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EC202 Week 8 Notes

by: Kelsey Fagan

EC202 Week 8 Notes EC 202

Marketplace > University of Oregon > Economcs > EC 202 > EC202 Week 8 Notes
Kelsey Fagan
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Here are the notes for week 8
Intro Econ Analy Macro
Chad Fulton
Class Notes
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This 11 page Class Notes was uploaded by Kelsey Fagan on Wednesday May 18, 2016. The Class Notes belongs to EC 202 at University of Oregon taught by Chad Fulton in Spring 2016. Since its upload, it has received 15 views. For similar materials see Intro Econ Analy Macro in Economcs at University of Oregon.


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Date Created: 05/18/16
Day 15 (5/16)  Unemployment & Inflation  ● Types of Price Changes  ○ Prices rise due to increases in aggregate demand. This is called a ​demand­pull  increase in the price level.  ○ Prices rise due to decreases in short­run aggregate supply. This is called a  cost­push​ increase in the price level.       ■ If oil prices go up, then everything else’s price will essentially go up. The  SAS curve would shift to the left which shows the price increases on the  y­axis (point B). This is cost­push ​increase.  ■ If demand goes up then the prices increase as well, but this time it is a  demand­pull​  increase (point C). Because nominal wages are fixed in the  long­run the SAS would shift to the left (prices would increase) to be at  equilibrium with the LAS (point D).   ● Types of inflation  ○ Demand­pull inflation​ : an inflation that starts because aggregate demand  increases.  ■ Increases in aggregate demand:  ● An increase in the quantity of money  ● An increase in government expenditure or decrease in taxes  ● An increase in expected inflation or expected future income  ● An increase in investment stimulated by an increase in expected  future profits.  ● An increase in exports or decrease in imports  ○ The only one that can continually increase is the ​ quantity  of money  ■ “Labor Fooling Model” Graph    ● You are a politician and you announce a giant plan to increase  government spending.   ● Aggregate Demand increases (shifts to the right). New equilibrium  is at point B. Prices increased, but wages stayed the same. SAS  then shifts to the left to accommodate for wages and equilibrium is  now at point C.  ● As a politician you will just repeat the first step and the overall  shifts with result in the long­run equilibrium to be pushed to point  E.  ● Since people catch on, workers will demand higher wages and the  curve shifts will jump straight to point C.   ● It doesn’t work because people expect the price changes.   ○ Cost­pull inflation:​  an inflation that starts with an increase in costs.  ■ An increase in the money wage  ■ An increase in the money price of raw materials (i.e. oil)  ○ Example: Suppose the price level is 110 (CPI), and the nominal price of oil is $55  per barrel. What is the real price of a barrel of oil?      ■ Suppose you are an oil producer and you want to increase your price  (nominal price) to $60.50. What is the effect on the real price?      ■ Shift in the SAS to the left. This increases the price level from 110 to 117  (point A to point B) along the aggregate demand curve.     ■ To get out of this “recession” is for the government to cut taxes which  would cause the aggregate demand curve to shift to the right and the new  equilibrium would be at point C which would increase the price level 121.   ● What really happened in the late 1970s is that the government  printed more money which still moved the aggregate demand  curve to the right.     ■ This is a c​ost­push inflation ​ because the cycle repeats.  ● Stagflation  ○ The combination of a rising price level and a decreasing real GDP.  ● Expected Inflation  ○ When the inflation expectations are correct, temporary recessions or expansions  due to changes in aggregate demand are impossible.  ■ If people correctly anticipated a change in aggregate demand, they would  bargain for a different nominal wage right now.  ■ This immediately shifts the SAS curve to offset the change in aggregate  demand.   ■ The end result would be inflation/deflation, but without an  expansion/recession.  ○ If aggregate demand grows ​ faster than expected​ then:  ■ Real GDP moves above potential GDP  ■ The inflation rate exceeds its expected rate  ■ The economy behaves like it does in a demand­pull inflation  ○ If aggregate demand grows m ​ore slowly than expected t hen:  ■ Real GDP falls below potential GDP  ■ The inflation rate slows  ■ The economy behaves like it does in cost­push inflation.   ○   ■ China predicts aggregate demand to go up (point B). If there is more  aggregate demanded than expected then the aggregate demand would be at  point D. If there was less aggregate demanded than expected the aggregate  demand would be at point C.    ● Unemployment  ○ The AD­AS model also allows us to understand what happens with the  relationship between inflation and unemployment    Day 16 (5/18)  Inflation & Unemployment Cont.   ● Inflation expectations  ○ In the long­run, inflation occurs when the money supply (aggregate demand)  increases faster than potential GDP (long­run aggregate supply)  ■ In any long­run equilibrium, expected inflation is equal to actual inflation  ■ That’s because in order for people to select the correct nominal wage,  people must correctly identify changes in prices (inflation).  ○ In the short­run, we see business cycles when expected inflation is not equal to  actual inflation  ■ Individuals and firms form an expectation of how prices will change in the  coming year (expected inflation)  ■ They use that information to set the nominal wage rate, in order to achieve  a pre­specified real wage rate  ● If actual inflation ishigher​ than expected inflation, then prices  rose more than expected and the real wage is too low.  ● If actual is lower​ than expected inflation, the prices rose less than  expected and the real wage is too high.     ■ Start at A (equilibrium) and for some reason the aggregate demand  increases so short­run equilibrium shifts to point B. In the long­run wages  change which would shift the SAS curve to the left and the new  equilibrium is at point C    ■ Point E is the expected price so the aggregate demand curve would shift to  the left for any reason. This would also shift the short­run supply curve to  the left to get to equilibrium at point E. If there was more inflation than  you expected the price would be at point B and the demand curve shifted  farther to the right.   ■ The distance between point E and point B (the unexpected increase in  aggregate demand) is the same as the distance between point A and point  B from the graph of chapter 10 above.   ○ Example:   ● Suppose the CPI is currently 110, and the current nominal wage is  $10 per hour.   ● You’re happy with your current real wage (purchasing power).  ● You’re signing a contract with your boss for the next year.  ● You need to figure out the nominal wage on the contract.  ■ Since you’re happy with current real wage, you’d like to set the nominal  wage so that your real wage is unchanged.   ● The first step is to figure out what your real wage is.    ■ Your goal is to keep your real wage at $9.09 per hour in the next year.  You need to solve the following problem:    ● The problem is that you don’t know the CPI next year will be.  Instead, you need to come up with what you expect it will be.   ● Now suppose that inflation will actually be 10%. What does that  mean the CPI next year will be?    So    Finally    ● Then you should set your nominal wage according to:     The nominal wage next year = $11.00    ■ If you expect inflation to be 5%, then you think the CPI will be:    ● And you will set your nominal wage according to:    The nominal wage next year = $10.50  ● Now, what will your real wage be when inflation turns out to be  10%?    ○ Because you expected inflation to be lower than it actually  was, you set your nominal wage too low and real wage fell  ○ This is bad for you (less purchasing power)  ○ This is good for firms (more profits and they increase  output)  ○ This leads to an expansion  ■ If you expect inflation to be 10%, then you correctly think the CPI….    ● And you will correctly set your nominal wage to:    ● Or  Nominal wage next year = $11.00  ■ If you expect inflation to be 15%, then you think the CPI will be     ● And you will set your nominal wage according to:    ● Or  Nominal wage next year = $11.50  ■ Summary  ● If inflation expectations are correct​, then the economy moves  along the LAS​  curve.  ● If actual inflation ishigher​ than expected inflation, then the  economy is in an expansion  ● If actual inflation is lower​ than expected inflation, then the  economy is in a recession   ■ If expected inflation increases, actual inflation has to be even higher than  before if unemployment is to fall (due to expansion)  ■ If expected inflation decreases, actual inflation has to be even lower than  before if unemployment is due to rise (due to recession)    ● Phillips Curve  ○ Shows the relationship between the inflation rate and the unemployment rate.  ○ Just another way to visualize the AD­AS model.   ○ Two time frames for Phillips curves:  ■ The short­run Phillips curve  ● Shows the tradeoff between the inflation rate and unemployment  rate, holding constant:  ○ The expected inflation rate  ○ The natural unemployment rate  ● With a given expected inflation rate and natural unemployment  rate:  ○ If the inflation rate rises above the expected inflation rate,  the unemployment rate decreases  ○ If the inflation rate is equal to the expected inflation rate,  we have full employment  ○ If the inflation rate falls below the expected inflation rate,  the unemployment rate increases.  ● The point corresponding to correct inflation expectations and full  employment is always a point on the SRPC       ■ The long­run Phillips curve  ● Shows the relationship between inflation and unemployment when  the actual inflation rate equals the expected inflation rate.  ● In the long­run (along the LRPC) a change in the inflation rate is  expected, so the unemployment rate remains at the natural  unemployment rate.   ● The point corresponding to correct inflation expectations and full  employment is always a point on the LRPC    ○ Shifts in the Phillips Curves  ■ A change in expected inflation shifts ​ only the short­run Phillips curve    ■ A change in the natural unemployment rate shifts both the long­run and  short­run Phillips curve.     ○ Phillips Curves in the US  ■ Crazy weird looking graph  ● Theories of business cycles  ○ Mainstream:   ■ Potential GDP grows at a steady rate  ■ Aggregate demand grows at a fluctuating rate  ○ Real:  ■ Random fluctuations in productivity are the main sources of business  cycles 


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