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by: Harrison Fahey


Harrison Fahey
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M. Katayama

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M. Katayama
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This 23 page Class Notes was uploaded by Harrison Fahey on Tuesday October 13, 2015. The Class Notes belongs to ECON 4710 at Louisiana State University taught by M. Katayama in Fall. Since its upload, it has received 6 views. For similar materials see /class/223038/econ-4710-louisiana-state-university in Economcs at Louisiana State University.




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Date Created: 10/13/15
Unemployment Thursday October 13 2011 834 AM Job Loss Job Finding and the Natural Rate of Unemployment Natural rate of unemployment the average rate of unemployment around which the economy fluctuates The natural rate is the rate of unemployment toward which the economy gravitates in the long run given all the labormarket imperfections that impede workers from instantly findingjobs L E U L Labor force E Employed U Unemployed UL Unemployment rate s the rate ofjob separation f the rate ofjob finding The rate ofjob separation s and the rate ofjob finding f determine the rate of unemployment The steady state condition fU sE fU sLU The equation of the steadystate rate of unemployment UL depends on the rates ofjob separation s and the job findingf UL 11 fsll The higher the rate ofjob separation the higher the rate of unemployment The higher the rate ofjob finding the lower the rate of unemployment Any policy aimed at lowering the natural rate of unemployment must either reduce the rate of job separation or increase the rate of job nding Any policy that affects the rate of job separation or finding also changes the natural rate of unemployment Job Search and Frictional Unemployment Frictional unemployment the unemployment caused by the time it takes workers to search for a job Workers have different preferences and abilities Jobs have different attributes Job vacancies are imperfect Geographic mobility of workers is not instantaneous Causes of frictional unemployment The types of goods that firms and households vary over time u The demand for labor that produces those goods also varies over time Firms fail A worker39s job performance is deemed unacceptable When a worker39s skills are no longer needed Sectoral shift A change in the composition of demand among industries or regions As long as supply and demand for labor among firms is changing frictional unemployment is unavoidable Public Policy and Frictional Unemployment Many public policies seek to decrease the natural rate of unemployment by reducing frictional unemployment Other government programs inadvertently increase the amount of frictional unemployment Unemployment insurance a government program that allows unemployed workers to collect a fraction of their wages for a certain period after losing their jobs By softening the economic hardship of unemployment unemployment insurance increases the amount of frictional unemployment and raises the natural rate The unemployed who receive unemployment insurance are less pressed to find anotherjob and are more likely to turn down an unattractive job offer The program has the benefit of reducing workers39 uncertainty about their incomes Inducing workers to reject unattractive job offers may lead to a better matching between workers and jobs RealWage Rigidity and Structural Unemployment Wage rigidity The failure of wages to adjust to a level at which labor supply equals labor demand When the real wage is above the level that equilibrates supply and demand the quantity of labor supplied exceeds the quantity demanded Firms must ration the scarce jobs among workers Realwage rigidity reduces the rate ofjob finding and raises the level of unemployment If the real wage is stuck above the equilibrium level then the supply of labor exceeds the demand The result is unemployment Structural unemployment the unemployment resulting from wage rigidity and job rationing Workers are unemployed because there is a fundamental mismatch between the number of people who want to work and the number ofjobs that are available The going wage the quantity of labor exceeds the quantity of labor demanded so workers are left waiting forjobs to open up Three causes of WageRigidity 1 MinimumWage Laws 39 The government causes wage rigidity when it prevents wages from falling to equilibrium levels 2 The Monopoly Power of Unions Unions and collective bargaining 39 The wages of unionized workers are not determined by the equilibrium of supply and demand but by bargaining between union leaders and firm management Usually the final agreement raises the wage above the equilibrium level and the firm is allowed to decide how many workers to employ The result is a reduction in the number of workers hired a lower rate ofjob finding and an increases in structural unemployment Unions also influence the wages paid by firms whose workforces are not unionized because of the threat of unionization The threat keeps the wages above equilibrium level The unemployment