Ch. 6 Aggregate Demand & Aggregate Supply

Two major differences in the long run and short run of macroeconomics

(1) in the long run we assume that there is a separtion of real variables (which are adjusted for price level changes) and nominal variables (which are not adjusted for price level changes) - the concept of classical dichotomy (2) In the long run, the money supply affects only nominal variables and not real variables. This means that when there is a change in the money supply by the Federal Reserve Bank, then the only effect is a change in the price level, i.e. it causes inflation or deflation. In the long run, a change in the money supply has no effect on the real value people place on goods and services - monetary neutrality

the idea that there is a separation of real and nominal variables is called monetary nuetrality

False

An inflationary gap occurs when an economy is in a recession

False; an inflationary gap occurs when an economy is experiencing an economic expansion

The aggregate demand curve reflects the nominal gross domestic product demanded by all groups in the economy at any given price level

False; the aggregate demand curve reflects the real gross domestic product (GDP) demanded by all groups in the economy at a given price level.

when the labor force decreases

The LRAS (long run aggregate supply) curve shifts to the left

when the President and Congress permanently repeal all inter-state trade restrictions on the sale of wine

The LRAS (long run aggregate supply) curve shifts to the right

If the economy is in a deflationary gap, the federal reserve bank should use open market operations to purchase government bonds

True; If the economy is in a deflationary gap, the aggregate demand curve could be stimulated to bring the economy into long run equilibrium, In this case, the Federal Reserve Bank should use open market operations to purchase government bonds. By doing so, the Federal Reserve puts money into circulation and this increases the money supply. An increase in the money supply will decrease the interest rate, which will increase investment expenditure at every price level. The increase in investment causes the aggregate demand curve to shift to the north-east moving the economy towards long run equilibrium

the location of the long run aggregate supply curve depends on the economy's supply of land, supply of capital, supply of labor, entrepreneurial ability, and productivity of its scarce resources. The location of the long run aggregate supply curve does not depend on the price level

True; In the long run, everything in the economy is variable. Prices, wages, interest rates, and rents all fluctuate with market conditions. The long run provides enough of a time horizon for producers to figure out whether market price fluctuation is due to a change in consumer valuation or a change in the price level. Therefore, in the long run, the aggregate supply curve is at potential real gross domestic product, which is the economy's maximum sustainable output level given the supply factors of the production, the state of technology, and formal and informal institutions supporting the economy.

The open economy effect is observed when a decrease in the price level causes the real exchange rate to depreciate, which subsequently causes an increase in net exports

True; when the price level falls, it causes the real exchange rate to depreciate.

The profit effect

a concept that, ceteris paribus, sticky wages in the short run (1) induce firms to increase the production of goods and services when the price level increases and (2) induce firms to decrease their production of goods and services when the price level decreases because it leads to an increase in real profits

when the price level decreases

a movement along the aggregate demand curve results; a decrease in the price level causes an increase in the real GDP demanded by all groups in the economy. This is a movement along the aggregate demand curve because of a change in some exogenous factor. The aggregate demand curve does not shift in this case

open economy effect

also a factor in the negative slope of the aggregate demand curve. When the price level falls, it causes the real exchange rate to depreciate. The real exchange rate in the rate at which foreign made goods can be bought or sold for domestic made goods. The depreciation of the real exchange rate increases the quantity of exports, and decreases the quantity of imports and therefore it increases the net exports (NX) or exports minus imports. Because of the increase in net exports, the quantity demanded of real GDP increases

the menu costs effect

argues that because it can be expensive to change menus and pricing boards and because business owners don't want to constantly tell their customers that they have changed their prices, they don't do it often. This implies that when there is a change in the price level because of a contraction in the economy, for example producers keep their prices unchanged

the misperception effect

argues that in the short run, producers are temporarily fooled about what is really causing price changes in the markets in which they sell their products. Because of these misperceptions, producers respond to changes in the markets in which they sell their products. Because of these misperceptions, producers respond to changes in the price level despite no change in a product's real price, and this response leads to an upward sloping curve.

automatic stabalizers

automatically stimulate the economy when it enters a deflationary gap and automatically cools the economy down when it enters an inflationary gap. Automatic stabilizers are a just in time fiscal policy, because they operate without policymakers having to take any deliberate action. Examples f automatic stabilizers include unemployment insurance, welfare benefits, and income taxes.

assume that the economy is currently at potential real gross domestic product. Which of the following would put the economy in an inflationary gap? (a) temporary increase in wages, (b) greater stock market wealth, (c) higher business taxes, (d) decrease in income abroad

b) greater stock market wealth; Inflationary gap occurs when the actual real gross domestic product is greater than the economy's potential real gross domestic product.

Nominal GDP

calculated by summing up current dollar consumption spending, investment spending, government purchases, and net exports.

