Econ Ch. 20- Aggregate Demand and Aggregate Supply

The Misperceptions Theory- •If P rises above PE

-A firm sees its price rise before realizing all prices are rising. •The firm may believe its relative price is rising, and may increase output and employment. !!!!So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping.

Why the AD Curve Might Shift: changes in NX

-Booms/recessions in countries that buy our exports -Appreciation/depreciation resulting from international speculation in foreign exchange market

The Interest-Rate Effect (P and I) Suppose the price level, P, declines

-Buying goods and services requires fewer dollars: people buy bonds and other assets -Decrease in the interest rate -Increase spending on investment goods, I -Increase in quantity demanded of goods and services

In the short run

-Changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate).

The neutrality of money

-Changes in the money supply affect nominal but not real variables

The Exchange-Rate Effect (P and NX ) Suppose the U.S. price level, P, declines

-Decrease in the U.S. interest rate -U.S. dollar depreciates (decline in the real value of the dollar in foreign-exchange markets) -Stimulates U.S. net exports, NX -Increase in quantity demanded of goods and services

GDP in the short run

-Fluctuates around its trend

John Maynard Keynes, 1883-1946

The General Theory of Employment, Interest, and Money, 1936 •Argued recessions and depressions can result from inadequate demand; policymakers should shift AD. •Famous critique of classical theory: !!!The long run is a misleading guide to current affairs.In the long run, we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat

When the economy goes into a recession, real GDP ________ and unemployment ________. a. falls; rises b. rises; rises c. rises; falls d. falls; falls

a. falls; rises

According to the model of aggregate supply and aggregate demand, in the long run, an increase in the money supply should cause a. prices to rise and output to remain unchanged. b. prices to rise and output to rise. c. prices to fall and output to fall. d. prices to fall and output to remain unchanged.

a. prices to rise and output to remain unchanged.

Suppose the economy is initially in long-run equilibrium. Then suppose there is a drought that destroys much of the wheat crop. If policymakers allow the economy to adjust to long-run equilibrium on its own, according to the model of aggregate demand and aggregate supply, what happens to prices and output in the long run? a. Output falls; prices are unchanged from the initial value. b. Output and the price level are unchanged from their initial values. c. Output rises; prices are unchanged from the initial value. d. Prices rise; output is unchanged from its initial value. e. Prices fall; output is unchanged from its initial value.

b. Output and the price level are unchanged from their initial values.

The natural level of output is the amount of real GDP produced a. when the economy is at the natural level of investment. b. when the economy is at the natural rate of unemployment. c. when there is no unemployment. d. when the economy is at the natural level of aggregate demand.

b. when the economy is at the natural rate of unemployment.

•Causes of economic fluctuations: shifts in aggregate demand and aggregate supply.

c. irregularly.

In the model of aggregate demand and aggregate supply, the quantity of ________ is on the horizontal axis, and the ________ is on the vertical axis. a. output; interest rate b. money; interest rate c. output; price level d. money; price level

c. output; price level

Suppose the economy is operating in a recession such as point B in Exhibit 4. If policymakers wished to move output to its long-run natural level, they should attempt to a. shift aggregate demand to the left. b. shift short-run aggregate supply to the left. c. shift aggregate demand to the right. d. shift short-run aggregate supply to the right

c. shift aggregate demand to the right.

According to classical macroeconomic theory and monetary neutrality, changes in the money supply affect a. the unemployment rate. b. real GDP. c. the GDP deflator. d. none of the above.

c. the GDP deflator.

