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Domestic Demand = C + I + G
Net Export = (X-M)
Public Sector (Spending/Saving)= G + X
Private Sector = C+ I + M
Cyclical deficit is the portion of a country's budget deficit, which reflects changes in
the economic cycle. Budget positions tend to deteriorate as economies slow as tax
revenues fall and welfare spending rises; they improve as economic growth returns,
tax revenues rise and welfare spending is reduced.
Structural deficit is a budget deficit that results from a fundamental imbalance in
government receipts and expenditures, as opposed to one based on one-off or shortterm factors
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-2.0
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2012
2013
2014
0.0
United States
Spain
-4.0
-6.0
-8.0
GDP increase means real income and production are growing (real growth)
increasing living standard
Nominal terms GDP means that there is no real growth in living standards
(higher wages, higher prices, inflation)
Low inflation rate is important to economists, central bank directors, and politicians
because by keeping inflation rate low, a low unemployment rate will be the result in
the long run.
In the long run, the best way to keep unemployment low is to keep inflation low. In
the short run, these policies and strategies to lower inflation can cause
unemployment rates to increase temporarily. But over time this balances and the
inflation rate impacts the unemployment rate significantly.
8.0
7.0
6.0
5.0
4.0
Unemployment rate
3.0
Inflation
2.0
1.0
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
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2012
0.0
4.0
6.0
8.0
Cost-push
Increasing oil and other commodity prices
Increasing wages
Expected inflation
Inflation targets of the central bank
Historic inflation
***Expected inflation***
What do different parts of the economy expect of the inflation rate in the next
years (labor unions, employer associations)
Negotiating the wages for the next two years, inflation impacts the wages
Unions might request a wage increase of 5%
Nominal wage: 5%
CPI (inflation increase): 2%
Real wage = 3%
Expected inflation rate lately has been around 2% a year
Based on historic values of inflation rates in previous years, the inflation rate
can be expected to increase at the same rate
AD= C+I+G+(X-M)
C is 60% of the Aggregate Demand structure
Investment: house building, etc.
Government consumption: government salary, expenses, etc.
Net export: in Denmark it is positive to aggregate demand, export is higher
than import
Net export is the main reason that the AD curve slopes down, because the
price level creates a level of competitiveness that allows Denmark to
compete on a global scale and export more (if price was too high,
competitiveness would be low, and there would be less export and more
import)
AS short-run = MC (Marginal Costs)
If price level is low, it would be less profitable for companies to produce and
sell, so supply would be lower
AS long-run
In the long run, the economy will have the tendency to move towards the
long run aggregate supply curve
Economic forces will start to move output towards long run aggregate supply
Long term equilibrium also relates to the labour market (AD,ASL, and labour
market)
The natural unemployment rate or structural unemployment rate (5%-5.5%
in Denmark) has to do with the labour market and flexibility of citizens,
equilibrium is where the actual unemployment rate is equal to the structural
unemployment rate (Demand = Supply)
If it is regular 5%, and the rate is at 3% then companies cannot find the
qualified workers; the supply is lower than demand
If the rate is 8%, the supply is higher than the demand by 3%; this has to do
with cyclical unemployment (those who are in transition to a new job, or will
be unemployed for a short period of time)
Structural unemployment is very high in Spain; has something to do with
flexibility, where Spanish people are very unlikely to move to the other side
of the country for a job due to cultural factors
Inflation
2% inflation rate is a generally accepted target in most countries
Export prices go up with higher inflation (domestic inflation), bad for
competitiveness
Flexible exchange rate: If domestic inflation is higher than another country, the
competitiveness will go down, import will go up for foreign currency, the
demand for foreign currency will go up, exchange rate of foreign currency will
go up, the exchange rate of domestic currency will depreciate
With flexible exchange rates, higher inflation rate will cause currency to
depreciate and the competitiveness will go unchanged in relation to imports
and exports
Frictional (skiftearbejdslshed)
The number of unemployed people this week, will be
temporary in correspondence with the fact that the majority of
these frictionally unemployed people will get a new job the
next week (up to 50,000 out of 160,000 unemployed are
frictional)
In the summer 2008 the unemployment rate was down to 2 %. How is this
unemployment compared to the structural? Analyse in an AD/AS chart
inflationary/recessional gap.