Suppose that the economy is in a deflationary gap. What policy(ies) would help the economy get back to potential gross domestic product?

decrease in the required reserve deposit ratio, have the federal reserve buy back government bonds, have the president and congress cut marginal tax rates; When the economy is in a deflationary gap, then the actual real gross domestic product is below the economy's potential real gross domestic product.

If the economy is in a deflationary gap, the Federal Reserve should (increase/decrease or not change) the required reserve deposit ratio

decrease; If the economy is in a deflationary gap, the aggregate demand curve could be stimulated to bring the economy into long term equilibrium. Decreasing the required reserve deposit ratio will increase the money supply. An increase in the money supply will decrease the interest rate, which will increase the investment expenditure at every price level. The increase in investment causes the aggregate demand curve to shift to the north-east moving the economy towards the long run equilibrium

If the federal reserve bank sells government bonds, ceteris paribus, the policy change causes the price level to

decrease; When the federal reserve bank sells government bonds, it takes dollars out of circulation and thereby reduces the money supply. A reduction of the money supply causes the interest rate to increase. An increase in the interest rate causes a decrease in the quantity demanded at every price level. As a result, the aggregate demand curve shifts to the south-west.

If corporate taxes are temporarily lowered, ceteris paribus, the policy change will cause the price level to

decrease; temporarily lowering corporate taxes will cause the short run aggregate supply curve to shift to the south-east. An example of this effect, in the figure, is a movement from equilibrium "c" to equilibrium "b". The price level decreases when the economy moves from equilibrium "c" to equilibrium "b".

If the federal reserve bank sells government bonds, ceteris paribus, the policy change causes the economy to move into a(n)

deflationary gap; When the federal reserve bank sells government bonds, it takes dollars out of circulation and thereby reduces the money supply. A reduction of the money supply causes the interest rate to increase. An increase in the interest rate causes a decrease in the quantity demanded at every price level. As a result, the aggregate demand curve shifts to the south-west.

When the federal reserve increases the money supply the short run aggregate supply curve

does not shift when the federal reserve bank increases the money supply; the aggregate demand curve shifts to the north-east because of an increase in the money supply. The shifting aggregate demand curve moves along the short run aggregate supply curve. Thus, the statement causes a movement along the short run aggregate supply curve.

when the price level increases the short run aggregate supply

does not shift; if the price level increases, there is a movement along the upward sloping aggregate supply curve. The short run aggregate supply curve does not shift because of a change in the price level

Real GDP

equal to the nominal GDP adjusted for changes in the price level.

The idea that the money supply affects only nominal variables and not real variables is formally known as the classical dichotomy

false; In the long run, the money supply affects only nominal variables and not real variables. This means that when there is a change in the money supply by the Federal reserve bank, then the only change in the price level, ie it causes inflation or deflation. In the long run, a change in the money supply has absolutely no effect on the real value people place on goods and services. This second idea is formally known as neutrality

The aggregate demand curve is negatively sloped because of a combination of the interest rate effect, the menu costs effect and the wealth effect

false; The three general explanations for the negative slope of the aggregate demand curve are: the interest rate effect, real wealth effect, and the open economy effect. On the other hand, the short run aggregate supply curve is upward sloping because of the profit effect, the misperception effect and the menu costs effect

sticky wages induce firms to increase their production of goods and services when the price level decreases

false; salaried workers frequently sign one year, or multiple year labor contracts. Because such nominal wage contracts do not automatically adjust (by definition) to he ebb and flow of real-time labor market prices, they are considered sticky in the short run.

sticky wages induce firms to decrease their production of goods and services when the price level increases

false; salaried workers on contract do not automatically adjust to the ebb and flow of real time labor market prices, they are considered sticky in the short run. In an environment with a lot of long term labor contracts, if the price level increases, employment and production become more profitable because real wage expenditures (nominal wage/the price level) actually decrease. If businesses observe real wage expenditures decreasing because nominal wages are sticky, they are more likely to increase the production of their goods and services in an effort to increase real profits

Fiscal Policy

government's plan for managing aggregate demand through government's power to tax individuals and businesses and its power to spend and transfer tax revenues that it collects.

