ECON 102 Ch 26

Aggregate demand increases if expected (a), (b), (c) (decrease/increase)

(a) income (b) interest rate (c) future profits increase

What are the defining features of Monetarist macroeconomics and what policies do Monetarist macro-economists recommend?

- economy is self-regulating and it will operate normally at full-employment, provided that monetary policy is not erratic and that the pace of money growth is kept steady - key thinker: Karl Brunner - largest influence: quantity of money - recommendation: taxes should be kept low to avoid disincentive effects that decrease potential GDP

What are the defining features of classical macroeconomics and what policies do classical macro-economists recommend?

- the economy is self-regulating and always at full employment -key thinkers: Adam Smith, David Ricardo, John Stuart Mill - largest influence: technological advances - New Classical: business cycle fluctuations are the efficient responses of a well-functioning market economy that is bombarded by shocks that arise from the uneven pace of technological change - recommendations: taxes may stunt incentives and create inefficiency

What are the defining features of Keynesian macroeconomics and what policies do Keynesian macro-economists recommend?

- the economy left alone would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal and monetary policy is required - largest influence: expectation - key thinkers: John Maynard Keynes - new Keynesian: not only is money wage rate sticky but also that prices of goods and services are sticky -recommendation: actively offset changes in aggregate demand using fiscal and monetary policy

Identify and describe the three types of equilibrium in the AS-AD model

1. Above full-employment equilibrium: real GDP is greater than potential GDP 2. Full-employment equilibrium: real GDP = potential GDP 3. Below full-employment equilibrium: real GDP is less than potential GDP

What are the three schools of thought for macroeconomics?

1. Classical 2. Kenyensian 3. Monetarist

What are the two ways in which the world economy can influence aggregate demand?

1. Exchange rate 2. Foreign income

What are four factors that can shift the AD curve?

1. Expectations 2. Fiscal policy 3. Monetary policy 4. world economy

What are the two types of substitution effects?

1. Intertemporal substitution effect 2. International substitution effect

What are the two time frames in which we can study aggregate supply?

1. Long-run AS 2. Short-run AS

What are 4 main factors that quantity of real GDP demanded depend on?

1. The price level 2. Expectations 3. Fiscal policy and monetary policy 4. The world economy

What are two reasons for which the AD curve slopes downwards?

1. Wealth effect 2. Substitution effect

What are three reasons for which potential GDP will increase?

1. an increase in the full-employment quantity of labour 2. an increase in the quantity of capital 3. an advance in technology

What changes would cause a shift in AS curves?

1. changes in potential GDP 2. changes in money wage rate (and other price levels)

What are two reasons that can cause the money wage rate to change?

1. departure from full employment 2. expectations about inflation

Explain what happens to cause the aggregate supply to decrease, and what happens after.

A large but temporary rise in prices (say oil for example) will cause firms to decrease production since costs are high. SAS will consequently shift to the left, and price levels rise. We experience a recession because of the decrease in real GDP, and an inflation because of the increase in price level. This is also known as stagflation

Explain how inflation occurs with respect to the quantity theory of money, then related it back to AS-AD model.

According to the quantity theory of money: %M + %V = %P + %Y We know V = 0, so lets rearrange to solve for %P (i.e. price level): %P = %M - %Y So the change in price level (inflation) is equal to the change in quantity of money minus the change in potential GDP (or economic growth)

Why is the SAS curve an upward slope?

As price level increases, but money wage rate and other factor prices stay the same, firms can produce more goods, which increases real GDP

Why does an increase in money wage rate decrease the short-run aggregate supply?

Because it increases firms' costs

Why does an increase in money wage rate not affect LAS?

Because on LAS curve, the change in the money wage rate is accompanied by an equal percentage change in price level

Why is the LAS curve always vertical?

Because potential GDP is independent of the price level. (Imagine this: if the price of a product and all the factors of production to make this product all increase by the same percentage, the production power remains the same)

Why is it possible for the real GDP to be greater or less than potential GDP in the short-run?

Because the money wage rate is fixed, so it does not adjust to mov the economy to full employment

What happens to the LAS and SAS curves when potential GDP increases?

Both LAS and SAS curves will shift right

What happens if real GPD is above equilibrium GDP? lower than equilibrium GDP?

If real GPD is above equilibrium GDP, firms will decreases production and lower prices. If real GDP is below equilibrium GPD, firms will increase production and increase prices

Explain how inflation occurs in terms of aggregate supply and demand.

If the quantity of money grows faster than potential GDP, inflation will occur.

What is long-run aggregate supply?

It is the relationship between quantity of real GDP supplied and the price level when real GDP = potential GDP

What is aggregate demand?

It is the relationship between the quantity of real GDP demanded and the price level

What is short-run aggregate supply?

It is the relationship between the quantity of real GDP supplied and the price level when money wage rate, the prices of other resources, and potential GDP remain constant.

What is meant by the quantity of real GDP demanded?

