Macroeconomic Notes for Chapter 13
Macroeconomic Notes for Chapter 13 Econ 1012
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This 11 page Study Guide was uploaded by Kate Notetaker on Wednesday March 23, 2016. The Study Guide belongs to Econ 1012 at George Washington University taught by Dr. John Volpe in Spring 2016. Since its upload, it has received 51 views. For similar materials see Macroeconomics in Economcs at George Washington University.
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Date Created: 03/23/16
Chapter 13 o Aggregate demand and aggregate supply model o Explains short run fluctuations in real GDP and the price level o Aggregate demand curve relationship between the price level and the quantity of real GDP demanded by households, firms and the government o Short-run aggregate supply curve relationship in the short run between the price level and the quantity of real GDP supplied by firms o Why is the Aggregate Demand Curve Downward Sloping? o A fall in the price level increases the quantity of real GDP demanded o Change in Price Affects Consumption Current income is the most important variable determining consumption by households Income rises consumption will rise Income falls consumption will fall Household wealth difference between the value of a household’s assets and the value of its debts Sometimes held in cash or other nominal assets As total household wealth rises, consumption will rise When the price level rises, the real value of household wealth declines So will consumption Reduces the demand for goods and services When price level falls, the real value of household wealth rises So will consumption and the demand for goods and services Called the wealth effect o Change in Price Affects Investment When price level rises, households and firms will try to increase the amount of money they hold Withdrawing funds from banks, borrowing from banks or selling financial assets such as bonds Tend to drive up the interest rate banks charge on loans and the interest rate on bonds Higher interest rate raises the cost of borrowing for firms and households Firms will borrow less Households will borrow less Consumption will also fall as households borrow less to finance spending on durable goods Higher price level increases the interest rate and reduces investment spending In turn, it also reduces the quantity of goods and services demanded Lower price level will decrease the interest rate and increase investment spending Increases the quantity of goods and services demanded Called the interest-rate effect o Change in Price Affects Net Exports If the price level in the US rises relative to the price levels in other countries US exports will become relatively more expensive and foreign imports will become relatively less expensive Some consumers in foreign countries will shift from buying US products to buying domestic products o Some US consumers will also shift from US products to imported products US exports will fall and US imports will rise o Net exports will fall Reduces the quantity of goods and services demanded Lower price level in the US has the reverse effect Net exports will rise Increases quantity of goods and service demanded Called the international-trade effect o Shifts of the Aggregate Demand Curve Changes in government policies Monetary policy o Actions the Federal Reserve takes to manage the money supply and interest rates to achieve macroeconomic policy objectives Such as high employment, price stability, high rates of economic growth and stability of the financial system o Lower borrowing costs increase consumption and investment spending Shifts the aggregate demand curve to the right o Higher interest rates shift the aggregate demand curve to the left Fiscal policy o Changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives o Increase in government purchases shifts the aggregate demand curve to the right o Decrease in government purchases shifts the aggregate demand to the left o Increase in personal income taxes reduces the amount of spendable income available to households Reduces consumption spending Shifts the aggregate demand curve to the left o Lower personal income taxes shift the aggregate demand curve to the right o Increases in business taxes reduce the profitability of investment spending and shift the aggregate demand curve to the left o Decreases in business taxes shift the aggregate demand curve to the right Changes in the Expectations of Households and Firms o If households become more optimistic about their future incomes Likely to increase their current consumption Shift the aggregate demand curve to the right o If households are more pessimistic about their future incomes Shift to the left o If firms become more optimistic about the future profitability of investment spending Shift to the right o If firms are more pessimistic Shift the the left Changes in Foreign Variables o Firms and households in other countries buy fewer US goods or Firms and households in the US buy more foreign goods Net exports will fall Shift to the left o When GDP increases income available for consumers to spend rises o If real GDP in US increases faster than in other countries US imports will increase faster than exports Net exports will fall o Net exports will fall if the exchange rate between the dollar and foreign currencies rises Price in foreign currency for US products will rise Dollar price of foreign products sold in the US will fall US exports will fall US imports will rise Aggregate demand will shift the the left o Increase in net exports at every price level Shift to the right o Net exports will increase if real GDP grows more slowly in the US than in other countries Or if value of the dollar falls against other currencies o Change in net exports that results from a change in the price level in the US will cause a movement along the aggregate demand curve Not a shift of the aggregate demand curve Aggregate Supply o Long Run Aggregate Supply Curve shows the relationship in the long run between the price level and the quantity of real GDP supplied Level of real GDP is determined by the number of workers, the capital stock and the available technology Changes in the price level do not affect the level of real GDP Level of real GDP in the long run is called the potential GDP or full employment GDP At potential GDP firms operate at their normal level of capacity LRAS curve is a vertical line LRAS shifts to the right each year Potential GDP increases each year as the number of workers in the economy increases, the economy accumulates more machinery and equipment and technological change occurs o Short Run Aggregate Supply Curve Upward sloping As price increases, the quantity of goods and services firms are willing to supply will increase As prices of final goods and services rise, prices of inputs (wages of workers or the price of natural resources) rise more slowly Profits rise when the prices of goods and services firms sell rise more rapidly than the prices they pay for inputs o Higher price leads to higher profits o Increases the willingness of firms to supply more goods and services As the price level rises or falls some firms are slow to adjust their prices o Firm that is slow when price level is increasing May find its sales increasing and therefore will increase production o Firm that is slow when price level is decreasing Firm may find