ECON 337 Ch 22

Downward sloping Aggregate Demand Curve

quantity theory of money analysis If velocity stays constant, a constant money supply implies constant nominal aggregate spending, and a decrease in the price level is matched with an increase in aggregate demand.

Short-run Aggregate Supply Curve

1. Expected Inflation 2. Price Shocks 3. A persistent Output Gap Wages and prices are sticky Generates an upward sloping SRAS as firms attempt to take advantage of short-run profitability when price level rises

Expected Inflation

A rise in expected inflation causes the short-run aggregate supply curve to shift upward and tot he left. Conversely, a fall in expected inflation causes the short-run aggregate supply curve to shift down and to the right. The larger the change in expected inflation, the larger is the shift. When workers expect a positive inflation rate, they will adjust nominal wages upward one-to-one wit the expected inflation rate so that the real wages rate does not decrease

Aggregate Supply Curve

Curve that shows the relationship between the quantity of output supplied and the inflation rate Determined by amount of capital and labor and available technology

Increase in Aggregate Demand

Decrease r: Autonomous easing of monetary policy Increase G: Government Purchases Decrease T: Taxes Increase NX: Autonomous Net Export Increase C: Autonomous Consumption Expenditure Increase I: Autonomous Investment Decrease f: Decrease financial friction

Short-run Aggregate Supply Curve Equation

Pi = Pi^e + y(Y - Y^p) + p Inflation = Expected Inflation + y*Output Gap + Inflation Shock y = the sensitivity of inflation to the output gap

Natural Rate of Unemployment

Rate to which the economy gravitates in the long run

Natural Rate of Output or Potential Output

The level of aggregate output produced at the natural rate of unemployment

government purchases

spending by all levels of government (federal, state, and local) on goods and services

net exports

the net foreign spending on domestic goods and services

consumption expenditure

the total demand for consumer goods and services

planned investment spending

the total planned spending by business firms on new machines, factories, and other capital goods, plus planned spending on new homes

Real business cycle theory

theory of aggregate economic fluctuations business cycle fluctuations result from permanent supply shocks alone and their

Temporary Supply Shocks

-When the temporary shock involves a restriction in supply, we refer to this type of supply shock as a negative (or unfavorable) supply shock, and it results in a rise in commodity prices. -A temporary positive supply shock shifts the short-run aggregate supply curve downward and to the right, leading initially to a fall in inflation and a rise in output. In the long run, however, output and inflation will be unchanged (holding the aggregate demand curve constant)

Aggregate demand and supply analysis yields the following conclusions

1. A shift in the aggregate demand curve affects output only in the short run and has no effect in the long run. 2. A temporary supply shock affects output and inflation only in the short run and has no effect in the long run (holding the aggregate demand curve constant). 3. A permanent supply shock affects output and inflation both in the short and the long run. 4. The economy has a self-correcting mechanism that returns it to potential output and the natural rate of unemployment over time.

Permanent Supply Shocks

A permanent negative supply shock—such as an increase in ill-advised regulations that causes the economy to be less efficient, thereby reducing supply—would decrease potential output and shift the long-run aggregate supply curve to the left. Because the permanent supply shock will result in higher prices, there will be an immediate rise in inflation and so the short-run aggregate supply curve will shift up and to the left.

Self-Correcting Mechanism

Regardless of where output is initially, it returns eventually to the natural rate. Slow: -Wages are inflexible, particularly downward -Need for active government policy Rapid: -Wages and prices are flexible -Less need for government intervention

Long Run Aggregate Supply Curve

Shifts to the right/increases 1. An increase in the total amount of capital in the economy 2. An increase in the total amount of labor supplied in the economy 3. A decline in the natural rate of unemployment

Aggregate Demand Shocks

Shocks that cause the aggregate demand curve to shift right Decrease r: Autonomous easing of monetary policy (lowering the real interest rate Increase G: Government Purchases Decrease T: Taxes Increase NX: Autonomous Net Export Increase C: Autonomous Consumption Expenditure Increase I: Autonomous Investment Decrease f: Decrease financial friction Although the initial short run effect of the rightward shift in the aggregate demand curve is a rise in both inflation and output, the ultimate long-run effect is a rise in inflation only, because output returns to its initial level at Yp

Output Gap

The percent difference between aggregate output and potential output Y - Yp. Slack: Little slack when output exceeds potential level and output gap is high. Workers demand high wages and firms raise prices. Ends with higher inflation When aggregate output is above potential output, so that a persistent positive output gap exists, the short run aggregate supply curve shifts up and to the left

Aggregate Demand Curve

The relationship between the quantity of aggregate output demanded and the inflation rate when all other variables are held constant

Aggregate Demand

The total amount of output demanded at different inflation rates

Aggregate Supply

Total amount of output that firms in an economy want to sell at different inflation rates

Inflation (Supply) Shocks

Unfavorable supply shocks that drive up inflation cause the short-run aggregate supply curve to shift up and to the left, while favorable supply shocks that lower inflation cause short run aggregate supply curve to shift down and to the right. Supply Shocks: Shock to supply of goods and services produced in the economy. Creates inflation shocks Inflation Shocks: Shifts in inflation that are independent of the amount of slack in the economy or expected inflation Cost Push Shock: Workers push for wages that are higher than productivity gains, thereby driving up costs and inflation

General Equalibrium

When all markets are simultaneously in equilibrium at the point where the quantity of aggregate output demanded equals the quantity of aggregate output supplied.

Aggregate Demand Equation

Y^ad = C + I + G + NX