Which of the following is not a reason why the aggregate-demand curve slopes downward? a. the wealth effect b. the interest-rate effect c. the classical dichotomy/monetary neutrality effects d. the exchange-rate effect e. All of the above are reasons why the aggregate-demand curve slopes downward.

c. the classical dichotomy/monetary neutrality effects

Which of the following would shift the aggregate-demand curve to the left? a. A decline in the stock market b. An increase in taxes c. A decrease in government spending d. All of the above

d. All of the above

Which of the following would not cause a shift in the long-run aggregate-supply curve? a. an increase in the available labor b. an increase in the available capital c. an increase in the available technology d. an increase in price expectations e. All of the above shift the long-run aggregate-supply curve.

d. an increase in price expectations

An increase in the aggregate demand for goods and services has a larger impact on output ________ and a larger impact on the price level ________. a. in the long run; in the short run b. in the long run; also in the long run c. in the short run; also in the short run d. in the short run; in the long run

d. in the short run; in the long run

In the model of aggregate demand and aggregate supply, the initial impact of an increase in consumer optimism is to a. shift aggregate demand to the left. b. shift short-run aggregate supply to the left. c. shift long-run aggregate supply to the left. d. shift aggregate demand to the right. e. shift short-run aggregate supply to the right.

d. shift aggregate demand to the right.

Suppose the price level falls. Because of fixed nominal wage contracts, firms become less profitable and they cut back on production. This is a demonstration of the a. misperceptions theory of the short-run aggregate-supply curve. b. classical dichotomy theory of the short-run aggregate-supply curve. c. sticky-price theory of the short-run aggregate-supply curve. d. sticky-wage theory of the short-run aggregate-supply curve

d. sticky-wage theory of the short-run aggregate-supply curve.

real variables

quantities, relative prices

Depressions

-Severe recessions (very rare)

Four steps to analyzing economic fluctuations:

1.Determine whether the event shifts AD or AS. 2.Determine whether curve shifts left or right. 3.Use AD-AS diagram to see how the shift changes Y and P in the short run. 4.Use AD-AS diagram to see how economy moves from new SR equilibrium to new LR equilibrium .

The Misperceptions Theory- imperfections

Firms may confuse changes in P with changes in the relative price of the products they sell

The Great Depression

From 1929-1933, money supply fell 28% due to problems in banking system •stock prices fell 90%, reducing C and I •Y fell 26% •P fell 22% •Unemployment rate rose from 3% to 25%

The World War II boom

From 1939-1944, •government outlays rose from $9.1 billion to $91.3 billion •Y rose 90% •P rose 20% •unemployment fell from 17% to 1%

What the 3 theories have in common

In all 3 theories, Y deviates from YN when P deviates from PE. slide 34 and 35

Classical theory

-Describes the world in the long run, but not the short run

Why the LRAS Curve Might Shift: Changes in natural resources

-Discovery of new mineral deposits -Reduction in supply of imported oil -Changing weather patterns that affect agricultural production

Why the AD Curve Might Shift: changes in G

-Federal spending, e.g., defense -State & local spending, e.g., roads, schools

Why the AD Curve Might Shift: changes in I

-Firms buy new computers, equipment, factories -Expectations, optimism/pessimism -Interest rates, -Monetary policy, Investment Tax Credit or other tax incentives

Real GDP over the long run, U.S

-Grows about 3% per year on average

The Wealth Effect (P and C ) Suppose the price level, P, declines

-Increase in the real value of money -Consumers are wealthier -Increase in consumer spending, C -Increase in quantity demanded of goods and services

Why the LRAS Curve Might Shift: Changes in K or H

-Investment in factories, equipment -More people get college degrees Factories destroyed by a hurricane

The Sticky-Wage Theory- imperfection

-Nominal wages are sticky in the short run,they adjust sluggishly. •Due to labor contracts, social norms Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail

Recessions

-Periods of falling real incomes and rising unemployment

Why the LRAS Curve Might Shift: Changes in technology

-Productivity improvements from technological progress

The Sticky-Wage Theory: If P > PE

-Revenue is higher, but labor cost is not. -Production is more profitable, so firms increase output and employment. !!!!!Hence, higher P causes higher Y, so the SRAS curve slopes upward.

Why the AD Curve Might Shift: changes in c

-Stock market boom/crash -Preferences re: consumption/saving tradeoff -Tax hikes/cuts

The Classical Dichotomy

Separation of variables into two groups 1. real 2. nominal

The aggregate-supply (AS ) curves

The AS curve shows the total quantity of goods and services firms produce and sell at any given price level. AS is: §upward-sloping in short run §vertical in long run

The long-run aggregate-supply curve (LRAS)

The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate. Also called potential output or full-employment output.