caused by unions and by the threat of unionization is an instance of conflict between different groups of workers insiders and outsiders Those workers already employed by a firm the insiders typically try to keep their firm39s wages high The unemployed the outsiders bear part of the cost of higher wages because at a lower wage they might be hired 3 EfficiencyWage Efficiencywage theories theories of realwage rigidity and unemployment according to which firms raise labor productivity and profits by keeping real wage above the equilibrium level High wages make workers more productive 1 In poorer countries wages influence nutrition Betterpaid workers can afford a more nutritious diet and healthier workers are more productive 2 In developed countries higher wages reduce labor turnover 3 The average quality of a firm39s work force depends on the wage it pays its employees Adverse selection the tendency of people with more information the workers who know their own outside opportunities to selfselect in a way that disadvantages people with less information the firm By paying a wage above the equilibrium level the firm may reduce adverse selection improve the average quality of the workforce and thereby increase productivity 4 High wages improves workers effort Moral hazard the tendency of people to behave inappropriately when their behavior is imperfectly monitored The firm can reduce the problem of moral hazard by paying a higher wage The higher the wage the greater the cost to the worker of getting fired The higher wage induces more of its employees not to shirk and increases productivity LaborMarket Experience The United States The Duration of Unemployment If they goal is to lower substantially the natural rate of unemployment policies must aim at the longterm unemployed because these individuals account for a large amount of unemployment Transitions Into and Out of the Labor Force Discouraged workers individuals that want jobs but after unsuccessful searches have given up looking Discouraged workers are counted as being out of the labor force and do not show up in unemployment statistics LaborMarket Experience Europe The Rise in European Unemployment o The longstanding policy is generous benefits to unemployed workers 0 The recent shock is a technologically driven fall in the demand for unskilled workers relative to skilled workers Unemployment variation within Europe The unemployment rate can be separated into two pieces The percentage of the labor force that has been unemployed for less than a year The percentage of the labor force that has been unemployed for more than a year The longterm unemployment rate exhibits more variability from country to country than does the shortterm unemployment rate Unemployment rates are higher in nations with more generous unemployment insurance Economic Growth 2 Technology Empirics and Policy Wednesday October 1 9 2011 1122 AM Technological Progress in the Solow Model The Efficiency of Labor Y FK L x E Efficiency of Labor E A variable in the Solow growth model that measures the health education skills and knowledge of the labor force The efficiency of labor is meant to reflect society39s knowledge about production methods as the available technology improves the efficiency of labor rises and each hour of work contributes more to the production of goods and services The term L x E can be interpreted as measuring the effective number of workers It takes into account the actual number of workers L and the efficiency of the workers E 39 L measures the number of workers in the labor force L x E measures both the number of workers and the technology with which the typical worker comes equipped Technological progress causes the efficiency of labor E to grow at some constant rate g If g is 002 then each unit of labor becomes 2 percent more efficient each year output increases as if the labor force had increased by 2 percent more than it really did This for of technological progress is called labor augmenting Laboraugmenting technological progress Advances in productive capability that raise the efficiency of labor The labor force L is growing at rate n and the efficiency of each unit of labor is growing at rate g the effective number of workers L x E is growing at rate n g The Steady State With Technological Progress Technological progress does not cause the actual number of workers to increase but because each worker in effect comes with more units of labor over time technological progress causes the effective number of workers to increase Capital per effective worker k KL X E Output per effective worker y YL x E Aksfk 6 n gk Ak Change in Capital Stock sfk Investment 6 n gk breakeven investment Breakeven investment includes 3 terms to keep k constant 8k is needed to replace depreciating capital nk is needed to provide capital for new workers gk is needed to provide capital for the new quoteffective workersquot created by technological progress The Effects of Technological Progress Output per actual worker YL y X E y is constant in the steady state and E is growing at rate g output per worker must also be growing at rate g in the steady state Total Output Y y X E X