ECO LECTURE TWENTY-ONE 1 OKAY. WELL, LET'S GET STARTED FOR THE DAY. WHAT WE WANT TO

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1 ECO LECTURE TWENTY-ONE 1 OKAY. WELL, LET'S GET STARTED FOR THE DAY. WHAT WE WANT TO DO IS CONTINUE TALKING ABOUT THE AGGREGATE DEMAND CURVE. WE'VE TALKED ABOUT IT ALREADY SOME. WE WANT TO FINISH THAT UP AND THEN GO ON AND TALK ABOUT THE AGGREGATE SUPPLY CURVE. SO WHY DON'T WE DO THAT? AS I RECALL, WHAT WE WERE DISCUSSING IS THIS SUBJECT, IS WHAT DETERMINES THE POSITION OF THE AGGREGATE DEMAND CURVE? WE'LL DRAW A GRAPH ON THE HORIZONTAL AXIS, REAL GDP. I'VE BEEN ABBREVIATING THAT WITH A Q AND I'LL DO SO AGAIN, BUT I WANT TO GET 'EM BOTH UP THERE JUST SO THAT YOU'RE FAMILIAR WITH IT. HERE WE HAVE A PRICE INDEX SUCH AS THE CONSUMER PRICE INDEX OR THE GDP PRICE DEFLATOR. WE'LL DRAW AN AGGREGATE DEMAND CURVE, AD1, AND WE SEE IT IN ONE CERTAIN SPOT. AND THE QUESTION THAT WE WERE TALKING ABOUT LAST TIME IS, WHAT CAUSES THE AGGREGATE DEMAND CURVE TO BE AT THIS POINT, POSITION ONE, RATHER THAN AT A FURTHER POINT OUT, AD2, OR MAYBE AT SOME LESSER POINT -- AND I'LL JUST DRAW AD3 AS SOME CURVE THAT'S DOWN HERE AT THE LEFT. WHAT DETERMINES THE POSITION OF THE AGGREGATE DEMAND CURVE? AND WE'RE ALSO ASKING NOT ONLY THE POSITION, BUT WHAT CAUSES THE CURVE TO SHIFT?

2 ECO LECTURE TWENTY-ONE 2 FIRST OF ALL, HERE'S WHAT WE KNOW. LET ME JUST FIX A PRICE LEVEL, P BAR. FOR JUST A MINUTE WE WON'T LET THE PRICE LEVEL CHANGE. WE'LL JUST LEAVE IT RIGHT THERE. AND WHAT WE CAN SEE BY GOING ACROSS HERE WITH A DOTTED LINE, WE CAN SEE THAT BASICALLY THIS IS TOTAL EXPENDITURES, TE3, AND THIS IS TOTAL EXPENDITURES, TE1. HERE'S TOTAL EXPENDITURES, TE2 -- I'LL TALK ABOUT THAT IN JUST A SECOND -- EQUALS C PLUS I PLUS G PLUS XN. IF YOU'LL REMEMBER, WE HAD THIS TOTAL EXPENDITURES CONCEPT ON THE BOARD LAST TIME AND WE SAID TOTAL EXPENDITURES -- THAT'S THOSE THINGS THAT WE ADD UP TO GET GDP CONSUMPTION, PLUS INVESTMENT SPENDING PLUS GOVERNMENT SPENDING PLUS NET EXPORTS. AND IF YOU'LL REMEMBER WHAT I TOLD YOU LAST TIME, EACH POINT ON THE AGGREGATE DEMAND CURVE IS A TOTAL EXPENDITURE AMOUNT. OKAY. SO THIS POINT SHOWS TOTAL EXPENDITURES, THIS POINT -- LET ME PUT AN A THERE. POINT A ON THE ORIGINAL AGGREGATE DEMAND CURVE, THAT SHOWS TOTAL EXPENDITURES AT THIS PRICE LEVEL THAT WE'VE SET. AND SO IF WE ASK THE QUESTION, HOW COULD THE -- WE'D BE OUT AT POINT B. THE PRICE LEVEL HAS NOT CHANGED. THE ONLY WAY WE COULD BE AT POINT B IS FOR TOTAL EXPENDITURES TO HAVE GONE UP. AND IF TOTAL EXPENDITURES HAVE GONE UP, IT MUST BE BECAUSE OF CONSUMPTION OR INVESTMENT OR GOVERNMENT SPENDING OR NET EXPORTS. SOMETHING ELSE HAD TO GO UP.

3 ECO LECTURE TWENTY-ONE 3 AND SO IF CONSUMPTION HAS INCREASED, THEN TOTAL EXPENDITURES WOULD INCREASE AND THEN THE AGGREGATE DEMAND CURVE SHIFTS OUTWARD. WE GET A LARGER LEVEL OF SPENDING AT THE SAME OLD PRICE LEVEL AS BEFORE. IF THE CURVE SHIFTS TO THE LEFT, WE GO FROM POINT A TO POINT C. THE PRICE LEVEL HASN'T CHANGED BUT -- AND WE'VE GOT A LOWER LEVEL OF AGGREGATE DEMAND BECAUSE SOMETHING HAPPENED OVER HERE IN THE TOTAL EXPENDITURES OR TO ONE OF THE COMPONENTS OF TOTAL EXPENDITURES. ONE OF THOSE COMPONENTS MUST HAVE GONE DOWN. IT COULD BE CONSUMPTION OR INVESTMENT OR GOVERNMENT PURCHASES, OR SO FORTH. BUT ONE OF THOSE COMPONENTS HAD TO GO DOWN AND THAT'S WHAT DECREASED TOTAL EXPENDITURES. SO WHAT CAUSES A CURVE TO SHIFT OR WHAT DETERMINES ITS POSITION? THE ANSWER IS, THESE THINGS RIGHT DOWN HERE: THE CONSUMPTION AND INVESTMENT AND GOVERNMENT SPENDING AND NET EXPORTS. THOSE ARE THE THINGS THAT CAUSE THIS CURVE TO SHIFT. CHANGE IN CONSUMPTION, CHANGE IN INVESTMENT, CHANGE IN GOVERNMENT PURCHASES, CHANGE IN NET EXPORTS. THAT'S WHAT CAUSES THE CURVE TO SHIFT. NOW, I WANT TO JUST TAKE VERY LITTLE TIME. YOU CAN READ YOUR TEXTBOOK ABOUT THIS ALSO, BUT JUST A SECOND TO WALK THROUGH AND TALK ABOUT WHAT ARE SOME OF THE THINGS THAT CAUSE CONSUMPTION SPENDING TO CHANGE. THIS IS YOU AND ME. THIS IS HOUSEHOLDS WE'RE

4 ECO LECTURE TWENTY-ONE 4 TALKING ABOUT. WE'RE NOT THE HOUSEHOLD, BUT WE'RE THE PEOPLE IN THE HOUSEHOLD. BUT THIS IS OUR BEHAVIOR THAT'S BEING DESCRIBED. WHAT WOULD CAUSE US TO SPEND MORE OR TO SPEND LESS? LET ME INCLUDE A FEW THINGS. CHANGE IN HOUSEHOLD WEALTH. LET ME GIVE YOU AN EXAMPLE. YOU GO OVER TO THE QUIK SHOP HERE, YOU KNOW. YOU WANT TO GET YOURSELF -- I DON'T KNOW -- AN ICE CREAM SANDWICH FOR LUNCH. AND SO YOU'RE GETTING YOUR ICE CREAM SANDWICH AND YOU'RE EATING THAT DOWN AND YOU SAY, "WHY DON'T I JUST BUY ONE OF THOSE LOTTERY TICKETS WHILE I'M HERE." AND YOU BUY A LOTTERY TICKET AND YOU SCRATCH OFF THE DEAL, AND IT'S REALLY -- I HAVEN'T BOUGHT A LOTTERY TICKET SINCE THEY'VE -- THE FIRST DAY THEY OFFERED A LOTTERY, SO I DON'T REALLY KNOW ALL THE DETAILS OF THIS. SO PLEASE DON'T BE MOCKING ME OUT THERE IN THE CROWD. BUT ANYWAY, YOU SCRATCH OFF THE DEAL AND IT SAYS "ONE MILLION DOLLARS." YOU WON A MILLION DOLLARS. YOU GO, "HEY, THAT'S NOT BAD." SO YOU GO CASH IT IN, YOU GET YOUR MILLION DOLLARS, AND YOU PUT IT IN THE BANK. NOW, WE KNOW WHAT'S HAPPENED IS, YOUR WEALTH HAS GONE UP. THERE'S BEEN A CHANGE IN HOUSEHOLD WEALTH. IT'S INCREASED. WHAT HAPPENS TO YOUR SPENDING? DO YOU JUST SAY, "WELL, YOU KNOW, I WAS HAPPY THE WAY I WAS BEFORE AND THE FACT THAT I HAVE A MILLION DOLLARS WON'T CHANGE ME AT ALL. I WILL JUST LIVE THE SAME LIFE I WAS GONNA LIVE ANYWAY." OR WOULD YOU SAY, "I'VE ALWAYS WANTED A NEW

