We distinguish between Anticipated and Unanticipated changes, because dynamic adjustment differs depending on whether changes are expected or not. An anticipated change gives people time to make adjustments, whereas an unanticipated changes catches people off guard.

Example: inflation is 5% now and government announces that inflation will be 10% next year or that inflation will be 0% next year. That is different from inflation being 5% and unexpectedly going up to 10% or down to 0%.

Or researchers develop a new high yield drought resistant hybrid seed that increases grain production by 10% (anticipated) vs. unusually favorable weather conditions resulting in a 10% increase in output (unanticipated).

Unanticipated change is change that catches most people by surprise, so that decisions were already made that did not take the event into account. Most economic changes are unexpected, at least by the majority of the people. That is where the role of the entrepreneur becomes important.

P. 225: "Economics is largely about how people respond and markets adjust to change."
 

FACTORS THAT SHIFT AD

AD curve isolates the impact of the price level (P) on the AQ_D of Goods/Services (Real GDP). Factors besides price level (P) changes also affect Real Output (Q) and those factors SHIFT the entire AD curve. Six factors:

1. Changes in Real Wealth - Changes in the price level affect real wealth by changing the real value of cash balances. Real wealth can also be affected by other factors. Examples: a) Stock prices doubled between 1995 and 1998 - this boom represents an increase in real wealth of households holding stocks, mutual funds, pension funds, IRAs, etc. (more than 50% of the population owns stock).  b) The stock market crashed in 1987 by 20% in one day, a decrease in real wealth. AD shifts out (increases) from an increase in wealth, because there is an increase in demand for goods and services - people buy cars, go on vacation, etc. AD shifts back (decreases) from a decrease in real wealth, because people cut back on purchases.

2. Changes in the Real Interest Rate - Interest rates affect decisions of households and businesses in terms of their willingness and ability to borrow.  A new vehicle and an auto loan are like complimentary goods, goods that are consumed jointly. Or houses and mortgages, furniture and credit card debt. If the cost of financing a car or house or furniture goes down, the cost of the joint purchase falls, and the demand increases. Lower int. rates make the cost of buying a car/house cheaper, AD increases, shift out. If real int. rates increases, the joint cost of purchasing a car, home, etc. goes up and the demand decreases, causing AD to decrease (shift in). Same for business borrowing for expansion, property, plant, equipment, etc.

3. Business and Household Expectations about the Economy - Consumer/Business confidence about the future health of the economy, optimism or pessimism about the economy, affects AD. Increased optimism encourages consumption and production, increases AD. Pessimism about the future makes consumers and businesses nervous about spending, the economy contracts, AD falls.

4. Expected rate of inflation - Expected prices in the future, affect AD (AD curve reflects demand NOW - TODAY).  If inflation is expected to accelerate in the future, people will have an incentive to "buy now, before prices go up." AD will increase now when there is an increase in expected inflation.  Expectation of falling prices (deflation) in the future will reduce AD now. Example: waiting to buy a computer in the future when prices are lower.

5. Changes in Foreign Income - will influence our exports. If foreign incomes rise due to an economic expansion in Canada, Europe, etc., this will stimulate demand for US products, exports will increase and AD will increase (shift out).  About 12% of our domestic production is exported, for many European countries exports are closer to 50% of GDP.  If there is a recession in Canada, Japan, Europe or Mexico, demand for our exports will fall, AD will decrease (shift back).

6. Changes in Exchange Rates - To buy US products, foreigners first have to buy US dollars. To buy foreign products, we have to first buy foreign currency. The value of the $ relative to other currencies will influence our exports (sales) to other countries and our imports (purchases) from other countries.

If the dollar is very strong, we can buy lots of yen, pounds or marks, so Japanese, British and German products seem cheap so our imports go up. If our dollar is strong, the foreign currencies are weak, so they find US goods expensive, our exports go down. If Exports go down and imports go up, net exports goes down, and AD decreases.

If the dollar depreciates and foreign currencies appreciate, our goods are cheap to foreigners. Weak dollar means foreign products are expensive to us. Exports (X) will go up and imports (M) will go down, net exports will go up and AD will increase.

See Thumbnail Sketch Summary on page 228.
 

SHIFTS IN AGGREGATE SUPPLY -

What if AD stays the same and there is change in AS? We have to determine if the change is permanent or temporary. If the change is permanent, the LRAS and the SRAS both change, like from a technological change that lowers production costs (information technology, bar codes, etc.), see graph p. 229, panel (a).     