Yp, Yo= inflationary gap (% difference between the two) bottleneck (labor
market)
Yo= 2% unemployment rate
-Artificially low, unsustainable
-Qualified workers were in high demand, companies competed for the
highly skilled workers and so have to go into wage competition,
increasing wage costs therefore increasing prices of products
increasing inflation
-Shortage of qualified workers but a low unemployment rate =
bottleneck on the labor market
-Higher wages is a huge component of marginal costs on the aggregate
supply curve, which pushes up prices of products
Macroeconomic Policy
Impact on demand
Definition: when a government changes either the level of taxation and/or the level
of government spending to actively promote achievement of macroeconomic
objectives (note: short-term objectives)
Example When C and I decreased, AD decreased as well. This causes prices to drop (deflation,
price instability) and unemployment to go up, it also decreased national output.
The economy is expected to reach potential output in the long run; fiscal policy will
try to push the aggregate demand back to equilibrium with potential output.
With
lower
taxes, people have more money to spend, which increases aggregate demand and
then directly increases price levels, output, and lowers unemployment to reach
equilibrium once again.
By increasing G (direct component of AD), price levels will rise, output will increase,
and unemployment levels will improve)
Demand-pull inflation:
Phillips curve correlation ( increased private consumption (C)= lower
unemployment and higher inflation (moving to the left on the curve)
Issues: unsustainable unemployment (artificially low), inflationary problems i.e. high prices, and low
competitiveness
Goals: decrease AD, stabilize inflation and price level, adjust unemployment rate to match the
natural/structural level
Increased AD causes Inflationary Gap: real GDP is higher than potential output
They can increase taxes, and/or lower government spending to slow down an
economy that is moving too fast (or where unemployment is artificially low).
By
increa
sing taxes, the government will decrease the amount of money people have to spend
and private consumption will go down in response. Since C is a direct component of
AD, aggregate demand will decrease. Because of the decrease in AD, price levels will
start to go down and national output will decrease. Correspondingly, unemployment
levels will go up as the inflationary gap disappears. Normally this would be bad for
the economy, but because unemployment levels were above the natural level it was
bad for the economy.
Since G is a direct component of AD, it will directly lower aggregate demand. As this
occurs the price levels will go down, national output will reach potential output, and
unemployment levels will level out at the national natural level.
To illustrate contractional fiscal policys short-term impact on the inflation rate and
the unemployment rate, we can see that as the inflation rate (price level) decreases,
the unemployment rate will increase in response. This is okay when referring to
contractionary fiscal policy because those are two of the goals in the current
example.
***We would NOT use this policy if unemployment levels were an issue***
This policy is also used when there is a structural government deficit; by increasing
taxes and lowering government spending the government can start to repay its
debts.
The only way a country can repay their loans is to enforce a contractionary fiscal
policy, so that they can reach a surplus in the next booming period (if they have a
structural deficit). They are trying to correct the business cycle, and improve the
unemployment that is currently a problem in many countries. If they start to repay
their loans, and increase tax receipts compared to government spending, then they
can start to focus on increasing real growth.
With a contractional fiscal policy, they will reduce unemployment rates, lower
government debt, improve the current government balance, and later improve their
competitiveness and real growth. Ideally, if this policy works, then the structural
deficit and the financial crowding out will be significantly improved.
***General Fiscal Policy Note***
Crowding out
Financial crowding out (interest rate) expansionary fiscal policy
(increase GDP, increase interest rates, I&C will go down, GDP will go
down, and the process starts over with fiscal policy to increase GDP
As interest rates increase making it difficult for some countries to pay
back loaned money, the only way to fix it is to lower government debtcontractionary fiscal policy
Inflationary crowding out a fiscal policy that is too expansionary
causing inflation and lower aggregate demand. Risk of inflationary
crowding out in Denmark and German, is quite high; unemployment
Taxes Up
Income transfers
Down
Automatically and
without delay
Demand and
income rise
effectively reduced
Stabilized
business
cycle
More VAT will automatically increase through more people working, and income
rises. This will immediately impact private consumption as people pay more taxes.
