Macroeconomics: Ch.8

Short run aggregate supply curve

(SRAS) the relationship between total planned economywide production and the price level in the short run, all other things help constant. If prices adjust incompletely in the short run, the curve is positively sloped

Changes that cause a decrease in aggregate supply

-depletion of raw materials -decreased competition -an increase in international trade barriers -more regulatory impediments to buisness -a decrease in labor supplied -decreased traning and education -an increase in marginal income tax rates -an increase in input prices

Changes that cause an increase in aggregate supply

-discoveries of new raw material -increased competition -reduction in international trade buisness -an increase in the supply of labor -increase traning and education -a decrease in marginal income tax rates -a reduction in input prices

The classical model makes four major assumptions

-pure competition exists -wages and prices are flexible -people are motivated by self intrest -people cannot be fooled by money illusion

Effects of a decrease in aggregare demand in the classical model

-starting with the economy at full employment, aggregate demand decreases -real GDP tends to fall below its long run level as represented by the postion of LRAS -unemployment increases -competitions among workers pushes down wage rates. The same occurs for other input prices -the economy again finds itself on the vertical LRAS

Explain how a weaker dollar (depreciation of the dollar against a foreign currency) affects aggregate demand and aggregate supply.

A weaker dollar can significantly impact aggregate demand (AD) and aggregate supply (AS). A weaker dollar makes exports cheaper for foreign buyers, increasing demand for U.S. goods and services. Conversely, a weaker dollar makes imports more expensive, decreasing demand for imports and increasing aggregate demand. This leads to an increase in net exports, which contribute positively to aggregate demand. Aggregate supply (AS) also increases due to increased demand for U.S. goods, leading firms to increase production to meet the increased demand. However, a weaker dollar may also lead to higher input costs for firms relying on imported materials or components. The long-term effects of a weaker dollar on aggregate supply depend on factors like firms' ability to adjust to changes in input costs, market competition, and labor market responsiveness.

aggregate demand total planned expenditures in the entire economy

C,I,G,X

Given a scenario, show graphically and explain the effect on the price level and real GDP of a change in aggregate demand, using the Classical model.

In the Classical model, an increase in aggregate demand leads to higher prices and an expansion of real GDP. This is illustrated graphically using the curves AD1 and AS. The initial equilibrium point (E1) represents the equilibrium level of real GDP and price level. As aggregate demand increases, the curve shifts to AD2, resulting in a new equilibrium point (E2) at a higher level of real GDP and a higher price level. Firms respond by raising prices, leading to an increase in the overall price level. The real GDP level expands from the initial level (Y1) to a higher level (Y2), reflecting the economy's ability to produce more output.

Given a scenario, show graphically and explain the effect on the price level and real GDP of a change in aggregate demand, using the Keynesian model.

In the Keynesian model, an increase in aggregate demand leads to higher prices and an expansion of real GDP. This is illustrated graphically using the curves AD1, SRAS, and LRAS. The initial equilibrium point (E1) represents the equilibrium level of real GDP and price level. As aggregate demand increases, the curve shifts to AD2, resulting in a new equilibrium point (E2) at a higher level of real GDP and a higher price level. This upward pressure on prices leads to firms raising prices, resulting in a higher price level. Real GDP expands from the initial level (Y1) to a higher level (Y2), reflecting the economy's ability to produce more output in response to increased demand. This highlights the importance of aggregate demand management and government policies in stabilizing the economy and promoting full employment, especially in the short run.

Classical model Theory

Only structural and frictional unemployment will exist.Cyclical unemployment is equivalent to a surplus of workers, which would force the price of workers (wages) down, causing the quantity demanded of workers to increase and the quantity supplied to decrease. The "natural rate of unemployment equilibrium" would be reached again; Because of flexibility in wages, prices, and interest rates, out-of-equilibrium conditions don't last long so the concept of short run vs long run doesn't exist. Equilibrium settles at the level of real GDP that can be produced at a certain long-run employment level (the natural rate of unemployment). ; Since long-run aggregate supply (LAS) is the level of real GDP that can be produced at the natural rate of unemployment, the LAS curve won't shift. It won't increase because the economy is at "full employment" and it won't decrease because flexible wages, prices, and interest rates bring it back to equilibrium; Aggregate Demand can shift. An increase will cause the price level to rise, and a decrease will cause the price level to fall; Real GDP is affected only by aggregate supply, and the price level is affected only by aggregate demand.

