WGU FTC1 Chapter 13 & 16

What are the two main influences that the world economy has on aggregate demand

the foreign exchange rate and foreign income

What is the purpose of the aggregate supply-aggregate demand model

to explain how real GDP and the price level are determined

Holding other things the same, an increase in the price level increases the quantity of real GDP supplied.

true

Firms respond to a change in the real wage rate by changing the quantity of labor employed and the quantity produced. For the economy as a whole, employment and real GDP change. There are three ways in which these changes occur:

• Firms change their output rate. • Firms shut down temporarily or restart production. • Firms go out of business or start up in business.

AS-AD model The AS-AD model is used to study the business cycle. Fluctuations in aggregate demand are one of the sources of the business cycle.

The AS-AD model is used to study the business cycle. Fluctuations in aggregate demand are one of the sources of the business cycle.

The quantity of real GDP supplied is the total amount of final goods and services that firms in the United States plan to produce and it depends on the quantities of

• Labor employed • Capital, human capital, and the state of technology • Land and natural resources • Entrepreneurial talent

Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded; and the lower the price level, the

greater is the quantity of real GDP demanded

Other things remaining the same, a rise in the expected income would_____.

increase the AD

he AD curve would shift to the left if AD increases.

False. It would shift to the right.

THE BUSINESS CYCLE

-A cycle that results from fluctuations in the pace of growth of labor productivity and potential GDP. -Aggregate supply fluctuates because labor productivity grows at a variable pace, which brings fluctuations in the growth rate of potential GDP. -Aggregate demand fluctuations are the main source of the business cycle. - The key reason is that the swings in aggregate demand occur more quickly than changes in the money wage rate that change aggregate supply. -The result is that the economy swings from inflationary gap to full employment to recessionary gap and back again.

Mexico trades with the United States. Explain the effect of each of the following events on Mexico's aggregate demand. • The government of Mexico cuts income taxes. • The United States experiences strong economic growth. • Mexico sets new environmental standards that require factories to upgrade their production facilities.

-A tax cut increases disposable income, which increases consumption expenditure, which increases aggregate demand. -Strong U.S. growth increases the demand for Mexican-produced goods, which increases Mexico's aggregate demand. - As factories upgrade their facilities, investment increases. Aggregate demand increases. In each case, the AD curve shifts rightward

Economic Growth and Inflation Trends

-Economic growth results from a growing labor force and increasing labor productivity, which together make potential GDP grow (Chapter 9, pp. 216-222). -In the AS-AD model, economic growth is increasing potential GDP—a persistent rightward shift in the potential GDP line. -Inflation results from a growing quantity of money that outpaces the growth of potential GDP (Chapter 12, pp. 303-311). -Inflation arises from a persistent increase in aggregate demand at a faster pace than that of the increase in potential GDP—a persistent rightward shift of the AD curve at a faster pace than the growth of potential GDP.

Cost-push inflation

-Inflation that begins with an increase in cost is called cost-push inflation. -The two main sources of cost increases are increases in the money wage rate and increases in the money prices of raw materials such as oil.

Demand-pull inflation

-Inflation that starts because aggregate demand increases is called demand-pull inflation. - Demand-pull inflation can be kicked off by any of the factors that change aggregate demand but the only thing that can sustain it is growth in the quantity of money.

The state of the world economy

-Two main influences that the world economy has on aggregate demand are the foreign exchange rate and foreign income. - The foreign exchange rate is the amount of a foreign currency that you can buy with a U.S. dollar. Other things remaining the same, a rise in the foreign exchange rate decreases aggregate demand. -An increase in foreign income increases U.S. exports and increases U.S. aggregate demand. For example, an increase in income in Japan and Germany increases Japanese and German consumers' and producers' planned expenditures on U.S.-made goods and services.

Why the AS Curve Slopes Upward

-Why does the quantity of real GDP supplied increase when the price level rises and decrease when the price level falls? -The answer is that a movement along the AS curve brings a change in the real wage rate (and changes in the real cost of other resources whose money prices are fixed). -If the price level rises, the real wage rate falls, and if the price level falls, the real wage rate rises. -When the real wage rate changes, firms change the quantity of labor employed and the level of production.

