Aggregate demand and aggregate supply are graphic representations of short-run a
ID: 1185177 • Letter: A
Question
Aggregate demand and aggregate supply are graphic representations of short-run and long-run economic growth. If supply and demand are the bases of microeconomics, aggregate demand and aggregate supply are the bases of macroeconomic theory.
A) Is the short-run macro economy driven more by aggregate demand or aggregate supply?
B)Give an example in the present economy of short-run aggregate demand at work.
C)Give an example in the present economy of short-run aggregate supply at work.
D) Is keeping the short-run economy in balance the job of government or the private sector?
Explanation / Answer
In this topic we explore the concept of the business cycle. A business cycle occurs due to the fluctuations that an economy experiences over time resulting from changes in economic growth. Understanding business cycles is the essence of a course in macroeconomics. Economists try to discern where the economy is located and more importantly where it is heading in order to deal with possibly adverse future economic events. When the economy is at or is heading in an undesirable direction, economists may apply fiscal or monetary policy tools to change the course of the economy. In general, a business cycle describes changes in the demand-side of the economy as measured by GDP, where: GDP = C + I + G + NX Over time, GDP does not remain constant and will change for many reasons, economic and non-economic. Economic reasons include changes in government policies such as taxes and interest rates. The non-economic reasons are too many to even consider listing, but include factors such as war, drought, natural and man-made disasters. GDP = C + I + G + NX GDP is the sum of consumption + investment + government spending + net exports (exports - imports). This equation can be written in further detail as: GDP = C(Y - T) + I(r) + G + NX Y is equal to income and T represents taxes. (Y - T) gives us disposable income and thus consumption depends on the level of disposable income C(Y - T). r represents the interest rate and investment responds to changes in the interest rate. As r increases, I will decrease. As r decreases, I will increase. Fiscal Policy is represented by the executive and legislative branches of government and captures changes in taxes (T) and government spending (G). In the United States, the president and Congress make these decisions. As we can see from the equation, a decrease in T will increase disposable income (Y - T), increasing C and therefore increasing the growth rate of GDP. Government spending (G) directly affects GDP growth. If the economy is in a recession, a combination of tax cuts and increases in government spending can stimulate economic activity. For example, the U.S. economy saw its first recession in a decade in 2001. Taxes were reduced in 2001, 2002 and 2003 in combination with a 13% jump in government spending over those years. In part, due to the tremendous fiscal stimulus, by late 2003, real GDP growth was in the 7% (at an annual rate) range. Monetary Policy is conducted by the central bank of a country - in the United States this is the Federal Reserve Board. Details will be present later in the class, but the Federal Reserve can increase and decrease interest rates to change business investment (I) in the equation above. Changes in interest rates will also influence consumption, but our focus in this class will be the effect on investment. For example, in the year 2000, the federal funds interest rate was 6.5% and by the summer of 2003, the interest rate had fallen to 1%. Since the majority of interest rates key off the federal funds rate, interest rates fell across the board along with the federal funds interest rate. A critical contributor to the rapid economic growth seen as 2003 wrapped up was due to the economic stimulus provided by the Federal Reserve. Observers have concluded that economics is a somewhat imprecise field, especially when it comes to dealing with business cycles. Economic indicators such as GDP and the inflation rate are trailing indicators. They tell us a good deal about the economy, but importantly they tell us where the economy is at or has been, but not where it is going. For example, the latest quarterly GDP number informs us of economic growth in the past quarter. However, the statistic is not a reliable indicator of economic growth in the current or following calendar quarter. Although there is often a correlation between future GDP growth and past GDP growth, the relationship is easily disrupted and conditions can change rapidly. Economists need to be able to identify changes in the growth trend and to spot these variations by using leading indicators such as changes in business inventories. Knowing current economic conditions is useful information for economists, but knowing where it is going is critical. As noted, economists use leading indicators to try to accurately predict future changes in GDP and the inflation rate. Interpreting the signals given by the leading indicators on what direction the economy is taking is often weakly understood by economists, sometimes the indicators give conflicting signals and the conclusions made are often controversial. The goal of this topic is to discover how economic policy makers interpret and react to business cycles. The two most important macroeconomic variables are the real growth rate of GDP and inflation (the unemployment rate is also crucial, but is closely tied to GDP growth). The goals of economic policymakers are simple: To maintain real GDP growth at a relatively constant, positive level. For example, economists may desire 3.0% annual growth in GDP (1). Compatible with the growth in real GDP, keep the unemployment rate at a level consistent with the full-employment level of unemployment. Remember, full-employment is not zero unemployment, but a level where all those in the labor force seeking work, can find a job fairly quickly. Minimize the level of inflation and keep it there. Optimally, the economy will have a sustained