5 ECO LECTURE TWENTY-ONE 5 CAR. NOW'S THE TIME TO GET THAT NEAT BACHELOR APARTMENT I WANT," OR, YOU KNOW, WHATEVER IT IS YOU'VE BEEN WANTING. "NOW'S THE TIME I'M GONNA GET THE -- GO ON VACATION. NOW'S THE TIME" -- YEAH, THAT'S WHAT WE'D DO. WE'D SPEND THAT MONEY. WHEN THE HOUSEHOLD WEALTH CHANGES, THEN OUR SPENDING CHANGES AND USUALLY IN THE SAME DIRECTION. WE TALKED BEFORE ABOUT NORMAL GOODS AND THE SAME GENERAL IDEA APPLIES HERE. IF YOUR WEALTH GOES UP, JUST LIKE IF YOUR INCOME GOES UP, YOU BUY MORE OF NORMAL GOODS. HOW ABOUT THIS: A CHANGE IN EXPECTATIONS ABOUT FUTURE PRICES AND EARNINGS. THESE ARE PRICES YOU WOULD PAY AND EARNINGS YOU WOULD RECEIVE. LET ME GIVE YOU AN EXAMPLE HERE. SUPPOSE YOU SAY, "OH, I THINK PRICES OF EVERYTHING IS GONNA DOUBLE." WHEN? TOMORROW. IF YOU THINK THE PRICES OF THINGS ARE GONNA DOUBLE -- TOMORROW OR NEXT YEAR, IT DOESN'T MAKE ANY DIFFERENCE; BUT YOU THINK PRICES ARE GONNA GO UP -- HERE'S WHAT WE TEND TO DO. WE TEND TO SAY, "YOU KNOW, MAYBE I OUGHT TO BUY THOSE THINGS I NEED BEFORE THE PRICES RISE." NOW, IT'S EASY TO SEE THIS AT A SORT OF A SMALL LEVEL. SUPPOSE THAT OVER AT THE GAS STATION GAS IS SELLING FOR -- OH, I DON'T KNOW -- A DOLLAR A GALLON. AND SOMEBODY SAYS, "HEY, YOU KNOW, TOMORROW GASOLINE'S GONNA GO UP TO TWO DOLLARS A GALLON. IT'S GONNA DOUBLE." THEN WHAT YOU SAY IS, "HEY, THE PRICE IS GOING FROM A

6 ECO LECTURE TWENTY-ONE 6 DOLLAR TO TWO DOLLARS A GALLON. I THINK I'LL GO FILL UP MY GAS TANK BEFORE THE PRICE RISES, SAVE A FEW DOLLARS." WHAT IF YOU THINK THE PRICE IS GONNA GO DOWN? THEN WHAT YOU SAY IS, "I'M NOT GONNA FILL UP MY GAS TANK. I'LL WAIT UNTIL THE PRICE GOES DOWN AND THEN I'LL FILL UP. I CAN SAVE HALF." SO IF WE EXPECT FUTURE PRICES TO CHANGE, IF WE EXPECT FUTURE PRICES TO RISE, THEN RIGHT NOW WE WANT TO SPEND MORE AND BEAT THE PRICE INCREASE. IF WE EXPECT FUTURE PRICES TO FALL, THEN WE WANT TO HOLD BACK AND DON'T SPEND NOW, WAIT FOR THE PRICE TO GO DOWN. THAT AFFECTS OUR CONSUMPTION SPENDING. AND I'M SAYING DURING PERIODS WHEN THERE'S INFLATION, DURING PERIODS WHEN PEOPLE ARE SAYING, "BOY, PRICES ARE REALLY GOING UP, YOU KNOW?" THEN WHAT THEY DO IS THEY START SPEEDING UP THEIR PURCHASES AND BUYING THINGS EARLY. AND WHEN THEY DO, THEY'RE DRIVING UP CONSUMPTION SPENDING. AND THAT SHOWS UP AS A SHIFT IN AGGREGATE DEMAND. A CHANGE IN YOUR FUTURE EARNINGS. IF YOU HAVE EXPECTATIONS ABOUT THAT -- IN FACT, LET ME JUST SAY YOU DO HAVE EXPECTATIONS ABOUT THAT. I CAN READ MINDS. HOW CAN I READ MINDS? WELL, YOU'RE IN COLLEGE AND YOU'RE GOING TO COLLEGE, PARTLY TO HAVE HIGHER EARNINGS IN THE FUTURE. AND SO YOU THINK YOU'RE GOING TO COLLEGE, YOU ARE. YOU THINK YOU'RE GONNA GET A DEGREE, YOU PROBABLY WILL. YOU THINK YOU'RE GONNA GO OUT IN THE JOB MARKET AND EARN MORE

7 ECO LECTURE TWENTY-ONE 7 THAN YOU WOULD'VE HAD YOU NOT GONE ON TO COLLEGE. SO YOU DO HAVE AN EXPECTATION OF YOUR FUTURE EARNINGS GOING UP. AND SO IF I CAN GIVE AN EXAMPLE, JUST SUPPOSE THAT RIGHT NOW -- I'LL JUST PICK A NUMBER. SAY RIGHT NOW THAT YOUR EARNINGS ARE SIX THOUSAND DOLLARS A YEAR AND LET'S TALK ABOUT SOMEBODY ELSE'S EARNINGS ARE SIX THOUSAND DOLLARS A YEAR. THIS IS YOU AND SOMEONE ELSE. I'M NOT FEELING REAL IMAGINATIVE TODAY SO I JUST COULDN'T COME UP WITH A NAME. YOU'RE BOTH EARNING SIX THOUSAND DOLLARS A YEAR. BUT YOU'RE IN COLLEGE; YOU'RE YOUNG, YOU KNOW; YOU'RE EIGHTEEN, TWENTY YEARS OLD; YOU'RE IN COLLEGE; YOU'RE GONNA HAVE THESE HIGHER FUTURE EARNINGS. THIS SOMEONE ELSE IS -- I DON'T KNOW - - FIFTY YEARS OLD. THEY'RE NOT GOING TO COLLEGE; THEY KNOW THAT. YOU'RE EARNING SIX THOUSAND DOLLARS THIS YEAR. THE SOMEONE ELSE IS EARNING SIX THOUSAND DOLLARS THIS YEAR. WHICH ONE OF YOU IS GONNA SPEND MORE OF THAT SIX THOUSAND DOLLARS? HERE'S WHAT I'M GONNA TELL YOU. YOU WILL. 'CAUSE THIS SOMEONE ELSE IS FIFTY, AND EARNING SIX THOUSAND DOLLARS A YEAR, AND DOESN'T HAVE PROSPECTS OF -- YOU KNOW, LIKE "I'M GONNA BE RICH IN THE FUTURE" OR EVEN GONNA EARN MORE THAN THAT IN THE FUTURE. THIS PERSON IS THINKING, "MAN, I'M TRYING TO SAVE A COUPLE HUNDRED DOLLARS A YEAR BECAUSE I'M GONNA BE OLD BEFORE VERY LONG AND I DON'T HAVE VERY MUCH PUT BACK, AND I'M IN BAD SHAPE, AND SO I'M GONNA SAVE A LITTLE

8 ECO LECTURE TWENTY-ONE 8 BIT. I CAN'T AFFORD TO SAVE MUCH, BUT MAYBE THAT'S ALL I'LL SAVE. I'LL SAVE TWO HUNDRED DOLLARS A YEAR." HERE'S WHAT YOU'LL DO: YOU'LL SAY SAVE ZERO. WHY SAVE ZERO? AND THE ANSWER IS, BECAUSE THE NEXT YEAR AND THE YEAR AFTER THAT AND THE YEAR AFTER, YOUR EARNINGS ARE GONNA GO UP. IF YOU SAVE NOTHING, YOU SAY, "SO WHAT? I'VE GOT PLENTY OF TIME TO SAVE IN THE FUTURE. IN FACT, I MIGHT EVEN SAVE A NEGATIVE AMOUNT." AND THAT IS TO SAY, "I MIGHT BORROW EIGHT HUNDRED DOLLARS." WHY IS THAT? "I'LL PAY IT BACK NEXT YEAR. I'M GONNA HAVE ONE OF THEM JOBS PAYING ABOUT FORTY, FIFTY THOUSAND DOLLARS TO START," AND ANYWAY, THOSE SORTS OF DREAMS. WE EXPECT OUR FUTURE INCOME TO GO UP. WE SPEND SOME OF IT TODAY. WE SPEND IT EVEN IF WE GO INTO DEBT TODAY. MY PROBLEM IS, I'VE BEEN EXPECTING THAT FUTURE INCOME YEAR AFTER YEAR AFTER YEAR AND I'VE BEEN, YOU KNOW, LIKE SAVING NOTHING, AND IN THE FUTURE INCOME DOESN'T GO UP. BUT THE POINT IS, WHEN YOU EXPECT YOUR FUTURE EARNINGS TO RISE, THAT SORT OF GIVES YOU A REASON TO SPEND MORE TODAY. YOU DON'T EXPECT IT TO RISE, YOU DON'T SPEND MORE. IF YOU EXPECT YOUR EARNINGS TO GO DOWN -- WELL, LET'S SUPPOSE THAT YOU WORK IN THE AUTO INDUSTRY. YOU THINK, "GOSH, THERE'S GONNA BE A BIG DOWNTURN IN THE CAR INDUSTRY. I SEE THE INVENTORY IS BUILDING UP. I DON'T THINK -- HAVE GOOD FEELINGS ABOUT NEXT YEAR. I