Key Points

1 Define and explain the influences on aggregate supply. • Aggregate supply is the relationship between the quantity of real GDP supplied and the price level when all other influences on production plans remain the same. • The AS curve slopes upward because with a given money wage rate, a rise in the price level lowers the real wage rate, increases the quantity of labor demanded, and increases the quantity of real GDP supplied. • A change in potential GDP, a change in the money wage rate, or a change in the money price of other resources changes aggregate supply. 2 Define and explain the influences on aggregate demand. • Aggregate demand is the relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same. • The AD curve slopes downward because a rise in the price level decreases the buying power of money, raises the real interest rate, raises the real price of domestic goods compared with foreign goods, and decreases the quantity of real GDP demanded. • A change in expected future income, inflation, and profits; a change in fiscal policy and monetary policy; and a change in the foreign exchange rate and foreign real GDP all change aggregate demand—the aggregate demand curve shifts. 3 Explain how trends and fluctuations in aggregate demand and aggregate supply bring economic growth, inflation, and the business cycle. • Aggregate demand and aggregate supply determine real GDP and the price level in macroeconomic equilibrium, which can occur at full employment or above or below full employment. • Away from full employment, gradual changes in the money wage rate move real GDP toward potential GDP. • Economic growth is a persistent increase in potential GDP and inflation occurs when aggregate demand grows at a faster rate than potential GDP. • Business cycles occur because aggregate demand and aggregate supply fluctuate. • Demand-pull and cost-push forces bring inflation and real GDP cycles.

The U.S. economy is at full employment when the following events occur: • A deep recession hits the world economy. • The world oil price rises by a large amount. • U.S. businesses expect future profits to fall.

1. Explain the effect of each event separately on aggregate demand and aggregate supply. How will real GDP and the price level change in the short run? A deep recession in the world economy decreases U.S. aggregate demand. The AD curve shifts leftward. In the short run, U.S. real GDP decreases and the price level falls (Figure 1). A rise in the world oil price decreases U.S. aggregate supply. The AS curve shifts leftward. In the short run, U.S. real GDP decreases and the price level rises (Figure 2). A fall in expected future profits decreases U.S. aggregate demand. The AD curve shifts leftward. In the short run, U.S. real GDP decreases and the price level falls (Figure 1).

The quantity of real GDP supplied is the total amount of final goods and services that firms in the United States plan to produce and it depends on the quantities of

1. Labor employed, 2. Capital, human capital, and the state of technology, 3. Land and natural resources, and 4. Entrepreneurial talent

The U.S. economy is at full employment when the following events occur: • A deep recession hits the world economy. • The world oil price rises by a large amount. • U.S. businesses expect future profits to fall.

2. Explain the combined effect of these events on real GDP and the price level. All three events decrease U.S. real GDP (Figures 1 and 2). The deep world recession and the fall in expected future profits decrease the price level (Figure 1). The rise in the world oil price increases the price level (Figure 2). So the combined effect on the price level is ambiguous.

The U.S. economy is at full employment when the following events occur: • A deep recession hits the world economy. • The world oil price rises by a large amount. • U.S. businesses expect future profits to fall.

3. Which event, if any, brings stagflation? Stagflation is a rising price level and a decreasing real GDP together. The rise in the world oil price brings stagflation because it decreases aggregate supply, decreases real GDP, and raises the price level (Figure 2).

Explain the effect of each of the following events on the quantity of real GDP demanded and aggregate demand in Mexico. • Europe trades with Mexico and goes into a recession. • The price level in Mexico rises. • Mexico increases the quantity of money.

=A recession in Europe decreases the demand for Mexico's exports, so aggregate demand decreases. The AD curve shifts leftward (Figure 2). - A rise in the price level decreases the quantity of real GDP demanded along the AD curve, but the AD curve does not shift (Figure 3). - An increase in the quantity of money increases aggregate demand, and the AD curve shifts rightward (Figure 1).