L y is constant in the steady state E is growing at rate g and L is growing at rate n total output grows at rate n g in the steady state According to the Solow model only technological progress can explain sustained growth and persistently rising living standards The Golden Rule level of capital is now defined as the steady state that maXimizes consumption per effective worker c fk 6 n gk Steadystate consumption is maXimized if MPK6ng or MPK8ng The Golden Rule level of capital the net marginal product of capital MPK 6 equals the rate of growth of total output n g From Growth Theory to Growth Empirics Balanced Growth Balanced growth technological progress causes the values of many variables to rise together in the steady state Convergence Convergence Whether the world39s poor economies catch up to the world39s rich economies the property of quotcatchupquot Conditional convergence the economies of the world appear to be converging to their own steady states which in turn are determined by such variables as saving population growth and human capital Factor Accumulation Versus Product Efficiency International differences in income per person can be attributed to either 1 Differences in the factors of production such as the quantities of physical and human capital 2 Differences in the efficiency with which economies use their factors of production Policies to Promote Growth Evaluating the Rate of Saving How much a nation saves and invests is a key determinate of its citizen39s standard of living To decide if an economy is at above or below the Golden Rule steady state we need to compare the marginal product of capital net of depreciation MPK 6 with the growth rate of total output n g Golden Rule steady state MPK 6 n g If the economy is operating with less capital than in the Golden Rule steady state then diminishing marginal product tells us that MPK 6 gt n g In this case increasing the rate of saving will increase capital accumulation and economic growth and eventually lead to a steady state with higher consumption although consumption will be lower for part of the transition to the new steady state If the economy has more capital than in the Golden Rule steady state then MPK 6 ltn g In this case capital accumulation is excessive reducing the rate of saving will lead to higher consumption both immediately and in the long run Changing the Rate of Saving Budget deficit when a government39s spending exceeds its revenue Budget deficit raises interest rates and crowds out investments The resulting reduction in the capital stock is part of the burden ofthe national debt on future generations Budget Surplus when a government39s spending is less than the revenue it raises The government can use some of the surplus to retire some of the national debt and stimulate investment Allocating the Economy39s Investment Several types of Capital Human infrastructure etc Beyond the Solow Model Endogenous Growth Theory Endogenous growth theory Models of economic growth that try to explain the rate of technological change The Basic Model Y output K capital stock A a constant measuring the amount of output produced for each unit of capital This production function does not exhibit the property of diminishing returns to capital The absence of diminishing returns to capital is the key difference between the exogenous growth model and the Solow model Capital Accumulation AK sY 6K AK Change in capital stock sY investment 8K depreciation A Two Sector Model The Economy has two sectors 1 ManufacturingFirms that produce goods and services which are used for consumption and investment in physical capital 2 ResearchUniversities produce a factor of production called quotknowledgequot which is then freely used in both sectors Production function in manufacturing firms Y FK 1 uLE Production function in research universities AE guE Capital Accumulation AK sY 6K u is the fraction of the labor force in the universities u 1 is the fraction of the labor force in manufacturing E is the stock of knowledge which determines the efficiency of labor g is a function that shows how the growth in knowledge depends on the fraction of the labor force in the universities The Microeconomics of Research and Development Three apparent facts of Research and Development 1 Most research is done in firms that are driven by the profit motive 2 Research is profitable because innovations give firms temporary monopolies either because of the patent system or because there is an advantage to being the first firm on the market with a new product 3 When one firm innovates other firms build on that innovation to produce the next generation of innovations Accou nting for the Sou rces of Economic G rowth Sunday October 23 2011 621 PM Growthaccounting accounting that divides the growth in output into three different sources increases in capital increases in labor and advances in technology Increases in the Factors of Production Increases in Capital If the amount of capital increases by AK units by how much does the amount ofoutput increase MPK FK 1 L FKL MPK tells us how much output increases when capital increases by 1 unit Therefore when capital increases by AK