Long run labor contracts

if the price level decreases, employment and production become less profitable because real wage expenditures (nominal wage/price level)

Inflationary gap

in an economy when the actual price level is higher than what workers expected. Workers eventually figure out the actual price level and realize that their real wage, adjusted for inflation, is lower than they expected and they demand higher real wages. In the aggregate, businesses react to the increase in labor costs by decreasing the quantity that they are willing and able to produce at a given price level. This reaction by the business community causes the short run aggregate supply curve to shift to the north-west. If there is no monetary or fiscal policy intervention, the market will eventually eliminate the inflationary gap and return itself back to a sustainable level of output.

monetary neutrality

in the long run the money supply affects only nominal variables and not real variables. Where a change in the money supply by the Federal Reserve strictly causes the price level to change, i.e. it causes inflation or deflation, and it has no effect on the real value people place on goods and services.

suppose that the economy is in an inflationary gap. What policies could help the government get back to potential gross domestic product?

increase the discount rate; If the economy is in an inflationary gap, then the actual real gross domestic product is greater than the economy's potential real gross domestic product. Increasing the discount rate cold be implemented to achieve this objective

If consumers' expectations about the state of the economy improve, ceteris paribus, the change will cause the price level to

increase; A positive change in consumer expectations will cause the aggregate demand curve to shift to the north-east increasing he price level.

The depreciation of the real exchange rate....

increases the quantity of exports and decreases the quantity of imports. Therefore, the depreciation of the real exchange rate increases net imports (defined as exports minus imports)

If consumers' expectations about the state of the economy improve, ceteris paribus, the policy change will cause the economy to move to a(n)

inflationary gap; A positive change in consumer expectations will cause the aggregate demand curve to shift to the north-east.

If corporate taxes are temporarily lowered, ceteris paribus, the policy change will cause the economy to move into a(n)

inflationary gap; temporarily lowering corporate taxes will cause the short run aggregate supply curve to shift to the south-east. An example of this effect is moving from equilibrium "c" to equilibrium "b". The economy is in an inflationary gap at equilibrium "B"

when the price level decreases the long run aggregate supply curve

is not affected

interest bearing assets are commonly called

loanable funds

natural rate of unemployment

long run aggregate supply curve; exists when the economy is operating at potential real GDP; excludes cyclical unemployment

temporary supply shock

only affects short run aggregate supply curve; terrorist attacks, hurricanes, etc. temporary and does not alter the long run productive capacity of the market; causes a shift to the north west temporarily and then shifts back afterwards

aggregate demand curve

reflects the real gross domestic product demanded by all groups in the economy at any given price level. It is negatively sloped because of the interest rate effect, the wealth effect, and the open economy effect.

Short run aggregate supply curve

reflects the total quantity of goods and services that producers in the economy are willing and able to produce at any given price level. This is upward sloping because of the profit effect, the misperception effect ad the menu cost effect

when there is a decrease in the labor force, the short run aggregate supply curve

shifts to the north-west; this causes the price in labor to increase, ceteris paribus. Higher labor prices (wages) cause the short run aggregate supply curve to shift to the north-west

When the price of crude oil (an input into many production processes) decreases the short run aggregate supply

shifts to the south-east. Whenever input prices decrease the short run aggregate supply curve shifts to the south-east

when the president and the congress lower corporate taxes, the short run aggregate supply curve

shifts to the south-east; The effect of lower corporate marginal tax rates is to stimulate productive activity at every price level.

wealth effect

tells us that a decrease in the price level makes consumers feel wealthier because each nominal dollar can purchase more goods and services, relative to before the price level decrease. This causes an increase in real GDP demanded at every price level

interest rate effect

tells us that a reduction in the price level causes people to convert cash to interest bearing assets. An increase in the supply of loanable funds causes a south-east shift of the supply of loanable funds, which leads to a lower interest rate. Because the interest rate is equal to the price of investment goods, a decrease in the interest rate causes an increase in spending on investment goods (I) which by definition increase real GDP

when the president and the congress implement lower marginal federal income tax rates

the aggregate demand curve shifts to the north-east; after the fiscal policy change, at every price level real GDP will increase

When there is a decrease in government purchases

the aggregate demand curve shifts to the south-west; at every price level real GDP is decreased

inflationary gap

the amount by which the equilibrium level of real GDP exceed the potential real GDP

deflationary gap

the amount by which the equilibrium level of real GDP falls short f potential real GDP

when the price of crude oil (n input into many production processes) temporarily decreases

the long run aggregate supply (LRAS) curve is not affected; Temporary changes in input prices do affect the short run aggregate supply curve, but they do not affect the long run aggregate supply curve.

when a permanent technological change occurs

the long run aggregate supply curve shifts to the right; the long run aggregate supply (LRAS) curve is a vertical line located at the economy's potential real GDP. The location of the LRAS depends on the economy's supply of land, capital, labor, and entrepreneurial ability and the productivity of these resources, and not the price level. If there is a permanent increase in a technology, the the LRAS curve shifts o the right

Classical dichotomy

the two major differences between the short run and the long run. The long run assumes that there is a separation of real (adjusted for price level changes) and nominal (not adjusted for price level changes) variables. This separation of real and nominal variables is this concept.

If the U.S. and China are major trading partners. Suppose that the Chinese economy goes into a recessionary period, causing their national income to derease

then the aggregate demand curve shifts to the south-west; If the Chinese economy goes into a recession, their demand of foreign goods decreases at every price level. Therefore, if the Chinese economy goes into a recessionary period, the U.S. aggregate demand curve shifts to the south-west.