Changes in Aggregate Demand

A change in any factor that influences expenditure plans other than the price level brings a change in aggregate demand. When aggregate demand increases, the aggregate demand curve shifts rightward, which Figure 13.5 illustrates as the rightward shift of the AD curve from AD0 to AD1. When aggregate demand decreases, the aggregate demand curve shifts leftward, which Figure 13.5 illustrates as the leftward shift of the AD curve from AD0 to AD2. The factors that change aggregate demand are • Expectations about the future • Fiscal policy and monetary policy • The state of the world economy

Temporary Shutdowns and Restarts

A firm that is incurring a loss might foresee a profit in the future. Such a firm might decide to shut down temporarily and lay off its workers. The price level relative to the money wage rate influences temporary shutdown decisions. If the price level rises relative to wages, fewer firms decide to shut down temporarily; so more firms operate and the quantity of real GDP supplied increases. If the price level falls relative to wages, a larger number of firms find that they cannot earn enough revenue to pay the wage bill and so temporarily shut down. The quantity of real GDP supplied decreases.

The buying power of money

A rise in the price level lowers the buying power of money and decreases the quantity of real GDP demanded.

When the money wage rate increases, how does it affect aggregate supply?

AS would decrease as production cost increases.

Business cycle

According to the business cycle, a period of growth or expansion is followed by a recession or contraction and then a return to growth or recovery.

-The relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same -Other things remaining the same, the higher the price level, the smaller is the quantity of real GDP demanded; and the lower the price level, the greater is the quantity of real GDP demanded. This quantity is the sum of the real consumption expenditure (C), investment (I), government expenditure on goods and services (G), and exports (X) minus imports (M). That is, Y = C + I + G + X − M.

Aggregate demand

Aggregate Demand Aggregate demand is the relationship between the quantity of real GDP demanded and the price level.

Aggregate demand is the relationship between the quantity of real GDP demanded and the price level. In the AS-AD model, the aggregate demand curve gives the relationship between the quantity of real GDP demanded and the price level. Holding all other things constant, the higher the price level, the smaller the quantity of real GDP demanded. Therefore, the AD curve slopes downward.

The relationship between the quantity of real GDP supplied and the price level when all other influences on production plans remain the same Other things remaining the same, the higher the price level, the greater is the quantity of real GDP supplied, and the lower the price level, the smaller is the quantity of real GDP supplied.

Aggregate supply

Changes in Aggregate Supply

Aggregate supply changes when any influence on production plans other than the price level changes. In particular, aggregate supply changes when • Potential GDP changes. • The money wage rate changes. • The money prices of other resources change.

Aggregate demand is the relationship between the quantity of real GDP demanded and the price level.

All elements being equal, the higher the price level, the smaller the quantity of real GDP demanded. Real GDP is the sum of consumption, investment, government purchases, and net exports.Any factor that increases one of these componentswill increase aggregate demand. Anything that reduces any of these factors decreases aggregate demand.

Expectations about the future

An increase in expected future income increases the amount of consumption goods (especially big-ticket items such as cars) that people plan to buy now. Aggregate demand increases. An increase in expected future inflation increases aggregate demand because people decide to buy more goods and services now before their prices rise. An increase in expected future profit increases the investment that firms plan to undertake now. Aggregate demand increases. A decrease in expected future income, future inflation, or future profit has the opposite effect and decreases aggregate demand.

The factors that change aggregate demand are

Expectations about the future, fiscal policy and monetary policy, and the state of the world economy

Potential GDP is an upward sloping curve in the short-run.

FALSE

Why does a change in the money wage rate not change potential GDP?

Because potential GDP depends only on the economy's real ability to produce and on the full-employment quantity of labor, which occurs at the equilibrium real wage rate. The equilibrium real wage rate can occur at any money wage rate.

What occurs in the economy when the AD-AS determined real GDP fluctuates around potential GDP.

Business cycle

Irregularity

Business cycles are generally irregular, varying in frequency, magnitude, and duration. For example, the United States experienced a brief recession in 1991 and didn't experience another until 2001. In contrast, a brief recession in 1980 was followed by a much longer one beginning in 1981.

