Chapter-12
Policy dilemma
a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.
Negative supply shocks
a policy that stabilizes aggregate output by increasing aggregate demand will lead to inflation, but a policy that stabilizes prices by reducing aggregate demand will deepen the output slump
Stabilization policy
the use of government policy to reduce the severity of recessions and rein in excessively strong expansions.
short-run equilibrium aggregate price level
the aggregate price level in the short-run macroeconomic equilibrium.
nominal wage
the dollar amount of the wage paid
Demand Shocks
A demand shock shifts the aggregate demand curve, moving the aggregate price level and aggregate output in the same direction
A Movement Along versus a Shift of the Aggregate Demand Curve
A movement along the AD curve occurs when a change in the aggregate price level changes the purchasing power of consumers' existing wealth (the real value of their assets).
Shifts of the Short-Run Aggregate Supply Curve
Changes in commodity prices nominal wages productivity lead to changes in producers' profits and shift the short-run aggregate supply curve.
Factors that Shifts the Aggregate Demand Curve one
Changes in expectations When the future looks bright, firms and customers will be more willing to borrow against future earnings. Shift to the right: If consumers and firms become more optimistic, aggregate demand increases. Shift to the left: If consumers and firms become more pessimistic, aggregate demand decreases.
Changes in commodity(raw material) prices
If commodity prices fall, short-run aggregate supply increases. If commodity prices rise, short-run aggregate supply decreases.
Changes in nominal wages
If nominal wages fall, shift outward short-run aggregate supply increases. If nominal wages rise, short-run aggregate supply decreases.
Monetary policy
If the central bank increases the quantity of money, aggregate demand increases. If the central bank reduces the quantity of money, aggregate demand decreases
Fiscal policy
If the government increases spending or cuts taxes, aggregate demand increases. Note: it depends on what you are spending on, there is no right or wrong. If the government reduces spending or raises taxes, aggregate demand decreases. So which is better: increasing spending or cutting taxes? Note: the final outcome is always who benefits (everybody wants free handouts)
Changes in productivity
If workers become more productive, short-run aggregate supply increases. Shift out If workers become less productive, short-run aggregate supply decreases.
Short-Run Versus Long-Run Effects of a Negative Demand Shock
In the long run the economy is self-correcting: demand shocks have only temporary effects on aggregate output. n the long run nominal wages fall in response to high unemployment, and SRAS1 shifts rightward to SRAS2: In the short run the economy moves to E2 and a recessionary gap arises: the aggregate price level declines from P1 to P2, aggregate output declines from Y1 to Y2, and unemployment rises.
How Changes in the Aggregate Price Level Affect Income-Expenditure Equilibrium
Income-expenditure equilibrium occurs at the point where the curve AEPlanned, which shows real aggregate planned spending, crosses the 45-degree line. A fall in the aggregate price level causes the AEPlanned curve to shift from AEPlanned1 to AEPlanned2, leading to a rise in income-expenditure equilibrium GDP from Y1 to Y2.
Output gap formula
OG = (Actual aggregate output - potential output)/(potential output) *100
What is deflation
The AD-AS model says that either a negative demand shock or a positive supply shock should lead to a fall in the aggregate price level—that is, deflation.
The AS-AD model
The AS-AD model combines the short-run aggregate supply curve and the aggregate demand curve. Their point of intersection, ESR , is the point of short-run macroeconomic equilibrium where the quantity of aggregate output demanded is equal to the quantity of aggregate output supplied
Size of the existing stock of physical capital
The greater the existing stock of physical capital, the lower is the incentive to invest in more. This means the existing stock of physical capital affects aggregate demand through planned aggregate investment. Shift aggregate demand curve to the right: If the existing stock of physical capital is relatively small, aggregate demand increases. Shift to the left: If the existing stock of physical capital is relatively large, aggregate demand decreases.
Aggregate downward-sloping reason one
The wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households' wealth and reduces consumer spending.
Changes in wealth
The wealthier households are, the more autonomous spending they will engage in. Shift to the right: If the real value of household assets rises, aggregate demand increases. Shift to the left: If the real value of household assets falls, aggregate demand decreases
Shifts of the Aggregate Demand Curve
changes in expectations changes in wealth changes in the stock of physical capital government policies fiscal policy monetary policy
Aggregate downward-sloping reason two
interest rate effect of a change in aggregate the price level—a higher aggregate price level reduces the purchasing power of households' money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending.
Sticky wages
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.
Negative Demand Schock
shifts the aggregate demand curve leftward from AD1 to AD2, reducing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2
Negative Supply Shock
shifts the short-run aggregate supply curve leftward, causing stagflation—lower aggregate output and a higher aggregate price level. Here the short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2. The aggregate price level rises from P1 to P2 , and aggregate output falls from Y1 to Y2.
Positive Supply Shock
shifts the short-run aggregate supply curve rightward, generating higher aggregate output and a lower aggregate price level. The short-run aggregate supply curve shifts from SRAS1 to SRAS2 , and the economy moves from E1 to E2.
supply shock
shifts the short-run aggregate supply curve, moving the aggregate price level and aggregate output in opposite directions.
Positive Demand Shock
shock shifts the aggregate demand curve rightward, increasing the aggregate price level from P1 to P2 and aggregate output from Y1 to Y2.
aggregate demand curve
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.
The Aggregate Demand Curve
shows the relationship between the aggregate price level and the quantity of aggregate output demanded. The curve is downward-sloping due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level
aggregate supply curve
shows the relationship between the aggregate price level and the quantity of aggregate output in the economy.
The long-run aggregate supply curve
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. note: It doesn't matter what the price level is. Its fixed by the productive capacity of our economy.
output gap
the percentage difference between actual aggregate output and potential output.
long-run macroeconomic equilibrium
the point of short-run macroeconomic equilibrium is on the long-run aggregate supply curve.
Short-run equilibrium aggregate output
the quantity of aggregate output produced in the short-run macroeconomic equilibrium.
short-run aggregate supply curve
upward-sloping because nominal wages are sticky in the short run: A higher aggregate price level leads to higher profits and increased aggregate output in the short run. Note: wages are slow to change in response to aggregate unemployment.
AS-AD model
uses the aggregate supply curve and the aggregate demand curve together to analyze economic fluctuations.
Active stabilization policy
using fiscal or monetary policy to offset shocks.
inflationary gap
when aggregate output is above potential output.
recessionary gap
when aggregate output is below potential output.
self-correcting
when shocks to aggregate demand affect aggregate output in the short run, but not the long run.
short-run macroeconomic equilibrium
when the quantity of aggregate output supplied is equal to the quantity demanded
