MACROECONOMICS EXAM 2

***USE PRACTICE EXAM QUESTIONS & PREVIOUS QUIZ QUESTIONS!!!

***KNOW THE EQUATIONS & HOW TO USE THEM!!!!! (calculations & application questions)

UNEMPLOYMENT & LABOR FORCE PARTICIPATION Pt.1

Business Fluctuations: (business cycles) → short run movements in real GDP around its long
term trend
Measuring Unemployment & Labor Force Participation:
Unemployed workers are adult non-institutionalized civilians who do not have a job but who are
looking for work
- An adult is considered a “non-institutionalized civilian” if they are:
- 16 years of age or older
- Not institutionalized (not in prison, not in a health institution)
- A civilian (not in the military)
- A person is counted as unemployed if they:
- Don't have a job
- Are looking for work
- Are an non-institutionalized civilian
- A person is counted as employed if they:
- Have a job
- Are a non-institutionalized civilians
- A person is counted as in the Labor Force if they are:
- Employed or unemployed
- Examples of people not in the labor force: stay-at-home parents, retirees, etc
Unemployment Rate (UR): the percentage of the labor force without a job
- UR = (unemployed) / (unemployed + employed) x100
- UR = Unemployed / Labor Force x 100
Example: last month, in a country, there were 6.54 million people unemployed & 156.69 million
employed
- Together the employed and the unemployed make up the labor force of 163.23 million
- What is the unemployment rate?
- UR (%) = (6.54 million) / (163.23 million) x 100 = (6.54 / 163.23) x 100 = 4%
Labor Force Participation Rate (LFPR): the percentage of the adult non-institutionalized civilians
(adults for short) in the labor force
- LFPR = (unemployed + employed) / (adult population) x 100
- LFPR = Labor Force / Adult Population x100
Example: last month, in a country, there were 6.54 million people unemployed & 156.69 million
employed
- Together the employed and the unemployed make up the labor force of 163.23 million
- In total there were 258.24 million non-institutionalized, civilian adults
 - What was the labor force participation rate?
- LFPR (%) = (163.23) / (258.24) x100 = 63.2%
Unemployment Rate → is a good indicator of how well the labor market is working but… it is
incomplete because it does NOT include discouraged workers & underemployed workers
Discouraged Workers: are workers who have given up looking for work but who would still like
a job
- Discouraged workers are difficult to measure because the concept is not well defined
- One definition is workers who want and are available for work, & who have looked for a
job sometime in the last year but not in the last month because they believe that no jobs
were available for them
- The number of discouraged workers is small relative to the number of
unemployed workers (based on this definition)
Underemployment: this concept emphasizes that the unemployment rate does not measure the
quality of the jobs or how well workers are matched for their jobs
- Skill mismatch is a key factor that contributes to underemployment
- Examples:
- A hair stylist at Great Clips with a PhD in nuclear physics is counted as fully
employed
- Doctor / surgeon who can only find employment at Wendys
- A worker with part-time job who wants to work full time is counted as fully
employed
- A measure that the BLS uses for underemployment is:
- Part-time workers who would rather have a full-time position & people who
would like to work but have given up looking for a job
- Using this measure, as of July 2017, the underemployment rate was unusually
high at about 12.5 %
- Involuntary part-time workers want a full time job, while voluntary workers just
want a part-time job
- Example: people switching from involuntary to voluntary with the
emergence of Uber
- Want the flexibility of the part-time job
Unemployment Rate - It is a Good Measure!
- Despite its limitations, the unemployment rate is a good measure in determining how
well the labor market is performing, it might be the best measure we have
- To get a better sense of what is going on in the labor market, economists can also look at
other indicators:
- Labor force participation rate
- Employment-population ratio
- Number of full-time jobs
- Average wages
 - Fortunately, these other measures of labor market are highly correlated with the
unemployment rate
- Hence the unemployment rate is a good summary indicator of the state of the labor
market
Example Question: Which of the following people are counted as unemployed?
A. A person out of work & actively searching for work → correct by definition
B. A person in prison → prison = institutionalized
C. A person who wants to work but stopped searching six months ago → not in labor force
D. A person who works part-time, but who wants to work full time → underemployment

THREE BROAD CATEGORIES OF UNEMPLOYMENT:

1. Frictional unemployment
2. Structural unemployment
3. Cyclical unemployment
(1) Frictional Unemployment: short term unemployment caused by the ordinary difficulties of
matching employee to employer
- Cause: scarcity of information
- Finding a job the you want at a wage the you will accept, and the employer will
pay takes time
- Potential remedy: technological innovation that increases the spread of information may
reduce frictional unemployment
- Duration of frictional unemployment → short
- In 2005 in the U.S →
- More than ⅓ of the unemployment spells lasted less than 5 weeks
- Nearly 80% of unemployment spells lasted less than 26 weeks
- Frictional unemployment is a large share of the US unemployment because the US is a
large economy with dynamic labor markets
Separations and Hires → in any given month, millions of jobs are created and millions of jobs
are destroyed
- During recession: new separations > new hires → causes net job destruction
Creative Destruction:
- Innovations, new ideas and new products imply that →
- Competition among firms will result in some companies growing and other
companies shrinking or going out of business
- Growing retailers: Albertsons, Nike, Amazon, Dollar Tree
- Declining: Toys R US, Sears, JCPenney, Radio Shack
- Demand for some products or occupations decline and some will increase
- Occupations with declining demand: switchboard operators, textile workers,
travel agent, typewriter repairs
 - Occupations with increasing demand: home health aide, physical therapist, web
developers, computer programmers, data analysts
- These shocks (rapid changes) caused by technology, globalization, or changes in
resources have resulted in structural unemployment for some individuals
(2) Structural Unemployment: persistent, long-term unemployment caused by long-lasting
shocks or permanent features of an economy that may make it more difficult for some workers to
find jobs
- One cause of structural unemployment is large, economy-wide shocks such as oil shocks
- Other causes include restructuring because of globalization, new information technology,
and the shift from manufacturing to services
- Structural unemployment has significant costs:
- Loss of economic output
- The longer a worker remains out of the labor force, the more his or her skills
become obsolete
- The unemployed suffer higher levels of stress and lower rates of measured
happiness
- Institutions can have an influence on the severity of structural unemployment in an
economy
- In the U.S. unemployment tends to increase with a shock then decrease
- In Europe, unemployment has increased with shocks and then remained at high levels
Why the difference?
- In Europe …
- Unemployment compensation is more generous in terms of length & money
- The minimum wage rate is higher
- Labor unions are a greater share of labor force
- Employment laws differ
Minimum Wage:
- Minimum wages in Europe are higher than the U.S. (e.g. France = 32% higher)
- Results: minimum wage will affect more workers and create more unemployment in
Europe than in the U.S.

-
- Minimum wage raises the wage, thus decreasing the quantity of labor demanded
- W1 > W *
Labor Unions:
- Union: an association of workers that bargains collectively with employers over wages,
benefits, and working conditions
- Often act to raise the wage for the people that have union jobs
- Many people would like to work for that wage, but will not be hired by the firm
- Unions may take many forms → some act to increase wages simply by restricting entry
into a profession with licencing requirements
Employment Protection Laws (summary)
- Employment protection laws have the following effects:
- Create valuable insurance for workers with full-time jobs
- Make labor markets less flexible & dynamic
- Increase the duration of unemployment
- Increase unemployment rates among young, minority, or otherwise “riskier”
workers
Structural Unemployment & Labor Rigidities

-
- Graphically, higher long-term unemployment is positively correlated with more rigidity
of employment index
Structural Unemployment → summary of causes & potential remedies

Economic “Shocks” Regulations & Policies

Oil shocks Unemployment benefits

Shift from manufacturing to service economy Minimum wage laws

Globalization Unions

Technology Employment protection laws

Policies that can Reduce Structural Unemployment:

- Job retraining
- Job search assistance
- Work tests
- Early employment bonuses
UNEMPLOYMENT & LABOR FORCE PARTICIPATION Pt.2
(3) Cyclical Unemployment: unemployment correlated with the business cycle → short-term
unemployment that increases during recessions & declines during expansions
- cyclical unemployment is correlated with the ups and downs of the business cycle
- Unemployment increases dramatically during recessions for at least two reasons:
1. When GDP is falling, firms often lay off workers, which increases unemployment
2. When workers are idle, it’s likely that related capital is also idle, and the economy
cannot be maximizing growth

- The shaded regions of the graph are periods of recession:

- Unemployment is higher “around” recessions
- Unemployment is lower when the economy is expanding
- The definition of cyclical unemployment implies that we would expect to a negative
relationship between economic growth and unemployment rate
Natural Unemployment Rate: is the rate of structural unemployment plus frictional
unemployment (i.e. it doesn't include cyclical unemployment)
- The natural rate changes slowly only through time and the actual rate of unemployment
varies around the natural rate
- The underlying rates of frictional and structural unemployment change slowly
through time as major, long-lasting features of the economy
- Cyclical unemployment can increase or decrease dramatically over a matter of
months
Labor Force Participation:
- Recall that the labor force participation rate is the percentage of adult,
noninstitutionalized, civilian population (adults for short) who are working or actively
looking for work → i.e. the percentage of adults who are in the labor force
- LFPR = (labor force / adult population) x 100
 - As the labor force ages the labor force participation rate falls
- In 2000, only 12.4% of the population was 65+
- By 2030, it is expected that 20% of the population will be 65+
Labor Force Participation Rates → Males Aged 55-64 (1998)

Why such a large difference in LFP rates across countries for these older men?
- In addition to lifecycle effects and demographics, Labor Force participation is also
affected by incentives
- Taxes discourage work and benefits encourage non-work
Many countries penalize workers who work past the normal early retirement age
- E.g. Netherlands in the 1990s: working past the age of 60 meant losing one year of
government retirement benefits (an implicit tax on working)
- Result: an individual working past age 60 after paying payroll taxes made less
money that a worker who retired
- Graphically: as the male labor force participation rate decreases the implicit tax index
increases
Female Labor Force Participation Rates Over Time (1948-2016)

Increased female labor force participation rate causes:

- Changing cultural norms → acceptance of equity for women
- Economic factors (helped to facilitate the changing cultural norms)
- Home production & labor-saving innovations
- Increase in service jobs relative to manufacturing jobs
- Effectiveness of birth control
INFLATION & THE QUANTITY THEORY OF MONEY PT.1
Inflation: an increase in the average level of prices
- At any point in time, some prices are rising & some prices are falling
 - When we look over time if it is the case that the “average” prices are rising, we say there
is inflation
Measuring Inflation:
Inflation Rate (Πt): the percentage change in the average level of prices (as measured by the
price index) over a time period
- Πt = (P(t) - P(t-1) / P(t-1)) x100
- Where P(t) is the price value in year t and P(t-1) is the price index value in year
t-1
- A 15% inflation rate means, for example, that goods and services are priced (on average)
15% higher than they were a year ago
Calculate inflation in the following cases:
Price Level in 2010 Price Level in 2011 2011 Inflation Rate

100 110 (110 - 100) / (100) x 100 = 10%

250 300 (300 - 250) / (250) x 100 = 20%

4,000 4,040 (4,040 - 4,000) / (4,000) x 100 = 1%

Price Indexes: give us a measure of the average level of prices

- The 3 most common price indexes used are:
1. Consumer Price Index (CPI)
2. GDP Deflator
3. Producer Price Index (PPI)
(1) Consumer Price Index (CPI): measures the average price for a basket of goods and services
bought by a typical American consumer
- The index covers around 80,00 goods and services
- The index is weighted so that an increase in the price of a major item counts for more
than an increase in the price of a minor item
Relevance of CPI as a Price Index →
- For Americans, CPI is the measure of inflation that corresponds most directly to their
daily economic activity
- For businesses and government, the PPI and GDP Deflator take on a greater
relevance
- The BLS, who computes the CPI, tries to take both new goods & better-quality goods
into account when computing the CPI
(2) GDP Deflator: the ratio of nominal to real GDP multiplied by 100
- GDP Deflator = (Nominal GDP / Real GDP) x 100
- The GDP Deflator covers all final goods only
(3) Producer Price Index (PPIs): measure the average price received by producers
- Unlike the CPI and GDP Deflator, the producer price indexes measure prices of
intermediate as well as final goods
 - PPIs exist for different industries and are often used to calculate changes in the cost of
inputs
Inflation Rate in the U.S. (1950-2016):
- The average inflation rate since 1950 was 3.6%, but in many periods, especially in the
1970’s, inflation was significantly higher
- From 2006-2016, inflation in the United States has averaged about 2.1%
Real Prices: use to compare prices over time, because real prices have been adjusted for inflation
- The CPI can be used to calculate real prices using the following equation:
- Y Real Price in X Dollars = (CPIx / CPIy) x Price in y Dollars
- Where x and y denote specific years
Calculating Real Prices Example:
1982 2006