As unemployment rate goes down, more people are working so government income
transfers will go down (social benefits). In Denmark, there is a high level of income
transfers & high level of taxes, which makes the automatic fiscal stabilizers very
effective; private consumption will be limited effectively from the high taxes.
In Denmark the increase in income will be taxed by at least 50%; in USA the
increase in income will be taxed by less so their private consumption is not very
limited. In this way, the USA also has a very weak unemployment benefit system
compared to Denmark so the recessional period would also be much more severe
than there.
Discretionary Fiscal Policy
A boom with rising demand and income =>A political decision to increase taxes or to
reduce G =>Demand and income down => Risk of destabilization of business cycle
Boom with
rising demand
& income
Political
decision:
increase taxes
or reduce G
Demand and
income
decrease
Risk of
destabilizing
business
cycle
(time lag)
This also means active fiscal policy, through political decisions to increase taxes and
reducing government spending. Through this system, the time might cause a delay
in the response to the economic cycle. This is a political decision to intervene, and
directly impact the aggregate demand through government policy. Discretionary
fiscal policys aim is to correct a business cycle that they do not believe will correct
itself in the short run or at all.
Automatic adjustment of LONG-TERM economy:
Recession ( increased cyclical unemployment ( wages go down ( competitiveness
goes up ( net export goes up ( GDP goes up (AS1 marginal costs decrease with lower
wages, curve shifts to the right to meet equilibrium with AD)
Are wages flexible or sticky? With cyclical unemployment, wages are very sticky, it
takes a very long time for wages to decrease (in a recessional period, the growth
rate of wages will decrease, but actual wages will not drop quickly)
Fiscal Policy & Government Balance
***Important to distinguish between Cyclical & Structural government deficit***
G is increased by 10 billion, and the government deficit is changed from 0 to 10 in the short run (a)
After 1 to 2 years Y is increased according to the multiplier, F.x by 12 bill (b)
Due to increased Y, tax receipts will go up and income transfers down and
government deficit will go down by for example 6 bill (c)
In the end an expansionary fiscal policy will increase government deficit, but
less than the increase in G
Tax receipts Government expenditures = government balance
Automatically, by spending 10, billion government deficit will increase in the short
run, but after 1-2 years GDP will increase and deficit will decrease with increased
tax receipts as unemployment decreases
Government Balance & Debt
Government deficit
o Cyclical: increasing unemployment decreases taxes and increases
government transfers
o Structural: if there is a deficit without cyclical unemployment, taxes
are basically smaller than government expenditures
o Deficit as pct. of GDP>GDP growth rate => Debt as pct. of GDP
increases =>Financial markets demand higher interest rates (risk
premium) => Financial crowding out
the capital markets will increase interest rates with an added risk premium for the
countries they are skeptical about. This effect can be bad for GDP; increased interest
rates are worse for GDP than the positive effects of the expansionary fiscal policy on
GDP (cancels out positive effects). The financial crowding out has been reduced
significantly over the past couple years, due to a contractionary fiscal policy to
reduce the structural deficit so that they can face a surplus on the government
balance; only then can the countries start to repay their loans.
***If a country has a fixed exchange rate you should not use monetary policy (very
bad), but with a fiscal policy***
***If a country has a flexible exchange rate you should use monetary policy, but NOT
fiscal policy***
Expansionary Monetary policy, fixed exchange rates ( cannot be used in Denmark
because as soon as the Danish interest rate is a little lower than the Euro interest
rate there will be a capital outflow from Denmark into the Eurozone, and the
solution is to increase the interest rate to match the Euro interest rate. Denmark
cannot change its interest rate independent of the Euro interest rate, so it must be
the same. Otherwise, there will be a large capital inflow or outflow. Not an option for
Denmark (dependent on central bank in Frankfurt).
Capital outflow occurs because there is no risk taking advantage of the higher
interest rate in the Euro; no risk of loss due to fixed exchange rate (in USA with a
flexible exchange rate, there would be a risk that the dollar could depreciate and
there would be a loss in the savings).
A low interest rate is good for private consumption and more investments, which is
used to improve the economic growth. If the economic situation in Denmark is
similar to the economic situation in the Eurozone, there is no problem that Denmark
cannot enforce monetary policy (normally, the economic needs are the same in
Denmark and the Eurozone). If the relationship is unharmonious then it becomes a
problem that Denmark cannot use monetary policy to impact interest rate.