9 ECO LECTURE TWENTY-ONE 9 THINK THAT WE'RE GONNA BE LAID OFF." AS SOON AS YOU START THINKING "WE'RE GONNA BE LAID OFF NEXT YEAR," THEN YOU START SAYING, "MY FUTURE EARNINGS ARE GOING DOWN. AND YOU KNOW WHAT I BETTER DO IS, I BETTER CUT BACK ON MY SPENDING TODAY. I STILL HAVE MY JOB TODAY, BUT THINK NEXT YEAR I WON'T OR I'LL BE WORKING HALF TIME OR WHATEVER, SO I'D BETTER CUT BACK ON MY SPENDING TODAY 'CAUSE I EXPECT MY FUTURE EARNINGS TO FALL AND I'LL NEED TO FINANCE SOME OF NEXT YEAR'S SPENDING BY SAVING TODAY." SO IF WE EXPECT THE FUTURE TO BE DIM IN TERMS OF OUR EARNINGS, WE SPEND LESS. OUR CONSUMPTION SPENDING TODAY, I'M SAYING, WOULD GO DOWN. HOW ABOUT A CHANGE IN INTEREST RATES? BIG TICKET ITEMS -- AND WE'VE CALLED THESE DURABLE GOODS BEFORE -- SUCH AS TV SETS, REFRIGERATORS, CARS -- WHEN WE START TALKING ABOUT DURABLE GOODS, WE TYPICALLY WILL BUY THOSE ON TIME. BUY DURABLES ON TIME. LET'S SAY CREDIT. AND PAY INTEREST. SO IF INTEREST RATES START GOING UP -- LET'S SAY INTEREST RATES ARE SIX PERCENT TO BEGIN WITH. I EQUALS SIX PERCENT. THEN ALL OF A SUDDEN THEY SAY, "OH, YEAH, THAT'S YESTERDAY'S INTEREST RATE. TODAY IT'S EIGHT PERCENT." IF INTEREST RATES GO UP, THEN MORE PEOPLE START SAYING, "MAN, IT'S GONNA COST ME A LOT MORE TO BE MAKING THOSE CAR PAYMENTS. IT'S GONNA COST ME MORE TO PAY FOR THAT REFRIGERATOR OR MORE TO PAY FOR A HOUSE." AND SO AS SOON AS WE START SEEING RISING INTEREST RATES, THEN WE

10 ECO LECTURE TWENTY-ONE 10 START SEEING HIGHER MONTHLY PAYMENTS. AND WHEN WE SEE THOSE HIGHER MONTHLY PAYMENTS, WE SAY, "YOU KNOW, MAYBE I DON'T HAVE TO BUY A NEW CAR TODAY. MAYBE I COULD WAIT FOR A YEAR OR TWO." AND SO RISING INTEREST RATES, THAT PUSHES DOWN OUR SPENDING. YOU GET THE IDEA, AND I'LL JUST ADD ONE MORE -- CHANGE IN TAXES. THAT WOULD AFFECT CONSUMPTION SPENDING. IF YOUR TAXES ARE GOING UP, YOU HAVE LESS DISPOSABLE INCOME IN YOUR POCKET. LESS DISPOSABLE INCOME, LESS SPENDING. RISING TAXES LEAVES YOU WITH LESS SO YOU SPEND LESS. IF TAXES WOULD GO DOWN -- AND I KNOW THAT'S NEVER HAPPENED, BUT JUST IN THEORY IT COULD ALWAYS HAPPEN. IF TAXES WERE TO GO DOWN -- NO, THEY HAVE GONE DOWN BEFORE. THERE WERE SOME PRETTY MASSIVE TAX CUTS IN THE 1980S AND BEFORE THAT IN THE '60S, AND SO THERE HAVE BEEN TIMES. IF TAXES WERE TO GO DOWN, THEN WHAT WE WOULD SAY IS, "GOSH, MY DISPOSABLE OR MY TAKE HOME INCOME IS GOING UP. I CAN AFFORD TO SPEND A LITTLE BIT MORE NOW." SO ANYWAY, THIS IS JUST A FEW. YOU CAN PROBABLY THINK OF OTHER THINGS, BUT I DOUBT IF YOU CAN THINK OF MANY THINGS THAT ARE MORE IMPORTANT THAN THESE. PROBABLY SOME THAT ARE OF LESSER IMPORTANCE. PERHAPS YOU CAN COME UP WITH ONE THAT'S MORE IMPORTANT. BUT THESE ARE PRETTY IMPORTANT IN TERMS OF INFLUENCING CONSUMPTION SPENDING. WHAT INFLUENCES SPENDING BY BUSINESSES? YOU KNOW, THESE

11 ECO LECTURE TWENTY-ONE 11 ARE BUSINESSES -- THIS I, INVESTMENT. THIS IS BUSINESSES BUYING STRUCTURES, CAPITAL EQUIPMENT SUCH AS MACHINES OR COMPUTERS, DELIVERY TRUCKS AND SO FORTH. WHAT INFLUENCES THEIR SPENDING? A CHANGE IN INTEREST RATES. AND IT AFFECTS THEIR SPENDING IN EXACTLY THE SAME WAY AS IT DOES HOUSEHOLDS THAT WE WERE JUST TALKING ABOUT A MOMENT AGO. A CHANGE IN EXPECTATIONS REGARDING FUTURE SALES. WHAT DO I MEAN BY THAT? SUPPOSE THAT YOU'RE A BUSINESS MANAGER AND YOU START SAYING, "GOSH, I DON'T KNOW. IT'S KIND OF WEIRD, ISN'T IT? THERE'S MORE CUSTOMERS COMING THROUGH THE DOOR EACH DAY. I HADN'T REALLY THOUGHT ABOUT THAT. BUT NOW THAT I STOP AND REFLECT, WE'VE JUST HAVING MORE CUSTOMERS THAN NORMAL AND THEY SEEM TO BE SPENDING A LITTLE BIT MORE THAN NORMAL." AND YOU START THINKING THIS AND YOU START THINKING, "NEXT YEAR IS GONNA BE" -- I MEAN, "THE REST OF THIS YEAR IS GONNA BE FINE AND NEXT YEAR'S GONNA BE FINE, TOO. I SEE SALES PICKING UP REALLY STRONG." YOU'RE THINKING THIS. THEN WHAT DO YOU DO? THEN WHAT YOU START SAYING IS, "YOU KNOW WHAT WE BETTER DO IS, WE BETTER MANAGE OUR BUSINESS IN SUCH A WAY AS TO BE ABLE TO SUPPLY THIS GROWING DEMAND. THERE'S A SURGE IN DEMAND FOR OUR PRODUCT. WHAT ARE WE GONNA DO ABOUT IT?" AND THE ANSWER IS, GO OUT AND HIRE MORE WORKERS; GET SOME MORE EQUIPMENT; MAYBE ADD ON TO THE BUILDING OR RENT SOME

12 ECO LECTURE TWENTY-ONE 12 BUILDING SPACE, AND SO FORTH. SO AS SOON AS WE HAVE THESE EXPECTATIONS OF THE BUSINESS IS GROWING OR BUSINESS EXPANDING, WE START SPENDING MORE FOR CAPITAL GOODS. WE START INVESTING MORE. THREE, CHANGE IN BUSINESS TAXES. THE REASONS THAT BUSINESSES ARE INVESTING, PURCHASING CAPITAL GOODS AND SO FORTH -- YOU UNDERSTAND THERE'S A RISK THERE. AND THE ONLY REASON COMPANIES ARE TAKING THAT RISK IS THEY WANT A PROFIT, RIGHT? AND SO IF THEY'RE DOING THIS FOR THE PROFIT, THEN IF YOU START RAISING THEIR TAXES AND SAYING TO 'EM, "OH, WE'RE GONNA TAKE ALL YOUR PROFITS FOR TAXES," THEN WHAT THE BUSINESS MANAGER SAYS IS, "IF YOU'RE GONNA TAKE ALL MY PROFITS, I'M NOT GONNA TAKE THE RISK. WHY SHOULD I DO THAT?" SO IF TAXES ARE GOING UP, THE BUSINESS MANAGER'S JUST SAYING, "I'M DUMB IF I TAKE RISKS. I'M NOT GONNA BE PUTTING MY CAPITAL AT RISK." IF BUSINESS TAXES START GOING DOWN, THE BUSINESS MANAGER STARTS SAYING, "WOW. ANY RISK I TAKE, IF THAT'S A GOOD RISK -- I MEAN, IF I'M RIGHT IN MY JUDGEMENT AND THIS IS A GOOD THING TO BE INVESTING IN, THEN WHEN I GET MY -- THE PROFITS BACK, THEY WILL BE LARGER" AND THEN BUSINESSES WANT TO INVEST MORE AND TAKE THOSE RISKS. IT'S AN INDUCEMENT. OKAY. SO ANYWAY, RISING BUSINESS TAXES, LESS INVESTMENTS MADE BY BUSINESSES AND VICE VERSA. LOWER TAXES, HIGHER BUSINESS SPENDING. REAL SORT OF OBVIOUS STUFF, BUT STILL IT'S SOMETHING THAT CAN SHIFT

