Question

Analyze the short run and long run effects of an unanticipated decrease in the money supply in the misperceptions model. Tell me what happens to output, the actual price level and expected price level in both the short run and long run.

Answer 1

The Misperceptions Theory

a. Changes in the overall price level can temporarily fool suppliers about what is happening in the markets in which they sell their output.

b. As a result of these misperceptions, suppliers respond to changes in the level of prices and thus, the short-run aggregate-supply curve is upward-sloping.

c. Example: The price level falls unexpectedly. Suppliers mistakenly believe that as the prices of their products fall, it is a drop in the relative price of their product. Suppliers may then believe that the reward of supplying their product has fallen, and thus they decrease the quantity that they supply. The same misperception may happen if workers see a decline in their nominal wage (caused by a fall in the price level).

d. Thus, a lower price level causes misperceptions about relative prices, and these misperceptions lead suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

Societies experience short-run economic fluctuations around long-run trends. These fluctuations are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of income, spending, and production fall, and unemployment rises.

Economists analyze short-run economic fluctuations using the model of aggregate demand and aggregate supply. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply.

The aggregate-demand curve slopes downward for three reasons. First, a lower price level raises the real value of households’ money holdings, which stimulates consumer spending. Second, a lower price level reduces the quantity of money households demand; as households try to convert money into interest-bearing assets, interest rates fall, which stimulates investment spending. Third, as a lower price level reduces interest rates, the dollar depreciates in the market for foreign-currency exchange, which stimulates net exports.

Any event or policy that raises consumption, investment, government purchases, net exports or an increase in the money supply at a given price level increases aggregate demand. Any event or policy that reduces consumption, investment, government purchases, net exports or a decrease in the money supply at a given price level decreases aggregate demand.

The long-run aggregate-supply curve is vertical. In the long run, the quantity of goods and services supplied depends on the economy’s labor, capital, and technology, but not on the overall level of prices.

Three theories have been proposed to explain the upward slope of the short-run aggregate-supply curve. According to the misperceptions theory, an unexpected fall in the price level leads suppliers to mistakenly believe that their relative prices have fallen, which induces them to reduce production. According to the sticky-wage theory, an unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production. According to the sticky-price theory, an unexpected fall in the price level leaves some firms with prices that are temporarily too high, which reduces their sales and causes them to cut back production. All three theories imply that output deviates from its natural rate when the price level deviates from the price level that people expected.

Events that alter the economy’s ability to produce output, such as changes in labor, capital, natural resources, or technology shift the short-run aggregate supply curve (and may shift the long-run aggregate supply curve as well). In addition, the position of the short-run aggregate supply curve depends on the expected price level.

One possible cause of economic fluctuations is a shift in aggregate demand. When the aggregate-demand curve shifts to the left, output and prices fall in the short run. Over time, as changes in the expected price level cause perceptions, wages, and prices to adjust, the short-run aggregate-supply curve moves to the right, and the economy returns to its natural rate of output at a new, lower price level.

A second possible cause of economic fluctuations is a shift in aggregate supply. When the aggregate-supply curve shifts to the left, the short-run effect is falling output and rising prices―a combination called stagflation. Over time, as perceptions, wages, and prices adjust, the price level falls back to its original level, and output recovers.

I. Economic activity fluctuates from year to year.

A. Definition of Recession: a period of declining real incomes and rising unemployment.

B. Definition of Depression: a severe recession.

II. Three Key Facts about Economic Fluctuations

A. Fact 1: Economic Fluctuations Are Irregular and Unpredictable

B. Fact 2: Most Macroeconomic Quantities Fluctuate Together

C. Fact 3: As Output Falls, Unemployment Rises

III. Explaining Short-Run Economic Fluctuations

A. How the Short Run Differs from the Long Run

1. Most economists believe that the classical theory ( MV=PY) describes the world in the long run but not in the short run.

2. Beyond a period of several years, changes in the money supply affect prices and other nominal variables, but do not affect real GDP, unemployment, or other real variables.

3. However, when studying year-to-year fluctuations in the economy, the assumption of monetary neutrality is not appropriate. In the short run, most real and nominal variables are intertwined.

B. The Basic Model of Economic Fluctuations

1. Definition of Model of Aggregate Demand and Aggregate Supply: the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend.