units output increases by approximately MPK x AK units AY MPK x AK We use the marginal product of capital to convert changes in capital into changes in output Increases in Labor If the amount of labor increases by AL units by how much does output increase MPL FK L 1 FKL MPL tells us how much output increases when labor increases by 1 unit Therefore when labor increases by AL units output increases by approximately MPK x AL units AY MPL x AL We use the marginal product of labor to convert changes in labor into changes in output Increases in Capital and Labor There is an increase in both factors of production capital and labor AY MPK x AK MPK x AL This equation shows how to attribute growth to each factor of production AYY MPK x KY AKK MPL x LY ALL AYY growth rate of output AKK growth rate of capital ALL growth rate of labor MPK x K total return to capital MPK x K Y capital39s share of output MPL x L total return to labor MPL x L Y labor39s share of output AYY dAKK 1 dALL d capital39s share 1 d labor39s share Technological Progress Production function including technology v AFK L A is a measure of the current level of technology called totalfactor productivity AYY dAKK 1 dALL AAA Growth in Output Contribution of Capital Contribution of Labor Growth in Total Factor Productivity Total factor productivity captures anything that changes the relationship between measured inputs and measured outputs Economic Growth 1 Capital Accumulation and Population G rowth Thursday October 13 2011 300 PM Solow Growth Model A model showing how saving population growth and technological progress determine the level of and growth in the standard of living The Accumulation of Capital The Supply and Demand for Goods Production Function YFKL The Solow growth model assumes that the production function has constant returns to scale zY FzK zL The assumption of constant returns to scale implies that the size of the economy as measured by the number of workers does not affect the relationship between output per worker and capital per worker Output per worker y y YL Capital per worker k k KL The production function rewritten v fk The slope of the production function shows how much extra output a worker produces when given an extra unit of capital The Marginal Product of Capital MPK MPK fk 1 fk As the amount of capital increases the production function becomes flatter indicating that the production function exhibits diminishing marginal product of capital When k is low the average worker has only a little capital to work with so an extra unit of capital is very useful and produces a lot of additional output When k is high the average worker has a lot of capital already so an extra unit increases production only slightly The Demand for Goods and the Consumption Function The demand for goods in the Solow growth model comes from consumption and investment The perworker version of the national income accounts identity for an closed economy y c i y output per worker c consumption per worker i investment per worker The Solow model assumes that each year people save a fraction of their income s and consume a fraction 1 s The consumption function c 1 sy s the saving rate is a number between one and zero The consumption function in terms of investment i sy Investment equals saving closed economy For any given capital stock k the production function y fk determines how much output the economy produces and the saving rate 5 determines the allocation of that output between consumption and investment Growth and Capital Stock in the Steady State Two forces influence capital stock 1 Investment is expenditure on new plant and equipment and it causes capital stock to rise 2 Depreciation is the wearing out of old capital and it causes the capital stock to fall Investment per worker expressed as a function of the capital stock per worker i sfk This equation relates the existing stock of capital k to the accumulation of new capital i The impact of investment and depreciation on the capital stock Change in Capital Stock Investment Depreciation Aki8k Ak the change in capital stock i investment 6k depreciation Ak sfk 6k The higher the capital stock the greater the amounts of output and investment Also the higher the capital stock the greater the amount of depreciation Steadystate k is the level of capital stock at which the amount of investment equals the amount of depreciation At this level of capital stock the capital stock will not change because the two forces actin on it investment and depreciation balance each other k Ak O An economy at the steady state will stay there An economy not at the steady state will go there The steadystate represents the long run equilibrium of the economy How Saving Affects Growth If the saving rate is high the economy will have a large capital stock and a high level of output in the steady state If the saving rate is low the economy will have a small capital stock and a low level of output in the steady state Growth effect Policies that alter the steadystate growth rate of income per person By contrast a higher saving rate is said to have a level effect because only the level of income per person not its growth rate