Chapter 23: Aggregate Demand and Aggregate Supply

Similarities between all three supply curve theories

All three theories suggest that output deviates in the short run from its natural level when the actual price level deviates from the price level that people had expected to prevail.

Shifts arising from changes in technology

An advance in technological knowledge shifts the aggregate-supply curve to the right. A decrease in the available technology (perhaps due to government regulation) shifts the aggregate-supply curve to the left.

Shifts arising from changes in capital

An increase in physical or human capital shifts the aggregate supply curve to the right. A decrease in physical or human capital shifts the aggregate-supply curve to the left.

Shifts arising from changes in natural resources

An increase in the availability of natural resources shifts the aggregate-supply curve to the left.

General lesson of each theory of aggregate supply

An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right.

the business cycle

fluctuations in the economy. they cannot be predicted

example of stagflation

geopolitical crisis in the middle east that causes less crude oil to flow from this region. Especially from 1973 to 1975

the stance of economists on classical theory

most economists believe that classical theory describes the world in the long run but not in the short run

Quantity of output supplied (equation)

natural level of output + a(Actual price level - Expected price level)

model of aggregate demand and aggregate supply

the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend tells us the quantity of all goods and services demanded in the economy at any given price level.

wage-price spiral

the phenomenon of higher prices leading to higher wages, in turn leading to even higher prices

securitization

the process by which a financial institution (specifically a mortgage originator) makes loans and then (with the help of an investment bank) bundles them together into financial instruments called mortgage-backed securities.

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

when real GDP declines (output of goods and services)

the rate of unemployment rises (use of labor force)

subprime borrowers

those borrowers with a higher risk of default based on their income and credit history

GDP measures ...

used to monitor short-run changes in the economy, measures the value of all final goods and services produced in any given time, measures the total income (adjusted for inflation) of everyone in the economy

In the long run, an economy's production of goods and servies

(its real gdp) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services.

What should policymakers do when faced with a sudden fall in aggregate demand?

-an increase in government spending or an increase in the money supply would increase the quantity of goods and services demanded at any price and would shift the aggregate-demand curve to the right.

Four steps for analyzing macroeconomic fluctuations

1) Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve (or perhaps 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 new long-run equilibrium

Shifts in aggregate demand has three lessons:

1) In the short run, shifts in the aggregate demand cause fluctuations in the economy's output of goods and services. 2) In the long run, shifts in aggregate demand affect the overall price level but do not affect output. 3) Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations.

Why might the aggregate-demand curve shift?

1) Shifts arising from changes in consumption 2) shifts arising from changes in investment 3) shifts arising from changes in government purchases 4) shifts arising from changes in net exports

Three reasons a fall in the 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

Why might the short-run aggregate-supply curve shift?

1) shifts arising from changes in labor 2) Shifts arising from changes in capital 3) Shifts arising from changes in natural resources 4) shifts arising from changes in technology 5) shifts arising from changes in the expected price level

Why might the short-run aggregate-supply curve shift?

1) shifts arising from changes in labor 2)shifts arising from changes in capital 3) shifts arising from changes in natural resources 4) shifts arising from changes in technology 5) shifts arising from changes in the expected price level

This story about shifts in aggregate supply has two lessons

1) shifts in aggregate supply can cause stagflation - a combination of recession (falling output) and inflation (rising prices). 2) Policymakers who can influence aggregate demand can potentially mitigate the adverse impact on output but only at the cost of exacerbating the problem of inflation

Why does the aggregate demand curve slope downward?

1) wealth effect: a lower price level increases real wealth, which stimulates spending on consumption 2) The interest-rate effect: A lower price level reduces the interest rate, which stimulates spending on investment 3) The exchange-rate effect: a lower price level causes the real exchange rate to depreciate, which stimulates spending on net exports

Shifts arising from changes in the expected price level

A decrease in the expected price level shifts the short-run aggregate-supply curve to the right. An increase in the expected price level shifts the short-run aggregate-supply curve to the left.

The price level and consumption: the wealth effect

A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. An increase in the price level reduces the real value of money and makes consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded.

The price level and investment: the interest-rate effect

A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. A higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and servies demanded.

Why does the short-run aggregate supply curve slope upwards? Misperceptions theory

According to this theory, changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. As a result of these short-run misperceptions, suppliers respond to changes in the level of prices, and this response leads to an upward-sloping aggregate-supply curve.

Shifts arising from changes in labor

An increase in the quantity of labor available (perhaps due to a fall in the natural rate of unemployment) shifts the aggregate-supply curve to the right. A decrease in the quantity of labor available (perhaps due to a rise in the natural rate of unemployment) shifts the aggregate-supply curve to the left.

Why does the short-run aggregate supply curve slope upwards? The sticky-price theory.

An unexpectedly low price level leaves some firms with higher-than-desired prices, which depresses their sales and leads them to cut back production. This arises from menu costs that prevent firms from changing their prices constantly. These firms temporary lag behind in cutting prices so their sales decline.

Why does the short-run aggregate supply curve slope upwards? The sticky wage theory.

An unexpectedly low price level raises the real wage, which causes firms to hire fewer workers and produce a smaller quantity of goods and services. Contracts with employees often freeze their pay, allowing firms to take advantage of them and not raise their pay to reflet changes in price level.

Always remember that long-run trends are the background on which short-run fluctuations are superimposed.

The short run fluctuations in output and the price level that we will be studying should be viewed as deviations from the long-run trends of output growth and inflation.

underwater

When housing prices declined, homeowners were ---- (they owed more on their mortgages than their homes were worth).

GDP equation

Y=C + I + G + NX

when policy makers accommodate the shift in aggregate supply

a ---- policy accepts a permanently higher level of prices to maintain a higher level of output and employment.

aggregate supply curve

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

aggregate-demand curve

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

Opec is a cartel

a group of sellers that attempts to thwart competition and reduce production to raise prices

recession

a period of declining real incomes and rising unemployment

Stagflation

a period of falling output (stagnation) and rising prices (inflation)

depression

a severe recession

Mortgage-backed securities

financial instruments. They're a type of asset-backed security. A security is an investment that is traded on a secondary market. It allows investors to benefit from the mortgage business without ever having to buy or sell an actual home loan.

The shape of the aggregate supply curve

in the long run, the aggregate supply curve is vertical, whereas in the short run, the aggregate-supply curve slopes upward.

classical dichotomy

separation of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money)

The key difference between the economy in the short run and the long run

the behavior of aggregate supply. Long run supply is vertical but short run supply is upward sloping because price level effects the economy in the short-run, but not in the long run. The quantity of output supplied deviates from its long-run, or natural, level when the actual price level in the economy deviates from the price level that people expected to prevail.