Monetary Policy
Monetary policy mainly short term interest rates and money supply (affects
investments and asset prices: house prices and share prices) Lower interest rates
will cause house prices to increase (demand goes up), share prices will increase
because it becomes more attractive to buy shares than bonds because bonds have a
ridiculous interest rate.
***Important for countries with flexible exchange rates***
Definition: The actions of a central bank, currency board or other regulatory
committee that determine the size and rate of growth of the money supply, which in
turn affects interest rates. Monetary policy is maintained through actions such as
increasing the interest rate, or changing the amount of money banks need to keep in
the vault (bank reserves).
In the United States, the Federal Reserve is in charge of monetary policy. Monetary
policy is one of the ways that the U.S. government attempts to control the economy.
If the money supply grows too fast, the rate of inflation will increase; if the growth of
the money supply is slowed too much, then economic growth may also slow. In
general, the U.S. sets inflation targets that are meant to maintain a steady inflation of
2% to 3%.
Expansionary Monetary Policy
MS = IR = I
= AD PL , Y , Competitiveness , X , M
Money market
rate down
MD>MS
Central bank
increases MS
Money Demand
=
Money supply
The leading rate is the interest rate that is controlled by the central bank in
Denmark it is called the 1-Week interest rate
-
The central bank will first lower the short term interest rate, which will
cause money demand to increase ( since the central bank is also in control of
money supply, they will then increase the money supply until a new
equilibrium is formed at the higher level of demand for money
When the central bank lowers the interest rate, the demand for money
increases and equilibrium is lost (this is why the money supply also needs to
shift in order for there to be a balance of supply and demand curves)
The central bank will also impact the market rate from banks
Expansionary monetary policy normally only affects the short term interest
rate (refer to the horizontal interest rate structure)
Long- term interest Rate
Central bank buys long term bonds on the market =>Bonds price up =
Interest rate down
Bond's prices go up
For 30 years, until 1-2 years ago, long-term interest rate was not a factor in
expansionary monetary policy instruments (historically, this monetary policy only
directly affected the short term interest rates)
***A lower interest rate will attract consumers to spend now and save less; with
a low interest rate the demand for houses will go up and the house prices will go
up; asset prices will go up i.e. house prices and share price; psychological effect
will cause people to feel they have more money, which increase private
consumption due to an optimistic view on economic stance for private
consumers***
Exchange-rate transmission mechanism
-
Interest rate down, demand for foreign assets up, exchange rate down =
capital outflow causing demand for foreign currency to go up, and the
exchange rate will go down (depreciation of domestic currency), increases
This policy is typically used to slow down economic growth, prevent or reduce
inflation increases, increase interest rates, lower investments, and decrease AD. Not
usually seen unless inflation rates are above the 2% target rate.
MS = IR
=I
= AD PL , Y , Competitiveness , X , M
The increase in interest rates will decrease investments and lower AD, the
government will sell bonds . As bond prices drop, the interest rates go up and capital
investments decrease. The higher interest rates make domestic bonds more attractive on
the foreign market, and the exchange rate goes up (currency appreciates). This lowers their
competitiveness, and it becomes more expensive for countries to import from them; their
exports decrease and their imports increase, negatively affecting their net export and AD.
As the AD drops the price level drops and their national output decreases, with this the
unemployment levels will rise and in the best case scenario a new equilibrium will be met
and the inflationary gap will be closed.
Exchange Rate Policy Devaluation
Reasons to Devaluate a Currency:
Promote price stability, allowing a low & stable inflation rate
Improving a countries competitiveness
Promoting consumer and investor certainty
Enhancing export competitiveness
Devaluation with fixed (but adjustable) exchange rates
Examples
Greece leaves the EUR and Drachmer depreciates
Denmark devaluates DKK (EUR 100 = DKK 700)
Depreciation = a fall in the value of a currency in a floating exchange rate. This is not
due to a governments decision, but due to supply and demand side factors,
although, if the government sold a lot of pounds, they could impact the depreciation.