low inflation rate, 3% or below for example. Taking the perspective of the Federal Reserve, ranking the above goals in order of importance yields: Most important - minimize the inflation rate. The Federal Reserve will force economic growth to slow down or even fall into a recession if it sees inflation as too high. Evidence is given by the 1982 recession when the Federal Reserve raised interest rates until the economy tumbled and inflation was taken down. Economists recognize that once high rates of inflation are established, they are very difficult to reduce and should be avoided in the first place. Once the inflation rate is tamed, the Federal Reserve will try to lower the unemployment rate to a level consistent with full employment - currently about 4% in the United States. And once the economy is at full employment, the Federal Reserve will attempt to maintain real GDP growth at a rate equal to the economy's supply side growth rate. (1) Once the unemployment rate is minimized, the Federal Reserve targets a the non-inflationary growth rate of real GDP. This rate is based on supply-side factors of the growth in the labor supply and worker productivity. For example, if the U.S. labor force increases by about 1.0% annually and the yearly increase in worker productivity or output per worker at private nonfarm businesses is estimated to average about 2% each year then the target growth rate equals 3%. It is critical to note that monetary and fiscal policies have no effect on the supply-side growth rate. The policies are used to change demand-side (GDP) growth Before we go into the details of the business cycle, here is a summary of some important points to remember. The policymakers desire to smooth out the business cycle by minimizing the magnitude of variations in economic growth over the course of the business cycle. It is crucial to understand where the economy is going in the future. If the path is not desired, then changes in economic policy can be made today to prevent that path from being realized. For example, assume that real GDP is growing at a desired 3% annual rate. If the Federal Reserve determines that GDP growth will soon slow down to a significantly lower growth rate, it can reduce interest rates today to stimulate future economic growth and try to maintain real GDP growth at 3% in the future. Leading economic indicators are the crystal ball for economic policymakers, and are used to predict the economy's future. Unlike your neighborhood fortune-teller, the economic crystal ball is usually cloudy. As a result, errors in judgment and public policy are possible. Economic policy errors include: GDP growth is too rapid and inflation rates increase to uncomfortable levels, GDP growth slows down too much, leading to an increase in the unemployment rate and possibly a recession. In an attempt to reduce inflationary pressures, economic policymakers will attempt to slow economic growth. The reduction in the growth rate of real GDP corresponds to an economic downturn, where GDP growth has fallen from its peak level. Are economic policymakers stupid? Historically, economic downturns are eventually followed by a recession when real GDP growth actually becomes negative. Recessions are often synonymous with rising rates of unemployment. Rising unemployment rates certainly get the attention of economic policy makers who furiously enact expansionary policies (the durations of recessions tend to be much shorter than positive growth periods). The closest that economic policymakers come to nirvana is during the expansionary phase. The worst is over, economic growth is increasing (often very quickly), jobs are being created, and inflation remains muted. Everyone deserves their day in the sun, but after a brief interlude of happiness, rising inflation causes a storm of tears for even the most optimistic economists. Leading Economic Indicators As noted earlier, economic policymakers try to predict where the economy is heading in the near future based on leading economic indicators. The Fed follows many economic indicators which can give signs regarding changes in future economic growth and inflation. For example, as these economic indicators reach the danger zone, there is increasing likelihood that the economy is overheating and increasing the danger of rising inflation in the near future. Important leading economic variables that the Fed closely monitors include: 1) The unemployment rate: in relation to full-employment. On average, labor comprises roughly 2/3 of total production costs for businesses. When the unemployment rate reaches and then falls below full-employment, labor shortages build. As producers trying to expand production find new workers becoming increasingly scarce, they are forced to add costly overtime and offer higher wages to entice non-labor force members to work. The result is upward wage pressures. Wage increases translate into higher production costs, higher prices for goods and services and an increase in the inflation rate. Another important indicator related to employment is new jobless claims. Released every Thursday, new jobless claims give the number of people who are making an initial claim for unemployment benefits. If the number of new jobless claims is rising over time, the indication is that firms are increasingly laying off workers who then are filing for unemployment. A persistent increase in claims indicates that demand for goods and services is falling and unemployment rates will be rising. On the other hand, if new jobless claims remain constant or are falling, then labor markets are in good shape. Currently, economists consider 400,000 new weekly jobless claims to be the dividing line between a labor market to is adding jobs (on a net basis) and one that is experiencing net job losses. Even in the best of times, workers lose jobs and a number of 300,000, for example, signifies that the economy and labor market are doing very well. The lower the number of new jobless claims, the better for the labor market and people seeking employment. 2) The Labor Cost Index: measures what the title indicates