ECO 252 Chapter 20

Economy's GDP (Y) =

Consumption [c] + investment (I) + government purchases (G) + Net exports (NX)

If policymakers choose to try to move the economy out of a recession, they should use their policy tools to decrease aggregate demand.

False

One reason aggregate demand slopes downward is the wealth effect: A decrease in the price level increases the value of money holdings and consumer spending rises.

True

Suppose the economy is operating in a recession such as point B in Exhibit 4. If policymakers wished to move output to its long-run natural rate, they should attempt to

shift aggregate demand to the right.

Model of aggregate demand and aggregated supply

the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend

Natural level of output

the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate

A contraction in aggregate demand:

- A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve. Output falls and the price level falls - Over time, as the expected price level adjusts, the short-run aggregate-supply curve shifts to the right, and the economy reaches a new equilibrium, where the new aggregate-demand curve crosses the long-run aggregate-supply curve. - In the long-run, the price level falls and the output returns to its natural level

Three reasons a fall in price level increases the quantity of goods and services demanded:

1. Consumers are wealthier, which stimulates the demand for consumption goods 2. Interest rates fall, which stimulates the demand for investment goods 3. The currency depreciates, which stimulates the demand for net exports

Four steps for analyzing Macroeconomic fluctuations:

1. Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve (or both) 2. Decide the direction in which the curve shifts 3. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run 4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its long-run equilibrium.

Three key facts about economic fluctuations:

1. Economic fluctuations are irregular and unpredictable 2. Most macroeconomic quantities fluctuate together 3. As output falls, unemployment rises

5. According to the wealth effect, aggregate demand slopes downward (negatively) because A variety of spending, income, and output measures can be used to measure economic fluctuations because most macroeconomic quantities tend to fluctuate together. A recession is when output rises above the natural rate of output. Economic fluctuations have been termed the "business cycle" because the movements in output are regular and predictable. A depression is a mild recession. None of these answers are true.

A variety of spending, income, and output measures can be used to measure economic fluctuations because most macroeconomic quantities tend to fluctuate together.

Determine how each event affects the position of the long-run aggregate supply (LRAS) curve: 1. Many workers leave to pursue more lucrative careers in foreign economies. 2. This economy's primary source of foreign oil decides to cease exports for political reasons. 3. A government-sponsored training program increases the skill level of the workforce

Left Left Right

Suppose the economy is initially in long-run equilibrium. Then suppose there is a increase in military spending due to rising international tensions. According to the model of aggregate demand and aggregate supply, what happens to prices and output in the short run?

Price rise, output rises

Suppose the economy is initially in long-run equilibrium. Then suppose there is a drought that destroys much of the wheat crop. According to the model of aggregate demand and aggregate supply, what happens to prices and output in the short run ?

Prices rise; output falls

A look at short-run economic fluctuations:

Real GDP and investment spending both decline during recessions, while unemployment rises

Suppose the government passed a law that significantly increases the minimum wage. The policy will cause the natural rate of unemployment to _____ which will:

Rise

If the classical dichotomy and monetary neutrality hold in the long run, then the long-run aggregate-supply curve should be vertical.

True

Aggregate-supply curve

a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

According to the wealth effect, aggregate demand slopes downward (negatively) because

lower prices increase the value of money holdings and consumer spending increases.

Suppose the price level falls but suppliers only notice that the price of their particular product has fallen. Thinking there has been a fall in the relative price of their product, they cut back on production. This is a demonstration of the

misperceptions theory of the short-run aggregate supply curve.

Quantity of output supplied =

natural level of output + a(actual price level - expected price level) a = the number that determines how much output responds to unexpected changes in the price level

Refer to Exhibit 4. Suppose the economy is operating in a recession such as point B in Exhibit 4. If policymakers allow the economy to adjust to the long-run natural rate on its own,

people will reduce their price expectations and the short-run aggregate supply will shift right

Policymakers are said to "accommodate" an adverse supply shock if they

respond to the adverse supply shock by increasing aggregate demand, which further raises prices.

Stagflation occurs when the economy experiences

rising prices and falling output

Suppose the price level falls. Because of fixed nominal wage contracts, firms become less profitable and they cut back on production. This is a demonstration of the

sticky-wage theory of the short-run aggregate supply curve

The natural rate of output is the amount of real GDP produced

when the economy is at the natural rate of unemployment.