Presently, Denmark does not need to devaluate the kroner because their
inflation rate is only at 1.5%. If they did, the capital market would expect the
exchange rate to go down, there would be a capital outflow and the interest
rate would increase immediately (people would take their money out of
Denmark before they devaluated the currency).
***If a country has a fixed exchange rate you should not use monetary policy (very
bad), but with a fiscal policy and vise versa
If a country has a flexible exchange rate you should use monetary policy, but NOT
fiscal policy***
The increased SRAS (short-run aggregate supply) closes the recessionary gap
while lowering price level at the same time (shift Phillips curve to the left)
Increase SRAS= higher national output, decreased unemployment rate, lower prices
The deflation is desirable for consumers, lower prices promotes spending.
Market-based supply side policy Instruments (Recessionary Gap)
Market-based supply side policies are used when government wants to reduce its
role in the economy. They are policies that are implemented by the government,
aimed at encouraging production and consumption by the free market and thus
stimulating economic activity without increased government intervention.
Deregulation: leads to lower costs among producers, encouraging producers to
increase their output, hire more workers, & charge lower prices for their goods to
lead to higher national output, improved unemployment rate, and lower prices.
(Examples: environmental regulation, work place safety laws,
requirements for employers to give benefits to employees, all cause higher
costs for companies)
Deregulation will attempt to remove these regulations
More output at lower costs of production (GDP up)
Free market competition, improves efficiency
The unemployment rate being reduced from 4 to 2 years could reduce the structural
unemployment rate, because it causes a sense of urgency for people to accept
various jobs instead of waiting for the perfect one to appear. First 6 months, most
unemployed workers will find a job. After 6 months, it becomes very unlikely for
people to return into the labor market, until the period right before the 4 years
unemployment is finished (people are more accepting of lower paid jobs, because it
is necessary). After 2 years of unemployment, it becomes structural unemployment
employers feel that the person mightve lost their skills and abilities and it is
almost impossible to come back to a well-paid job. The probability of returning to
the labor market after 2 years is much higher than the probability after 4 years
lowering the structural unemployment rate permanently.
Shift long run aggregate supply curve to the right through supply side economic
policy ( Yp to Y2
Supply side economic policy is important to move potential output to the right
because increasing the annual growth rate (3%) causes a progressive curve (100,
103.1, 106.4, etc.). Means living standard goes up every year. But, there will be
business cycle fluctuations over the GDP annual growth curve NOT shown above.
(Recessional gap = GDP could be higher = monetary, fiscal, devaluation policy to
reduce the gap) (Inflationary gap = GDP is higher than its potential).
USA has a huge IT sector, higher productivity per person than in Denmark. Per
working hour productivity, proficiency is much higher. Potential output curve is
a result of the production factors size and quality of these factors impact the
potential output. Structural reforms must be used on the supply side to impact the
potential increase size of production factors and quality of them.
Aging of the population will cause the potential output to go down the labor force
participation rate will decrease as more people retire. This would cause potential
output to move to the left from Yp.
The living standard will go down in the future fewer taxes will cause a permanent
structural government deficit. Can use contractionary fiscal policy to impact the
structural deficit. Or reforms such as increasing retirement age to impact the labor
force.
Impact the structural unemployment rate reducing unemployment benefit from 4
to 2 years to lower structural unemployment rate unemployed people will be
more accepting and willing to take different jobs quicker = good for structural
unemployment rate.
Hi Chelsea,
Supply side policy could be labour market policy. This will increase labour
supply and shift long run AS to the right. In this way Y can rise without an
inflationary gap. If increasing labour supply means lower wage growth this
policy reduces company costs (MC) and short run AS shifts to the right.
I hope - and I am sure - that you will perform very well tomorrow.
Niels
6. Using the tax system to provide incentives to help stimulate factor output, rather
than to alter demand, is often seen as central to supply-side policy. This
commonly means reducing direct tax rates, including income and
corporation tax. Lower income tax will act as an incentive for unemployed
workers to join the labor market, or for existing workers to work harder.
Lower corporation tax provides an incentive for entrepreneurs to start and
so increase national output.
