Lecture 15 - Short Run Macro Basics (easy)

Question 1

Key feature of short run

Answer 1

Prices are fixed, so AD determines real output (create diagram to see)

(In long run, prices flexible and all factors employed so supply determines output)

Question 2

How do the components C&I of AD follow the real economy (growth)

Answer 2

Consumption tracks real output closely (I.e is a likely driver of growth in the short run)

Investment - tracks real output but with large volatility and so is likely a big driver too

Question 3

How does unemployment follow the business cycle

Answer 3

Rises in a recession, falls in post-recession.

Question 4

Okun’s law and equation.

Answer 4

Looks at relationship between change in growth and change in unemployment rate.

%change in G = 3% - 2x (change in unemployment rate)

E.g if unemployment rose by 2% G falls by 1%.

Question 5

Why are prices sticky (2)

Answer 5

The way firms set prices
Nominal wage determination (they don’t move a lot)

Question 6

What assets are not sticky in short run (2)

Answer 6

Commodity
Financial assets

Question 7

Firm pricing behaviour : first reason why prices are sticky in SR (3)

Answer 7

Menu costs (costs to change prices)
Search behaviour
Coordination failure

Question 8

Search behaviour

Answer 8

Firms and households have to search for each other. I.e find each other then engage in a transaction which takes time. Once firms have customers they’d rather keep prices the same to retain

Question 9

Coordination failure

Answer 9

Markets don’t have a mechanism for firms to coordinate on price rises

Reluctant to change prices in case other firms won’t follow and gain market share.

Question 10

Nominal wage determination (nominal wages hard to change) : 2nd reason for sticky prices (3)

Answer 10

Contracts keep workers tied to jobs so nominal wage fixed.

Efficiency wages - costly for firms to reduce wages (as workers will reduce their effort n productivity)

Trade unions and legal structure slow labour market adjustment in short run. Difficult to hire/fire change wages.

Question 11

How to model the demand side for SR, and how this determines it’s downward sloping curve.

Answer 11

Use Quantity theory demand for money equation
Md =kPY

Then, Md=Ms, then make Y subject for demand side
Y=Ms/kP

From this we can see when P increases, Y falls.
Which explains the downward sloping demand curve

Question 12

What causes shifts in AD curve

Answer 12

Change in the Ms.

Y=Ms/kP

E.g an increase in Ms means Y increases,

Question 13

How is SRAS and LRAS drawn

Answer 13

SRAS - horizontal line, as price is fixed. Supply at whatever is demanded.

(due to the way firms set prices, and nominal wage determination explained earlier)

LRAS - vertical line, shows flexible prices. Demand determines price level.

Question 14

Expecations and shocks : what does the long run model incorporate (2)

Answer 14

Forward looking behaviour

Households saving
Firms investment

(Remember this from Lec 2 demand in long run)

Question 15

Unexpected vs expected changes

Answer 15

If a predictable change in economic conditions is expected (e.g. demographic changes) then the long-run model should explain the behaviour of the economy

If a change is unexpected then it will shift the economy away from long-run equilibrium since wages and prices take time to adjust

Question 16

Fall in AD e.g an unexpected fall in Ms , to SR/LR diagram

Answer 16

A fall in Ms means a shift downwards in AD.

Lowers output in SR. (Prices stable as SR)

But in the long run, only the price level is affected (we end up back at natural Ybar but a lower price)

Question 17

Scenario 2:
Unexpected Increase in money supply

Answer 17

Increase in Ms shift right in AD.
Only output rises in SR (as prices fixed)

Long run only price rises (we go back to original Y but higher price)

Question 18

What would the effect of recent energy price shocks look like?

Answer 18

Adverse supply shock, shift up in SRAS2 so prices increase and output falls. Recession
(No coordination failure meaning sticky prices since it impacts everyone, so prices are allowed to change despite being SR)

Then we assume that in the LR economy will adjust back to original point. E.g adjust to less energy intensive production methods

Question 19

However we can speed the process of returning to the long run equilibrium up.

What does a stabilisation policy look like, following a adverse supply shock (like the recent energy prices)

Answer 19

Shift up in SRAS. Prices up

But gov uses policy (expansionary monetary policy to increase Ms and AD, which results into a permanently higher price level, with no change in output.

Note: if prices continue to rise naturally then it is a risk to use this approach as prices may get too high.

Question 20

Impact of COVID

Answer 20

Fall in LRAS.

Fall in AD. (k rise)

We went to at a new point of same prices (as SR) but lower output. When lockdown ends we go back to original

Question 21

So how do we deal with UNEXPECTED changes/shocks

Answer 21

Stabilisation policy to shift economy back towards the long run equilibrium.