If the change is temporary, only the SRAS shifts, see graph on p. 229, panel (b). An example of a temporary change to the supply side of the economy: a drought in the Midwest. Output temporarily drops that year, but will return to long run potential after the drought, next season, so there is no impact on LRAS.  

What will change LRAS? Same factors that shift the PPF (Chap. 2).

1. An Increase in the Quantity of Resources will Increase LRAS and SRAS.

Examples: a) investment in physical capital results in more machines and equipment
b) investment in human capital results in a more educated, skilled workforce
c) increases in the labor force due to an increase in population or an increase in labor force participation (more women working),
d) increased supply of natural resources, materials (oil exploration), etc.

Any of these increases in either the quantity or quality of resources will allow the economy to produce a permanently higher level of output, shifting out both the SRAS and LRAS.

2. Improvements in Technology That Increase the PRODUCTIVITY of the Labor Force will increase LRAS and SRAS.

Research, development and discovery lead to more efficient methods of production. Machine Age developments - steam engine, internal combustion engine, electricity, nuclear power, etc. Information Age developments - computer and electric technology, fax machines, Internet, VCRs, calculators, bar code systems, etc.  Because of technological advances, we are much more productive in U.S. today than 100 years ago and are much more productive than most other countries.  Productivity increases average about 2% / year for U.S. economy.

3. Institutional/legal factors can influence the LRAS and SRAS.

Having an efficient legal system and institutional framework with enforcement of property rights, including intellectual prop rights, contracts, etc. can increase LRAS and SRAS. Patents, copyrights, trademarks, corporate law, etc. increase LRAS. Having an efficient legal system provides the underlying framework for a market economy.  Emerging economies like Russia, Eastern Europe, have weak legal systems since they have not had private property or private companies for generations.  As they improve the legal framework, they can make significant advances in economic growth.

LRAS (and SRAS) in US has increased annually at 3% on average, LRAS and SRAS curves are shifting out, some periods a little faster than 3% and other periods a little slower than 3 percent.
 

CHANGES IN THE SRAS -

Factors that will temporarily change the SRAS without affecting LRAS:

1. Temporary changes in resource prices and production costs. If a price change is from a permanent change in supply, the LRAS will shift. If the price change is temporary, only the SRAS will change.

Example: temporary favorable or unfavorable ex-rate (strong or weak dollar) for buying foreign resources.

2. Favorable or unfavorable, but temporary, "supply shocks."

Supply shocks are unexpected favorable or unfavorable events that either increase or decrease SRAS.

Examples: unusually good (or bad) weather resulting in large (small) amount of corn/soybeans in one year. OPEC in the 1970s restricting the supply of oil and temporarily raising the world price by a cartel arrangement to temporarily restrict output.  It was not a permanent decrease in the world supply of oil, but an artificial or created shortage by the OPEC cartel.  

3. Changes in the expected rate of inflation.

Changes in expected future inflation influence SRAS, which captures the willingness of suppliers to produce NOW in the current period. If producers expect prices to rise in the future, their willingness to supply them today is reduced - they can wait and get a higher price in the future. An increase in expected inflation will reduce SRAS now. A reduction in expected inflation will increase the incentive to produce now, causing SRAS to increase. Sell now before prices fall (assuming deflation), or sellers will figure: why delay production if prices won't be very much higher in future?

See Thumbnail Sketch, p. 231.  

ANTICIPATED CHANGES IN LRAS

Over time, with improved economic performance due to investments in R&D, investments in human capital, capital formation, technological improvements, gains in institutional efficiency, greater productivity, population increases, etc., the economy expands and the LRAS increases.  Changes in LRAS graphically - see page 232. Starting at equilibrium - LRAS₁, SRAS₁, E₁, P₁ and Y_F1, we have an increase to LRAS₂, SRAS₂, E₂, P₂ and Y_F2 representing a sustainable level of higher real output and income. If MS is fixed, the increase in output will be deflationary, price level falls to P₂.  The long run trend has been a 3% increase in LRAS which would be deflationary as p. 232 shows.  The price level has NOT fallen because of a decrease in the MS.