13 ECO LECTURE TWENTY-ONE 13 THESE CURVES AROUND AND THAT'S WHAT WE ULTIMATELY WANT TO TALK ABOUT. REALLY WHAT WE'RE DOING -- AND I'VE GOT SOME MORE TO DO RIGHT HERE IN JUST A SECOND, BUT REALLY WHAT WE'RE DOING IS MAKING A LIST OF THINGS THAT CAN SHIFT THIS AGGREGATE DEMAND CURVE. OKAY. SO A CHANGE IN GOVERNMENT SPENDING. WHAT CAUSES GOVERNMENT SPENDING TO CHANGE? ALL SORTS OF THINGS. AND WE WON'T EVEN TRY TO LIST THEM ALL. BUT, I MEAN, THERE ARE SOME THINGS WHY GOVERNMENT SPENDING CHANGES BUT SOMETIMES THERE'S FISCAL POLICY. AND, BY THE WAY, FISCAL IS NOT SPELLED "PHYSICAL" LIKE, "TOM, YOU'RE A MISERABLE PHYSICAL SPECIMEN OF A MAN," YOU KNOW, AND THAT SORT OF THING. IT'S NOT PHYSICAL LIKE THAT. FISCAL. WE'RE TALKING ABOUT THIS GOVERNMENT SPENDING AND TAXING POLICY. AND SO WE COULD HAVE THE GOVERNMENT SPENDING MORE, INCREASE IN G, OR WE COULD HAVE THE GOVERNMENT TAXING LESS, DECREASE IN T. BUT IF THE GOVERNMENT CHANGES THE TAXES, WE'VE ALREADY ACCOUNTED FOR HOW THAT AFFECTS AGGREGATE DEMAND. IF THE GOVERNMENT AFFECTS TAXES, IT COULD AFFECT BUSINESS TAXES OR PERSONAL TAXES AND WE'VE ALREADY TAKEN THOSE INTO ACCOUNT. SO IT'S REALLY WHEN THE GOVERNMENT'S PURCHASING MORE GOODS AND SERVICES ON ITS OWN OR IT COULD BE PURCHASING LESS. WHY WOULD IT DO THAT, PURCHASE MORE OR LESS? VARIOUS

14 ECO LECTURE TWENTY-ONE 14 REASONS. IT COULD BE SOMETHING SORT OF REAL SIMPLE THAT HAS NOTHING TO DO WITH THE ECONOMY. THE GOVERNMENT COULD BE SPENDING MORE MONEY 'CAUSE THERE'S AN ELECTION COMING UP AND WE, MEMBERS OF CONGRESS OR WHATEVER, WE WANT VOTERS TO FEEL POSITIVE TOWARD US SO LET'S JUST START SPENDING SOME MONEY IN AN ELECTION YEAR. AND THEN MAYBE IT'S NOT AN ELECTION YEAR. LET'S DON'T SPEND SO MUCH MONEY. COULD BE SOMETHING LIKE THAT. COULD BE SOMETHING MORE FUNDAMENTAL IN NEEDS FOR GOVERNMENT. IF YOU'LL REMEMBER BACK, YEARS BACK, WHEN THE SOVIET UNION COLLAPSED AND BECAME JUST RUSSIA, A SMALLER COUNTRY, LESS POWERFUL, LESS THREATENING, THEN WHAT HAPPENED IS OUR NEED FOR DEFENSE SERVICES WENT DOWN. AND SINCE OUR NEED FOR DEFENSE SERVICES WENT DOWN, THE GOVERNMENT STARTED SPENDING LESS ON NATIONAL DEFENSE. DURING THE PERIOD WHEN THE ECONOMY IS STRONG, FEWER PEOPLE ARE UNEMPLOYED; FEWER PEOPLE ARE ASKING FOR UNEMPLOYMENT COMPENSATION; FEWER PEOPLE ARE ASKING FOR FOOD STAMPS, AND SO FORTH. AND SO A STRONG ECONOMY, LESS GOVERNMENT SPENDING. BUT IF WE HAVE A RECESSION AND THERE'S A LOT OF UNEMPLOYED PEOPLE, THE GOVERNMENT HAS TO STEP IN AND -- IT DOESN'T HAVE TO, BUT IT DOES STEP IN AND HELP MORE IN TERMS OF UNEMPLOYMENT COMPENSATION, THAT SORT OF THING. SO ANYWAY, FISCAL POLICY COULD

15 ECO LECTURE TWENTY-ONE 15 SHIFT. AND IF IT DOES, THE CURVE SHIFTS. IF THERE'S AN INCREASE IN GOVERNMENT SPENDING, THE CURVE SHIFTS TO THE RIGHT. IF THERE'S A DECREASE IN GOVERNMENT SPENDING, AGGREGATE DEMAND WOULD SHIFT TO THE LEFT. NET EXPORTS. WHAT WOULD CAUSE THAT TO CHANGE? WELL, NET EXPORTS IS TWO THINGS. IT'S EXPORTS AND IT'S IMPORTS, X AND M. EXPORTS, IMPORTS. WE DON'T ACTUALLY -- IT'S X AND M AND NEITHER ONE OF THOSE WORDS STARTS WITH AN X OR AN M. BUT ANYWAY, WHAT WOULD CAUSE NET EXPORTS TO RISE? WELL, NET EXPORTS WILL GO UP IF OUR EXPORTS TO OTHER COUNTRIES, OUR SALES TO OTHER COUNTRIES, RISE OR IF OUR IMPORTS FROM OTHER COUNTRIES GOES DOWN. EITHER ONE OF THOSE WOULD CAUSE AN INCREASE IN NET EXPORTS. SO WHAT COULD CAUSE THIS TO HAPPEN, AN INCREASE IN OUR EXPORTS? HOW ABOUT THIS POSSIBILITY. FOREIGN INCOMES RISE. THINK HOW THAT WOULD WORK OUT. IF PEOPLE IN JAPAN AND EUROPE, AND SO FORTH -- IF THEY BECOME BETTER OFF AND BETTER OFF, INCOMES ARE GOING UP, THEN THEY START SAYING, "GOSH, I'M FEELING PRETTY WELL OFF HERE. I'M NOT REAL SCARED ABOUT LOSING MY JOB, OR WHATEVER. I THINK I'M GONNA BUY SOME THINGS." AND WHEN THEY SAY "I THINK I'M GONNA BUY SOME THINGS," PART OF WHAT THEY BUY IS THEY BUY GOODS FROM THE UNITED STATES. AND SO OUR EXPORTS WILL GO UP WHEN THE REST OF THE WORLD GETS RICHER. SO WE WANT THE REST OF THE WORLD TO BE

16 ECO LECTURE TWENTY-ONE 16 RICHER. WE WANT THEM TO BE RICHER SO THEY CAN BUY MORE FROM US. IF FOREIGN INCOMES WOULD FALL, THEN OUR EXPORTS TO THE FOREIGNERS WOULD GO DOWN. OKAY. ANOTHER THING THAT WOULD INFLUENCE -- LET ME DO THIS ONE WITH RESPECT TO IMPORTS. WHAT WOULD CAUSE IMPORTS TO GO DOWN? WHERE WE DON'T BUY AS MANY FOREIGN GOODS. HOW ABOUT IF SOMETHING LIKE THIS HAPPENED. THE DOLLAR DEPRECIATES RELATIVE TO OTHER CURRENCIES. I WAS GONNA HAVE TO WRITE THOSE LAST WORDS ON THE CHALK TRAY THERE. IF THE DOLLAR DEPRECIATES -- AND, BY THE WAY, ANOTHER WAY OF SAYING THIS IS THAT THE FOREIGN CURRENCIES APPRECIATE. THEIR VALUE GOES UP RELATIVE TO THE DOLLAR. THE DOLLAR'S VALUE GOES DOWN. IT DEPRECIATES. THOSE ARE THE TERMS FOR RISING AND FALLING VALUE OF A CURRENCY RELATIVE TO OTHER CURRENCIES, APPRECIATE AND DEPRECIATE. AND THESE THINGS MEAN THE SAME. LET ME PUT LIKE AN EQUAL SIGN HERE. THIS IS JUST TWO DIFFERENT WAYS OF SAYING THE SAME THING. OKAY. SO IF THE DOLLAR DEPRECIATES RELATIVE TO OTHER CURRENCIES -- LET'S TAKE AN EXAMPLE. I WANT TO BUY A JAPANESE CAR, A TOYOTA, AND MAYBE IT COSTS TWENTY THOUSAND DOLLARS OR AN EQUIVALENT NUMBER OF YEN. OKAY. IF THE DOLLAR DEPRECIATES IN VALUE, THAT MEANS THAT NOW FOR ME TO BUY THAT JAPANESE CAR, IF I'M GONNA PAY THE SAME NUMBER OF YEN, I HAVE TO GIVE MORE DOLLARS TO GET THE SAME NUMBER

