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ECN 301 (20)
David Lee (4)
Chapter 8

Week 6 Chapter 8

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ECN 301
David Lee

Intermediate Macroeconomics 1: Theory Week 6 Chapter 8 Real GDP in Canadian History • The flexible-price model does not give a complete picture of the macroeconomy – real GDP does not always grow by the same rate as potential output – the unemployment rate is not always at the natural rate – inflation is not always steady Business Cycles • Fluctuations in economic growth are called business cycles • A business cycle has two phases – expansion or boom • production, employment, and prices all grow rapidly – recession or depression • production falls, unemployment rises, and inflation falls • To understand business cycles, we need a model that does not always guarantee full employment • We will no longer assume that prices are flexible • Instead, prices will be assumed to be “sticky” – they will remain fixed at predetermined levels as businesses expand or contract production The Sticky Price Model • When prices are "sticky” they will remain fixed as businesses expand or contract production in response to changes in demand and costs. • Sticky prices drive a wedge between real GDP and potential output and between the supply of workers and the demand for labour. • When prices are "sticky” firms change output in response to changes in aggregate demand – We then say, output is demand determined. • Hence, in studying the mechanics of the sticky price model we start with a detailed study of the components of aggregate expenditures – Consumption, investment, government expenditures and net exports Flexible vs. Fixed Price Models www.notesolution.com • To contrast the difference between the flexible price model and the fixed price model consider the effects of a fall in autonomous consumption (C0). A Decrease in Autonomous Consumption (C0) • Under the flexible-price model, the decline in the real interest rate will lead to a decline in the velocity of money – the price level will fall • In the flexible-price model, the consequences of a fall in consumers’ desired baseline consumption are – a drop in consumption – an increase in savings – a decline in the real interest rate – a rise in investment – a rise in the value of the exchange rate -a decline in the price level • In the sticky-price model, a drop in consumption leads to a drop in aggregate demand • As businesses see the demand for their products falling, they cut back production – they will lay off some of their workers – incomes will fall • In the sticky-price model, a drop in consumption does not lead to an increase in savings – the increase in savings (from the fall in consumption) is exactly offset by a decrease in savings (from the fall in income) • The real interest rate is unaffected – no change in investment or net exports Summary of A Decrease in Autonomous Consumption (C0) • In the sticky-price model, the consequences of a fall in consumers’ desired baseline consumption are – a drop in consumption – a decline in production – a decline in employment – a decrease in national income – no change in the real interest rate, investment, or the exchange rate Expectations • Price stickiness causes problems only in the short run www.notesolution.com • If individuals had time to foresee and gradually adjust their wages and prices to changes in aggregate demand, sticky prices would not be a problem – both the stickiness of prices and the failure to accurately foresee changes are needed to create business cycles Short Run vs. Long Run • In the short run, prices are sticky – shifts in policy or in the economic environment that affect the level of aggregate demand will affect real GDP and employment • In the long run, prices are flexible – individuals have time to react and adjust to changes in policy or the economic environment – real GDP and employment are unaffected Why Prices Are Sticky • Menu costs are costs associated with changing prices – changing prices can be costly for a variety of reasons – managers and workers may prefer to keep prices and wages stable as long as the shocks that affect the economy are relatively small • Managers and workers lack full information about the state of the economy • They may confuse changes in economy-wide spending with changes in demand for their particular products – cut production rather than cutting the price of the product • The level of prices is often determined by “what is fair” • Work effort and work intensity depend on whether or not workers feel that they are treated fairly – most managers are reluctant to cut wages – if wages are sticky, firms will adjust employment when aggregate demand changes • Managers and workers may suffer from money illusion – confuse changes in nominal prices with changes in real prices • firms react to higher nominal prices by believing that it is profitable to produce more • worker
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