Why LRAS is vertical

YN determined by the economy's stocks of labor, capital, and natural resources, and on the level of technology. An increase in P does not affect any of these, so it does not affect YN. (Classical dichotomy)

Which of the following statements is true regarding the long-run aggregate-supply curve? The long-run aggregate-supply curve a. is vertical because an equal change in all prices and wages leaves output unaffected. b. is positively sloped because price expectations and wages tend to be fixed in the long run. c. shifts right when the government raises the minimum wage. d. shifts left when the natural rate of unemployment falls.

a. is vertical because an equal change in all prices and wages leaves output unaffected.

According to the wealth effect, aggregate demand slopes downward (negatively) because a. lower prices increase the value of money holdings and consumer spending increases. b. lower prices reduce money holdings, increase lending, interest rates fall, and investment spending increases. c. lower prices increase money holdings, decrease lending, interest rates rise, and investment spending falls. d. lower prices decrease the value of money holdings and consumer spending decreases.

a. lower prices increase the value of money holdings and consumer spending increases.

Suppose the economy is operating in a recession such as point B in Exhibit 4. If policymakers allow the economy to adjust to the long-run natural level on its own, a. people will reduce their price expectations and the short-run aggregate supply will shift right. b. people will raise their price expectations and the short-run aggregate supply will shift left. c. people will raise their price expectations and aggregate demand will shift left. d. people will reduce their price expectations and aggregate demand will shift right.

a. people will reduce their price expectations and the short-run aggregate supply will shift right.

One reason the short-run aggregate-supply curve slopes upward is that a higher price level a. reduces real wages if nominal wages are sticky. b. raises nominal wages if real wages are sticky. c. raises real wages if nominal wages are sticky. d. reduces nominal wages if real wages are sticky.

a. reduces real wages if nominal wages are sticky.

A change in which of the following would shift the short-run aggregate-supply curve but not the long-run aggregate-supply curve? a. the expected price level b. the capital stock c. the state of technology d. the labor force

a. the expected price level

A sudden increase in business pessimism shifts the aggregate-________ curve, leading to ________ output. a. demand; higher b. demand; lower c. supply; lower d. supply; higher

b. demand; lower

According to the interest-rate effect, aggregate demand slopes downward (negatively) because a. lower prices decrease the value of money holdings and consumer spending decreases. b. lower prices reduce money holdings, increase lending, interest rates fall, and investment spending increases. c. lower prices increase money holdings, decrease lending, interest rates rise, and investment spending falls. d. lower prices increase the value of money holdings and consumer spending increases.

b. lower prices reduce money holdings, increase lending, interest rates fall, and investment spending increases.

Suppose the price level falls but suppliers only notice that the price of their particular product has fallen. Thinking there has been a fall in the relative price of their product, they cut back on production. This is a demonstration of the a. classical dichotomy theory of the short-run aggregate-supply curve. b. misperceptions theory of the short-run aggregate-supply curve. c. sticky-wage theory of the short-run aggregate-supply curve. d. sticky-price theory of the short-run aggregate-supply curve.

b. misperceptions theory of the short-run aggregate-supply curve.

The aggregate-demand curve slopes downward because a fall in the price level causes a. real wealth to decrease. b. the interest rate to decline. c. the currency to appreciate. d. All of the above

b. the interest rate to decline.

Suppose the economy is initially in long-run equilibrium. Then suppose there is a reduction in military spending. According to the model of aggregate demand and aggregate supply, what happens to prices and output in the short run? a. Prices fall; output rises. b. Prices rise; output rises. c. Prices fall; output falls. d. Prices rise; output falls.

c. Prices fall; output falls.

Which of the following events shifts the short-run aggregate-supply curve to the right? a. an increase in government spending on military equipment b. an increase in price expectations c. a drop in oil prices d. a decrease in the money supply e. none of the above

c. a drop in oil prices

Most economists believe that classical macroeconomic theory a. is always valid. b. is never valid. c. is valid only in the long run. d. is valid only in the short run.

c. is valid only in the long run.