17 ECO LECTURE TWENTY-ONE 17 OF YEN TO BUY THE CAR. AND SINCE I HAVE TO PAY MORE DOLLARS, TO ME THAT LOOKS LIKE A PRICE INCREASE FOR CARS AND THEN I'M MOST LIKELY TO BUY THE CAR. SO WHEN THERE'S A CHANGE IN THE VALUE OF THE DOLLAR, THEN FOREIGN GOODS BECOME MORE OR LESS EXPENSIVE. IF THE VALUE OF THE DOLLAR GOES DOWN OR IF THE VALUE OF THE FOREIGN CURRENCY GOES UP, THEN THOSE FOREIGN GOODS BECOME MORE EXPENSIVE. I'M LESS LIKELY TO BUY THEM AND I'M LESS LIKELY TO IMPORT -- OR YOU, TOO. AND THE SAME IDEA. NOW, WE COULD REVERSE THIS. WE WOULD HAVE MORE IMPORTS. WE WOULD BUY MORE FROM FOREIGNERS IF THE DOLLAR GOT STRONGER, 'CAUSE ALL OF A SUDDEN WE'D SAY, "OH, THOSE FOREIGN GOODS, THOSE ARE SO CHEAP." 'CAUSE OF THE DOLLAR GETS TEN PERCENT STRONGER, THE PRICE OF FOREIGN GOODS BECOMES TEN PERCENT CHEAPER TO THOSE OF US WHO ARE SPENDING DOLLARS. OKAY. SO ANYWAY, A CHANGE -- AND, BY THE WAY, I COULD'VE PUT THE FOREIGN INCOMES AND THE DOLLAR DEPRECIATION -- I COULD'VE PUT BOTH OF THESE ON, YOU KNOW, BOTH IMPORTS AND EXPORTS. BUT THE POINT IS, FOREIGN INCOMES AND THE VALUE OF THE DOLLAR RELATIVE TO OTHER CURRENCIES, THAT SHIFTS THIS CURVE. BOY, THERE'S REALLY KIND OF A LOT OF THINGS THAT SHIFT THOSE AGGREGATE DEMAND AND AGGREGATE SUPPLY. HOW ABOUT THIS ONE? I'M GONNA PUT THIS: CHANGE IN THE MONEY

18 ECO LECTURE TWENTY-ONE 18 SUPPLY. WOULD THAT SHIFT THAT CURVE? AND THE ANSWER IS, YES, IT WOULD. BUT THE CHANGE IN THE MONEY SUPPLY DOES NOT SHOW UP DOWN HERE -- I'LL PUT AN X THROUGH THAT 'CAUSE IT DOES NOT SHOW. THERE'S NOTHING DOWN HERE THAT SAYS TOTAL EXPENDITURES INCLUDE MONEY SUPPLY. HERE'S WHAT HAPPENS. IF THERE'S A CHANGE IN THE MONEY SUPPLY, THEN IT AFFECTS MAINLY THE C AND MAINLY THE I. BUT IF THERE'S A CHANGE IN THE MONEY SUPPLY, IT AFFECTS THESE OTHER THINGS THAT ARE COMPONENTS OF TOTAL EXPENDITURES. SO IF THERE'S AN INCREASE IN THE MONEY SUPPLY, THEN THERE'D BE AN INCREASE IN CONSUMPTION SPENDING AND AN INCREASE IN INVESTMENT SPENDING. AND SO, YES, A CHANGE IN THE MONEY SUPPLY OR MONETARY POLICY, THAT CAN CAUSE THESE CURVES TO SHIFT. IF THERE'S A DECREASE IN THE MONEY SUPPLY -- AND WE'LL COME BACK LATER IN THE SEMESTER AND TALK ABOUT HOW THIS OPERATES. IF THERE'S A DECREASE IN THE MONEY SUPPLY, THEN CONSUMPTION AND INVESTMENT SPENDING GO DOWN AND THIS AGGREGATE DEMAND CURVE SHIFTS TO THE LEFT. OKAY. SO ANYWAY, SOME DAY SOMEBODY'S GONNA GIVE YOU A TEST AND IT'LL SAY, "WHAT CAUSES THE AGGREGATE DEMAND CURVE TO SHIFT?" AND THEN MAYBE THERE'LL BE FOUR OR FIVE CHOICES UNDER THERE -- A, B, C, D, E -- AND YOU WANT TO START LOOKING FOR SOME OF THIS STUFF. AND IF YOU DON'T SEE IT, THEN SAY "NONE OF THE ABOVE." BUT IF YOU DO SEE IT, THEN THAT'S WHEN YOU NEED TO PUT ON YOUR THINKING CAP AND SORT OF

19 ECO LECTURE TWENTY-ONE 19 GO BACK IN HERE AND SAY, "NOW, WHAT DID WE SAY ABOUT THAT?" AND THERE'S OUR LIST. SO WE'LL COME BACK WITH THIS LATER ON. BECAUSE LATER ON, I'M JUST GONNA START SHIFTING THAT AGGREGATE DEMAND CURVE AND YOU'RE SUPPOSED TO HAVE IT IN MIND THAT THE AGGREGATE DEMAND CURVE SHIFTS BECAUSE TOTAL EXPENDITURES CHANGE. AND TOTAL EXPENDITURES CHANGE, THESE THINGS CHANGE, BECAUSE THERE WAS SOMETHING UNDERLYING THAT TOTAL EXPENDITURE. THERE'S SOMETHING THAT UNDERLIES JUST THIS. YOU KNOW, CONSUMPTION SPENDING DOESN'T CHANGE BY ITSELF. IT CHANGES BECAUSE SOMETHING HAPPENS. AND SO THAT'S WHAT YOU NEED TO DO. LET'S GO ON TO THE NEXT TOPIC AND THAT IS AGGREGATE SUPPLY. I'LL SWITCH MY AXES -- WELL, I'M NOT SWITCHING THE AXES, BUT THE LABELS I'LL CHANGE. THIS TIME I'LL PUT THE Q THERE RATHER THAN THE RGDP, AND I'LL JUST WRITE THAT REAL GDP DOWN HERE BELOW. I WANT YOU TO BE COMFORTABLE WITH THIS IDEA, THOUGH, IS THAT WHEN WE PUT THE QUANTITY -- AND THAT'S WHAT THE Q STANDS FOR, QUANTITY OF GOODS AND SERVICES, THAT WE'RE JUST -- WE HAVE REALLY A PROXY FOR, REAL GROSS DOMESTIC PRODUCT. LET ME DRAW THE AGGREGATE SUPPLY CURVE AND THEN I'LL GIVE YOU A DEFINITION. AGGREGATE SUPPLY. AND WHY DON'T I LABEL THIS SRAS. THIS IS THE SHORT RUN AGGREGATE SUPPLY CURVE. WE'LL TALK ABOUT WHAT MAKES

20 ECO LECTURE TWENTY-ONE 20 IT SHORT RUN AND LONG-TERM, AND SO FORTH, LATER ON. BUT -- AND I'VE JUST LABELED THIS AGGREGATE SUPPLY UP HERE, THE CURVE ITSELF, BUT I WANT YOU TO KNOW THAT'S THE SHORT RUN AGGREGATE SUPPLY CURVE. THIS -- THE AGGREGATE SUPPLY CURVE IS A CURVE SHOWING VARIOUS QUANTITIES OF REAL GDP -- THAT IS TO SAY, NEWLY PRODUCED GOODS AND SERVICES -- THAT WILL BE OFFERED FOR SALE AT VARIOUS -- AT DIFFERENT, LET'S SAY, AGGREGATE PRICE LEVELS. AND YOU CAN SEE EXACTLY THAT AS THE PRICE LEVEL CHANGES. YOU CAN SEE THAT THERE ARE PRICE LEVEL GOING UP, HIGHER PRICE LEVEL, LARGER LEVEL OF GOODS AND SERVICES OFFERED FOR SALE. THIS IS NOT A MICROECONOMIC CURVE. WE TALKED ABOUT MICROECONOMIC SUPPLY AND DEMAND BEFORE. THIS IS NOT A MICROECONOMIC CURVE. THIS IS SAYING THAT THE ENTIRE ECONOMY, AS THE PRICE LEVEL GOES UP -- OH, I SHOULD SAY HERE: AS THE PRICE LEVEL GOES UP, THEN PRODUCERS THROUGHOUT THE ECONOMY, DIFFERENT GOODS AND SERVICES -- BASKETBALLS AND DINNER AND BUILDINGS AND SHOES AND WHATEVER YOU CAN IMAGINE -- THAT THEY START OFFERING MORE AND MORE GOODS FOR SALE. WHY IS THAT? PROFIT PER UNIT EQUALS PRICE PER UNIT MINUS COST PER UNIT. LET'S TALK ABOUT THIS AND THEN WE'LL UNDERSTAND WHY THERE'S THIS UPWARD SLOPING CURVE. PROFIT PER UNIT IS JUST THE DIFFERENCE BETWEEN WHAT PRICE DO YOU CHARGE AND WHAT'S YOUR COST ON A PER UNIT BASIS. SUPPOSE THE

21 ECO LECTURE TWENTY-ONE 21 PRICE PER UNIT RISES. THIS IS PER UNIT OF WHAT? PER UNIT OF Q, GOODS AND SERVICES. SUPPOSE THE PRICE LEVEL GOES UP. NOW, YOU'RE GONNA HAVE TO TAKE MY WORD FOR IT RIGHT HERE AND THEN WE'LL COME BACK AND TALK ABOUT IT MORE LATER. BUT TAKE MY WORD FOR THIS. THESE COSTS DON'T CHANGE VERY FAST. HERE'S WHAT HAPPENS -- AND THEN WE'LL SORT OF GO ON, BUT HERE'S WHAT HAPPENS OUT THERE IN THE REAL WORLD. WORKERS WILL GO IN AND, LIKE, BARGAIN WITH THEIR EMPLOYERS FOR WAGES. AND SOMETIMES, PARTICULARLY IF IT'S A UNION, THEY MIGHT BARGAIN THREE OR FOUR YEARS OUT. SOMETHING MIGHT HAPPEN LIKE THE AUTO WORKERS UNION WOULD GO TO FORD AND GENERAL MOTORS AND CHRYSLER, AND SO FORTH, AND BARGAIN ON WAGES AND THEY MAY SAY SOMETHING LIKE THIS: "OKAY, WE GET FIFTEEN DOLLARS AN HOUR THIS YEAR. NEXT YEAR IT WILL GO UP TO SIXTEEN DOLLARS AN HOUR, THE NEXT YEAR SEVENTEEN DOLLARS AN HOUR, AND THE NEXT YEAR EIGHTEEN DOLLARS AN HOUR. DEAL? DEAL." SHAKE HANDS, THAT'S OUR DEAL. AND SO WE START AT SIXTEEN, SEVENTEEN, EIGHTEEN, AND THAT'S LOCKED IN. AND SO COST PER UNIT, THAT'S JUST A FIXED AMOUNT. HOW ABOUT THE BUILDING THAT FORD OR GENERAL MOTORS IS IN? THEY PAID FOR THAT BUILDING SEVERAL YEARS AGO. THE COST PER UNIT OF PRODUCING CARS -- THE RENT DOESN'T GO UP ON THE BUILDING. SO THERE'S THE TWO MOST IMPORTANT INGREDIENTS IN PRODUCING MOST