is influenced by the saving rate in the steady state The Golden Rule of Capital Comparing Steady States Golden Rule level of capital The steadystate value of k that maximizes consumption People don39t care about the amount of capital in the economy or the amount of output They care about the amount of goods and services they can consume Steadystate consumption per worker c fk 6k Steadystate consumption is what39s left of steadystate output after paying for steadystate depreciation More capital means more output More capital also means that more output must be used to replace the capital that is wearing out The slope of the production function is the Marginal Product of Capital MPK The slope of the Steadystate depreciation and investment line 8k is equal to the slope of the Steadystate output line fk at the kgold Therefore the Golden Rule equals MPK8 At the Golden Rule level of capital the marginal product of capital MPK equals the depreciation rate 6 The Transition to the Golden Rule Steady State Starting with too much capital 1 The economy begins in a steady state with more capital than in the Golden Rule steady state 2 The policymakers should pursue policies aimed at reducing the rate of saving in order to reduce the capital stock The reduction in the saving rate causes an immediate increase in consumption and a decrease in investment Investment and depreciation were equal in the initial steady state and now investment will be lower than depreciation The economy is no longer in a steady state Capital stock falls leading to reductions in output consumption and investment These variables continue to fall until the economy reaches a new steady state The new steady state will be the Golden Rule steady state consumption must be higher than it was before the change in the saving rate even though output and investment are lower 3 Eventually the policies succeed at time to and the saving rate falls to the level that will eventually lead to the Golden Rule steady state When the economy begins above the Golden Rule reaching the Golden Rule produces higher consumption at all points in time When the capital stock exceeds the Golden Rule level reducing saving is clearly a good policy because it increases consumption at every point in time Starting with too little capital 1 The economy begins in a steady state with less capital than in the Golden Rule steady state 2 The policymakers should pursue policies aimed at increasing the rate of saving in order to increase the capital stock 3 The increase in the saving rate at time to causes an immediate fall in consumption and a rise in investment 4 Higher investment causes the capital stock to rise As capital accumulates output consumption and investment gradually increase approaching the new steady state levels When the economy begins below the Golden Rule reaching the golden Rule requires initially reducing consumption to increase consumption in the future Population Growth The Steady State with Population Growth Investment raises capital stock Depreciation reduces capital stock The growth in the number of workers causes capital per worker to fall The change in capital stock per worker Ak i 6 nk y YL Output per worker k KL Capital per worker Ak Change in capital stock per worker i Investment 6 nk break even investment Breakeven investment the amount of investment necessary to keep the capital stock per worker constant Includes the depreciation of existing capital 6k Includes the amount of investment necessary to provide new workers with capital nk There are n new number of workers for each existing worker and there is k amount of capital for each worker Population growth reduces the accumulation of capital per worker much the way depreciation does Depreciation reduces k by wearing out capital stock Population growth reduces k by spreading the capital stock more thinly among a larger population of workers Ak sfk 8 nk An economy is in a steady state if capital per worker k is unchanging Steady state value of k is k If k is less than k investment is greater than breakeven investment so k rises If k is greater than k investment is less than breakeven investment so k falls In the steady state the positive effect of investment on the capital stock per workers exactly balances the negative effects of depreciation and population growth At k Ak O and i 8k nk Once the economy is in the steady state investment has two purposes 1 Some of the investment 6k replaces the depreciated capital 2 The rest of the investment nk provides the new workers with the steady state amount of capital The Effects of Population Growth Population Growth alters the Solow model in three ways 1 The number of workers is growing at rate n and total capital and total output must also be growing at rate n Explains sustained growth in total output 2 Why some countries are rich and some are poor Economies with higher rates of population growth will have lower levels of capital per workers and therefore lower incomes 3 Population growth affects the criterion for determining the Golden Rule consumptionmaximizing level of capital Steadyconsumption c fk 8 nk The level of k that maximizes consumption is