When the federal reserve bank increases the required deposit-reserve ratio

then the aggregate demand curve will shift to the south-west, ceteris paribus. The effect of the Federal Reserve Bank's change is to decrease the money supply. The decrease in money supply increases all nominal prices, and this causes the aggregate demand curve to shift to the south-west

the long run aggregate supply curve

this curve is vertical in the long run. The location of the long run aggregate supply curve depends on the economy's supply of land, capital, labor, and entrepreneurial ability and the productivity of these resources, and not the price level. The long run supply curve is located at the economy's potential real GDP, which is defined as the economy's maximum sustainable output level given the supply of factors of production, the state of technology and formal and informal institutions supporting the economy

the idea that the money supply affects only nominal variables and not real variables is formally known as monetary neutrality

true;

The long aggregate supply curve shifts to the right when the government permanently lowers trade barriers

true; If there is a permanent decrease in trade barriers, then the short run aggregate supply curve shifts to the south-east and the long run aggregate supply curve shifts to the right. If lowering of trade barriers is temporary, then only the short run aggregate supply curve will shift to the south-east

the menu cost effect tells us that when there is a real price level decrease in the economy, businesses do not quickly change the price of their products. This behavior generates a real price increase for their products, thereby decreasing the the quantity

true; The menu costs argues that because it can be expensive to change menus and pricing boards and because business owners don't want to constantly tell their customers that they have changed their prices, they don't do it often, This implies that when there is a decrease in the price level because of a contraction in the economy, for example, producers keep their prices unchanged. In this case, the real price charged by a producer actually increases, and customers subsequently demand smaller quantity because of these higher real prices. This behavior forces the business to then cut back on production and employment. In the short run, when price level decreases and menu changing costs are high, real gross domestic product declines.

if the economy is in a deflationary gap, congress should increase government spending

true; The president and congress could increase government spending. This causes the aggregate demand curve to shift to the north-east, moving the economy towards long run equilibrium

If the economy is in a deflationary gap, the federal reserve bank should decrease the discount rate

true; if the economy is in a deflationary gap, the aggregate demand curve could be stimulated to bring the economy into long run equilibrium. The Federal Reserve bank could decrease the discount rate. By doing so, the federal reserve effectively lowers interest rate. A decrease in the interest rate will increase investments at every price level. An increase in investment expenditure causes the aggregate demand curve to shift to the north-east, moving the economy towards long run equilibrium

a deflationary gap occurs when an economy is in a recession

true; occurs when an economy is in a recession. An economy that is in a deflationary gap experiences an unemployment rate that is higher than the natural rate of unemployment. This is the case because cyclical unemployment is now added to the natural rate of unemployment

the aggregate demand curve reflects the real gross domestic product demanded by all groups in the economy at any given price level

true; recall that nominal GDP is calculated by summing up current dollar consumption spending, investment spending, government purchases, and net exports. And that real GDP is equal to the nominal GDP adjusted for changes in the price level

the interest rate effect tells u that a reduction in the price level causes people to convert cash to interest bearing assets. This behavior causes a decrease in the interest rate, which subsequently causes and increase in real gross domestic product demanded

true; results in a shift to the south-east. This is the result of a decrease in the interest rate and and increase in the quantity demanded of loanable funds. Because the interest rate is equal to the price of investment goods, a decrease in the interest rate causes an increase in spending on investment goods, which by definition increases real gross domestic product

the short run aggregate supply curve is upward sloping because of a combination of the profit effect, the misperception effect, and the menu cost effect

true; the aggregate supply curve reflects the total quantity of goods and services that producers in the economy are willing and able to produce at any given price level. In the short run, the aggregate supply curve is upward sloping because of a combination of the profit effect, the misperception effect, and the menu costs effect.

if the economy is in a deflationary gap, the president and congress should decrease the federal marginal income tax rates

true; the economy can be stimulated to bring the economy into long run equilibrium. The president and congress could lower marginal income tax rates. This would increase disposable income and lead to increased consumption expenditure. The increase in consumption causes the aggregate demand curve to shift to the north-east, moving the economy towards long run equilibrium

The idea that there is a separation of real and nominal variables in the long run is called the classic dichotomy

true; the statement is true. In macroeconomics, the separation of real and nominal values is one of the major differences between the short run and the long run. In the long run, real variables are separated from nominal variables. Real variables are variables that are adjusted for changes in the price level. Nominal variables, therefore, are not adjusted for changes in the price level.

The aggregate supply curve

vertical in the long run The location of the long run aggregate supply curve depends on the economy's supply of land, capital, labor, and entrepreneurial ability and the productivity of these resources, and not the actual price level.