UNANTICIPATED CHANGES and MARKET ADJUSTMENTS

In many cases, the factors that shift the AD curve or SRAS will be unexpected. For example, there will be unpredictable fluctuations in exchange rates and foreign incomes that will shift the AD curve. Consumer/business confidence fluctuates, int. rates and the stock market are constantly changing. Equilibrium will be disrupted by these unexpected changes, which will result in dynamic changes in the macroeconomy that will take place during an adjustment period. It will take time for consumers and producers to adjust to the new market conditions.

For example - producers see a strong increase in demand for their product, sales suddenly increase.  Is this just a random, one time occurrence or a real change/shift in demand for their product?  Is it a temporary increase or a permanent increase in demand? Even if they are convinced that it is a permanent increase/decrease in the demand for their product, it takes time to adjust, expand/contract output, etc.  There might be long-term contracts for labor, bank loans, raw materials, parts, etc. that will delay the adjustment process.  

Long Run Equilibrium = Economy is operating on the LRAS.
Short Run Disequilibrium = Economy is operating off the LRAS (above or below)
Assume: Economy ALWAYS returns to LRAS eventually after an adjustment period.     

INCREASE IN AD:

See page 233 for a graph of the effects of an unanticipated increase in AD. We start at point E₁/Y_F. Suppose that there is a stock market boom (increase in wealth) and a surge in consumer and producer optimism, and AD increases (shifts out).

First effect: AD₁ shifts to AD₂ in Panel (a).  The strong increased demand for final goods puts upward pressure on retail prices and profit margins increase, so producers expand output along SRAS₁ to e₂.    

(NOTE: Small e means SR, big E means LR, economy always returns eventually to Y_F, which is E).

At e₂, un rate temporarily falls below the natural rate, Y temporarily > Y_F (full employment output).  In the short run, the economy will deviate from LRAS (Y_F), because the Actual Price Level (105) > Expected Price Level (100).

Second Effect: The strong demand for final goods increases demand for inputs (derived demand) which eventually puts upward pressure on prices in the resource markets (labor, inputs, parts, materials) and the loanable funds markets. Also, since Actual P > Expected P, input prices, wages and interest rates eventually rise.  As input prices increase, it will shift the SRAS₁ curve back to SRAS₂, and output falls from Y₂ to Y_F.

LR equilibrium is re-established at E₂, Y_F and P₁₁₀ in Panel (b).  Economy can only temporarily be above Y_F, it's not sustainable in the LR.  As soon as all factor/input prices (wages, int. rates) adjust, economy moves back to LRAS. Un returns to nat rate. Since the increase in AD does not permanently affect any of the factors that influence the LRAS, it cannot expand output above Y_F permanently, because that level of output in the LR cannot be supported with the economy's resources and technology. 

DECREASE IN AD:

Suppose that there is increased pessimism or a decline in income abroad or a stock market crash. AD shifts back from AD₁ to AD₂ on page 234, Panel (a), E₁ to e₂, Y_F to Y₂.  Weak demand will reduce Price Level from P₁₀₀ to P₉₅. Workers will be laid off, un > nat rate temporarily as producers contract output. Input prices/labor costs are fixed, but retail prices fall, so profits will decrease, producers decrease output, there will temporarily be recessionary conditions in the economy.

The weak demand, weak economic conditions will soon put downward pressure on input/resource prices (input prices, wages, int. rates). Once the input prices have fallen, the SRAS will increase, shift out to SRAS₂ and the economy will recover and be back at Y_F, E₂ and P₉₅.

The speed of correction (adjustment) for the economy depends on how flexible resource prices (wages) are.  If wages, input prices and int. rates fall quickly, the recession will be brief.  However, workers and unions may be reluctant to accept wage cuts. Wages are "sticky" (inflexible) downward, unlike other prices like stock prices or interest rates. Prices (wages) go up easier than they fall!  If wages are sticky downward, there could be a prolonged period of recession.
 

UNANTICIPATED INCREASES IN SRAS

Suppose there is a temporary, favorable supply condition that will not be permanent - good weather or a temporary price decline for a foreign input - oil. The LRAS will not change, but the SRAS will shift out/increase.

See page 235. Output will temporarily expand to Y₂. The increase in SRAS will put downward pressure on prices to P₉₅. As the economy returns to normal weather, normal oil prices, normal conditions, the SRAS will return to its original position.  SRAS₁ to SRAS₂ back to SRAS₁ with LRAS unaffected by the short run conditions.  
 

