Pctg. Points in Q4 By JeannaSmialek and Ian Katz - Sep 27, 2013 A shutdown of the U.S. government would reduce fourth-quarter economic growth by as much as 1.4 percentage points depending on its length, economists say, as government workers from park rangers to telephone receptionists are furloughed …

35. Drop in Government Spending Drop by laid off government workers Original drop in government spending P AD1 AD2 Drop by people who used to sell to gov. workers AD3 AD4 Q

36. So if a $10 billion drop in government spending ultimately causes purchases to drop by $30 billion, the multiplier is 3. m = (change in RGDP demanded at a price level) / (initial or starting change in purchases)

37. So you might read a story about the government not paying its workers and think, that doesn’t affect me, since I don’t work for the government. But what if you sell to government workers? Or a lot of your customers do?So the end effect on the economy of a starting drop in spending might be multiple times bigger.

38. It is often suggested that the big drop in housing prices of 2007/2008 was a significant cause of the bad recession of 2008-2010. It is obvious why that would be bad for the housing market, but why should it affect everyone else?

39. Housing prices plummetHousing construction People’s houses workers are laid off are worth lessThey stop buying They are less wealthy so theyThe people they buy buy lessfrom are laid off and stop buying and so on Multiplier

40. Drop in Housing Prices and Associated Drop in Spending P AD2007 AD2008 AD2009 Q

41. What we this class:1) Inflationary and recessionary gap in the AS/AD diagram2) Marginal propensity to consume (MPC)3) Keynesian table4) The multiplierHomework:1) Assigned reading2) Homework #5 due next class

42. Welcome to Day 15 Principles of Macroeconomics

43. What we did last class:1) Inflationary and recessionary gap in the AS/AD diagram2) Marginal propensity to consume (MPC)3) Keynesian table4) The multiplier

44. Goals For Today1) Understanding the Phillips Curve.2) Expansionary and Contractionary Fiscal Policy.3) Problems with Fiscal Policy.

45. Phillips Curve – A graph showing the trade-off between inflation and unemployment.

47. The more you increase AD, the higher inflation is and the lower unemployment

48. In the long-run, the Phillips curve has not held, and the next chapter is about why. The short answer is supply shocks and changes in expectations. We will look at expectations next unit, but here is a quick look at supply shocks.

49. Higher oil prices move SRAS to the left. AS2

50. So one thing we can guess about the 1960s is that, since they had a stable Phillips curve, they probably had stable oil prices.