Chapter 27

Why do negative supply shocks pose a policy dilemma? ***

Fighting the slump in aggregate output worsens inflation and fighting inflation worsens the slump.

Short-Run Equilibrium Aggregate Price Level (803)

The aggregate price level in the short-run macroeconomic equilibrium.

AD-AS Model (803) ****

The aggregate supply curve and the aggregate demand curve are used together to analyze economic fluctuations.

Comparing Classical and Keynesian Models ***

The classical model uses supply shocks to explain the business cycle - 1 reason for business cycle. The Keynesian Model is where either demand shocks or supply shocks can lead to business cycles - 2 reasons for business cycle.

Stagflation (805) ***

The combination of inflation and falling aggregate output. The consequence of a negative supply shock.

Nominal Wage (793)

The dollar amount of the wage paid.

Self-Correcting (809) ***

The economy is self-correcting when shocks to aggregate demand affect aggregate output in the short run, but not the long run.

Long-Run Macroeconomic Equilibrium (806) ***

When the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve/

Short-Run Macroeconomic Equilibrium (803) ***

When the quantity of aggregate output supplied is equal to the quantity demanded. Occurs at the intersection of the short-run aggregate supply and aggregate demand curves. This determines the short-run equilibrium aggregate price level and the level of short-run equilibrium aggregate output.

Classical Demand Model Shocks ***

With Flexible wages and prices, demand shocks affect only the price level. They do not affect real variables such as output, employment, or unemployment.

Classical Model Supply Shocks

With flexible wages and prices, adverse supply shocks raise the price level and reduce output.

Three Major Factors that cause AD to be negatively sloped

1) The real balance effect 2) The interest rate effect 3) The Foreign trade effect.

Two Schools of Thought

1) Wages and Prices move together 2) Wages do not change when prices change

Aggregate Demand ***

AD Curve shows the real GDP that households, businesses, government, and foreigners are prepared to buy at different prices.

The self-correcting mechanism (in the Keynesian model) ***

Achieves the same result as flexible wages and prices. A reduction in AD does not affect output or employment in the LR. It only affects the price level.

Demand Shock (803) ***

An event that shifts the aggregate demand (AD) curve, causes the aggregate price level and aggregate output to move in the same direction as the economy moves along the short-run aggregate supply curve.

Supply Shock (804) ***

An event that shifts the short-run aggregate supply (SRAS) curve, causes aggregate price level and aggregate output to move in the opposite directions as the economy moves along the aggregate demand curve.

What shifts the short-run aggregate supply curve and leads to changes in producers' profits? ***

Changes in commodity prices, nominal wages, and productivity.

What shifts the aggregate demand curve? ***

Changes in expectations, changes in wealth not due to changes in the aggregate price level, and the effect of the size of the existing stock of physical capital.

Flaws in the Classic Model ***

Classical economies explains many of the basic correlations, but it has a difficult time explaining deep depressions.

How does Fiscal policy affect the aggregate demand?

Directly through government purchases and indirectly through changes in taxes or government transfers.

If the economy is at the natural rate of unemployment, then the number of vacancies: ***

Equals the number unemployed.

Classical Model ***

Flexible Wages and Prices. As curve shows the amount of real GDP firms in the economy are prepared to supply at different price levels. W/P (flexible) Workers demand 10% more wage, able to raise price 10% then it moves together and the ratio is unchanged. An increase in prices should have no effect on the real output supplied in an economy if prices, wages, and other costs are all rising at the same rate. When wages and prices are flexible, as it is vertical at the natural level of output.

Adverse demand shocks in keynesian model, effects on real variables: ***

Go down.

Keynesian Model Demand Shocks ***

In the SR, increases in AD will raise output, employment and the price level. Fluctuations in AD can cause business cycles. Government can add incentives for spending and the AD will increase, give people back jobs but prices will be higher. Attractive government policy, could be economically suicidal - hyperinflation.

How does monetary policy affect aggregate demand?

Indirectly through changes in the interest rate.

Keynesian Model ***

Inflexible Wages (Ws inflexible), Ps Flexible. Pay employees $50/hour price of product decreases, still obligated to pay some wage. Positive slope. Wages do not change. When wages are sticky (inflexible), falling prices raise real wages and firms reduce their employment and output. As, therefore, has a positive slope.

Flaws in the Keynesian Model ***

Keynesian economics explains deep depressions, but it has a difficult time explaining key facts of the business cycle.

What happens when potential output exceeds actual aggregate output? ***

Nominal wages eventually fall in response to high unemployment and aggregate output will rise and the short-run aggregate supply curve shifts rightward.

What happens when actual aggregate output exceeds potential output? ***

Nominal wages eventually rise in response to low unemployment and aggregate output will fall and the short-run aggregate supply curve shifts leftward.