7. Other supply-side policies include the promotion of greater competition in labor
markets, through the removal of restrictive practices, and labor market
rigidities, such as the protection of employment. For example, as part of
supply-side reforms in the 1980s, trade union powers were greatly reduced
by a series of measures including limiting worker's ability to call a strike, and
by enforcing secret ballots of union members prior to strike action.
8. Measures to improve labor mobility will also have a positive effect on labor
productivity, and on supply-side performance. This improves labor market
flexibility.
9. Better education and training to improve skills, flexibility, and mobility also
called human capital development. Spending on education and training is
likely to improve labor productivity and is an essential supply-side policy
option, and one favored by recent UK governments. A government may
spend money directly, or provide incentives for private suppliers to enter the
market. Government may also set and monitor standards of teaching, and
force schools to include a skills component in their curriculum.
10.
Government can encourage local rather than central pay bargaining. National pay
rates rarely reflect local conditions, and reduce labor mobility. For example, national
pay rates for Postmen do not reflect the fact that in some areas they may be in short
supply, while in other areas there may be surpluses. Having different rates would
enable labor to move to where it is needed most.
barriers to entry, encourage new and dynamic market entrants, and improve
overall supply-side performance. The effect of this would be to make
markets more competitive and increase efficiency. Promoting competition is
called competition policy.
3. Privatization of state industry was a central part of supply-side policy during
the 1980s and 1990s, and helped contribute to the spread of an enterprise
culture. As long as privatization is accompanied by measures to promote
competition, there are likely to be efficiency gains for the firm, and
productivity gains for the employees.
Supply side performance can also be improved if there is a constant supply of new
firms. Small businesses are often innovative and flexible, and can be helped in a
number of ways, including start-up loans and tax breaks.
Aggregate supply (AS) measures the volume of goods and services produced
within the economy at a given price level.
AS represents the ability of an economy to deliver goods and services to meet
demand
The nature of this relationship will differ between the long run and the short
run
1. Short run aggregate supply (SRAS) shows total planned output when prices
in the economy can change but the prices and productivity of all factor inputs
e.g. wage rates and the state of technology are held constant.
2. Long run aggregate supply (LRAS): LRAS shows total planned output when
both prices and average wage rates can change it is a measure of a
countrys potential output and the concept is linked to the production
possibility frontier
In the long run, the LRAS curve is assumed to be vertical (i.e. it does not change
when the general price level changes)
In the short run, the SRAS curve is assumed to be upward sloping (i.e. it is
responsive to a change in aggregate demand reflected in a change in the general
price level)
The main cause of a shift in the supply curve is a change in business costs for
example:
Changes in unit labor costs: Unit labor costs are wage costs adjusted for the
level of productivity. A rise in unit labor costs might be brought about by
firms paying higher wages or a fall in the level of productivity
Commodity prices: Changes to raw material costs and other components e.g. the
prices of oil, copper, rubber, iron ore, aluminum and other inputs will affect a
firms costs
Exchange rates: Costs might be affected by a change in the exchange rate, which
causes fluctuations in the prices of imported products. A fall (depreciation) in
the exchange rate increases the costs of importing raw materials and
component supplies from overseas
Government taxation and subsidies:
Lower duty on petrol and diesel would lower costs and cause an outward
shift in SRAS
The price of imports:
Cheaper imports from a lower-cost country has the effect of shifting out SRAS
demand is based on the state of production technology and the availability and
quality of factor inputs.
Seemingly small differences in growth rates can have a large impact over a
period of many years. For example, if an economy grew by 2 per cent every
year, it would double in size within 35 years; if it grew at 2 per cent a year, it
would double in size after 28 years - seven years earlier
A long run production function for a country is often written as follows:
Y*t = f (Lt, Kt, Mt)
Y* is a measure of potential output
t is the time period
L represents the quantity and ability of labor input available
Kt represents the available capital stock
Mt represents the availability of natural resources
LRAS is determined by the stock of a countrys resources and by the productivity of
factor inputs (labor, land and capital). Changes in the technology also affect
potential real national output.
Causes of shifts in the long run aggregate supply curve
Any change in the economy that alters the natural rate of growth of output shifts
LRAS. Improvements in productivity and efficiency or an increase in the stock of
capital and labour resources cause the LRAS curve to shift out. This is shown in the
diagram below.
