Textbook Notes (363,501)
Canada (158,383)
Economics (923)
ECN 301 (20)
David Lee (4)
Chapter 8

Week 6 Chapter 8

7 Pages
Unlock Document

Ryerson University
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
More Less

Related notes for ECN 301

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.