Sticky Wages (793) ***

Nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labor shortages.

Foreign trade effect

Occurs when a rise in the domestic price level lowers the aggregate quantity demanded by pushing down net exports (x-m).

Real balance effect

Occurs when desired consumption falls as increases in the price level reduce the purchasing power of money.

Interest rate effect

Occurs when increases in the price level push up interest rates in credit market, which lowers real investment.

Do output and employment move in the same direction? ***

Output and employment go in same direction (more you produce, more can hire). Output and unemployment go in opposite direction.

Output ***

RGDP (Real GDP). Real Wages are money wages divided by the price level, w/p [W (Money Wage) / P (Price Level which is Price Index)].

SR (Short Run) Production Function ***

Shows the output produced with a given amount of employment when capital and technology are fixed.

Aggregate Demand Curve (784) ***

Shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world. It's downward sloping because of the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level. Shows how income-expenditure equilibrium GDP changes when the aggregate price level changes.

Aggregate Supply Curve (793) ***

Shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the economy.

Short-Run Aggregate Supply Curve (794) ***

Shows the relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs can be taken are fixed. Upward sloping: a higher aggregate price level leads to a higher aggregate output given that nominal wages are sticky.

Long-Run Aggregate Supply Curve (798) ***

Shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. Vertical at potential output because in the long-run, all prices are flexible and changes in the aggregate price level ave no effect on aggregate output.

According to the Keynesian macroeconomics, the aggregate supply curve: ***

Slopes Upward

Keynesian Model Supply Shocks ***

Supply shocks can also cause business cycles. An adverse supply shock raise the price level but lowers output and employment. More production, more people you can employ.

Natural Level or Output (Real GDP) ***Endogenous Growth Theory/Neo-Schumpeterian

That level corresponding to equality in the demand and supply of labor.

Interest Rate Effect of a Change in the Aggregate Price Level (793) ***

The effect on consumer spending and investment spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers' and firms' money holdings, changes in expectations and by the size of existing stock of physical capital. Shifts the aggregate demand curve. A higher aggregate price level reduces the purchasing power of households' and firms' money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending.

Wealth Effect of a Change in the Aggregate Price Level (786)

The effect on consumer spending caused by the effect of a change in the aggregate price level on the purchasing power of consumers' assets, expectations about the future. Shifts the aggregate demand curve. A higher aggregate price level reduces the purchasing power of a households' wealth and reduces consumer spending.

Stabilization Policy (811) ***

The high cost, in terms of unemployment, of a recessionary gap and the future adverse consequences of an inflationary gap lead many economists to advocate active stabilization policy. The use of government policy to reduce the severity of recessions and rein in excessively strong expansions. The use of fiscal or monetary policy to offset demand shocks. There can be drawbacks, however. Such policies may lead to a long-term rise in the budget deficit and lower long-run growth because of crowing out. And, due to incorrect predictions, a misguided policy can increase economic stability.

Potential Output (799) ***

The level of real GDP the economy would produce if all prices, including nominal wages, were fully flexible.

Output Gap (809)

The percentage difference between actual aggregate output and potential output. Always tends toward zero because the economy is self-correcting in the long run.

Short-Run Equilibrium Aggregate Output (803)

The quantity of aggregate output produced in the short-run macroeconomic equilibrium.

Natural Rate of Unemployment (Full Employment) ***

The rate at which the labor force is in balance. Number of job seekers and number of vacancies are equal but not together.

Adverse demand shocks in classical model, effects on real variables: ***

Unaffected.

Your study partner is confused by the upward-sloping short-run aggregate supply curve and the vertical long-run aggregate supply curve. How would you explain this? ***

Upward sloping because a higher aggregate price level leads to a higher aggregate output given that nominal wages are sticky and Vertical at potential output because in the long-run, all prices are flexible and changes in the aggregate price level ave no effect on aggregate output.

Aggregate Supply (AS): Wage and Price ***

W's and P's are flexible: if numerator and denominator move together, you have no incentive to produce more or less, no better or worse off.

Why are wages and prices more inflexible in the short run than in the long run?

Wages and prices may be constrained by contracts in the short run. In the long run all contracts can be renegotiated.

Inflationary Gap (808) ***

When aggregate output is above potential output. A rise in nominal wages occurs in response to an inflationary gap. Moves the economy to long-run macroeconomic equilibrium, where the AD, SRAS, and LRAS curves intersect.

Recessionary Gap (806)

When aggregate output is below potential output. A fall in nominal wages occurs in response to a recessionary gap. Moves the economy to long-run macroeconomic equilibrium, where the AD, SRAS, and LRAS curves intersect.