Stagflation is caused by a a. leftward shift in the aggregate-demand curve. b. rightward shift in the aggregate-demand curve. c. leftward shift in the aggregate-supply curve. d. rightward shift in the aggregate-supply curve.

c. leftward shift in the aggregate-supply curve.

Policymakers are said to "accommodate" an adverse supply shock if they a. respond to the adverse supply shock by decreasing aggregate demand, which lowers prices. b. fail to respond to the adverse supply shock and allow the economy to adjust on its own. c. respond to the adverse supply shock by increasing aggregate demand, which further raises prices. d. respond to the adverse supply shock by decreasing short-run aggregate supply.

c. respond to the adverse supply shock by increasing aggregate demand, which further raises prices.

Stagflation occurs when the economy experiences a. falling prices and falling output. b. rising prices and rising output. c. rising prices and falling output. d. falling prices and rising output

c. rising prices and falling output.

Which of the following statements about economic fluctuations is true? a. A recession is when output rises above the natural level of output. b. A depression is a mild recession. c. Economic fluctuations have been termed the "business cycle" because the movements in output are regular and predictable. d. A variety of spending, income, and output measures can be used to measure economic fluctuations because most macroeconomic quantities tend to fluctuate together. e. None of the above is true.

d. A variety of spending, income, and output measures can be used to measure economic fluctuations because most macroeconomic quantities tend to fluctuate together.

Suppose the economy is initially in long-run equilibrium. Then suppose there is a reduction in military spending. According to the model of aggregate demand and aggregate supply, what happens to prices and output in the long run? a. Prices rise; output is unchanged from its initial value. b. Output and the price level are unchanged from their initial values. c. Output rises; prices are unchanged from the initial value. d. Prices fall; output is unchanged from its initial value. e. Output falls; prices are unchanged from the initial value.

d. Prices fall; output is unchanged from its initial value.

Suppose the economy is initially in long-run equilibrium. Then suppose there is a drought that destroys much of the wheat crop. According to the model of aggregate demand and aggregate supply, what happens to prices and output in the short run? a. Prices fall; output rises. b. Prices rise; output rises. c. Prices fall; output falls. d. Prices rise; output falls.

d. Prices rise; output falls.

The Great Recession of 2008-2009

•Large contractionary shift in AD -Real GDP fell sharply •By 4.2% between the forth quarter of 2007 and the second quarter of 2009 -Employment fell sharply •Unemployment rate rose from 4.4% in May 2007 to 10.0% in October 2009 •The housing market played a central role in this recession. •Rising house prices during 2002-2006 due to: -Low interest rates -Easier credit for subprime borrowers -Government policies to increase homeownership -Securitization of mortgages: investment banks purchased mortgages from lenders, •Created securities backed by these mortgages, •Sold the securities to banks, insurance companies, and other investors. -Mortgage-backed securities perceived as safe, since house prices "never fall" •Consequences of 2006-2009 housing market crash: -Millions of homeowners "underwater"—owed more than house was worth. -Millions of mortgage defaults and foreclosures. -Banks selling foreclosed houses increased surplus and downward price pressures. -Housing crash badly damaged construction industry: 2010 unemployment rate was 20.6% in construction vs. 9.6% overall. •Consequences of 2006-2009 housing market crash: -Mortgage-backed securities became "toxic," •Heavy losses for institutions that purchased them, •Widespread failures of banks and other financial institutions. -Sharply rising unemployment and falling GDP. •The policy response: -Federal Reserve reduced Fed Funds rate target to near zero. -Federal Reserve purchased mortgage-backed securities and other private loans. -U.S. Treasury injected capital into the banking system to increase banks' liquidity and solvency in hopes of staving off a "credit crunch." -Fiscal policymakers increased government spending and reduced taxes by $800 billion.

Why the LRAS Curve Might Shift: Changes in L or natural rate of unemployment

-Immigration -Baby-boomers retire Government policies reduce natural u-r

nominal variables

measured in terms of money

SRAS and LRAS

•The imperfections in these theories are temporary. Over time, -Sticky wages and prices become flexible -Misperceptions are corrected •In the LR, -PE = P -AS curve is vertical slide 37