Price of a Gallon of Gas $1.25 $2.50

CPI 100 202

What is the real price of gas in 2006 using 1982 dollars?
- 2006 Real Price In 1982 Dollars = (CPI 1982 / CPI 2006) x Price in 2006 Dollars →
= (100/202) x $2.50 ≈ $1.24
- The real price of gas (adjusted for inflation) was slightly lower in 2006 than it was in
1982
What is the real price of gas in 1982 using 2006 dollars?
- 1982 Real Price In 2006 Dollars = (CPI 2006 / CPI 1982) x Price in 1982 Dollars →
= (202/100) x $1.25 ≈ $2.53
- Again this illustrates that the real price of gas (adjusted for inflation) was slightly lower
in 2006 than it was it 1982
Inflation Rates in Selected Countries (2016)
- South Sudan and Venezuela had the highest inflation rates in the world in 2016, both
approaching 500%
- Italy, Greece, and Japan experienced slight deflations (decreases in the average level of
prices)
Hyperinflation: is monthly inflation that exceeds 50%
What Causes Inflation? → To know the answer we need to know about “money”
Money: is any good that is widely used and accepted in transactions involving the transfer of
goods and services from one person to another
- “Money” → colloquially we use the term money to represent income and to represent
wealth
- Money can take on many different forms
Two Types of Money:
- Commodity Money: a good used for transactions where the good has “consumption
value
 - Examples: gold, silver, copper, tea, salt, tea, cigarettes, etc
- Fiat Money: is a good, the value of which is less than the value it represents as money
- Currency without intrinsic value → derives its value from government regulation
or law
- Examples: paper money (U.S. dollar)
Functions of Money:
1. Medium of exchange → money is used in exchange of goods and services
2. Unit of Account→ things are priced in terms of money
- Goods, services, the value of labor are all priced in terms of dollars per unit
3. Store of Value → like many other assets, money (typically) retains its value over time
Quantity Theory of Money:
- The quantity theory of money does two main things:
1. It sets out the general relationship between money, velocity, real output, and
prices
2. It helps explain the critical role of the money supply in determining the inflation
rate
Velocity of Money (v): the average number of times a dollar is spent on final goods and services
in a year
- In short, it refers to how fast money passes from one holder to the next
- In 2010, Real GDP was about 14 trillion in the U.S. but the money supply (the amount of
money in circulation was only about 2 trillion. How is that possible
- Each dollar was spent about 7 times
- i.e. the velocity of money was 7 (v = 7)
EXAMPLE: Imagine every month you are paid $4000 and you spend $4000. In a year, how
much money did you spend on goods and services?
- There are two ways to figure this out:
1. You spend $4000 12 times (your money supply (M) is $4000 and the velocity of
money (v) is 12), so your total yearly spending is $4000 x 12 = $48,000
- M x v = $4,000 x 12 = $48,000
2. Alternatively, you could add up all the goods and services that you buy and
multiply their prices (i.e. take the price level (P) and times it by real GDP (YR)):
- P x YR = $48,000
- Hence in this simplified setting, it’s clear that by definition: Mv = PYR = $48,000
A similar identity holds for the entire nation, and we call this the Quantity Theory of Money:
- Mv = PYR
- Where M = money supply
- v = velocity of money
- P = price level
- YR = real GDP
- Note that this identity is true (by definition)
 - Note also that since Mv is the total amount spent on final goods and services and PYR is
the price level times real GDP, both sides of the equation are also equal to nominal GDP
Given Mv = PYR, then it is also true that:
→ → → →
- 𝑀 + 𝑣 ≈ 𝑃 + 𝑌𝑅
- Where M = growth rate of the money supply
- v = percentage change in the velocity of money
- P = percentage change in prices (inflation rate!)
- YR = Growth Rate of Real GDP (or short-run economic growth rate)
- Note that the percentage change in price is inflation, which we typically denote by Π
- So the quantity theory of money can be re-written:
→ → →
- 𝑀 + 𝑣 ≈ Π + 𝑌𝑅
Potential Causes of Inflation
- Solving for Π we get:
→ → → → →
- 𝑀 + 𝑣 ≈ Π ≈ 𝑀 + 𝑣 - 𝑌𝑅
- Given this equation, what could potentially cause inflation?
- An increase in the money supply (M ↑)
- An increase in the velocity of money (v ↑)
- A decrease in the real GDP (YR ↓)
Inflation Caused by Decrease in YR?
- Recall that Real GDP is fixed by real factors of production:
- Physical capital, human capital, technological knowledge
- Inflation can be 10%, 500%, 5000% a year, or much higher
- Very few countries grow faster than 8% per year (especially for an extended period)
- A deep recession typically results in real GDP falling by about 2% (and this only lasts for
a short period of time)
- Conclusion: it is unlikely that changes in real GDP are the main cause of inflation (even
more unlikely to be the cause of high & persistent inflation)
Inflation Caused by Increase in v?
- The velocity of money is affected by factors such as whether workers are paid monthly or
biweekly, how long it takes to clear a check, and how easy it is to find and use an ATM,
etc…
- These factors change over time but only slowly
- Other factors can change v more quickly, but not enough to account for large sustained
increases in prices
- Conclusion: it is unlikely that changes in the velocity of money are the main causes of
inflation

Inflation Caused by Increase in M?

 - Given that inflation can be 10%, 500%, 5000% a year, or much higher, whatever is
causing it likely must exhibit similar intensity of growth in rather short amounts of time
- Contrary to Real GDP and the velocity of money, it is not uncommon to see large and
quick increases in the supply of money
- Conclusion: the quantity theory of money predicts that the MAIN cause of inflation is an
increase in the money supply (M)!
Inflation IS Caused by Increase in M?
- Given YR & v are relatively constant or “fixed” over time (denoted by 𝑌𝑅 & 𝑣 ), then the
quantity theory of money predicts that inflation must result from increases in the money
supply:

-
- This is perhaps clearer when looking at the quantity theory of money in terms of growth
rates. If YR & v are fixed, then their growth rates equal zero (𝑌𝑅 = 0 & 𝑣 = 0), implying
again that inflation must be caused by increases in the money supply:
→ → → →
- 𝑀 + 𝑣 ≈ Π + 𝑌𝑅 → 𝑀 ≈ Π
Graphically we see a positive correlation between inflation rates and money growth rate →
increase in inflation rate, higher/ increased money growth rate
- Nations with rapidly growing money supplies had high inflation rates
- Nations with slowly growing money supplies had lower inflation rates
- On average, the relationship is almost perfectly linear, with a 10 percentage point
increase in the money growth rate leading to a 10 percentage point increase in the
inflation rate
Inflation & Money Supply:
- (sustained) “inflation is always and everywhere a monetary phenomenon” - Milton
Friedman
- If we want to explain inflation in a country over time, it always has its roots in faster
money growth
- If we want to explain inflation across countries, it always has roots in faster money
growth
INFLATION & THE QUANTITY THEORY OF MONEY PT.2
Causes of Inflation → Clarification
- Although increases in the money supply are the main causes of inflation, changes in the
velocity of money and real GDP can affect prices
- During times of high inflation, the velocity of money can increase and exacerbate
inflation
- The velocity of money can also decrease, especially in times of economic panic. If the
velocity of money slows a lot, this can lead to disinflation and even deflation
- Disinflation: a reduction in the inflation rate
 - Deflation: a decrease in the average level of prices (a negative inflation rate)
Money Neutrality:
- The quantity theory assumes that changes inn M cannot change YR, at least in the
long-run
- This what is meant by money neutrality → in the long-run, increases in the money supply
have no impact on real GDP (growth)
*** In the long run, money is neutral ***
- i.e. changes in the money supply do NOT affect Real GDP in the long run
Money Neutrality: Intuition
- Changes in real GDP result from changes in capital, labor, or technological knowledge,
or from changes in the productivity of the factors of production
- Increases in the number of paper or coins will not make workers or capital more
productive in the long run
- Increases in the number of pieces of paper will only make that “paper” less valuable; that
is, the paper will be able to buy fewer goods or services
- That means it will take more paper to buy goods and services (inflation)
The Costs of Inflation: Introduction
- If wages and income increase with inflation, then, on average, real purchasing power
does not decrease
- If all prices including wages are going up, then what is the problem with inflation?
- If everyone knew what the inflation rate was and could prepare for it, then
inflation might not pose much of a problem
- Unfortunately, inflation is not known by everyone and is very hard to predict
- The underlying reason that inflation is so costly is that inflation destroys the ability of
market prices to send signals about the value of resources and opportunities
(1) Price Confusion & Money Illusion:
- Prices are signals and inflation makes price signals more difficult to interpret
- This is true for consumers, workers, & entrepreneurs
- Money Illusion: when people mistake changes in nominal prices for changes in real
prices
- It is not always clear weather prices are rising because of increased demand or
just an increase in the money supply
- We sometimes mistake inflation for higher wages and prices in real terms
- Example: Mary receives a 10% increase in salary and taxes on a higher mortgage
payment
- If the rate of inflation is 10%, she is no better off in terms of real salary
- She now has a higher house payment and is in danger of losing her home
- So, resources are wasted in activities that appear profitable but are not
(2) (Unanticipated) Inflation can Redistribute Wealth:
Unanticipated inflation can redistribute wealth in two ways:
 1. Inflation causes wealth to be transferred from citizens to the government
- This is often referred to as the “inflation tax”
2. Unanticipated inflation transfers wealth between lenders and borrowers
- Unexpected inflation reduces the real return that lenders receive on loans,
transferring wealth from lenders to borrowers
- When inflation and interest rates fall unexpectedly, wealth is redistributed from
borrowers (who are paying the higher rates) to lenders
EXAMPLE:
- If Daniel borrowed $10 from Mary and agrees to pay her at 20% interest rate next year.
- Next year, Daniel will pay Mary (10+10) x (20%) = $12
- What if the inflation rate increases?
- Increases in the inflation rate means a piece of dollar is worth less than before
- The actual wealth transfers from Mary to Daniel
- From lender (Mary) to borrower (Daniel)
- What if the interest rate decreases?
- Decreases in the inflation rate means a piece of dollar is worth more than before
- The actual wealth transfers from Daniel to Mary
- From borrower (Daniel) to lender (Mary)
Inflation Redistributes Wealth:
Nominal Rate of Returns (i) → the rate of return that does not account for inflation
Real rate of return (𝑟𝑟𝑒𝑎𝑙) → the nominal rate of return minus the inflation rate
- i.e. the rate of return that does not account for inflation
- 𝑟𝑟𝑒𝑎𝑙 = i - Π
***Lenders will not lend money at a loss
- Example: if lenders expect that the inflation rate will be 7% and the equilibrium real rate
is 5%, then lenders will ask for a nominal interest rate of approximately 12%
- 7% to break even given the expected inflation rate plus the 5% equilibrium rate
- The equilibrium real rate of return is determined in the market for loanable funds
Inflation Redistributes Wealth:
- When lenders expect inflation to increase, they will demand a higher nominal interest rate
- Fisher Effect: the tendency of nominal interest rates to rise with expected inflation rates
- As an approximation we can write the Fisher Effect as:
- i = E [Π] + r(Eq)
- i = nominal interest rate
- E [Π] = expected inflation rate
- r(Eq) = equilibrium real rate of return (determined in the market for
loanable funds)
The Fisher Effect:
- Whenever the inflation rate increases, the nominal interest rate rises as well
- This figure provides support for the Fisher Effect:
 -
BUSINESS CYCLE FLUCTUATIONS & THE AD/ AS FRAMEWORK Pt. 1
Business Cycles (Business Fluctuations): fluctuations in the growth rate of real GDP around its
trend growth rate