22 ECO LECTURE TWENTY-ONE 22 GOODS AND SERVICES, IS YOU'VE GOT YOUR -- YOU KNOW, LIKE THE COST OF RENT AND YOU'VE GOT YOUR EMPLOYEES. AND WHAT I'M SAYING IS, THE EMPLOYEE WAGES, THOSE ARE KIND OF FIXED FOR A YEAR OR TWO OR THREE, OR WHATEVER. AND I HAVE A CONTRACT THAT STARTS EVERY YEAR -- WHAT WOULD IT BE -- IN MID- AUGUST AND TAKES ME THROUGH THE NEXT YEAR, MID-AUGUST, AND THEN I START ANOTHER YEAR. BUT WE DON'T GET TOGETHER LIKE AT CHRISTMAS AND -- WHERE, YOU KNOW, MY BOSS GOES, "YOU KNOW, YOU DID A HECK OF A GOOD JOB TEACHING THAT CLASS AND I JUST WANTED TO GIVE YOU AN EXTRA FIVE PERCENT BONUS." WE DON'T HAVE ANY BONUSES LIKE THAT. I TEACH THAT TWELVE MONTHS FOR WHATEVER I STARTED THE YEAR OFF AT. AND THE NEXT YEAR I HOPE IT GOES UP AND IF IT DOESN'T, IT DOESN'T. BUT WE DON'T HAVE ANY INTRA-YEAR BARGAINS. AND I'M SAYING IN MANY INDUSTRIES THEY HAVE EVEN LONGER-TERM DEALS. SO THE COST PER UNIT IS FIXED. AND SO NOW IF THE PRICE PER UNIT GOES UP, THEN WHAT THAT MEANS IS PROFIT PER UNIT WENT UP. IF WE STARTED OFF CHARGING, LET'S SAY, A DOLLAR AND THE COST PER UNIT IS FIFTY CENTS, WE HAD A PROFIT PER UNIT OF FIFTY CENTS. THESE ARE JUST FOR ILLUSTRATION. BUT I'M SAYING IF THE PRICE GOES UP TO A DOLLAR TEN, NOW PROFITS WENT UP TO SIXTY CENTS BECAUSE THOSE COSTS DON'T CHANGE BY VERY MUCH. SO IF THE AGGREGATE PRICE LEVEL RISES, THE PER UNIT PROFIT

23 ECO LECTURE TWENTY-ONE 23 RISES. AND INCENTIVES BEING WHAT THEY ARE, PRODUCERS SAY, "OH, PROFIT PER UNIT UP. LET'S PRODUCE SOME MORE. LET'S WORK THE WORKERS OVERTIME. LET'S DO WHATEVER WE CAN DO. LET'S ADD ON TO THE BUILDING IF WE CAN. BUT LET'S DO WHATEVER WE CAN DO TO GET -- TO TAKE ADVANTAGE OF THE RISING PROFIT PER UNIT." SO HERE WE HAVE THE UPWARD SLOPING AGGREGATE SUPPLY GROUP. THIS IS SHORT RUN. AND, LIKE I SAY, WE'LL COME BACK AND TALK ABOUT WHAT IS LONG RUN LATER ON. OKAY. WE ALSO -- AND THIS IS THE SAME WITH RESPECT TO AGGREGATE SUPPLY AND DEMAND AS THE MICROECONOMIC SUPPLY AND DEMAND. WE ALWAYS WANT TO DISTINGUISH BETWEEN A MOVEMENT ALONG THE CURVE -- AND HERE'S WHAT I'M SEEING HERE IS, WE MOVE ALONG THE CURVE IF THE PRICE LEVEL CHANGES. HIGHER PRICE LEVEL, LARGER QUANTITY OF REAL GDP'S BEING SUPPLIED BUT WE'RE MOVING ALONG THE CURVE. WE WANT TO DISTINGUISH BETWEEN THE MOVEMENT ALONG THE CURVE WHICH CAN ONLY BE CAUSED BY A CHANGE IN THE PRICE LEVEL. BY THE WAY, IT WAS THE SAME THING WITH THE AGGREGATE DEMAND CURVE TO MOVE FROM ONE POINT TO ANOTHER ALONG THE AGGREGATE DEMAND CURVE. THAT WOULD ONLY BE CAUSED BY A CHANGE IN THE PRICE LEVEL. AND THEN EVERYTHING ELSE, THOSE THINGS WE TALKED ABOUT EARLIER ABOUT CHANGES IN HOUSEHOLD WEALTH AND CHANGES IN INTEREST RATES AND SO FORTH, THOSE SHIFT THE CURVE. WE MOVE

24 ECO LECTURE TWENTY-ONE 24 ALONG THE CURVE IF THERE'S A CHANGE IN THE PRICE LEVEL. OKAY. SO ANYWAY, WE'VE GOT THAT CURVE. WHAT WE WANT TO DO NOW IS -- DID I SKIP ANYTHING THAT I WANT TO TALK ABOUT? NO, I DON'T THINK SO. WHAT WE ALSO -- WHAT WE WANT TO DO NOW IS TALK ABOUT WHAT WOULD CAUSE THE CURVE TO SHIFT. WHAT SHIFTS THE AGGREGATE SUPPLY CURVE? NUMBER ONE, A CHANGE IN WAGES. AND, BY THE WAY -- WELL, MAYBE YOU SHOULD KNOW THIS. BUT LET ME REMIND YOU IN CASE YOU DON'T KNOW IT. I WANT THIS TO BE REAL CLEAR TO YOU. IF YOU'LL GO BACK IN YOUR NOTES AND LOOK -- AND YOU DON'T HAVE TO ACTUALLY DO THAT RIGHT NOW, BUT I'M SAYING AT SOME POINT -- WE HAD A LIST OF THE ENTRIES INTO NATIONAL INCOME. WE TALKED ABOUT COMPENSATION OF EMPLOYEES. WE TALKED ABOUT PROPRIETORS' INCOME. WE TALKED ABOUT CORPORATE INCOME OR CORPORATE PROFITS. WE TALKED ABOUT INTEREST AND WE TALKED ABOUT RENT -- 1, 2, 3, 4, 5 -- WE TALKED ABOUT THOSE. IF YOU'LL GO BACK AND LOOK AT THE NUMBERS I GAVE YOU, BY FAR AND AWAY THE BIGGEST ITEM OF NATIONAL INCOME, BY FAR AND AWAY THE BIGGEST FORM OF FACTOR INCOME OR RESOURCE INCOME, IS COMPENSATION OF EMPLOYEES. AND HERE WE ARE TALKING ABOUT AGGREGATE SUPPLY, WHAT CAN CAUSE THAT AGGREGATE SUPPLY CURVE TO SHIFT. WHAT I'M TELLING YOU IS, IS THAT COMPENSATION OF EMPLOYEES -- THESE ARE BALLPARK

25 ECO LECTURE TWENTY-ONE 25 NUMBERS, BUT THIS IS SIXTY-FIVE, SEVENTY PERCENT OF THE COST OF RUNNING MOST BUSINESSES. OKAY. AND IF IT'S SIXTY-FIVE OR SEVENTY PERCENT OF THE COST OF RUNNING MOST BUSINESSES, THEN A CHANGE IN WAGES IS A BIG DEAL TO BUSINESSES. THAT'S LIKE, "OH, MAN. IF WAGES GO UP TEN PERCENT AND THAT'S SEVENTY PERCENT OF OUR COST OF DOING BUSINESS, THAT'S A BIG DEAL TO US." OKAY. SO LET ME DRAW THAT AGGREGATE SUPPLY CURVE. AND WHAT I'M SAYING IS THIS: IF WAGES WOULD RISE, THE AGGREGATE SUPPLY CURVE SHIFTS TO THE LEFT, AS2. I'LL PUT A ONE THERE. AND I'LL SAY THIS IS WHEN WAGES ARE TEN DOLLARS AND HERE'S WHERE WAGES -- THE AS2, THE SECOND SUPPLY, THAT'S WHEN WAGES ARE TWELVE DOLLARS AN HOUR -- THE AGGREGATE SUPPLY CURVE SHIFTS TO THE LEFT. TO THE LEFT MEANING, PRODUCERS ARE NOT AS WILLING TO OFFER GOODS AND SERVICES FOR SALE AS BEFORE, AT THE HIGHER WAGE. WHY NOT? AND THE ANSWER IS: WHEN THE WAGE GOES UP, THE PROFIT PER UNIT GOES DOWN. SO IF THE PRICE IS CONSTANT, IF PRICE IS AT P BAR, AND WE WERE EARNING A PRETTY GOOD PROFIT AND WE WERE SELLING QUITE A BIT OF REAL GDP, Q1, RISING WAGES FROM TEN TO TWELVE DOLLARS AN HOUR, THAT MEANS OUR PROFIT PER UNIT IS NOT AS HIGH. OUR PRICE IS THE SAME AT P BAR BUT OUR COST WENT UP, SO PROFIT PER UNIT DOWN AND NOW IT'S JUST NOT AS PROFITABLE SELLING THIS PRODUCT. LET'S SELL LESS. SO ANYWAY. RISING WAGES, INCREASE IN THE WAGE IS A LEFTWARD SHIFT IN

