ECON 209 Lecture Notes - Lecture 10: Output Gap, Aggregate Supply, Potential Output

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14 Feb 2016
In the aggregate supply shocks, P and Y change in opposite directions and the reduction is
AS causes AD > AS
I. increase in P reduces AE
II. New E at higher P and lower Y because of a change of P of inputs, a change in wages, a
change in tech
A. ***many econ events, especially changes in the world prices or raw materials cause a
shock in both AD and AS shocks — complex shocks. The overall effect on the economy
depends on the relative importance of the to separate effects
B. EX: when Korea and Japan went into recession, the demand for raw materials in the
West minimized because we were exporting less to them
C. EX: the price of crude oil is falling, so our oil producing provinces had a negative AD
shock but on its own, this would push both Canada’s GDP and P down
1. It is a positive shock in that there is P reduction for products that need oil so these
Chapter 24 - Short and Long Run
I. Short Run:
A. factor prices are assumed to be constant, technology and factor supplies are assumed
to be constant
B. the adjustment of factor prices occurs in that they are flexible but tech and factor
supplies are constant
II. Long Run:
A. factor prices are fully adjusted
***table 24.1 is very useful in the textbook***
A. output gap = Y - Y*
B. When Y > Y*, the demand for labour and other factor services is relatively high = an
inflationary output gap.
C. Adjustment Asymmetry: pressure for wages to go up, the speed of adjustment can be
reasonably fast in an inflationary gap but in a recessionary gap, it takes a long time for
people to lower their expectations of wages
D. Adjustment asymmetry and downward stickiness of money wages mean adjustment
pressures differ between Y>Y* and Y<Y*
E. —> the relationship between output gap and factor Ps not only method of adjustment
1. an example of additional pressures for adjustment is: if Y<Y* but W sticks
downwards, how could it adjust? If expectations of recovery are there, stock prices
rise and there is rise in wealth!
2. after a while, investment in replacement of worn-out durables raises confidence
further increasing investment, hence, E so these may play an even larger role than
falling wages in closing recessionary gap
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F. Potential Output as an Anchor says if AD and AS shock pushes Y away from Y* in short
run (output gap) but then the W adjusts until Y = Y*, Y* is an anchor for output and here
U rate = NAIRU, U* so there is both structural and frictional unemployment
G. ***look at graph slide***
H. it matters HOW QUICKLY, wages adjust: when Y doesn't = Y*, the speed of return to Y*
I. if you are a firm, you don't care about the wage P if the P you can sell your product at
the higher wage is higher than the P at the lower wage. So even though money wages
may not come down, it is the adjustment that matters.
J. in the LONG-RUN E: reach it when factor Ps no longer adjust to output gaps, Y = Y*
1. The vertical line at Y* is sometimes called the LG aggregate supply cute, or classical
aggregate supply curve
The Fiscal Stabilization Policy
The motivation for fiscal stabilization policy is to reduce the volatility of aggregate outcomes
I. When an AD or AS shock pushes Y AWAY from Y*, the alternatives are:
A. use fiscal stabilization policy through change in the budget deficit and surplus
The paradox of Thrift and Recessions:
I. to get economy out of recession in SR, it is better for spending to increase i.e for SAVING
II. in the long run, there is no paradox between what the individual wants and how economy
III. an increase in desired saving has the effect of price level falling, investment rising and this
all causes the growth of aggregate output (Y*)
Automatic vs. Discretionary Fiscal Policy
I. transferring money from people at the top, to people at the bottom end who spend just about
everything they have to create stabilization.
A. There is a difference between economies in that some are more advanced than others in
being able to take from the top and give to the bottom through final policy. The average
tax rate makes the simple multiplier decrease = a response to the shock
B. The lower tax rate at lower incomes INCREASES simple multiplier
Practical Limitations as Discretionary Fiscal Policy
-most economists agree automatic fiscal stabilizers generally work well but they are
concerned about discretionary fiscal policy
-limitations come from:
1. long and uncertain lags
2. different policy impact on temp vs. permanent changes (like houses increase spending less
if they think tax cuts are temp rather than permanent)
3. fine tuning is VERY HARD so gross tuning to big output gaps is more feasible
Fiscal Policy and Growth
I. Fiscal stabilization policy is the trade off between SR benefits vs LR econ growth
Is there any increase G can increase Y*?
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