Chapter 20 Notes
Chapter 20 Notes Econ201
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Date Created: 05/15/16
Chapter 20: Aggregate Demand and Aggregate Supply 3 Key Facts about Economic Fluctuation 1. Economic fluctuations are irregular and unpredictable -fluctuations in the economy are called the business cycle -fluctuations reflect changes in business conditions -when realGDP grows, business is good and vice versa 2. Most macroeconomic quantities fluctuate together -real GDP is variable most commonly used to monitor short run changes -real GDP measures value of all final goods/services and total income -if real GDP falls then so does personal income, profits, consumer spending -when econ. Conditions falls, decline is due to reductions in spending on new factories, housing, inventories. 3. As Output falls, Unemployment Rises -when real GDP declines, rate of unemployment rises - firms choose to produce a lower quantity of goods, lay off workers Assumptions of Classical Economics -money doesn’t matter in a classical world – its only nominal change -people focus more on their job, what they can afford, etc -“Money is a veil” ( see nominal, but behind that real is what is important Reality of Short-Run Fluctuations -Most economists believe classical theory describes world in long run not short run Model of Aggregate Demand and Supply -short-run model focuses on behavior of 2 variables 1. output of goods/services as measured by real GDP(real variable) 2.avg level of prices as measured by CPI/GDP deflator(nominal variable) -vertical axis=price level -horizontal axis-quantity of goods/services produced in the economy -Aggregate demand-shows quantity of goods/services that households, firms, govt, and customers abroad want to buy -Aggregate Supply-quantity of goods/services that firms produce/sell at each level Aggregate Demand Curve - tells quantity of goods/services at any given price level - slopes downward - decrease in overall level of prices, raises quantity of goods/services demanded and vice versa Why AD Curve Slopes Downward - Y=C+I+G+NX Chapter 20: Aggregate Demand and Aggregate Supply - Assume govt spending is fixed but other variables depend on price level Price level and Consumption:Wealth Effect -when price level falls, dollars held in value, increases real wealth and ability to buy goods/services -decrease in price level increases real value of money and vice versa Price level and Investment – Interest Rate Effect - A lower price level reduces interest rate, encourages greater spending on investment goods, increases quantity of goods and services demanded - Higher price level raises the interest rate, discourages investment spending, decreases quantity of goods/services demanded Price level and Net Exports: Exchange Rate Effect -Fall in US price level causes US interest rates to fall- real value of dollar declines in foreign exchange markets. Depreciation stimulates US net exports/increases quantity of goods/services demanded -Increase in US price level, causes interest rates to rise, real value of dollar increases, appreciation reduces US net exports Why Aggregate Demand Curve Might Shift - Consumption: any event that changes how much people want to consume shifts the curve. Cut taxes-shift right, Raise Tax=shift left - Investment: quantity of goods/services demanded at any price level , shifts right. Cutting back on invest. Spending, shifts curve left. -tax policy: investment tax credit increases quantity, shifts right and repeal reduced investment and shifts left -money supply- decrease in MS raises interest rate, discourages investment spending -Govt purchases: most direct way to shift the AD curve, ex reducing purchases of new weapon system, AD shifts left and if building more highways, shifts right - Net exports: recession reduced net exports, recovery: shifts right The Aggregate Supply Curve -tells total quantity of goods/services that firms produce and sell at any given price level -in the long-run aggregate supply curve is vertical, short-run slopes upward Why Aggregate Supply Curve is Vertical in the Long Run -Real GDP depends on supplies of labor, capital, natural resources, and available technology to turn factors of production into goods and services. -Price level does not affect long run determinants of realGDP -Implies that quantity of output does not depend on level of prices(nominal ) Chapter 20: Aggregate Demand and Aggregate Supply Why the Long-Run Aggregate Supply Curve Might Shift - aka potential output or full employment output - for precision its called natural level of output bc it shows what econ. Produces when unemployment is at its natural/normal rate. - Natural rate is rate of production where economy gravitates in long run. - Shifts result in changes in labor, capital, natural resources, and technological knowledge Shifts from changes in labor -increase in immigration, leads to more workers, quantity of goods/services supplied increase, shift right -any change in natural rate of unemployment shift LRAS -Congress raise min. wage, natural rate of unemployment would rise, econ would produce smaller quantity of g/s, shift left. Shifts from changes in capital -increase in capital, increases productivity, and quantity of goods/services supplied, shifts right and vice versa. -doesn’t matter what type of capital (human /physical) all has same effect. Shifts from changes in Natural Resources - includes land, minerals, weather. - New mineral deposit shifts right, while change in weather patterns shifts left. Shifts from Changes in Tech Knowledge - advancements in technology have shifted LRAS right Sticky Wage Theory -SRAS slopes upward because nominal wages are slow to adjust to changing econ. conditions. - nominal wages are based on expected prices and do not respond immediately when actual price level turns to be different than expected. -stickiness gives incentive to produce less output when price level turns out lower than expected and to produce more when prices are higher than expected. Sticky Price Theory -prices adjust sluggishly due to costs in adjusting prices(menu costs) -menu costs include cost of printing and distributing catalogs and time to change price tags. Misperceptions Theory -changes in overall price level can mislead suppliers about what is happening in individual markets where output is sold. -misperceptions on relative prices - Quantity of output supplied= Natural level of output + a( Actual price level- expected Chapter 20: Aggregate Demand and Aggregate Supply - a determines how much output responds to unexpected changes in price level. Why SRAS Might Shift -Changes in labor, increase shifts right, decrease shifts left -Changes in capital- increase shifts right -Changes in Natural Resources-increase in availability shifts right and vice versa -Changes in technology- advances shift right -Changes in Expected Price Level- decrease shifts right, increase shifts left Effects of shifts in aggregate demand - (short run)shifts in aggregate demand cause fluctuations in output of goods/services - in long run, shifts iin aggregate demand affect overall price level but not output - policy makers influence aggregate demand, they can mitigate severity of economic situations Effects of shifts in aggregate supply - can cause stagflation, combo of recession(falling output) and inflation( rising prices) - policy makers who can influence aggregate demand can mitigate impact on output but only at cost of exacerbating problem of inflation.
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