It is the total amount of final goods and services produced in Canada that people, businesses, governments, and foreigners plan to buy

What is meant by the quantity of real GDP supplied?

It is the total quantity of goods and services, valued in constant base-year (2002) dollars, that firms plan to produce during a given period

If the money wage rate is too low, what does this mean for the short-run equilibrium and how do we get to long-run equilibrium?

It means the short-run equilibrium is above potential GDP and unemployment rate is below natural. The supply of labour is lower than the demand for labour, so the money wage rate rises and SAS shifts to the left

If the money wage rate is too high, what does this mean for short-run equilibrium and how do we get to long-run equilibrium

It means the short-run equilibrium is below potential GDP and the unemployment rate is above natural. The supply of labour is higher than the demand for labour, so the money wage rate falls and SAS shifts to the right

What is an adverse supply shock?

One that increases a firm's costs and consequently the firm produces less. SAS curve shifts to the left

What happens to the LAS and SAS curves when money wage rate increases?

SAS curve shifts to the left, LAS remains the same

What is monetary policy?

The Bank of Canada's attempt to influence the economy by changing interest rates and the quantity of money

What is stagflation?

The combination of recession and inflation

What is the output gap?

The difference between real GDP and potential GDP

What is fiscal policy?

The government's attempt to influence the economy by setting and changing taxes, making transfer payments, and purchasing goods and services

Explain the international substitution effect.

When Canadian price levels increases and everything else stays the same, people may opt to purchase foreign goods instead since it is less expensive. With this decision, imports increase and exports decrease, which overall will decrease the real GDP demanded

Explain what happens when aggregate demand increases.

When aggregate demand increases, the AD curve shifts to the right. Now the price level is higher and the real GDP is also higher, but everything else remains the same (money wage rate and all). At this point, firms will produce more since price level has increased, however households won't be able to spend as much money since now they can afford less. They will demand higher wages, and firms will comply in fear of loses employees. As they raise the wages, they will be able to put less money towards production, shifting the SAS curve to the left. The real GDP decreases and price level rises. Eventually the rise in money wage rate will equal the rise in price level and real GDP will be back at potential GPD

What is the recessionary gap?

When potential GDP exceeds real GDP, the output gap is known as the recessionary gap.

Explain the intertemporal substitution effect

When price level increases and everything else remains the same, the real money that people have decrease. With less money around, banks and loaners can charge a higher interest rate on loans. People may delay purchasing plans since borrowing rates are higher, which in turn decreases spending right now, which decreases real GDP demanded

Explain the wealth effect

When price level increases, and everything else remains the same, people can afford less, so they end up saving more and spending less (i.e. real wealth decreases), which decreases the real GDP demanded. Likewise, when price level decreases, and everything else remains the same, real wealth increases and real GDP demanded increases

When does long-run macroeconomic equilibrium occur?

When real GDP equals potential GDP (i.e. at the intersection of the AD curve and the LAS curve)

What is the inflationary gap?

When real GDP exceeds potential GDP, the output gap is called an inflationary gap.

What does it mean when the LAS curve shifts to the right, and what causes it to shift to the right?

When the LAS curve shifts to the right, it means that potential GDP has increased. Possible cause of this include increase in quantity of labour, capital is accumulated, and technological advances

When does the short-run macroeconomic equilibrium occur?

When the quantity of real GPD demanded equals the quantity of real GDP supplied at the point of intersection of the AD and SAS curve

Aggregate demand increases if interest rate (decreases/increases) and quantity of money (decreases/increases)

decrease; increase

So then when price level rises and other things remain the same, the quantity of real GDP demanded (decreases/increases).

decreases

Aggregate demand increases if exchange rate (decreases/increases) or foreign income (decreases/increases)

decreases; increases

What direction does the aggregate demand curve slope?

downward

An increase in disposable income (decreases/increases) aggregate demand

increases

Aggregate demand increases if government expenditure (decreases/increases), taxes (decreases/increases), and transfer payment (decreases/increases).

increases; decrease; increase

What is aggregate supply?

it is the relationship between the quantity of real GDP supplied and the price level

How do we calculate the quantity of real GDP demanded(Y)

it is the sum of real consumption expenditure (C), investments (I), government expenditure (G) and net exports (X-M) Y = C + I + G + X - M

Do changes in price level shift the AD curve?

no

Do changes in price level shift the AS curves?

no

Along the SAS curve, what is the relationship between real GDP and potential GDP when the price level is above the level where SAS and LAS intersect?

real GDP is above potential GDP

Along the SAS curve, what is the relationship between real GDP and potential GDP when the price level is below the level where SAS and LAS intersect?

real GDP is below potential GDP

What is "real wealth"?

the amount of money in the bank, bonds, stocks, and other assets that people own, measure not in dollars but in terms of the goods and services that the money, bonds, and stocks will buy

In short-run equilibrium, can the real GDP be greater or less than potential GDP?

yes