Macro: Chapter 15

Short run aggregate supply curve

A relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand.

Wages are the largest cost of production for most firms

Consequently, as labor costs increase, firms have no choice but to increase the prices of their products. However as prices rise, workers need higher nominal wages to maintain their real wages.

Demand policies may be used to reduce aggregate demand.

Demand policies can also prevent a wage-price spiral from emerging if the economy is producing at a level output above full employment. Rather than letting an increase in wages and prices bring the economy back to full employment, we can reduce aggregate demand. Either contractionary monetary policy-open-market sales- or contractionary fiscal policy- cuts in government spending or tax increases- can be used to reduce aggregate demand and the level of GDP until it reaches potential output.

The economy will adjust to recover from and economic downturn.

If the economy is operating below full employment, prices will fall, shifting down the short-run aggregate suppky curve. This will return output to its full-employment level.

The determinants of GDP shift from the short run to the long run.

In the short run, GDP is determined by the current demand for goods and services in the economy, so fiscal policy- such as tax cuts or increased government spending- and monetary policy such as adjusting the money supply can affect demand and GDP. In the long run, GDP is determined by the supply of labor, the stock of capital, and technological progress- in other words, the willingness of people to work and the overall resources the economy has to work with.

Crowding out

The decrease in private expenditures that occurs as a consequence of increased government spending or the financing needs of a budget deficit.

Aggregate demand curve

A curve that shows the relationship between the level of prices and the quantity of real GDP demanded.

Liquidity trap

A situation in which nominal interest rates are so slow, they can no longer fall.

Long run aggregate demand curve

A vertical aggregate supply curve that reflects the idea that in the long run, output is determined solely by the factors of production and technology.

Classical economist vs. Keynesian economists

Classical economics is often known with Say's Law the doctrine that "supply creates its own demand". Spending on consumption and investment together would be sufficient enough so that all the goods and services produced in the economy would be purchased. Keynes believed that there would be situations in which total demand fell short of total production in the economy for extended periods of time. in particular, if consumers increased their savings, there was no guarantee that investment spending would rise to offset the decrease in consumption.

Theory of John Maynard Keynes versus Milton Friedman

Economist like M. Friedman believed the economy adjusts rapidly to full employment and generally opposed using monetary or fiscal policy to stabilize the economy. Economists like John Maynard Keynes believed that the economy slowly and were more sympathetic using monetary or fiscal policy to stabilize the economy.

Policymakers do have options if an economy is in a recession and a liquidity trap.

First, expansionary fiscal policy-cutting taxes or raising government spending- still remains a viable option to increase aggregate demand. Second, the Fed could become extremely aggressive and try to expand the money supply so rapidly that the public begins to anticipate future inflation. Finally, by paying interest on bank reserves, the Fed can give itself more leverage for controlling the supply of loans. Even though the liquidity trap may make it more difficult for an economy to recover on its own, there is still room for proper economic policy to have an impact.

The economy will adjust from and economic boom.

If output is less than full employment, prices will fall as the economy returns to full employment. If output exceeds full employment, prices will rise and output will fall back to full employment. If the economy is operating above full employment, prices will rise, shifting the short-run aggregate supply curve upward. This will return output to its full-employment level.

Long run neutrality of money

Note that output is a function of capital, labor, and technology. Money is not involved. We find that an increase in the growth rate of money will proportionately increase all nominal variables leaving all real variables unchanged

It is important to consider both the short run consequences and the long run cons. of govt. policies.

Some say increases in spending only provide temporary relief and ultimately harm thee economy because government spending "crowds out" investment spending. Similar arguments are made with tax cuts. Initially, they will increase consumer spending and lead to a higher GDP but in the long run, adjustments in wages and prices restore the economy to full employment. In the long run, increases in the supply of money are neutral.

Inflation plays an ongoing role in the economy.

Suppose an economy has been operating at full employment has been experiencing 4 percent annual inflation. if output later exceeds full employment, prices will begin to rise at a rate faster than 4 percent. Conversely, if output falls to a level less than full employment, prices will then rise at a slower rate than 4 percent. When output exceeds full employment, prices will begin to rise at a rate faster than 4 percent. Conversely, if output falls to a level less than full employment, prices will then rise at a slower rate than 4 percent.

Political business cycle

The effects on the economy of using monetary or fiscal policy to stimulate the economy before an election to improve reelection prospects.

There are links between presidential elections and macroeconomic performs.

The original business cycle theories focused on incumbent presidents trying to manipulate the economy in their favor to gain reelection.

Short run in macroeconomics

The period of time in which prices do not change or do not change very much.

Long run in macroeconomics

The period of time in which prices have fully adjusted to any economic changes.

Wage price spiral

The process by which changes in wages and prices cause further changes in wages in prices.

Expansionary policies may be used when the economy is operating below full employment.

Us expansionary policies, such as open market purchases by the Fed or increases in government spending and tax cuts, to shift the aggregate demand curve to the right.

Changes in wages and prices restore the economy to full employment.

With the economy initially below full employment, the price level falls, stimulating output. The lower price level decreases the demand for money and leads to lower interest rates. Lower interest rates lead to higher investment spending. As the economy moves down the AD curve toward full employment in investment spending increases along the AD curve.

Says Law

supply creates its own demand production creates exactly enough income to buy what has been produced