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Econ Lecture February 13 Ch. 23 part 2 continued

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Professor Cottrel

February 13, 2014 Economic Shocks and Business Cycles • AD and AS subject to continual random shocks • Automatic adjustment mechanism converts shocks into cyclical fluctuations in real GDP • Lags cause changes in output to be extended over long periods of time Long-Run Equilibrium • Excess demand or supply of labour (and other factors) will be eliminated • Full employment of factors • Output at potential level, Y* • Potential GDP is vertical at Y* • There is no relationship in long run between price level and output produced • Unemployment is U* • Firms’ output same, regardless of price level Potential GDP may increase over time: Change in Productivity or Change in Technology Economics growth Fiscal Policy and the Business cycle Fiscal Stabilization Fiscal Policy: • Use government taxes and spending • To stabilize level of GDP at potential • Maintain full employment If Y < Y* (recessionary gap): • Wait for gap to close on its own – long time Or, use fiscal policy: • increase government spending or, cut taxes to increase private spending • so that way, the aggregate is increasing within the economy At Y0, P0 • Wait for wage rates to fall AS0 shifts rightward to AS1 • Back to potential GDP • Price level falls to P1 • Can take a long time Alternative Increase government spending Cut taxes Shifts AD rightward - GDP returns to Y* - Price level rises to P1 If Y > Y* (Inflationary gap): - Wait for wage rates to rise - Shifts AS leftward OR, use fiscal policy - To lower AD - Reduce government spending, or raise taxes to reduce private spending - AD shifts leftwardY At Y 0 low U • Wage rates rise [W] • AS0 decreases to AS1 • Return to Y* • Price level rises Alternative: Inflationary gap [Y* - Y0] - Increases taxes - Reduce government spending - AD0 shifts leftward to AD1 - Return to Y* - Price level falls to P1 Role for fiscal policy: Inflationary gap: • Cut government spending Or raise taxes to reduce private spending, keeps prices from rising Recessionary gap: • Increase government spending • Or lower taxes to encourage more private spending • Avoids long wait to return to potential GDP (full employment) Self-adjustment: - Very slowly Possibly: • With price increases • Long-lasting unemployment Paradox of thrift: An increase in saving (Less spending) by private and public sectors • Reduces the level of real GDP (by reducing AD) • “Paradox”: • Good behaviour
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