26 ECO LECTURE TWENTY-ONE 26 AGGREGATE SUPPLY. AND VICE VERSA. IF WAGES GO DOWN, THERE'S A RIGHTWARD SHIFT. OKAY. QUESTIONS ABOUT THIS? NOW, THAT'S A BIG DEAL. AND BECAUSE WAGES WERE SUCH A BIG CHUNK OF ALL THE PAYMENTS TO FACTORS OF PRODUCTION, WE SINGLED THAT OUT. BUT THERE'S A SECOND THING WHICH IS A CHANGE IN OTHER FACTOR PRICES. THESE ARE JUST NOT AS IMPORTANT AND THAT'S WHY WE DON'T -- WE JUST BLEND WAGES AND EVERYTHING ELSE IN. ALL THESE OTHER THINGS, I'M SAYING, ADD UP TO ABOUT THIRTY PERCENT. AND SO IF THERE'S A LITTLE BIT OF AN INCREASE IN RENT AND A LITTLE BIT OF AN INCREASE IN INTEREST, THAT'S GONNA DRIVE UP COST. BUT NOT ANYTHING LIKE AN EQUIVALENT, TEN PERCENT OR WHATEVER, CHANGE IN COMPENSATION OF WORKERS. ANYWAY, IT'S THE SAME SORT OF A DEAL. IF THERE'S AN INCREASE IN THESE OTHER FACTOR PRICES, THEN THERE'D BE A LEFTWARD SHIFT IN AGGREGATE SUPPLY AND THERE'S BE A DECREASE IN AGGREGATE SUPPLY. IF THERE'S A DECREASE IN OTHER FACTOR PRICES, THEN THERE'D BE A RIGHTWARD SHIFT IN AGGREGATE SUPPLY. RIGHTWARD SHIFT? OH, I'M MORE WILLING TO SELL GOODS AND SERVICES IF MY COSTS GO DOWN AND I CAN EARN BIGGER PROFITS. WHAT ELSE? THAT WAS NUMBER TWO. THREE. I KNOW WHAT I WANT IT TO BE SO IT WILL BE. PRODUCTIVITY, CHANGES IN PRODUCTIVITY. THREE, CHANGES IN FACTOR -- AND, BY THE WAY, "FACTOR"? I'M TALKING ABOUT, WHAT, WORKERS -- LAND, LABOR,

27 ECO LECTURE TWENTY-ONE 27 CAPITAL, ENTREPRENEURSHIP. CHANGES IN FACTOR PRODUCTIVITY. THAT WILL SHIFT THIS CURVE. AND HOW, YOU WANT TO KNOW. BY THE WAY, YOU KIND OF ALREADY KNOW THE ANSWER BECAUSE WE'VE KIND OF TALKED ABOUT THIS BEFORE. AND HERE'S WHEN WE TALKED ABOUT IT BEFORE. IT'S KIND OF A SIMILAR CONCEPT OF THIS. BUT BEFORE, WE WERE TALKING ABOUT SOMETHING LIKE THIS. WE'VE GOT A GOOD X, WE'VE GOT A GOOD Y, AND WE HAD A PRODUCTION POSSIBILITIES FRONTIER, PPF. AND WHAT WE SAID IS, MAYBE WE START OFF AT SOME POINT LIKE A, PRODUCING SOME GOOD X AND SOME GOOD Y. BUT THEN IF OUR FACTORS OF PRODUCTION BECOME MORE PRODUCTIVE, THE PRODUCTION POSSIBILITIES CURVE SHIFTS OUTWARD. THIS IS REALLY -- THIS IS SORT OF LIKE AGGREGATE SUPPLY. IT'S NOT AGGREGATE SUPPLY BECAUSE THE AGGREGATE SUPPLY CURVE'S GOT THE PRICE LEVEL HERE AND WE'RE NOT TALKING ABOUT THE PRICES DOWN HERE. BUT THE POINT IS, OUR ABILITY TO PRODUCE GOODS AND SERVICES, THAT WOULD BE GROWING IF LABOR AND CAPITAL AND SO FORTH BECAME MORE PRODUCTIVE. OUR PRODUCTION POSSIBILITIES CURVE WOULD SHIFT OUTWARD. WELL, SO DOES OUR AGGREGATE SUPPLY CURVE, AS2. WE HAVE A GREATER AGGREGATE SUPPLY IF WE HAVE AN INCREASE IN FACTOR PRODUCTIVITY. INCREASE IN -- LET ME PUT IT DOWN HERE. INCREASE IN PRODUCTIVITY, T-I-V-I-T-Y, RESULTS IN AN INCREASE IN

28 ECO LECTURE TWENTY-ONE 28 AGGREGATE SUPPLY. AN INCREASE, A RIGHTWARD SHIFT. IF THERE WAS A DECREASE IN PRODUCTIVITY, WE WOULD HAVE A LEFTWARD SHIFT AND A DECREASE IN AGGREGATE SUPPLY. USUALLY, PRODUCTIVITY DOES NOT GO DOWN BUT WHAT IT SOMETIMES -- USUALLY PRODUCTIVITY IS GROWING. EACH YEAR, PRODUCTIVITY OF WORKERS AND SO FORTH, A LITTLE HIGHER THAN THE YEAR BEFORE. BUT SOMETIMES IT STOPS GROWING. IT USUALLY DOESN'T GO DOWN WHERE WORKERS BECOME LESS PRODUCTIVE THAN THEY WERE THE YEAR BEFORE. NOW, I'M GONNA GO ON AND ADD SOMETHING TO MY LIST HERE IN A SECOND, BUT WHAT I WANT TO DO IS BRING NUMBER ONE AND NUMBER THREE TOGETHER. OKAY. BECAUSE THESE TWO THINGS COME TOGETHER INTO SOMETHING CALLED UNIT LABOR. COST OF LABOR USED TO PRODUCE ONE UNIT OF OUTPUT. UNIT LABOR COST. IT'S A COST FIGURE, IT'S A COST OF LABOR, AND IT'S THE COST OF THAT QUANTITY OF LABOR NEEDED TO PRODUCE ONE UNIT OF OUTPUT. AND BOTH OF THESE THINGS ARE REALLY INCLUDED IN UNIT LABOR COSTS. LET ME SHOW YOU HOW. SUPPOSE, FOR EXAMPLE, THAT WAGES GO UP. SUPPOSE WAGES GO UP. IF THEY DO, THE COST OF LABOR, IT GOES UP. AND OTHER THINGS BEING EQUAL, CETERIS PARIBUS, IF THE COST OF LABOR GOES UP, IF WAGES GO UP, UNIT LABOR COSTS ROSE. THERE'S ANOTHER WAY FOR UNIT LABOR COSTS TO GO UP. SUPPOSE THE COST OF LABOR DOES NOT CHANGE BUT SUPPOSE WORKERS BECOME LESS PRODUCTIVE. IF WORKERS BECOME

29 ECO LECTURE TWENTY-ONE 29 LESS -- MAYBE RIGHT NOW WE COULD PAY TEN WORKERS FOR ALL DAY LONG AND THOSE TEN WORKERS COULD ASSEMBLE ONE CAR. TEN WORKERS, ALL DAY, ONE CAR. SUPPOSE THOSE WORKERS BECOME LESS PRODUCTIVE. THEN WE NEED NOT TEN WORKERS TO ASSEMBLE THAT ONE CAR BUT ELEVEN BECAUSE THOSE TEN WORKERS ARE NOT AS PRODUCTIVE AS BEFORE. SO IF FACTOR PRODUCTIVITY GOES DOWN, THEN IT TAKES MORE LABOR THAN BEFORE AND SO UNIT LABOR COSTS ARE GOING UP AGAIN. WE'RE NOW HIRING ELEVEN WORKERS. EVEN AT THE SAME WAGE, BUT ELEVEN WORKERS RATHER THAN TEN. SO WHAT I'M SAYING TO YOU IS, CHANGES IN WAGES OR CHANGES IN FACTOR PRODUCTIVITY, BOTH OF THOSE THINGS WILL COME OVER HERE AND AFFECT UNIT LABOR COSTS. OKAY. AND UNIT LABOR COST TAKES INTO ACCOUNT BOTH THE PRODUCTIVITY AND THE WAGES. NOW, THE REASON I SORT OF EMPHASIZE THIS IS THIS: IS UNIT LABOR COSTS RISE, THIS CURVE SHIFTS TO THE LEFT, THE AGGREGATE SUPPLY CURVE. OKAY. AND WE ALREADY KNOW THAT BECAUSE WE'VE ALREADY BEEN THROUGH THE TWO COMPONENTS. THIS CURVE WOULD SHIFT TO THE LEFT IF WAGES RISE OR PRODUCTIVITY FALLS. OKAY. AND IT WOULD SHIFT TO THE RIGHT IF WAGES FALL OR PRODUCTIVITY RISES. BUT THE POINT IS, YOU KNOW LABOR COSTS. YOU DON'T HAVE TO SORT OF TALK ABOUT THE ONE VERSUS THE OTHER AND DISTINGUISH THOSE. YOU CAN JUST SAY, "OH, UNIT LABOR COSTS ARE GOING UP."