the one at which MPK6n or MPK6n In the Golden Rule steady state the marginal product of capital MPK net of depreciation 6 equals the rate of population growth n Introduction to Economic Fluctuations Sunday October 23 2011 1013 PM The Business Cycle Recession when the economy experiences a period of falling output and rising unemployment Business cycIe shortrun fluctuations in output and employment The official arbiter of when recessions begin an den is the National Bureau of Economic Research NBER The NBER39s Business Cycle Dating Committee chooses the starting date of each recession called the business cycle peak and the ending date called the business cycle trough Growth in Consumption and Investment When the economy heads into a recession Households respond to the fall in their incomes by consuming less but the decline in spending on business equipment structures new housing and inventories is even more substantial Because of this investment spending is considerably more volatile than consumption spending Unemployment and Okun39s Law Okun39s Law The negative relationship between unemployment and real GDP according to which a decrease in 39 of 1 r g point is 39 J with additional growth in real GDP of approximately 2 percent Percentage Change in Real GDP 3 2 x Change in Unemployment Rate A Real GDP 3 2 AUnemployment rate Leading Economic Indicators Leading indicators Economic variables that fluctuate in advance of the economy39s output and thus signal the direction of economic fluctuations Average workweek of production workers in manufacturing Average initiaI weekly claims for unemployment insurance New orders for consumer goods and materials adjusted for inflation New orders for nondefense capital goods Index of supplier deliveries New building permits issued Index of stock prices Money supply M2 adjusted for inflation Interest rate spread the yield spread between 10year Treasury notes and 3month Treasury bills Index of consumer expectations Time Horizon in Macroeconomics How the Short Run and Long Run Differ In the long run prices are flexible and can respond to changes in supply or demand In the short run many prices are quotstickyquot at some predetermined level Classical Dichotomy the theoretical separation of real and nominal variables Monetary Neutrality the irrelevance of the money supply for the determination of real variables During the time horizon over which prices are sticky the classical dichotomy no longer holds nominal variables can influence real variables and the economy can deviate from the equilibrium predicted by the classical model The Model of Aggregate Supply and Aggregate Demand Aggregate Demand AD the relationship between the quantity of output demanded and the aggregate price level The aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices The Quantity Equation as Aggregate Demand MP MPd W k 2 IN which is a parameter representing how much money people want to hold for every dollar of income The quantity equation states that the supply of real money balances MP equals the demand for real money balances MPd and that the demand is proportional to output Y The velocity of money V is the quotflip sidequot of the money demand parameter k The assumption of constant velocity is equivalent to the assumption of constant demand for real money balances per unit of output The Downward Slope of the AD Curve The AD curve slopes downward the higher the price level P the lower the level of real balances MP and therefore the lower the quantity of goods and services demanded Y Shifts in the AD Curve Changes in the Money Supply shift the AD Curve An increase in the money supply M shifts the AD curve outward A decrease in the money supply M shifts the AD curve inward Aggregate Supply AS the relationship between the quantity of goods and services supplied and the price level Because the firms that supply goods and services have flexible prices in the long run and sticky prices in the short run the aggregate supply relationship depends on the time horizon Two AS curves 1 Longrun aggregate supply curve LRAS 2 Shortrun aggregate supply curve SRAS The Long Run The Vertical AS Curve If the AS curve is vertical then changes in aggregate demand affect prices but not output Example If the money supply falls the aggregate demand curve shifts downward This shift in aggregate demand will only affect prices because the AS curve is vertical The vertical supply curve satisfies the classical dichotomy because it implies that the level of output is independent of the money supply The long run level of output is called thefullemployment or natural level ofoutput Thefullemployment or natural level ofoutput is the level of output at which the economy39s resources are fully employed more realistically at which unemployment is at its natural rate The Short Run The Horizontal Aggregate Supply Curve Because of this price stickiness the shortrun aggregate supply curve is not vertical Shifts in AD in the Long Run Because the AS curve is vertical in the long run the reduction in aggregate demand affects the price level but not the level of output Shifts in AD in the Short Run Because the AS curve is horizontal