One of several specific aggregate supply determinants assumed constant when the
aggregate supply curves (both long run and short run) are constructed, and which
shifts the aggregate supply curves when it changes. An increase in the capital stock
causes an increase (rightward shift) of both aggregate supply curves. A decrease in
the capital stock causes a decrease (leftward shift) of both aggregate supply curves.
Other notable aggregate supply determinants include the technology, energy prices,
and the wages. Capital stock comes under the resource quantity aggregate supply
determinant.
Capital stock is the total quantity of capital used in the production of goods
and services, including factories, buildings, equipment, tools, and machinery.
Without capital, workers obviously have to do ALL production by hand. Capital
makes labor productive. More capital makes labor more productive. Changes
in the capital stock depend on the difference between business investment
expenditures and capital depreciation. If investment in new capital exceeds
the depreciation of existing capital, then the capital stock expands. If
depreciation exceeds investment, then the capital stock contracts.
The size of the capital stock affects the economy's production capabilities. A larger
capital stock means greater production capabilities and a small capital stock means
lesser production capabilities. In particular, a larger capital stock enables more real
production at a given price level, causing an increase in both long-run and short-run
aggregate supply. A smaller capital stock means less real production at a given price
level, causing a decrease in both long-run and short-run aggregate supply.
Evaluation
The Advantages
1. Supply-side policies can help reduce inflationary pressure in the long term
because of efficiency and productivity gains in the product and labor markets.
2. They can also help create real jobs and sustainable growth through their positive
effect on labor productivity and competitiveness. Increases in competitiveness will
also help improve the balance of payments.
3. Finally, supply-side policy is less likely to create conflicts between the main
objectives of stable prices, sustainable growth, full employment and a balance
of payments. This partly explains the popularity of supply-side policies over the last
25 years.
The Disadvantages
1. However, supply-side policy can take a long time to work its way through the
economy. For example, improving the quality of human capital, through
education and training, is unlikely to yield quick results. The benefits of
deregulation can only be seen after new firms have entered the market, and
this may also take a long time.
2. In addition, supply-side policy is very costly to implement. For example, the
provision of education and training is highly labor intensive and extremely
costly, certainly in comparison with changes in interest rates.
3. Furthermore, some specific types of supply-side policy may be strongly
resisted as they may reduce the power of various interest groups. For
example, in product markets, profits may suffer as a result of competition
policy, and in labor markets the interests of trade unions may be threatened
by labor market reforms.
4. Finally, there is the issue of equity. Many supply-side measures have a
negative effect on the distribution of income, at least in the short-term. For
example, lower taxes rates, reduced union power, and privatization have all
contributed to a widening of the gap between rich and poor.
Furthermore.
Most supply-side policies are designed to improve the long-term performance of the
economy. They clearly have short run effects - but we should really judge supplyside policies by measuring the extent to which the United Kingdom economy is able
to sustain economic growth over a number of years and raise total employment and
average living standards.
Long run aggregate supply is determined by productive resources available to meet
demand. Also, by the productivity of factor inputs (labor, land and capital). Changes
in technology also affect the potential level of national output in the long run.
In the short run, producers respond to higher demand (and prices) by bringing
more inputs into the production process and increasing the utilization of their
existing inputs. Supply does respond to change in price in the short run - we move
up or down the short run aggregate supply curve.
In the long run we assume that supply is independent of the price level (money is
said to be neutral) - the productive potential of an economy (measured by LRAS) is
driven by improvements in productivity and by an expansion of the available factor
inputs (more firms, a bigger capital stock, an expanding active labor force etc.). As a
result we draw the long run aggregate supply curve as vertical.
Balance of Payments
compensate. The two ratios reflect each other, it is also seen in historic economic
data.
Real GDP growth
An inflation-adjusted measure that reflects the value of all goods and services
produced in a given year, expressed in base-year prices. Often referred to as
"constant-price," "inflation-corrected" GDP or "constant dollar GDP".
Unlike nominal GDP, real GDP can account for changes in the price level, and
provide a more accurate figure.