sales falling and will decrease production Why do some firms adjust prices more slowly? o Firms and workers fail to accurately predict changes in the price level o How does the failure of workers and firms to predict the price level accurately result in an upward-sloping SRAS curve? Contracts make some wages and prices “sticky” Rising prices lead to higher output Short run aggregate supply would be upward sloping Firms are often slow to adjust wages Rise in the price level will increase the profit ability of hiring more workers and producing more output Fall in the price level will decrease the profitability of hiring more workers and producing more output Firms are often slower to cut wages than to increase them Menu costs make some prices sticky Costs to firms of changing prices are called menu costs Higher price level leads to a larger quantity of goods and services supplied o Shifts of the Short Run Aggregate Supply Curve Increases in the Labor Force and in the Capital Stock More workers and physical capital = more supply Shift to the right Decrease in labor force shift to the left Technological Change Positive tech change productivity of workers and machinery increases o Firms can produce more will same amount of labor and machinery Increase in productivity reduces firms cost of production o Product more output Shift to the right Expected changes in the future price level If workers and firms expect the price level to increase by a certain percentage o SRAS curve shifts by an equivalent amount Adjustments of workers and firms to errors in past expectations about the price level If workers and firms are adjusting to the price level being higher than expected o Shift to the left Adjusting to the price level being lower than expected o Shift to the right Unexpected Changes in the Price of an Important Natural Resource Supply shock Unexpected even that causes the short run aggregate supply curve to the left Rising oil prices lead to rising gasoline prices, which raise transportation costs for many firms o Face rising costs supply the same level of output only if they receive higher prices o Shift to the left In any particular year the SRAS curve shifts to the left or to the right depends on how large an effect these variables have during that year Macroeconomic Equilibrium in the Short Run and the Long Run Recessions, Expansions and Supply Shocks o Two assumptions The economy has not been experiencing any inflation The economy is not experiencing any long-run growth o Recession Short Run effect of a decline in aggregate demand Decline in investment will shift the aggregate demand curve to the left Lower level of GDP will result in declining profitability for many firms and layoffs for some workers Economy in recession Adjustment back to Potential GDP in Long Run Workers and firms begin to adjust to price level being lower than expected Workers will to accept lower wages Firms willing to accept lower prices SRAS curve will shift to the right Economy will be back in long run equilibrium May take the economy several years Decline in aggregate demand o Recession in short run o Long run only a decline in price Automatic mechanism adjustment back to potential GDP Could use monetary and fiscal policy o Quicker but permanently higher price level o Expansion Short Run effect of Increase in aggregate demand Many firms become optimistic Increase in investment Shift of Aggregate demand to the right Real GDP is above potential o Firms are operating beyond normal level of capacity Some workers who would ordinarily be structurally or frictionally unemployed are employed Adjustment back in the Long Run Automatic mechanism Workers and firms begin to adjust to the price level being higher Workers push for higher wages Firms will charge higher prices Low levels of unemployment will make it easier for workers to negotiate higher wages SRAS curve shift to the left o Supply Shock Short Run Oil prices increase Increases may firms costs SRAS shifts to the left Price level is higher but real GDP is lower Combination of inflation and recession stagflation Adjustment Back in the Long Run Recession by supply shock increases unemployment and reduces output Workers are willing to accept lower wages Firms will be willing to accept lower prices Real GDP is back to potential GDP at the original price level May take several years Could use monetary and fiscal policy o Quicker but permanently higher price level Dynamic Aggregate Demand and Aggregate Supply Difficulty with basic model because we assume: o The economy does not experience continuing inflation o Economy does not experience long run growth Develop a more useful model by dropping assumptions o Takes into account the economy is not static o Economy is dynamic Potential GDP that grows over time and inflation that continues every year Dynamic aggregate demand and supply model o Potential GDP increases continually, shifting the long-run aggregate supply curve to the right o During most years, the aggregate demand curve shifts to the right o Except during periods when workers and firms expect high rates of inflation, the short run aggregate supply curve shifts to the right Changes in the price level and in real GDP in the short run are determined by how much the SRAS and AD curves shift Usual Cause of Inflation If total spending in the economy grows faster than total production, prices rise If the AD curve shifts to the right by more than the LRAS curve o Inflation results because equilibrium occurs at a higher price level Inflation generally results from total spending growing faster than total production o A shift to the left of the short-run aggregate supply curve can also cause an increase in the price level If aggregate demand increases by the same amount as short and long run aggregate supply o Price level will not change o Economy experiences economic growth without inflation Recession of 2007-2009 End of the housing bubble o Spending on residential construction increased rapidly from 2002 to 2005 Declined more than 60 percent between the end of 2005 and the beginning of 2010 o As interest rates on mortgage loans declined, more consumers began to buy new homes o A bubble occurs when people become less concerned with the underlying value of an asset And focus instead on expectations of the price of the asset increasing o Housing bubble started to deflate in 2006 New home sales and housing prices began to decline o Growth of aggregate demand slowed as spending on residential construction fell Component of investment spending Financial crisis o Problems in housing market bad news for workers involved in residential construction o Falling housing prices led to increased number of borrowers defaulting on mortgage loans Caused banks and other financial institutions to suffer heavy losses o Led to a credit crunch Made it difficult for many households and firms to obtain the loans they needed to finance their spending Drying up of credit contributed to declines in consumption spending and investment spending Rapid increase in oil prices during 2008 o Oil prices rose by mid 2008 o Increase cause by increased demand in rapidly growing economies and by the difficulty in developing new supplies of oil in the short run o Rising oil prices can result in a supply shock Causes the short run aggregate supply curve to shift to the left
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