2. We can show this model using a graph.

a. On the vertical axis is the overall price level in the economy.

b. On the horizontal axis is the overall quantity of goods and services.

c. Definition of Aggregate-Demand Curve: a curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

d. Definition of Aggregate-Supply Curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level.

IV. The Aggregate-Demand Curve

A. Why the Aggregate-Demand Curve Is Downward Sloping

1. Recall that GDP (Y) is made up of four components: consumption (C), investment (I), government purchases (G), and net exports (NX).

2. Each of the four components is a part of aggregate demand.

3. The Price Level and Consumption: The Wealth Effect

a. A decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more.

b. The increase in consumer spending means a larger quantity of goods and services demanded.

4. The Price Level and Investment: The Interest-Rate Effect

a. The lower the price level, the less money households need to buy goods and services.

b. When the price level falls, households try to reduce their holdings of money by lending some out (either in financial markets or through financial intermediaries).

c. As households try to convert some of their money into interest-bearing assets, the interest rate will drop.

d. Lower interest rates encourage borrowing by firms that want to invest in new plants and equipment and by households who want to invest in new housing.

e. Thus, a lower price level reduces the interest rate, encourages spending on investment goods, and therefore increases the quantity of goods and services demanded.

5. The Price Level and Net Exports: The Exchange-Rate Effect

a. A lower price level in the United States lowers the U.S. interest rate.

b. American investors will seek higher returns by investing abroad, increasing U.S. net foreign investment.

c. The increase in net foreign investment raises the supply of dollars, lowering the real exchange rate.

d. U.S. goods become relatively cheaper to foreign goods. Exports rise, imports fall, and net exports increase.

e. Therefore, when a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, and U.S. net exports rise, thereby increasing the quantity of goods and services demanded.

6. All three of these effects imply that, all else equal, there is an inverse relationship between the price level and the quantity of goods and services demanded.

B. Why the Aggregate-Demand Curve Might Shift

1. Shifts Arising from Consumption

a. Americans become more concerned with saving for retirement and reduce current consumption. This will decrease aggregate demand.

b. When the government cuts taxes, it encourages people to spend more, resulting in an increase in aggregate demand.

2. Shifts Arising from Investment

a. The computer industry introduces a faster line of computers and many firms decide to invest in new computer systems. This will lead to an increase in aggregate demand.

b. If firms become pessimistic about future business conditions, they may cut back on investment spending, shifting aggregate demand to the left.

c. An investment tax credit increases the quantity of investment goods that firms demand, which results in an increase in aggregate demand.

d. An increase in the supply of money lowers the interest rate in the short run. This lead to more investment spending, which causes an increase in aggregate demand.

3. Shifts Arising from Government Purchases

a. Congress decides to reduce purchases of new weapon systems. This will decrease aggregate demand.

b. If state governments decide to build more state highways, aggregate demand will shift to the right.

4. Shifts Arising from Net Exports

a. When Europe experiences a recession, it buys fewer American goods which lowers net exports. Aggregate demand will shift to the left.

b. If the exchange rate of the U.S. dollar increases, U.S. goods become more expensive to foreigners. Net exports fall and aggregate demand shifts to the left.

V. The Aggregate-Supply Curve

A. The relationship between the price level and the quantity of goods and services supplied depends on the time horizon.

B. Why the Aggregate-Supply Curve Is Vertical in the Long Run

1. In the long run, an economy’s supply of goods and services depends on its supplies of resources along with the available production technology.

2. Because the price level does not affect the determinants of output in the long run, the long-run aggregate-supply curve is vertical at the natural rate of output.

C. Why the Long-Run Aggregate-Supply Curve Might Shift (Remember that I focus on the short-run changes, therefore, you should not expect to see many LRAS shifts on my tests.)

3. Shifts Arising From Labor

a. Large increases in immigration increase the number of workers available. The long-run aggregate-supply curve would shift to the right.

4. Shifts Arising from Capital

a. A dramatic increase in the economy’s capital stock raises productivity and thus shifts long-run aggregate supply to the right.

b. This would also be true if the increase occurred in human capital rather than physical capital.

5. Shifts Arising from Natural Resources

a. A discovery of a new mineral deposit increases long-run aggregate supply.

b. A change in weather patterns (Global Warming) that makes farming more difficult shifts long-run aggregate supply to the left.

6. Shifts Arising from Technological Knowledge