30 ECO LECTURE TWENTY-ONE 30 NOW, WHO CARES ABOUT THAT? HERE'S WHO CARES ABOUT IT. WE ALL CARE ABOUT IT. THERE ARE ALL THE TIME STATEMENTS BEING MADE, SOMETHING LIKE THIS: WAGES WERE UP FIVE PERCENT, PRODUCTIVITY UP THREE PERCENT. HERE'S WHAT I SAY: "HUH, WAGES UP FIVE PERCENT. THAT'S SHIFTING THAT CURVE TO THE LEFT. WAGES UP FIVE PERCENT, SHIFT IN THE AGGREGATE SUPPLY CURVE TO THE LEFT. BUT PRODUCTIVITY IS UP THREE PERCENT. THAT SHIFTS THE CURVE BACK TO THE RIGHT BY THREE PERCENT, OR BY WHATEVER AMOUNT." THOSE THINGS ARE OFFSETTING EACH OTHER. MY NET INCREASE IN UNIT LABOR COSTS, UP TWO PERCENT. SO IT'S REALLY THE ONE THING OFFSETTING THE OTHER THING. AND POLICYMAKERS VERY OFTEN -- THEY SAY, YOU KNOW, "I'M NOT ALL THAT INTERESTED IN THE FACT THAT WAGES WENT UP FIVE PERCENT," THEY MIGHT SAY, "BECAUSE, YOU KNOW, PRODUCTIVITY WENT UP FIVE PERCENT. AND IF WAGES GO UP FIVE PERCENT, ALL WE'RE DOING IS WE'RE PAYING THOSE WORKERS FIVE PERCENT MORE TO PRODUCE FIVE PERCENT MORE. OUR UNIT LABOR COST DIDN'T CHANGE. THAT DOESN'T SCARE ME. THE AGGREGATE SUPPLY CURVE DOESN'T SHIFT." SO THE POINT IS, IF WE CAN KEEP WAGES GOING UP AT ABOUT THE SAME RATE AS PRODUCTIVITY IS RISING, UNIT LABOR COSTS DON'T CHANGE AND SO THIS CURVE DOESN'T MOVE. AND THAT IS THE THING THAT VERY OFTEN PEOPLE WILL FORGET. THEY'LL SAY SOMETHING LIKE THIS: "OH,

31 ECO LECTURE TWENTY-ONE 31 WAGES WENT UP FIVE PERCENT. THAT CURVE SHIFTED TO THE LEFT." AND WHAT I SAY IS, YOU KNOW, THAT'S JUST PART OF THE STORY. EMPLOYERS WON'T PAY HIGHER WAGES IF THEY'RE NOT GETTING MORE OUT OF THEIR EMPLOYEES. AND SO IF WAGES WENT UP FIVE PERCENT, I WANT TO KNOW THE OTHER HALF OF THE STORY. WHAT DO EMPLOYERS KNOW ABOUT THOSE WORKERS? OH, THEY FOUND OUT THAT THE WORKERS ARE MORE PRODUCTIVE SO THE FIVE PERCENT WAGE INCREASE IS JUSTIFIED BY AN INCREASE IN PRODUCTIVITY. UNIT LABOR COSTS? THEY DIDN'T CHANGE. THIS IS NO BIG DEAL. POLICYMAKERS TALK ABOUT THAT. AND SO WHAT I'M SAYING TO YOU IS, EVEN THOUGH IT'S PERFECTLY ALL RIGHT TO TALK ABOUT WAGES AND FACTOR PRODUCTIVITY, IT'S TWO SEPARATE VARIABLES THAT SHIFT THAT CURVE. IT'S AN EASY ENOUGH THING TO TALK ABOUT UNIT LABOR COSTS AND TAKE BOTH OF THESE THINGS INTO ACCOUNT AT ONCE. AND THESE ARE THINGS THAT DO GET ANNOUNCED ON THE NEWS ALL THE TIME -- I MEAN, ONCE A MONTH THERE'S SOMETHING WILL COME OUT AND TELL ABOUT HOW MUCH WAGES CHANGED THE MONTH BEFORE AND TALK ABOUT, IN THE SAME REPORT, WORKER PRODUCTIVITY. AND I'M SAYING PUT THE TWO TOGETHER AND THAT'LL TELL YOU IF UNIT LABOR COSTS -- AND LET ME ERASE TWO OF THESE AND JUST KIND OF DO IT THIS WAY. AS2, UNIT LABOR COSTS DOWN, WAGES INCREASE LESS THAN PRODUCTIVITY INCREASED. THERE WE GO. SO IF UNIT LABOR COSTS ARE DECLINING, WE'VE GOT A GREATER AGGREGATE SUPPLY AND VICE

32 ECO LECTURE TWENTY-ONE 32 VERSA. I WON'T DRAW THE OTHER ONE AND PUT THE LABELS THERE, BUT YOU GET THE IDEA. YOU KNOW, LABOR COST IS AN IMPORTANT THING. BECAUSE, AS I SAY, IN THE REAL WORLD WAGES DON'T CHANGE BY THEMSELVES AND PRODUCTIVITY DOESN'T CHANGE BY ITSELF. IN THE REAL WORLD, IF WORKERS BECOME MORE PRODUCTIVE, THEN EMPLOYERS SAY, "WOW, WORKERS ARE MORE PRODUCTIVE. LET'S GO OUT AND HIRE SOME MORE." AND THEN THEY DRIVE UP WAGES. AND SO REALLY, THESE TWO THINGS ARE CHANGING TOGETHER ALL THE TIME. AND WHAT WE WANT TO KNOW IS NOT HOW MUCH DID THIS CHANGE OR THAT MUCH, HOW MUCH DID THEY CHANGE WITH RESPECT TO EACH OTHER? AND WE CAN NET THE ONE OUT AGAINST THE OTHER. UNIT LABOR COSTS GO UP WITH WAGES RISING, THEY GO DOWN WITH PRODUCTIVITY RISING. AND SO WHAT'S THE NET CHANGE? AND THAT IS, I THINK, A MORE USEFUL WAY OF LOOKING AT THIS. OKAY. AND NUMBER -- DO I HAVE SOMETHING LEFT? IT SEEMS LIKE I DO. YES, I DO. ONE MORE THING. SUPPLY SHOCKS. LAST THING ON THE LIST. LET ME JUST SHOW -- THIS IS A VERY SIMPLE CONCEPT AND IT'LL JUST TAKE US A SECOND TO GET THROUGH IT. A SUPPLY SHOCK WOULD BE SOMETHING LIKE -- WELL, LET'S SAY WE HAVE HAILSTORMS EVERY PLACE IN THE UNITED STATES. AND IT JUST COMES DOWN AND JUST BEATS ALL THE WHEAT AND THE CROPS, AND SO FORTH, INTO THE GROUND AND JUST KILLS IT. THAT WOULD BE A SUPPLY SHOCK, AN ADVERSE SUPPLY SHOCK. IT WOULD SHIFT

33 ECO LECTURE TWENTY-ONE 33 THE AGGREGATE SUPPLY CURVE TO THE LEFT. AS2. HOW ABOUT A -- YOU'VE HEARD ABOUT THESE BIG HURRICANES THAT SORT OF COME ALONG THE EAST COAST AND JUST SORT OF RAKE ONE STATE AFTER ANOTHER, DESTROYING PROPERTY AND HOUSES AND CROPS. THAT'S AN ADVERSE SUPPLY SHOCK. BUT A SHOCK, WHAT WE MEAN IS, IT'S GOT NOTHING TO DO WITH THE OPERATION OF THE ECONOMY ITSELF. IT'S SOMETHING COMING IN FROM OUTSIDE AND JUST LANDING ON US. WELL, LET'S SAY THERE'S A METEOR THAT FALLS ONTO NEW YORK CITY AND DESTROYS NEW YORK CITY, AND A BIG CLOUD, YOU KNOW, COVERS -- I DON'T KNOW -- THE WHOLE WORLD. THEN RURAL PRODUCTION WOULD GO DOWN AND WE'D HAVE AN ADVERSE SUPPLY SHOCK. A BENEFICIAL SUPPLY SHOCK WORKS IN THE OPPOSITE DIRECTION. LET'S SAY THAT SOMEBODY JUST GOES, "WOW, I DISCOVERED A NEW WAY OF PUMPING OIL OUT OF THE GROUND AND NOW WE CAN PUMP TWICE AS MUCH AS BEFORE. AND NO COST. THIS IS FREE." THAT WOULD BE A BENEFICIAL SUPPLY SHOCK AND ALL OF A SUDDEN THAT AGGREGATE SUPPLY CURVE WOULD SHIFT TO THE RIGHT. THAT'S WHERE WE'LL END FOR THE DAY. AND NEXT TIME WHAT WE'LL DO IS WE'LL PUT AGGREGATE SUPPLY AND AGGREGATE DEMAND TOGETHER AND FIND THE EQUILIBRIUM FOR THE MARKET. SO LONG.

34 ECO LECTURE TWENTY-ONE 34