The aggregate-demand curve

- A fall in the price level increases the quantity of goods and services demanded. - There are three reasons for this negative relationship. As the price falls, real wealth rises, interest rates fall, and the exchange rate depreciates. - These effects stimulate spending on consumption, investment, and net exports - Increased spending on any or all of these components of output means a larger quantity of goods and services demanded

Long-run growth and inflation in the model of aggregate demand and aggregate supply:

- As the economy becomes better able to produce goods and services over time, primarily because of technological progress, the long run aggregate-supply curve shifts to the right. - At the same time, as the Fed increases the money supply, the aggregate-demand curve also shifts to the right - Thus, the model of aggregate demand and aggregate supply offers a new way to describe the classical analysis of growth and inflation

Aggregate demand and aggregate supply curve chart:

- Economics use the model of aggregate demand and aggregate supply to analyze economic fluctuations. - On the vertical axis is the overall level of prices - On the horizontal axis is the economy's total output of goods and services - Output and the price level adjust to the point at which the aggregate-supply and aggregate-demand curves intersect.

Indicate the change in each determinant necessary to increase aggregate demand: Consumer expectations about future profitability Government spending The value of the domestic currency relative to the foreign currency

- Improve - Increase - Depreciate

The long-run aggregate-supply curve

- In the long-run, the quantity of output supplied depends on the economy's quantities of labor, capital, and natural resources and on the technology for turning there inputs into output - Because the quantity supplied does not depend on the overall price level, the long-run aggregate-supply curve is vertical at the natural level of output.

If the Federal Reserve increases the money supply, the aggregate-demand curve shifts to the left.

False

Three important lessons about shifts in aggregate demand:

- In the short run, shifts in aggregate demand cause fluctuations in the economy's output of goods and services - In the long run, shifts in aggregate demand affect the overall price level but do not affect output - Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations

The short-run Aggregate-supply curve:

- In the short-run, a fall in the price level reduces the quantity of output supplied. - This positive relationship could be due to sticky wages, sticky prices, or misperceptions - Over time wages, prices, and perceptions adjust, so this positive relationship is only temporary

Accommodating an adverse shift in aggregate supply:

- Policymakers may try to shift the aggregate-demand curve to the right. - This policy would prevent the supply shift from reducing output in the short run, but the price level would permanently rise

The Long-run equilibrium:

- The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve. - When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. - As a result, the short-run aggregate-supply curve crosses this point as well

An adverse shift in aggregate supply:

- When some event increases firms' costs, the short run aggregate-supply curve shifts to the left - The result is stagflation, output falls, and the price level rises

Suppose the economy is initially in long-run equilibrium. Then suppose there is a reduction in military spending due to the end of the Cold War. According to the model of aggregate demand and aggregate supply, what happens to prices and output in theshort run ?

Prices fall; output falls.

In the short run, if the government cuts back spending to balance its budget, it will likely cause a recession.

True

Aggregate-demand curve

a curve that shows the quantity of goods and services that households, firms, the government, and consumers abroad want to buy at each price level

Which of the following events shifts the short-run aggregate-supply curve to the right?

a drop in oil prices

Stagflation

a period of falling output and rising prices

In the model of aggregate demand and aggregate supply, the initial impact of an increase in consumer optimism is to

shift the aggregate demand curve to the right.

Which of the following statements is true regarding the long-run aggregate-supply curve? The long-run aggregate-supply curve:

shifts right when the government raises the minimum wage.

Sticky-wage theory

states that the short-run aggregate supply curve slopes upward because nominal wages are slow to adjust to economic conditions. If the price level turns out to be higher than what firms and workers anticipated when they negotiated wage contracts, output price will rise even as wages remain fixed at the agreed-upon level. As firms see their output price rise faster than their input prices, their profits rise, which gives them an incentive to increase production. Conversely, if the price level is unexpectedly low, firms will see their output prices fall below expected levels with no change in their labor costs. They will respond by reducing output.

2. Which of the following is not a reason why the aggregate-demand curve slopes downward? The exchange-rate effect the classical dichotomy/monetary neutrality effects the interest-rate effect the wealth effect All of these answers are reasons why the aggregate-demand curve slopes downward

the classical dichotomy/monetary neutrality effects