Aggregate Supply

Changes in the price level result in three possible reactions that create a positive slope of the AS line. All three of the reactions show that real GDP will deviate from potential GDP when the actual price level deviates from the price level that people expect.

Excess quantity demanded

Consider also the opposite case where the quantity of real GDP demanded exceeds the quantity supplied. At this point businesses are not producing enough to satisfy all the wants. This is a below full-employment equilibrium that occurs when real GDP is less than potential GDP. If such a case occurs, inventories will be depleted and firms will soon increase production or raise prices.

A change in the money wage rate produces a shift in the aggregate demand (AD) curve.

FALSE, ONLY IN AGGREGATE SUPPLY DOES MONEY WAGE RATE SHIFTS

Suppose the economy is at full exployment and real GDP equals potential GDP. Now assume there is sudden increase of AD. How does this change macroeconomic equilibrium? What gap would this change cause? What might be a severe problem in this gap?

Due to increase in AD, price level will increase, so does real GDP. There will be inflationary gap. Inflation is a big problem.

When AD increases, Equalibrium________

Equilibrium price level increases, real GDP increases

Changes in the price level produce a shift in the aggregate demand (AD) curve.

False

third level for aggregate supply

Finally, changes in overall prices affect the amount of business failures and startups. A rise in the price level relative to business costs increases profits. Here again the number of firms operating increases to a point above what is expected and the quantity of real GDP supplied increases.

Expectations

First, household and business expectations influence aggregate demand. Expectations of higher future income, expectations of higher future inflation, and expectations of higher future profits all increase aggregate demand. When expectations are higher, the AD curve shifts to the right.

Changing taxes, transfer payments, and government expenditure on goods and services

Fiscal policy

When equilibrium real GDP equals potential GDP

Full-employment equilibrium

Three Types of Macroeconomic Equilibrium

Full-employment equilibrium Recessionary gap Inflationary gap

Fiscal Policy

Government policy influences government spending directly and the other components of real GDP indirectly. Fiscal policy changes affect aggregate demand through tax rates, transfer payments (like Medicaid and Social Security), and the government purchase of goods and services. Tax cuts, increased transfer payments, or increased government purchases increase aggregate demand. Monetary policy

Fiscal policy and monetary policy

Here, we'll just briefly note that the government can use fiscal policy—changing taxes, transfer payments, and government expenditure on goods and services—to influence aggregate demand. The Federal Reserve can use monetary policy—changing the quantity of money and the interest rate—to influence aggregate demand. A tax cut or an increase in either transfer payments or government expenditure on goods and services increases aggregate demand. A cut in the interest rate or an increase in the quantity of money increases aggregate demand.

review

Increase Caused by Rising Price Level Demand for money Nominal interest rate Demand for imports Real interest rate Decrease Caused by Rising Price Level Buying power of money Demand for domestic goods

When the potential GDP increases, the aggregate supply______

Increases and AS curve shifts to the right

A gap that exists when real GDP exceeds potential GDP and that brings a rising price level

Inflationary gap

Real GDP exceeds potential GDP and that brings a rising price level.

Inflationary gap

The short-run conditions match the long-run conditions.

Macroeconomic equilibrium

Macroeconomic Equilibrium

Macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the AS curve. Figure 13.7 shows such an equilibrium at a price level of 110 and real GDP of $13 trillion.

Changing the quantity of money and the interest rate

Monetary policy

Business Failure and Startup

People create businesses in the hope of earning a profit. When profits are squeezed or when losses arise, more firms fail, fewer new firms start up, and the number of firms decreases. When profits are generally high, fewer firms fail, more firms start up, and the number of firms increases. The price level relative to the money wage rate influences the number of firms in business. If the price level rises relative to wages, profits increase, the number of firms in business increases, and the quantity of real GDP supplied increases. If the price level falls relative to wages, profits fall, the number of firms in business decreases, and the quantity of real GDP supplied decreases. In a severe recession, business failure can be contagious. The failure of one firm puts pressure on both its suppliers and its customers and can bring a flood of failures and a large decrease in the quantity of real GDP supplied.