in the short run the reduction in aggregate demand reduces the level of output The price level is quotstickyquot The shortrun equilibrium of the economy is the intersection of the aggregate demand curve and the horizontal shortrun aggregate supply curve A fall in aggregate demand reduces output in the short run because prices do not adjust instantly After the sudden fall in aggregate demand firms are stuck with prices that are too high With demand low and prices high firms sell less of their product so they reduce production and lay off workers The economy experiences a recession From the Short Run to the Long Run Over long periods of time prices are flexible the aggregate supply curve is vertical and changes in aggregate demand affect the price level but not output Over short periods of time prices are sticky the aggregate supply curve is flat and changes in aggregate demand do affect the economy39s output of goods and services A Reduction in Aggregate Demand The economy begins in the longrun equilibrium A reduction in aggregate demand caused by a reduction in the money supply moves the economy to where output and employment are below their natural levels This puts the economy into a recession Over time in response to the low demand wages and prices fall The economy gradually recovers from the recession by moving back to the original level of output at the new long run equilibrium The new longrun equilibrium output and employment are back to their natural levels but prices are lower than the original equilibrium point A shift in aggregate demand affects output in the short run but this effect dissipates over time as firms adjust their prices Stabilization Policy Shocks exogenous events that shift the AD and AS curves Demand shock a shock that shifts the aggregate demand curve Supply shock a shock that shifts the aggregate supply curve These shocks disrupt the economy by pushing output and employment away from their natural levels Stabilization Policy policy actions aimed at reducing the severity of shortrun economic fluctuations Shocks to Aggregate Demand An Increase in Aggregate Demand 1 The economy begins in longrun equilibrium An increase in aggregate demand perhaps due to an increase in the velocity of money moves the economy to a point in which its output is above its natural level An increase in the velocity of money is equivalent to a reduction in money demand 3 As prices rise output gradually returns to its natural level and the economy moves from an equilibrium point on the SRAS curve to the LRAS curve Iquot Shocks to the Aggregate Supply A supply shock is a shock to the economy that alters the cost of producing goods and services and as a result the prices that firms charge Because supply shocks have a direct impact on the price level they are sometimes called price shocks Adverse supply shock supply shocks that push costs and prices upwards Favorable supply shock supply shocks that reduces costs such as a break up of an international oil cartel f aggregate demand is held constant the economy moves from one equilibrium point to another at a higher price and lower than the LRAS level of output The price level rises and the amount of output falls below its natural level An experience like this is called stagflation because it combines economic stagnation falling output with inflation rising prices Faced with an adverse supply shock a policymaker with the ability to influence aggregate demand The Fed has a difficult choice to make between two options 1 Hold aggregate demand constant and output and employment are lower than the natural level Eventually prices will fall to restore full employment at the old price level but the cost of this adjustment process is a painful recession 2 Expand aggregate demand to bring the economy toward the natural level of output more quickly If the increase in aggregate demand coincides with the shock to aggregate supply the economy goes immediately to the new equilibrium point The Fed quotaccommodatesquot the supply shock The drawback of this option is that the price level is permanently higher There is no way to adjust aggregate demand to maintain full employment and keep the price level stable An Adverse Supply Shock The economy starts in equilibrium The adverse supply shock pushes up costs and thus prices SRAS curve goes up 3 If aggregate demand is held constant then the economy moves from the original equilibrium point to a new equilibrium point behind the LRAS curve and below original level of employment 4 This leads to stagflation a combination of increasing prices and falling output Eventually as prices fall the economy returns to the natural level of output Iquot 5 Accommodating an Adverse Supply Shock 1 The economy starts in equilibrium 2 An adverse supply shock occurs shifting the SRAS curve upward P 5 In response to the adverse supply shock the Fed increases aggregate demand to prevent a reduction in output The economy movers from the original equilibrium point to a new equilibrium point higher and at the same level ofoutput The cost of this policy is permanently higher level of prices


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