-
- Recession: a significant, widespread decline in real income (real GDP) and employment
- The shaded regions on the graph
Why do we care? → during recessions, net job loss can be high
Business Cycles & Public Policy:
- Perhaps one of the most contested areas of economic policy is related to the nature and
causes of business cycles
- To understand booms & recessions (business cycles), we are going to look at two models
of business cycles built on an aggregate demand and aggregate supply curve (AD/AS)
framework
- The models will show how unexpected economic disturbances “shocks” to aggregate
demand or aggregate supply can temporarily increase or decrease the economies rate of
growth
- i.e. how shocks to AD or AS can cause business fluctuations
Models of Business Cycles:
- Real Business Cycle (RBC) Model:
- Aggregate demand (AD)
- Long-run Aggregate Supply (LRAS)
- New Keynesian Model:
- Aggregate Demand (AD)
- Long-run Aggregate Supply (LRAS)
- Short-run Aggregate Supply Schedule (SRAS)
Aggregate Demand (AD) Curve: shows all the combinations of inflation and real growth that are
→ →
consistent with a specified rate of spending growth (𝑀 + 𝑣 )
Quantity Theory of Money (in levels): the money supply times the velocity of money equals
(nominal) GDP
- MV = PY
- M = money
- V = velocity
- P = price index
- Y = real GDP
Quantity Theory of Money (in Growth Rates): a relationship between the growth rates of money,
velocity, real GDP, and prices
- %ΔM + %ΔV = Π + %Δy
- %ΔM = growth rate of money
- %ΔV = percentage change in velocity
- Π = inflation
- %Δy = growth rate of real GDP
- Rearrange the quantity theory to express a relationship between inflation, money growth,
(percentage change in) velocity, and real GDP growth
- Π = (%ΔM + %ΔV) - %Δy
EXAMPLE: Suppose money growth is 5%, growth in velocity is 0%, and real growth is 0%,
what must the inflation rate be?
→ → →
- Π = (𝑀 + 𝑣 ) - 𝑌𝑅 = (5% + 0%) - 0% = 5%
- In other words, if the money supply is growing, velocity is constant, and there is no
additional goods, then prices must go up
EXAMPLE: Suppose instead that money growth is 4%, growth in velocity is 1%, and real
growth is 3%, what must the inflation rate be?
→ → →
- Π = (𝑀 + 𝑣 ) - 𝑌𝑅 = (4% + 1%) - 3% = 2%
- Are both combinations of inflation and real growth on the same AD curve? Why or why
not?
- YES, both are constant with a spending growth rate of 5%
- An AD curve tells us all the combinations of inflation and real growth that are consistent
with a specified rate of spending growth
- In our example, any combination of inflation and real growth that adds up to 5% is on the
same AD curve
 -
- If real growth increases, then inflation will decrease
Aggregate Demand: Π = (%ΔM + %ΔV) - %Δy
- Suppose (%ΔM + %ΔV) - 5%
%Δy (%ΔM + %ΔV) Π

0% 5% 5%

1% 5% 4%

2% 5% 3%

3% 5% 2%
-
Aggregate Demand Representation

-
- %Δy = % change in real GDP
- If spending increases, either because of an increase in money supply or an increase in
velocity, then the AD curve shifts up and to the right
- Intuition: increased spending must flow into either a higher inflation rate or a
higher growth rate
- A decrease in spending growth shifts the AD curve inward
 -
→ →
1. Increases in spending growth (↑ 𝑀 and/or ↑ 𝑣 ), shift the AD curve to the right
→ →
2. Decreases in spending growth (↓ 𝑀 and/or ↓ 𝑣 ), shift the AD curve to the left
What Causes AD to Shift?
- The Aggregate Demand Schedule shifts if the money growth rate changes or the growth
rate of velocity changes
- Changes in the growth rate of the money supply is primarily driven by the central
bank (the Federal Reserve in the US)
- Changes in velocity occur if people choose to hold more or less money
- What if people are optimistic about the current economy? → AD curve
shifts right
- What if investors are pessimistic about the current economy? → AD curve
shifts left

-
Aggregate Demand → move along the curve or shift the curve
- Given the spending growth (%ΔM + %ΔV), if either inflation or real GDP growth rate
changes, what happens to the curve?
- No shifts of curve → move along the curve
- If the spending growth changes (either %ΔM or %ΔV changes), what happens to the
curve?
- Shifts to curve!
Recall from chapter 7 & 8 that every economy has a potential growth rate determined by:
- Increases in the stocks of labor and capital
- Increases in productivity
The rate of growth, as given by these real factors of production, is called the “Solow growth
rate”
 - The long-run supply curve is a vertical line at the Solow growth rate, independent of the
inflation rate

- Because money is neutral in the long-run, the LRAS curve is a vertical line
- Potential growth does not depend on the rate of inflation
Solow Growth Rate: an economy’s potential growth rate, the rate of economic growth that
would occur given flexible prices and the existing real factors of production
- Long Run Aggregate Supply Curve (LRAS): vertical line at the Solow Growth Rate
Real Shock: (also called a productivity shock) is any shock that increases or decreases the
potential (“Solow”) growth rate
- Shocks to the LRAS curve, or “real shocks”, are rapid changes in economic conditions
that increase or diminish the productivity of capital and labor
- When there is a positive real shock, the LRAS curve shifts to the right
- When there is a negative real shock, the LRAS curve shifts to the left
What causes the Solow Growth Curve to shift?

-
- Real shocks (“productivity shocks”) which increases or decreases the potential growth
rate
- Positive productivity shocks → increase the ability of the economy to produce
- Negative productivity shocks → decrease the ability of the economy to produce
Real Business Cycle (RBC) Model:
- When we put the AD and LRAS curve together we can see how business fluctuations can
be caused
- Real Business Cycle (RBC) Model: business cycles and recessions are primarily due to
real shocks (shifts in the LRAS Curve)
- Assumption: prices are fully flexible (quick to adjust to economic shocks)
- Limited role for government intervention
- Primary role of the government is to provide a stable environment for long term
growth
- Primary role of the central bank is to conduct monetary policy to keep inflation
low
 - In this model, the equilibrium inflation rate & growth rate are determined by the
intersection of the AD and LRAS curves
Real Business Cycle (RBC) Model → graphically