Aggregate supply changes when any influence on production plans other than the price level changes. In particular, aggregate supply changes when?

Potential GDP changes, the money wage rate changes, and the money prices of other resources change

first level for aggregate supply

Price level changes cause changes in the output rate. A rise in the price level when wages are unchanged increases the quantity of labor demanded and causes production to increase. The AS line is upward sloping, reflecting the fact that higher overall prices combined with a fixed money wage rate lowers the real wage rate. With a lower real wage rate, more labor will be employed, and real GDP will increase.

review

Price level changes cause changes in the output(s) rate. A rise in the price level when wage(s) remain(s) unchanged increases the quantity of labor demanded and causes production to increase.

A gap that exists when potential GDP exceeds real GDP and that brings a falling price level

Recessionary gap

The AS curve and the AD curve intersect to the left of the potential GDP line.

Recessionary gap

Change in Money Wage Rate

So an increase in the money wage rate decreases aggregate supply. shifts to the left

The combination of recession (decreasing real GDP) and inflation (rising price level) is the worst of both worlds, as unemployment and the cost of living both increase.

Stagflation

What causes economic recession? What's the relationship between equilibrium real GDP and potential GDP during a recession?

Sudden decrease in AD. Real GDP is below potential GDP during recession.

Excess quantity supplied

Suppose first that the quantity of real GDP supplied exceeds the quantity demanded. This is an above full-employment equilibrium because real GDP exceeds potential GDP. At this point businesses are producing more than people want. When this happens, inventories will pile up, and firms will soon cut production or prices.

The Aggregate Demand Multiplier

Suppose that an increase in expenditure induces an increase in consumption expenditure that is 1.5 times the initial increase in expenditure. Figure 13.6 illustrates the change in aggregate demand that occurs when investment increases by $0.4 trillion. Initially, the aggregate demand curve is AD0. Investment then increases by $0.4 trillion (ΔI) and the purple curve AD0 + ΔI now describes aggregate spending plans at each price level. An increase in income induces an increase in consumption expenditure of $0.6 trillion, and the aggregate demand curve shifts rightward to AD1. Chapter 14 (pp. 360-363) explains the expenditure multiplier in detail.

Stagflation is a combination of a rising price level when real GDP is declining.

TRUE

second level for aggregate supply

Temporary business shutdowns and restarts result from changes in overall prices. If the price level rises relative to costs, fewer firms will decide to shut down. If more firms are operating than should be expected, the quantity of real GDP supplied increases.

Monetary Policy

The Fed can also influence aggregate demand. Changes in monetary policy result in changing interest rates and in the quantity of money in the economy. Lower interest rates increase aggregate demand, and higher interest rates reduce aggregate demand. In times of financial crisis, the Fed may act even further. During the 2008 financial crisis, the Fed prevented many banks and other troubled financial institutions from closing. Combined with its traditional monetary actions, the monetary base doubled and the quantity of money kept growing. Fiscal and monetary policy combined to limit the decline in aggregate demand.

The Aggregate Demand Curve

The aggregate demand curve slopes downward for three reasons. -First, the buying power of money decreases when the price level rises. This is sometimes called a wealth effect. A higher price level lowers the real value of money holdings, which discourages consumer spending. -Second, short-run price changes affect the real interest rate. A rise in the price level increases the demand for money, which raises the nominal interest rate. Since the inflation rate does not immediately change, the real interest rate also rises. A higher real interest rate decreases consumption expenditure, as households save more and firms decrease their investment. -Third, the AD curve slopes downward because of changes in the real price of exports and imports. This is sometimes called the exchange-rate effect. When the price level rises, domestic goods become more expensive relative to foreign goods. Demand for domestic goods falls relative to imported goods, which reduces net exports. Conversely, a lower price level reduces demand for imports and stimulates net exports.

The price level influences the quantity of real GDP demanded because a change in the price level brings a change in?

