ECON 102 Tutorial 4: Midterm Review

Transcription

1 ECON 102 Tutorial 4: Midterm Review TA: Iain Snoddy 1 June 2015 Vancouver School of Economics

2 The Plan The plan for today is to Review some key topics Look into common issues raised in the midterm Look at the Midterm Answers Give back the Midterms 2/28

3 The most common problem The most common problem I encountered was that the relationship between prices, AS and AD is not clear for some students. So let s review the AD-AS model and try to fix this problem. 3/28

4 AD-AS review The short run AD-AS model looks very simple. An upward sloping supply curve and a downward sloping demand curve. Equilibrium occurs at the point where they intersect. 4/28

5 But what are these curves We know that the AD curve just represents all expenditure that will take place in the economy at a given price level. Remember that the price level here is the price level of all goods in the economy. In other words this Price is basically something like the consumer price index (CPI). If the average price of all goods change, they will be less expenditure in the economy. This is a movement along the demand curve. The demand curve shifts if autonomous expenditure changes. 5/28

6 But what are these curves The Supply curve represents total output supplied by all firms in the economy as the average price of goods changes. We know that the supply curve shifts when unit costs change. That is, when inputs to production become more expensive firms will supply less goods. 6/28

7 A Common Problem It was common to see people say things like, inflation increases prices and shifts the demand curve. But this is wrong. Prices in the economy adjust to ensure equilibrium. Prices therefore just represent supply and demand in the economy, supply and demand determine prices, not the other way around. The price that holds in equilibrium depends on where the demand and supply curves lie. If prices have risen (ie inflation) it must be that the demand and supply curves have shifted. 7/28

8 A Common Problem Prices do not rise on their own! Or fall on their own! Prices respond to changes in AS and AD. Inflation does not shift the curves, it is the shift in these curves that causes inflation! People often said that inflation reduced the demand for goods, but this is represented by a movement along the demand curve and inflation only takes place if demand and supply have shifted and moved us to a new equilibrium. 8/28

9 A Second Problem A related problem was that people seemed to think that inflation (or increasing prices) shifted the supply curve left as the costs of production increased, but this is not true. We know that as prices change we move along the supply curve. The price level P is not the same price that firms pay to produce goods! When the price level rises unit costs do not rise! Factor prices are the prices of inputs! Mostly wages. Factor prices and the Price level are not the same. 9/28

10 A Second Problem Perhaps the best way to think of it is like this: The price level is something like the CPI, it is the average price of goods purchased by households. The factor costs paid by firms are wages paid to staff and the cost of intermediate goods. These intermediate goods are not the same as the prices paid by households. 10/28

11 Question 1 So let s look at question 1. We are asked to show good inflation and bad inflation. Firstly we need to know what these concepts mean. Good inflation means that prices have risen, but so has real GDP. Bad inflation means that prices have risen but output has fallen. 11/28

12 Question 1 For good inflation this means that there has been an increase in demand. The demand curve has shifted out, maybe due to an increase in government spending, an increase in exports, investment or autonomous consumption. 12/28

13 Question 1 AS P rice AD 1 AD 2 Real GDP (Y) 13/28

14 Question 1 What happens following the shift in demand is that there is excess demand in the market. There is not enough supply to meet demand. Prices are bid up and output increases until we return to the new equilibrium. It is the shift in demand that has led to inflation and an increase in real GDP here. 14/28

15 Question 1 Bad inflation is caused by a fall in supply, which pushes up prices and reduces output. 15/28

16 Question 1 AS 2 AS P rice Real GDP (Y) AD 1 16/28

17 Question 1 What happens following the shift in supply is that there is again excess demand in the market at the current market price. Prices are bid up and output decreases until we return to the new equilibrium. 17/28

18 A quick review of the Long-run Long run growth in the economy is represented by a shift in the LRAS curve to a new point where potential output is higher. This means that technology has increased, or that the economy producing at full capacity can now produce more than before. Long-run equilibrium occurs when their is no output gap. In other words when the AD-AS curves intersect at potential output. If this does not happen we are not in long-run equilibrium. We are in short-run equilibrium with a recessionary or inflationary gap. 18/28

19 Adjustment to the Long-run To be clear automatic adjustment to the Long-run equilibrium comes from a shift in the AS curve. Factor prices adjust to return us to long-run equilibrium and close the inflationary or recessionary gap. Fiscal policy can also close the output gap, but this adjustment will shift the AD curve and is not automatic. It happens only with deliberate government intervention. 19/28

20 Question 2 Use the dynamic model of aggregate demand and supply to illustrate a situation where the economy is growing in the long run between year 1 and year 2 but experiencing inflation from one long run equilibrium to another. Assume the economy starts at the long run equilibrium in year 1. 20/28

21 Question 2 The key words for this question are Long-run, growing, and inflation. We know that the economy is growing and we are moving from 1 long-run equilibrium to another. This means that the LRAS must shift if there is long-run growth, and that the new short-run equilibrium must take place at the new level of potential output. We also know that prices must have risen, so we know there must have been an increase in AD. 21/28

22 Question 3 C = YD I = 200 G = 200 T = 0.25Y X = 200 IM = 0.2Y (a) Compute the equilibrium level of national income. (b) What is the (simple) multiplier in this case? What does the coefficient of the multiplier mean? (c) If the potential GDP, Y*, for this economy is 3500, how much should the government change the amount of government purchases to move the economy back to the full employment output? 22/28

23 Question 3: part a We know that equilibrium is where AE = Y and the AE curve crosses the 45 degree line. To get the answer we first need to derive the AE curve. To do this first note that C = (Y T ) = (1 0.25)Y = Y Then AE = Y Y = Y To solve for equilibrium Y = Y and so Y = 1400/0.6 = /28

24 Question 3: part b 1 We know that the multiplier is 1 z where z is the marginal propensity to spend. We also know that the marginal propensity to spend is 0.4. So the multiplier is = = /28

25 Question 3: part c So we know that potential GDP is 3500 and we know that the current equilibrium level of output is This means that there is a recessionary gap, the economy is producing below potential. We know that government spending has a multiplier effect. What we want to determine is how much government spending will move the economy to a new equilibrium level of output equal to /28

26 Question 3: part c We know the multiplier is Y AE and is equal to We want to change output by = So we can rearrange the multiplier formula: Y/1.67 = AE and plug in the desired change in output: /1.67 = AE = 700. So if Government spending increases by 700 output will return to potential 26/28

27 A very quick review of the Multiplier I just wanted to do a very quick review of the multiplier in the AD-AS model. In this model the multiplier effect is less strong because an increase in demand raises prices. As prices are higher the amount of new goods that can be purchased with the additional income from spending falls. In the AE model we had assumed that prices were fixed (constant) meaning that the AS curve was horizontal or perfectly elastic. In other words, the AE model is essentially the AD-AS model with a horizontal supply curve! 27/28

28 GDP v GNP The answer provided by the Professor is clear here. I just found an interesting figure I d like to share: 28/28