→ →
- If 𝑀 + 𝑣 is 10% and real growth is 3% then the inflation rate will be 7%

-
1. A positive real shock results in a higher real growth rate & lower inflation
2. A negative real shock results in lower real growth rate & higher inflation
3. RBC model predicts business fluctuations are caused (only) by real shocks that shift
the LRAS curve

1. A positive demand shock results in an unchanged real growth rate and higher inflation
2. A negative demand shock results in an unchanged real growth rate and lower inflation
3. RBC model predicts business fluctuations are not caused by shocks to the AD curve
The RBC model is based on the AD/AS framework
- It assumes that prices (and wages) are fully flexible → meaning they are quick to adjust
to economic shocks
- It concludes that business fluctuations are caused by real shocks (shocks to LRAS curve)
- Because prices are fully flexible in this model, shocks to the AD curve do NOT affect the
Solow growth rate, and hence it concludes that business fluctuations are NOT caused by
shocks to the AD curve
- ***Shocks to AD only affect inflation rates in this model
Increases in the Growth Rate of the Money Supply:

Real World Example: Increases in Oil Prices

- From 1979 to 1981, oil price increased from roughly $10/barrel to over $34/barrel
- Oil was an important input into the production process (manufacturing output was a
higher share of total GDP)
- The higher oil prices resulted in less oil being used in production → capital & labor
were less productive → decrease in output!!

-
- An increase in the price of oil that causes the Solow Growth Curve to shift
- Negative productivity shocks → decrease the ability of the economy to produce

Real World Example: Technology Boom in the 1990’s

- From 1992 to 2000, technology helped boost labor productivity
- The internet and widespread adoption of personal computers made workers (and
machines) more productive
- The increased technology → capital & labor were more productive → increase in
output!!
 -
- An increase in technology that causes the Solow Growth Curve to shift
- Positive productivity shocks → increase in the ability of the economy to
produce
BUSINESS CYCLE FLUCTUATIONS & THE AD/ AS FRAMEWORK Pt.2
Real Shocks → Some Factors that Shift the Long-Run Aggregate Supply Curve
Negative Shocks = LRAS Curve Moves Left Positive Shocks = LRAS Curve Moves Right

Bad weather (important in agricultural economy) Good weather (important in agricultural economy)

Higher price of oil or other important input Lower price of oil or other important input

Productivity slumps/ technology slump Productivity boom/ technology boom

Higher taxes or regulation Lower taxes or regulation

Disruption of production by war, earthquake, pandemic, etc. Smooth production without disruption

Self-Check: Higher business taxes will shift the long run aggregate supply curve…
- To the LEFT → higher taxes will decrease LRAS, shifting the curve to the left
- Negative real shock
RBC vs. Keynesian Model →
- Real Business Cycle: output fluctuations solely due to real shocks (supply shocks)
- According to the New Keynesian Model: business cycles are due to both supply &
demand shocks
- Seen in the Great Depression
Business Cycles & Public Policy:
- Real Business Cycle Models: business cycles and recessions are primarily due to shifts
in the Solow Growth Curve
- Prices are quick to adjust to economic shocks
- Productivity shocks like war, natural disasters, and so on
New Keynesian Theories: business cycles and recessions are driven both by shocks to demand
as well as shocks to the Solow Growth Curve
- Prices are slow to adjust
Recall in The RBC Model (Supply Side Shocks)
- Putting the AD & the Solow Growth Curve together

-
Conclusions:
1. A positive shock results in a higher real growth rate, 7%, and lower inflation, 3%
2. A negative shock results in a lower real growth rate, -1%, and a higher inflation, 11%
The RBC Model (Demand Shocks)
- Shocks to Aggregate Demand in the RBC Model

-
Conclusions:
→ →
1. A positive demand shock, ↑𝑀 and/or ↑𝑣 results in higher inflation
→ →
2. A negative demand shock, ↓𝑀 and/or ↓𝑣 results in lower inflation
Aggregate Demand Shocks: John Maynard Keynes explained that when prices were not
perfectly flexible, deficiencies in aggregate demand could not generate recessions
New Keynesian Model:
- Key assumptions: prices and wages do not adjust immediately to economic shocks
- Recall with RBC, any rise in money supply translated into higher prices
- Implies prices adjusted one to one to this money supply shock
- But money may not be neutral in the short run → use the New Keynesian model for
this short run result
Why Money May Not be Neutral in the Short Run
EXAMPLE: Imagine you are a baker in Zimbabwe →
- The Zimbabwean president prints more money and doubles soldiers’ salaries
- Soldiers start buying more bread from you
- You think the soldiers suddenly start loving your bread
 - You buy more inputs (flour, salt, etc.), pay overtime to your workers to produce more
bread
- This increases output in the short run
- BUT soldiers are buying more of everything → more clothes, more movies, etc
- So, when you and your workers go out to shop with higher incomes, you realize that
price of all goods are going up
- So what will you do?
- Increase/decrease price for your bread to match your purchasing power
- You adjust your prices
- Your production of bread goes to normal
How Long is the Short Run?
- How long will you and other stores take to adjust prices determines for how long will the
output increase
- Firms do not always increase prices immediately. Why?
- Customers do not like frequent price changes. Also costs you more money to
frequently update your menu (menu costs)
- Not sure whether soldiers start loving your bread more or is it due to other
factors?
Short-Run Aggregate Supply (SRAS):
- Key addition to New Keynesian Model → SRAS
- Not all goods prices adjust instantly to economic shocks
- Some prices adjust instantly to shocks → many of these goods are traded on
“exchanges”
The Short Run Aggregate Supply Curve: shows the positive relationship between the inflation
rate and real growth during the period when prices & wages are sticky
- Examples: gas and $/gallon, newspaper subscriptions over time
Example of Price Stickiness: Wage Stickiness
- Unemployment is one of the biggest costs during recessions
- Why don't firms just give everyone pay cuts and lower labor costs rather than laying off
workers? → wage stickiness
Wage Stickiness → Why?
- Workers’ morale will fall when we decrease their normal wages
- Workers will be disgruntled and will be less productive when they see a pay cut
- Although it would be better from recovery point of view to just decrease employees’
wages without laying anyone off
Short-Run Aggregate Supply:
- The short run aggregate supply (SRAS) curve is upward sloping
- In the short run, an increase in AD will increase both inflation and real growth
- A decrease in demand will decrease both the inflation rate and the growth rate
- ***Each SRAS curve is associated with a particular rate of expected inflation
 -
Aggregate Demand Shock: a rapid and unexpected shift in the AD curve (spending)
- A positive shock to spending must either increase inflation or the real growth rate
- In the short run, an increase in spending will be split between increases in inflation and
increases in real growth
- In the long run, the real growth is equal to the Solow rate, which is not influenced by
inflation
- In the long run, therefore, an increase in spending will increase only the inflation
rate
Short-Run Aggregate Supply Schedule