The buying power of money, the real interest rate, and the real prices of exports and imports

Changes in Aggregate Demand

The factors that influence aggregate demand fall in to one of three categories. Expectations Fiscal Policy Monetary Policy

Along the aggregate demand curve, the only influence on expenditure plans that changes is the price level. A rise in the price level decreases the quantity of real GDP demanded and brings a movement up along the aggregate demand curve; a fall in the price level increases the quantity of real GDP demanded and brings a movement down along the aggregate demand curve.

The price level influences the quantity of real GDP demanded because a change in the price level brings a change in • The buying power of money • The real interest rate • The real prices of exports and imports

Change in Output Rate

To change its output rate, a firm must change the quantity of labor that it employs. It is profitable to hire more labor if the additional labor costs less than the revenue it generates. If the price level rises and the money wage rate doesn't change, an extra hour of labor that was previously unprofitable becomes profitable. So when the price level rises and the money wage rate doesn't change, the quantity of labor demanded and production increase. If the price level falls and the money wage rate doesn't change, an hour of labor that was previously profitable becomes unprofitable. So when the price level falls and the money wage rate doesn't change, the quantity of labor demanded and production decrease.

Aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded, other things holding constant.

True

Changes in Aggregate Supply

When potential GDP increases, aggregate supply also increases in the short run. This means the AS curve shifts to the right. For any given price level, the aggregate supply of goods and services is higher. Recall that money wage rates or other resource prices were held constant when explaining the upward slope of the AS curve. The AS curve shifts when there is a change in the money wage rate or other resource prices. A rise in resource prices, for example, decreases short-run aggregate supply and shifts the AS curve to the left. The potential GDP line does not changing, so output falls below potential.

The real prices of exports and imports

When the U.S. price level rises and other things remain the same, the prices in other countries do not change. So a rise in the U.S. price level makes U.S.-made goods and services more expensive relative to foreign-made goods and services. This change in real prices encourages people to spend less on U.S.-made items and more on foreign-made items. For example, if the U.S. price level rises relative to the foreign price level, foreigners buy fewer U.S.-made cars (U.S. exports decrease) and Americans buy more foreign-made cars (U.S. imports increase).

The real interest rate

When the price level rises, the real interest rate rises. When the demand for money increases, the nominal interest rate rises. In the short run, the inflation rate does not change, so a rise in the nominal interest rate brings a rise in the real interest rate. Faced with a higher real interest rate, businesses and people delay plans to buy new capital and consumer durable goods and they cut back on spending. As the price level rises, the quantity of real GDP demanded decreases.

Inflation Cycles

You've seen that inflation occurs if aggregate demand grows faster than potential GDP. But just as there are cycles in real GDP, there are also cycles in the inflation rate. And the two cycles are related. To study the interaction of real GDP and inflation cycles, we distinguish between two sources of inflation: • Demand-pull inflation • Cost-push inflation

when the price level in China falls, China's aggregate supply______

does not change, but the quantity of real GDP supplied decreases and a movement down along the AS curve occurs

The aggregate demand schedule lists the quantities of real GDP demanded at?

each price level

In the short-run, for macroeconomic equilibrium, real GDP must equal potential GDP.

fALSE

The aggregate supply curve will shift to the left if the price level falls.

false

Change in Potential GDP Anything that changes potential GDP changes aggregate supply and shifts the aggregate supply curve. Figure 13.2 illustrates such a shift. You can think of point C as an anchor point. The AS curve and potential GDP line are anchored at this point, and when potential GDP changes, aggregate supply changes along with it. When potential GDP increases from $13 trillion to $14 trillion, point C shifts to point C', and the AS curve and potential GDP line shift rightward together. The AS curve shifts from AS0 to AS1.

shifts to the right

Among the other influences on production plans that remain constant along the AS curve are

• The money wage rate • The money prices of other resources In contrast, along the potential GDP line, when the price level changes, the money wage rate and the money prices of other resources change by the same percentage as the change in the price level to keep the real wage rate (and other real prices) at the full-employment equilibrium level.