Keynes's interest-rate effect law tells us that, as price levels decrease, saving
increases, and interest rates fall. This is good for individuals taking out money for
mortgages and loans. But for those investing in bonds and certificates of deposits
(CDs), this phenomenon decreases their return.
The Mundell-Fleming model proposes that in this situation people will begin to
invest in foreign countries. The real exchange rate for domestic currency
depreciates, and net exports increase because it is cheaper for foreigners to buy
domestic goods from a country whose currency value has decreased (Figure 1). The
increase in net exports causes aggregate demand to increase. As the price level
drops, interest rates fall, domestic investment in foreign countries increases, the
real exchange rate depreciates, net exports increase, and aggregate demand
increases. In other words, a lower price level at home will cause investment in other
currencies; this movement will depreciate the home currency. A lower-valued
currency will mean fewer imports and more exports. The change in net exports will
mean that the quantity of real GDP produced is higher.
1/0.01=100
Yen/USD = how many Yen you get for 1 USD
USD Appreciates
Yen Depreciates
Speculation: a prediction that the value of a certain asset will increase or decrease
in the future
Japanese investors would want to increase their amounts of assets in USD
now if it is expected to appreciate so that they can get a higher return on
their investment demand increases
Speculation of appreciation caused increased demand and appreciates the
currency as expected
Demand for USD in Japan increases supply of Yen in USA increases
4) How will this speculation impact the level of aggregate demand in the USA?
As the USD appreciates, Imports will increase and exports will decrease, causing
Aggregate Demand to decrease. Also, as prices go up consumer spending will go
down and domestic investments will go down as well. When the aggregate demand
decreases, their unemployment levels will worsen, national output will worsen, and
the price levels will go down.
Demand for a countrys exports and/or foreign investments increases then the
countrys currency will strengthen.
Changes in Consumption
Consumer expenditure is the largest element to aggregate demand, and it is
determined by a households disposable income.
Consumer Spending
Domestic consumers can affect aggregate demand because if they decide to buy
more output at each price level, the aggregate demand will shift to the left.
KEY POINTS
Disposable income is income after taxes, often written as (Y-T). Thus, a
change to either Y (income) or T (taxes) affects disposable income and
subsequently consumption.
If consumption decreases, the quantity demanded of goods and
services at every price level also decreases. The aggregate demand
curve thus shifts to the left.
Conversely, if consumption increases, the quantity demanded of goods
and services increases at every price level. The aggregate demand
curve thus shifts to the right.
EXAMPLES
The level of taxation is an example of an event that could change consumption
levels. Theoretically, people should know that an increase in taxes today means a
decrease in taxes tomorrow, so consumption should stay relatively the same.
However, humans do not always behave rationally. In actuality, decreased taxes
tend to lead to an increase in consumption and a rightward shift in aggregate
demand.
Recall that aggregate demand is made up of C + I + G + NX, with C being consumption,
I being investment, G being government spending, and NX being net exports.
Consumer expenditure, also termed consumption, is the largest element to
aggregate demand, and it is determined by a households disposable income.
Consumption is the amount of money people can and will spend on goods and
services. Disposable income is income after taxes, often written as (Y-T). Thus, a
change to either Y (income) or T (taxes) affects disposable income and subsequently
consumption.
Domestic consumers can affect aggregate demand because if they decide to buy
more output at each price level, the aggregate demand will shift to the left. However,
the opposite holds true when consumers buy less output.
The level of consumption is influenced by the following factors:
Consumer wealth: This includes financial assets such as stocks and bonds
and physical assets (house and land). An increase in the real value of
consumer wealth (the stock market) will convince people to buy more
products and save less. This is known as the wealth effect (the effect being a
shift to the right).
Consumer expectations: If people expect their income to rise in the future,
they will spend more of their current incomes, shifting the curve to the right.
Similarly, a widely held expectation of surging inflation in the near future
may increase aggregate demand today because consumers will want to buy
products before their prices escalate. Conversely, the aggregate demand
curve may shift to the left if the economy expects lower future income or
prices.
Household indebtedness: People will spend and borrow, but if they spend
past normal levels, consumers will cut spending, shifting the aggregate
demand curve to the left.
Taxes: A reduction of taxes will raise "take-home income" and ultimately
allow for more consumption. Tax cuts will shift the curve to the right.