-
- In the short run, following an increase in demand, some firms increase prices & other
firms increase output
- Because some prices are sticky, inflation does not increase all the way to point A
Unanticipated ↑ in Money Supply: Increase in Aggregate Demand

-
→
- If there is an unexpected ↑ in 𝑀, both inflation & growth rate increase in the short run
(a → b)
An Increase in Aggregate Demand:
- Prices do not adjust instantly because it is costly to change prices (“menu costs”)
- Firms may also hold off on price changes because they are not sure whether the change in
the market conditions is temporary or permanent
- As prices increase throughout the economy, workers demand even higher wages to catch
up to the higher inflation rate

-
- Eventually, inflation expectation adjust, SRAS shift to the left and the growth rate
returns to the Solow rate (b → c)
SRAS Curve: what happens to SRAS when expected inflation changes?
- An increase in the expected inflation rate will shift the SRAS up and to the left
- A decrease in the expected inflation rate will shift the SRAS down and to the right
A Decrease in Aggregate Demand → Decrease in Money Supply

-
- A decrease in AD can induce a lengthy recession
A Decrease in Aggregate Demand:
- When AD falls due to a fall in the money supply:
- The economy shifts to a new short run equilibrium point, b
- At point b, inflation rate decreases a little
- Real growth rate is reduced a lot (recession)
- Prices & wages are especially sticky in the downward direction
- It can take the economy a long time to move out of a recession
 -
- In the long run, prices will adjust, and the economy moves to a new equilibrium at c
- a → b, economy goes into recession
- b → c, economy recovers from recession
Shocks to Velocity:
→ →
- Changes in 𝑣 are the same as changes in spending rate, holding 𝑀 constant
→
- If 𝑣 increases, the growth rate of C, I, G, or NX must increase
- However, one major difference is:
→
- Changes in 𝑣 tend to be temporary but changes in money supply can be
permanent
Factors that Shift the Dynamic Aggregate Demand Schedule
Shift DAD down (to the left) Shift DAD out (to the right)

Decrease in money growth Increase in money growth

Decrease in consumer optimism (worry about job security and Increase in consumer optimism (more optimistic about job and
spend less → v ↓) income → v ↑)

Decrease in producer confidence (worry about future demands Increase in producer confidence (worry less about future
and buy fewer investment goods → v ↓) demand, buy more investment goods for less → v ↑)

Decrease in government expenditures (decrease in spending → v Increase in government expenditures (increase in spending, r →
↓) v ↑)

Increase in taxes (less disposable income → v ↓) Decrease in taxes (more disposable income → v ↑)
→
A Shock to the Growth Rate of Spending (Change in 𝑣 )

-
- Consumers’ fears → temporary decrease in AD
- Short-run: wages are sticky, real growth ↓
- Long-run: AD returns, real growth ↑
The Great Depression: was due primarily to a large fall in aggregate demand
- In 1929, the U.S. stock market crashed
- People felt poorer and decreased spending, reducing aggregate demand
- In 1930, depositors lost confidence in the banks
- By 1933, more than 40% of all American banks had failed
- The fear and uncertainty also reduced investment spending
- The U.S. capital stock was lower in 1940 than it had been in 1930
- In 1931, instead of increasing the money supply to boost the economy, the Federal
Reserve allowed the money supply to contract even further
- There was an additional monetary contraction during 1937-1938

-
The Great Depression → Real Shocks: real shocks also played a role in the Great Depression
- Bank failures not only reduced the money supply and spending (AD) but they also
reduced the efficiency of financial intermediation
- At the same time, the Federal Reserve allowed money supply to fall
- Policy makers added tariffs (tax on imported goods) to “help” domestic producers
- But foreign countries retaliate with higher tariffs