MACRO Chpt 13: The Aggregate Demand - Aggregate Supply Model

Sticky input prices

are said to be sticky because they "stick" at a certain levels and take time to change.

Supply shocks

are surprise events that change a firm's production costs.

Wealth

is the net value of one's accumulated assets. Your wealth is the total net value of everything you own, including the money in your wallet and in your bank accounts.

Aggregate demand

is the total demand for final goods and services in an economy.

What is the aggregate demand - aggregate supply model?

The aggregate demand - aggregate supply model is a model that economists use to study business cycles (short-run fluctuations in the economy).

What are three reasons the short-run aggregate supply curve slopes upward? Name at least three factors that shift the short-run aggregate supply curve.

The inflexible input prices, menu costs, and money illusion. All long-run aggregate supply curve shifts (caused by changes in resources, technology, and institutions) also cause the short-run aggregate supply curve to shift. Other shifts in the short-run aggregate supply curve are due to changes that directly affect firms' costs of production and form their incentives for supply. The primary cause of shifts in the short-run aggregate supply is changes in the input or resources in input or resource prices. When firms' production costs fall, forms produce more output at any given price level, which means that short-run aggregate supply increases, or shifts to the right. Even though input prices and other prices are sticky, they can still change, and when they do the short-run aggregate supply curve shifts.

How are the factors that shift the long-run aggregate supply curve different from those that shift the short-run aggregate supple curve.

The long-run aggregate supply curve shifts when there is a long-run change in a nation's ability to produce output, or a change in Y*. These factors are the same that determine economic growth: resources, technology, and institutions. All of these factors also cause the short-run aggregate supply curve to shift. But the short-run aggregate supply curve can also shift on its own due to changes that directly affect firms' costs of production and form their incentives for apply.

Interest rate effect

occurs when a change in the price level leads to a change in interest rates and therefore in the quantity of aggregate demand.

International trade effect

occurs when a change in the price level leads to a change in the quantity of net exports demanded.

What component (or piece) of aggregate demand is primarily affected by the wealth effect?

A rise in prices all over the economy reduces real wealth in the economy, and then the quantity of aggregate demand falls. In contrast, if prices fall, real wealth increases, and then the quantity of aggregate demand also increases.

What is aggregate demand?

Aggregate demand represents the spending side of the economy. It is the total demand for final goods and services in an economy. It includes consumption, investment, government spending, and net exports. The slope of the aggregate demand curve is negative due to the wealth effect, the interest rate effect, and the international trade effect. The aggregate demand curve shifts when there are changes in consumption factors (real wealth, expected future income, taxes), investment factors (investor confidence, interest rates, the quantity of money), government spending (at the federal, state, and local levels), or net export factors (foreign income and the value of the U.S. dollar).

What is aggregate supply?

Aggregate supply represents the producing side of the economy. It is the total supply of final goods and services in an economy. The long-run aggregate supply curve is relevant when all prices are flexible. This curve is vertical at full-employment output and is not influences by price level. In the short-run, when some prices are sticky, the short-run aggregate supply curve is relevant. This curve indicates a positive relationship between the price level and real output supplied.

How does strong economic growth in China affect aggregate demand in the United States?

As China grows wealthier, its demand for U.S. goods and services has increased. When the income of people in foreign nations grows, their demand for U.S. goods increases. The result is an increase in U.S. net exports, which are the final component of aggregate demand.

Suppose the economy is in a recession caused by lower aggregate demand. If no policy action is taken, what will happen to the price level, output, and employment in the long run?

Output and unemployment will return to their original levels in the long run and price level will continue to fall.

Consider two economies, both in recession. In the first economy, all workers have long-term contracts that guarantee high nominal wages for the next five years. In the second economy, all workers have annual contracts that are indexed to changes in the price level. Which economy will return to the natural rate of output first? Explain.

The second economy. Workers in the first economy likely negotiated their long-term contracts on the basis of higher expected future prices. Higher wages lead to higher labor costs and reduced profitability, which ultimately results in a lower quantity of AS.

What are the three reasons the aggregate demand curve slopes downward? Name at least three factors that shift the aggregate demand curve.

The wealth effect, the interest rate effect, and the international trade effect. Shifts in the demand curve can come from any of the components of aggregate demand: consumption, investment, government spending, or net exports. When people demand more goods and services at all price levels, aggregate demand increases and the AD curve shifts to the right. When people demand fewer goods and services at all price levels, aggregate demand decreases and the AD curve shifts to the left. The aggregate demand curve shifts to the right with increases in real wealth, expected income, expected future prices, and foreign income and wealth or with a decrease in the value of the dollar. The aggregate demand curve shifts to the left with decreases in real wealth, expected income, expected future prices, and foreign income and wealth or with an increase in the value of the dollar.

How does the aggregate demand - aggregate supply model help us understand the economy?

We can use the aggregate demand - aggregate supply model to see how changes in either aggregate demand or aggregate supply (or both) affect real GDP, unemployment, and the price level.

Why is the long-run aggregate supply curve vertical?

We plot LRAS with the economy's price level (P) on the vertical axis and real GDP (Y) on the horizontal axis, long-run aggregate supply is a vertical line at Y*, which is full-employment output. This is the output level that is sustainable for the long-run in the economy. Because prices don't affect full-employment output, the LRAS curve is a vertical line at Y*.

Long run

in macroeconomics is a period of time sufficient for all prices to adjust.

Short run

is a period of time in which some prices have no yet adjusted.

Wealth effect

is the change in the quantity of aggregate demand that results from wealth changes due to price-level changes.

Aggregate supply

is the total supply of final goods and services in an economy.