UNANTICIPATED DECREASES IN SRAS

Unfavorable supply shocks:  Examples: 1973 and 1979 oil shocks when OPEC doubled the world price of oil by artificially restricting supply. 1988 severe drought conditions resulted in very poor harvest in U.S. 1990 - Iraq invaded Kuwait, oil prices doubled from $15 to $30/bbl.  These were all temporary situations that did not affect LRAS, but affected SRAS.

See page 236. OPEC artificially and temporarily raises world oil prices.  For oil, S₁ decreases to S₂ in Panel (a), from Point a to Point b. SRAS₁ shifts back to SRAS₂ in Panel (b).  Output falls to Y₂ (e₂), prices rise to P₁₁₀.  Since the situation is temporary, resource prices will eventually start to fall and output will increase back to Y_F  (E₁) as SRAS₂ shifts back to SRAS₁.

If the supply shock was permanent - long term, permanent increase in price of oil because we are running out of oil  - the LRAS could shift back to a permanently lower output level.  

BUSINESS CYCLE REVISITED -

Using AD/AS, we can understand the business cycle. In a dynamic world of changing AD and supply shocks, there will be alternating periods of economic expansion and contraction. Macro markets do not adjust instantly and this leads to the business cycle. Part of the business cycle is due to the sluggishness of adjustment that has to do with living in a physical universe. The faster that information flows through the economy, the faster the adjustment and the shorter the fluctuations. Business cycles in the Information Age economy should be more stable than Machine Age.  Also, decision makers do not always correctly anticipate changes in the price level - this can lead to economic fluctuations, periods of expansion and contraction.

Examples: Expected and actual inflation are 5% for several years, 5% adjustments are factored into long-term contracts (labor, inputs, debt) and then actual inflation falls to 2%.  Firms can only raise retail prices by 2% and have 5% cost increases locked in by contracts.  Real wages, real prices and real interest rates increase, profits fall, output contracts, Economic Recession.  

Or actual inflation suddenly jumps to 8%. Real wages, real prices and real interest rates decrease, profits increase, output expands: Economic Expansion.   

RECESSIONS occur when prices in the market for final goods (retail prices) are LOW relative to the costs of production (input prices), causing profits to be temporarily below normal and output to be temporarily below normal.  This occurs when 1) there is an unexpected decrease in AD (lowers retail prices) or 2) a negative supply shock (raises input prices).

EXPANSIONS occur when retail prices are HIGH relative to input prices, causing profits to be temporarily above normal and output to be above normal.  This occurs when there is 1) an increase in AD or (raises retail prices) 2) a favorable supply shock (lowers input prices).

See page 239. We see the LR trend of real GDP (Panel a), and un rate (Panel b). We see alternating periods of econ expansion and contraction, which is the business cycle.  Recessions were in 1960, 1970, 74-75, 79, 82, 90-91, and 2001, yellow shaded areas.  Expansions were in 61-68, 71-73, 76-79, 83-89, 91-01.

Panel (b) shows the actual un rate compared to the estimated natural rate. During recessions of 74-75, 79-82, and 90-91, the actual rate was well above the natural rate.

Causes of recessions: 1974-75 and 79-82 recessions were mostly caused by negative supply shocks from the high world oil prices ("oil shocks"), OPEC restricting output.   Recessions of 1970, 1982 and 1990 were caused by unanticipated decreases in AD.  (Recessions are caused by either negative supply shocks or decreases in AD).
 

DOES A MKT. ECONOMY HAVE SELF-CORRECTING MECHANISMS?

Answer is YES, it has several, the debate is over how quickly they operate. Economy has sophisticated information feedback loops and at least three built-in self-correcting, self-stabilizing mechanisms.....

1. Consumption demand (C in GDP) is relatively stable over the bus cycle. Consumption spending is 2/3 of AD (GDP). Consumption spending tends to be relatively stable over the business cycle, which stabilizes the economy, because of the Permanent Income Hypothesis of Milton Friedman, which says that current consumption depends more on long-run expected lifetime income than current income in one period. We "smooth out" consumption over our lifetimes.

Example: when economy is expanding and incomes are temporarily high, people save more and consume at a steady level. This stability of C helps dampen the growth of AD and keep inflation under control.

During a contraction, incomes fall, but consumers smooth out consumption and keep it stable by drawing on savings. Even if your income falls, or your hours are reduced, or even if your are laid off, you still buy food, shampoo, etc.

