8.1 The Demand Side of the Economy Flashcards
What are the changes in price level that we will be focusing on in this chapter?
The AE curve shifts in response to a change in the price level—a change, that is, in the average price of all the goods and services in the economy.
This shift occurs because a change in the price level affects desired consumption expenditures and desired net exports. These are the changes on which we will focus in this chapter.
What is incorrect about the logic that a fall in price level leads to an increase in desired consumption?
You might think it is obvious that a fall in the price level leads to an increase in desired consumption for the simple reason that the demand curves for most individual products are negatively sloped. As we will see in a few pages, however, this logic is incorrect in the context of a macroeconomic model—our focus here is on the aggregate price level rather than on the prices of individual products.
What is the relationship between the price level and desired consumption?
The relationship between the price level and desired consumption has to do with how changes in the price level lead to changes in household wealth and thus to changes in desired spending.
What is most of the private sector’s total wealth held in the form of?
Much of the private sector’s total wealth is held in the form of assets with a fixed nominal value.
How does a rise and fall in price level affect the amounts of goods that can be purchased?
A rise in the price level lowers the real value of money held by the private sector.
A fall in the price level raises the real value of money held by the private sector.
The purchaser of the bond has lent money to the issuer of the bond and receives a repayment of principal and interest from the issuer when the bond matures. What happens when there is a change in the price level in the intervening period?
A rise in the price level means that the repayment to the lender is lower in real value than it otherwise would be. This is a decline in wealth for the lender. However, the issuer of the bond, having made a repayment of lower real value because of the increase in the price level, has experienced an increase in wealth. In dollar terms, the reduction in wealth for the bond purchaser is exactly offset by the increase in wealth for the bond issuer.
How do changes in the price level chage the wealth of bond purchasers and bond issuers?
Changes in the price level change the wealth of bond purchasers and bond issuers, but because the changes offset each other, there is no change in aggregate wealth.
How does a rise and fall in the price level effect the real vale of the private sectors wealth?
In summary, a rise in the price level leads to a reduction in the real value of the private sector’s wealth. And as we saw in Chapter 6, a reduction in wealth leads to a decrease in desired consumption and a downward shift in the AE function.
A fall in the domestic price level leads to a rise in wealth and desired consumption and an upward shift in the AE curve.
What happens to the price level of Canadian goods when the domestic price level rises?
When the domestic price level rises (and the exchange rate remains unchanged), Canadian goods become more expensive relative to foreign goods. As we saw in Chapter 7, this change in international relative prices causes Canadian consumers to buy fewer Canadian-made goods, which have now become relatively more expensive, and to buy more foreign goods, which have now become relatively less expensive.
How does a rise and fall in the domestic price level effect the AE curve?
A rise in the domestic price level (with a constant exchange rate) reduces net exports and causes a downward shift in the AE curve. A fall in the domestic price level increases net exports and causes an upward shift in the AE curve.
How does an exogenous change in the price level affect the AE curve and the equilibrium GDP?
What affect are we ignoring for simplicty in this chapter?
A change in the domestic price level leads to a change in international relative prices, which affects the marginal propensity to import (m) and thus the slope of the AE function. For simplicity, that effect is ignored in this and other diagrams in this chapter.
What is the effect of a fall in price level on the AE curve and the equilibrium level of GDP?
Conversely, with a fall in the price level, Canadian goods become relatively cheaper internationally, so net exports rise. Also, the purchasing power of nominal assets increases, so households spend more. The resulting increase in desired expenditure on Canadian goods causes the AE curve to shift upward. The equilibrium level of real GDP therefore rises.
Why do we lable the horizontal axis “Real GDP” instead of “Actual National income”?
In Chapters 6 and 7 the horizontal axis in our figures was labelled “Actual National Income” because we wanted to emphasize the important difference between actual income and desired expenditure. Notice in Figure 8-1, however, that we have labelled the horizontal axis “Real GDP.”
We use GDP rather than national income, but these have the same meaning. It is still actual, as opposed to desired, but we leave that off, also for simplicity.
Finally, we add real because from this chapter onward the price level will be changing and thus it is necessary to distinguish changes in nominal GDP from changes in real GDP.
Are price level and real equilibrim GDP positively or negativly related?
the price level and real equilibrium GDP are negatively related to each other. This negative relationship can be shown in an important new concept, the aggregate demand curve.
A
Pay attention to what the fall was. It was a fall in price level, not a fall in expenditure.
