ECON 337 Ch 22
Downward sloping Aggregate Demand Curve
quantity theory of money analysis If velocity stays constant, a constant money supply implies constant nominal aggregate spending, and a decrease in the price level is matched with an increase in aggregate demand.
Short-run Aggregate Supply Curve
1. Expected Inflation 2. Price Shocks 3. A persistent Output Gap Wages and prices are sticky Generates an upward sloping SRAS as firms attempt to take advantage of short-run profitability when price level rises
Expected Inflation
A rise in expected inflation causes the short-run aggregate supply curve to shift upward and tot he left. Conversely, a fall in expected inflation causes the short-run aggregate supply curve to shift down and to the right. The larger the change in expected inflation, the larger is the shift. When workers expect a positive inflation rate, they will adjust nominal wages upward one-to-one wit the expected inflation rate so that the real wages rate does not decrease
Aggregate Supply Curve
Curve that shows the relationship between the quantity of output supplied and the inflation rate Determined by amount of capital and labor and available technology
Increase in Aggregate Demand
Decrease r: Autonomous easing of monetary policy Increase G: Government Purchases Decrease T: Taxes Increase NX: Autonomous Net Export Increase C: Autonomous Consumption Expenditure Increase I: Autonomous Investment Decrease f: Decrease financial friction
Short-run Aggregate Supply Curve Equation
Pi = Pi^e + y(Y - Y^p) + p Inflation = Expected Inflation + y*Output Gap + Inflation Shock y = the sensitivity of inflation to the output gap
Natural Rate of Unemployment
Rate to which the economy gravitates in the long run
Natural Rate of Output or Potential Output
The level of aggregate output produced at the natural rate of unemployment
government purchases
spending by all levels of government (federal, state, and local) on goods and services
net exports
the net foreign spending on domestic goods and services
consumption expenditure
the total demand for consumer goods and services
planned investment spending
the total planned spending by business firms on new machines, factories, and other capital goods, plus planned spending on new homes
Real business cycle theory
theory of aggregate economic fluctuations business cycle fluctuations result from permanent supply shocks alone and their
Temporary Supply Shocks
-When the temporary shock involves a restriction in supply, we refer to this type of supply shock as a negative (or unfavorable) supply shock, and it results in a rise in commodity prices. -A temporary positive supply shock shifts the short-run aggregate supply curve downward and to the right, leading initially to a fall in inflation and a rise in output. In the long run, however, output and inflation will be unchanged (holding the aggregate demand curve constant)
Aggregate demand and supply analysis yields the following conclusions
1. A shift in the aggregate demand curve affects output only in the short run and has no effect in the long run. 2. A temporary supply shock affects output and inflation only in the short run and has no effect in the long run (holding the aggregate demand curve constant). 3. A permanent supply shock affects output and inflation both in the short and the long run. 4. The economy has a self-correcting mechanism that returns it to potential output and the natural rate of unemployment over time.
Permanent Supply Shocks
A permanent negative supply shock—such as an increase in ill-advised regulations that causes the economy to be less efficient, thereby reducing supply—would decrease potential output and shift the long-run aggregate supply curve to the left. Because the permanent supply shock will result in higher prices, there will be an immediate rise in inflation and so the short-run aggregate supply curve will shift up and to the left.
Self-Correcting Mechanism
Regardless of where output is initially, it returns eventually to the natural rate. Slow: -Wages are inflexible, particularly downward -Need for active government policy Rapid: -Wages and prices are flexible -Less need for government intervention
Long Run Aggregate Supply Curve
Shifts to the right/increases 1. An increase in the total amount of capital in the economy 2. An increase in the total amount of labor supplied in the economy 3. A decline in the natural rate of unemployment
Aggregate Demand Shocks
Shocks that cause the aggregate demand curve to shift right Decrease r: Autonomous easing of monetary policy (lowering the real interest rate Increase G: Government Purchases Decrease T: Taxes Increase NX: Autonomous Net Export Increase C: Autonomous Consumption Expenditure Increase I: Autonomous Investment Decrease f: Decrease financial friction Although the initial short run effect of the rightward shift in the aggregate demand curve is a rise in both inflation and output, the ultimate long-run effect is a rise in inflation only, because output returns to its initial level at Yp
Output Gap
The percent difference between aggregate output and potential output Y - Yp. Slack: Little slack when output exceeds potential level and output gap is high. Workers demand high wages and firms raise prices. Ends with higher inflation When aggregate output is above potential output, so that a persistent positive output gap exists, the short run aggregate supply curve shifts up and to the left
Aggregate Demand Curve
The relationship between the quantity of aggregate output demanded and the inflation rate when all other variables are held constant
Aggregate Demand
The total amount of output demanded at different inflation rates
Aggregate Supply
Total amount of output that firms in an economy want to sell at different inflation rates
Inflation (Supply) Shocks
Unfavorable supply shocks that drive up inflation cause the short-run aggregate supply curve to shift up and to the left, while favorable supply shocks that lower inflation cause short run aggregate supply curve to shift down and to the right. Supply Shocks: Shock to supply of goods and services produced in the economy. Creates inflation shocks Inflation Shocks: Shifts in inflation that are independent of the amount of slack in the economy or expected inflation Cost Push Shock: Workers push for wages that are higher than productivity gains, thereby driving up costs and inflation
General Equalibrium
When all markets are simultaneously in equilibrium at the point where the quantity of aggregate output demanded equals the quantity of aggregate output supplied.
Aggregate Demand Equation
Y^ad = C + I + G + NX