SRAS economic activity level may be inside

PPC

Modern Keynesian model Theory

Prices and wages are somewhat flexible (and not totally sticky); In the short run, real GDP can actually increase beyond that achieved at the natural rate of unemployment (Overtime for workers, Running machines longer, Higher prices required to induce firms to produce more and pay for overtime and expenses associated with running machines longer; Real GDP affected by shifts in SRAS, LAS, and aggregate demand; Prices affected by shifts in SRAS, LAS, and aggregate demand (Demand-Pull inflation, Cost-Push inflation); Foreign exchange implications on aggregate supply and aggregate demand; Weaker dollar means input prices increase, causing aggregate supply to decrease. Prices rise. Likewise, imports will decrease, causing net exports to increase, causing aggregate demand to increase. Prices will rise; Weaker dollar means export prices decrease; aggregate demand increases.Prices rise; Real GDP increases or decreases, depending on relative shifts in aggregate demand and aggregate supply.

Keynesian model Theory

Prices and wages are sticky (inflexible), especially downward, due to labor unions and long-term contracts; Because of sticky prices, unemployment and excess capacity can exist; Real GDP affected only by aggregate demand.

Define Say's Law and relate it to the Classical model.

Say's Law, named after French economist Jean-Baptiste Say, is an economic principle that states that supply creates its own demand. It suggests that every unit of production generates income, which in turn generates demand for other goods and services. This principle is a fundamental assumption in the Classical model, which believes markets tend towards equilibrium automatically without government intervention. In this model, a surplus of goods in one sector leads to lower prices, stimulating demand or encouraging resource allocation. Critics argue that Say's Law may not hold true in all circumstances, especially during economic recessions or depressions. Keynesian economists argue that government intervention may be necessary to stimulate demand and overcome economic downturns.

Explain why the Classical model assumes aggregate supply to be fixed.

The Classical model assumes that aggregate supply is fixed in the long run due to its foundational assumption of full employment. This means that the economy is always operating at full employment, with all available resources fully utilized in the production process. This leads to a fixed level of aggregate supply in the long run. The model also assumes that prices and wages are flexible and adjust quickly to changes in supply and demand, ensuring the economy always operates at full employment. In the long run, firms have sufficient time to adjust their production levels to match aggregate demand, leading to a fixed aggregate supply. However, short-term fluctuations in aggregate supply can occur due to technological changes, resource availability, and production possibilities.

List and explain the assumptions underlying the Classical model.

The Classical model in economics is based on several assumptions that simplify the analysis of economic behavior. These assumptions include full employment, flexible prices and wages, Say's Law (Law of Markets), rational expectations, and neutral money. Full employment implies that the economy is always at full employment, with all available resources utilized in the production process. Flexible prices and wages ensure markets clear efficiently, with no persistent shortages or surpluses. Say's Law states that supply creates its own demand, preventing overproduction or deficiency of demand. Rational expectations help ensure efficient market functioning and predictable outcomes. The neutrality of money suggests that changes in the money supply have no real effect on the economy in the long run. These assumptions are often relaxed or modified in more advanced models to better capture real-world economic phenomena.

Read and explain a graph showing the Classical model in equilibrium.

The Classical model is a framework used in economics to analyze the long-term behavior of an economy, assuming full employment and all available resources are fully utilized. The economy tends towards equilibrium, where aggregate demand (AD) equals aggregate supply (AS). The graph depicts the equilibrium point (E) where the quantity of real GDP demanded equals the quantity of real GDP supplied, indicating that the economy is producing at its full potential. Changes in aggregate demand or supply can cause shifts in the AD and AS curves, leading to changes in the equilibrium level of real GDP and the price level. An increase in aggregate demand leads to higher output levels and an increase in the price level, while a decrease in aggregate supply leads to lower output levels and higher prices.

List and explain the assumptions underlying the Keynesian model.

The Keynesian model in economics is based on several assumptions that provide a framework for understanding the dynamics of economies, particularly in the short run. These assumptions include involuntary unemployment, which suggests that markets may not always clear efficiently due to sticky wages and prices. Aggregate demand determines output and employment, and changes in aggregate demand can lead to fluctuations in output and employment levels. Sticky prices and wages in the short run can result in periods of disequilibrium, while interest rate determination influences investment decisions and aggregate demand. Keynesian economists advocate for active government intervention, such as fiscal and monetary policies, to stabilize the economy and promote full employment. The model primarily focuses on the short run, where prices and wages may become more flexible, allowing the economy to reach full employment equilibrium.

Read and explain a graph showing the Keynesian model in equilibrium.

The Keynesian model is a economic theory that posits that equilibrium occurs when aggregate demand equals aggregate supply, but this can occur at less than full employment. This is because the model acknowledges that sticky prices and wages can lead to periods of involuntary unemployment. The graph shows the intersection of aggregate demand (AD) and aggregate supply (AS), which may be relatively flat or upward sloping, suggesting that changes in output have a more significant impact on prices than changes in prices have on output. The equilibrium point (E) occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied, and in this case, the economy may remain at equilibrium with less than full employment of resources.

Explain why the Keynesian model includes a short-run aggregate supply curve and a long-run aggregate supply curve.