Point: Current Income can and does vary more than consumption (which is more stable).  The steady and stable consumption pattern of consumers stabilizes the entire economy without any formal policy, potentially prevents the economy from a prolonged recession.

Example: Most people who work in real estate, insurance, brokerage are paid on commission, which could vary greatly from month to month.  However, these people spend (consume) based more or expected income over the next year than on income during the current month.

2. Changes in real int. rates stabilize AD and counteract economic fluctuations.   Suppose that businesses and consumers are pessimistic about the economy and AD falls, economy slows down and we start to go into a recession. There is a general reduction in the demand for credit, reflecting the increased pessimism, which will put downward pressure on int. rates. At some point, int. rates will fall enough that businesses and consumers will start to borrow again, and the economy will recover by itself as current spending by firms and consumers increases. Falling int. rates during a recession will eventually stimulate ("jump start") the economy.

On the other hand, when there is an economic expansion, there is increased demand for credit/borrowing by consumers/businesses, putting upward pressure on int. rates. Eventually the higher int. rates will automatically slow the economy down. Int rates act like a shock absorber and provide a self- correcting mechanism for the economy.....  Interest rates are "procyclical" (meaning that they follow the business cycle - int. rates rise during expansion, fall during recession), which helps stabilize the economy by slowing down an econ expansion and stimulating an econ contraction, smoothing out and stabilizing the business cycle

3. Changes in resource prices will stabilize the economy. During an econ expansion, output will be greater than full-employment capacity and there will be upward pressure on resource prices including wages, raw materials, supplies, commodities, etc. At some point, these higher prices will help slow the economy down (reduce AD) and full-employment output will be re-established.

During a recession, output will be less than the full employment level, demand will weaken for resources inc labor, and resource prices will fall. The lower prices for wages and resources will eventually help to stimulate the economy, output will expand back to full-employment level (by increasing AD).

See pages 241 and 242 for several graphs of the self-correcting features of the market economy.

Graph on p. 241 illustrates how the "procyclical" nature of int. rates and resource prices stabilize the economy, and help smooth out the business cycle.  Lower int. rates and lower resource prices stimulate the economy during recession, higher int. rates and higher resource prices restrain the economy during an expansion.

Important Graph of self-correcting mechanisms, page 242. In Panel (a), we start at SRAS₁, e₁ (short run), AD₁ and Y₁. Output is temporarily greater than long run potential, economy "heats up", putting upward pressure on int. rates, resource prices and wages. Higher int. rates causes AD₁ to shift back to AD₂. Higher resource prices causes SRAS₁ shift back to SRAS₂. Economy is automatically directed back to E₂ and Y_F, sustainable full employment output.

Page 243 Panel (b), we start at e₁, Y₁, SRAS₁ and AD₁. Output is less than full capacity, economy is in a recession. Resource prices, wages, and int. rates decline and eventually stimulate the economy back to Y_F. Lower int. rates move AD₁ to AD₂ and lower resource prices move SRAS₁ to SRAS₂.

Conclusion:  AD/AS Model predicts that changing int. rates and resource prices will automatically redirect the economy back to Y_F. Market economy is self-stabilizing, self-correcting.  (Explains why economists are generally strongly opposed to price controls or int. rate controls, and also explains the failure of central planning.)

Empirical evidence, page 243.  There is historical evidence to support the predictions of the AD/AS Model, since real wages and real interest rates do generally INCREASE during expansions and DECREASE during contractions.  
 

GREAT DEBATE: HOW QUICKLY DOES ECONOMY SELF-CORRECT?

After the Great Depression, many people lost faith in the ability of the economy to self correct. We had a ten year recession with un rate as high as 25% (see p. 351). The consensus view was that activist, discretionary fiscal and monetary policy were necessary to stabilize and guide the economy to full employment, since the self-correcting mechanisms of the AD/AS model appeared NOT to work in the 1930s.  This view (active govt. intervention) was predominant for the next forty years until the 1970s, until we had stagflation - high inflation and high un at the same time. This was not supposed to happen.

The trend in the economics profession is now back to a restored faith in the economy to self-correct and many economists now advocate a fixed, passive, rule-based approach to fiscal and monetary policy. The feeling is that activist attempts to fine-tune the economy are actually disruptive and de-stabilizing. Predictable, passive policies are advocated like: balanced budgets and fixed money growth. We come back to this debate later.