The Keynesian model uses both short-run and long-run aggregate supply curves to understand how the economy responds to changes in aggregate demand and supply-side factors. The short-run SRAS curve assumes sticky prices and wages, which may not adjust quickly to changes in supply and demand conditions. This can lead to underutilization of resources and involuntary unemployment, resulting in a flat SRAS curve. The long-run LRAS curve acknowledges that prices and wages may become more flexible in the long run, leading to full employment equilibrium. This allows firms to adjust production levels to match changes in aggregate demand, leading to a vertical LRAS curve. In the long run, changes in supply-side factors, such as technological advancements and labor force changes, can affect the economy's potential output level. This model provides a more nuanced understanding of how the economy responds to changes in aggregate demand and supply-side factors.

Given a scenario, show graphically and explain the effect on the price level and real GDP of a change in aggregate demand, using the Modern Keynesian model.

The Modern Keynesian model, also known as New Keynesian economics, is a model that incorporates features such as nominal rigidities, price stickiness, and imperfect competition. It illustrates the effects of an increase in aggregate demand on the price level and real GDP. The model suggests that an increase in aggregate demand may initially lead to a smaller increase in prices due to nominal rigidities or price stickiness, and a smaller increase in real GDP due to firms' inability to adjust output immediately. This highlights the importance of considering the role of frictions in the economy when assessing the impact of changes in aggregate demand on output and inflation

Says law

a dictum of economist J.B say that supply creates it's own demand. Producing goods and services generates the means and the willingness to purchase other goods and services

according to keynes when there is excess capacity in an economy the equilbrium level of real GDP per year is determined by

aggregate demand

Classical model is graphed as

aggregate supply and aggregate demand

A recessionary gap is created when

aggregate supply remains stable but aggregate deamnd falls in the short run

Which of the following will occur when aggregate supply remains stable but aggregate demand increase in the short run

an inflationary gap is created

Aggregate demand shock

any event that causes the aggregate demand curve to shift inward or outward

aggregate supply shock

any event that causes the aggregate supply curve to shift inward and outward

People motivated by self interest is characterized by

business desire for maximum profits and consumers desire to maximize economic well being

Classical model underlying framework is

circular flow which demonstrates says law

Cost push inflation is caused persistent

decreases in short run aggregate supply

Aggregate demand is graphed as

downward sloping curve relating price level and amount of planned spending on real GDP

True or false: a stronger dollar contributes to inflation

false

Aggregate supply is

full employment (natural rate of unemployment) level of real GDP equals LRAS

SRAS is graphed as

horizontal line (fixed(sticky) prices)

Cost push inflation

inflation caused by decreases in short run aggregate supply

Demand pull inflation

inflation caused by increases in aggregate demand not matched by increases in aggregate supply

Saving and investments are planned levels determined by

interest rate

The lower the rate of intrest the _________ profitable it is to invest and the ________ the level of desired investment

more; higher

Pure completion is characterized by

no single buyer or seller can influence price

Equilibrium is where

planned saving= planned investment

3 models attempt to explain determinants of

price level, real gdp, employment, consumption, saving, investment

long run aggregate supply economy is on

production possibilities curve

Classical model assumptions

pure competition, flexible wages and prices, no money illusion, people motivated by self interest

Modern Keynesian model assumption

pure competition, some flexibility in wages and prices (not totally sticky), no money illusion, people motivated by self interest

Keynesian modem assumptions

pure competition, sticky wages and prices especially downward, no money illusion, people motivated by self interest

Money illusion

reacting to changes in money prices rather than relative prices. If a worker whose wages double when the price level also doubles thinks he or she is better off, that worker is suffering from money illusion

as the dollar becomes stronger in international foreign exchange markets; the short run aggregate supply curve will shift to the ________ and the aggregate demand curve will shift to the ________

right; left

Changes in factors of production that influence economic growth will

shift SRAS and LRAS

a short lived change in production input prices will

shift SRAS but not LRAS

Modern Keynesian model is graphed as

short run aggregate supply

Keynesian model is graphed as

short run aggregate supply (SRAS) and aggregate demand

Flexible wages and prices determined by

supply and demand (markets)

Says law asserts that

supply created its own demand

Inflationary gap

the gap that exists whenever equilbrium real GDP per year is greater than full employment real GDP, as shown by the postion of the long run aggregate supply curve

Recessionary gap

the gap that exists whenever equilibrium real GDP per year is less than full employment real GDP as shown by the postion of the long run aggregate supply curve

Keynesian short-run aggregate supply curve

the horizontal portion of the aggregate supply curve in which there is excessive unemployment and unused capacity in the economy

True or false: the classical economists believed that the leakage of saving would be matched by the injection of buisness investment

true

according to modern keynesian anaylsis the short run aggregate supply curve is

upward sloping

LRAS is graphed as

vertical line (fixed amount of real GDP, regardless of price level)