Aggregate Demand & Aggregate Supply Flashcards
Recession
A period of declining real incomes and rising unemployment.
Depression
A severe recession
Short run
Year to year
Best way to analyze short run fluctuations
Model of aggregate demand and aggregate supply
3 key facts about economic fluctuations
- Economic fluctuations are irregular and unpredictable.
- Economic Quantities tend to fluctuate together, albeit in different amounts.
- As output (production) falls, unemployment rises.
Business Cycle
Economic Fluctuations
Most commonly used variable to monitor short run changes in an economy. Why?
Real GDP, as it is the most comprehensive measure of economic activity.
Variable used to monitor short run fluctuations
For short run fluctuations, it doesn’t really matter which macroeconomic variable one looks at, as they tend to fluctuate together. However, variables fluctuate by different amounts.
Predominant variable in declining GDP
Investment
Real GDP and unemployment relationship
As real GDP falls, unemployment rises. As real GDP rises, unemployment falls to natural rate of 5 to 6 percent.
Classical View on Money
Money is a veil - Money has no impact on the classical world.
Classical Models
Growth and Productivity, Loanable Funds Model, Natural rate of unemployment, Classical theory on inflation
Most economists believe that classical theory
describes the world in the long run but not in the short run
What assumption is no longer valid for the short run?
Money Neutrality
What are highly intwined in the short run?
Real and Nominal variables
Name of Keynes’ Theory
General Theory
Keynes’ famous phrase
“In the long run we are all dead” - long run isn’t useful for real life
Output
Production of Goods and Services
X and Y axis of model of Aggregate Demand and Aggregate Supply
X axis: Quantity of Output
Y axis: Price Level
Aggregate Demand (AD)
Curve that shows the quantity of goods and services that households, firms, and the government would like to buy at each price level.
Aggregate Demand (AD) equation
AD = C + I + G + NX
Price Level
Overall level of prices
Increase in price level…
reduces the quantity of goods and services demanded
Type of slope of AD curve
Negative
3 reasons why AD slope is negative
Wealth Effect, Interest rate effect, Real exchange rate effect
Wealth Effect
Price level and consumption: Price levels fall, consumers are “wealthier,” increases consumption, increases quantity demanded of goods and services.
Interest Rate Effect
Price Level and Investment: Price levels fall, households and firms have extra money left over after buying what they want, increasing savings, increasing interest rate, increasing borrowing to purchase investment goods, increases quantity demanded of goods and services.
Real Exchange Rate Effect
Price level and net exports: Price levels fall, Canadian goods and services become cheaper, increases consumption of Canadian goods and services, increases quantity demanded of Canadian goods and services
Net Exports formula
NX = Exports - Imports
AD shifters
Changes in consumption, investment, government purchases, and net exports
Aggregate Supply (AS) curve
shows the total quantity of goods and services that firms produce and sell at any price level.
Aggregate Supply Curve direction
The long run aggregate supply curve (LRAS) is vertical.
The short run aggregate supply curve (SRAS) slopes upwards.
Natural rate of output
Real GDP - associated with natural rate of unemployment - production of goods and services when unemployment is at its normal rate.
What shifts LRAS?
Any change that alters the natural rate of output shifts LRAS. Changes in Labor, Capital, Natural Resources, Technological Knowledge, and Human Capital.
Bust
High unemployment
Boom
Low unemployment
How do firms operate?
They maximize profits
Profit equation
Profit = Income (p x q) - costs (w x L)
Why are wages sticky?
Wages are sticky and don’t change right away unlike prices as they are regulated by contracts.
When the economy is bad, firms do what because of sticky wages?
Firms fire people because it is easier than renegotiating contracts (lowering wages).
What happens to Qsras when price level falls?
Price level falls, firms get less income from sales, firms hire fewer workers, Qsras falls
SRAS shifters
Everything that shifts LRAS also shifts SRAS. Two extra shifters:
Changes in prices of inputs (wages, oil, energy, rents)
Changes in expected price level and wages
Adjustment mechanism of model of Aggregate demand and aggregate supply
SRAS
Nominal change vs real change
nominal change (change in price) real change (change in output)
What can governments do to increase aggregate demand?
Increase government spending and money supply
On the left of the LRAS,
wages go down as labor is plentiful. SRAS shifts to the right. Firms have the upper hand when negotiating wages. Firms need incentives to hire workers.
On the right of the LRAS,
wages go up as labor is scarce. SRAS shifts left. Workers have the upper hand when negotiating wages. Labor is scarce.
Two types of equilibrium
Short run equilibrium (intersection between AD and SRAS) and long run equilibrium (intersection between AD and LRAS)
In the short run, changes in aggregate demand…
cause fluctuations to an economy’s output of goods and services.
Shift in aggregate supply can cause what?
Stagflation
Stagflation
Economy experiences inflation (higher prices) and stagnation (lower output) at the same time
Shifting SRAS to the left effect on wages
Workers may initially ask for higher wages to prepare for the higher expected price level, but eventually, this process ends as firms have the upper hand when negotiating wages due to high unemployment. Workers will eventually accept lower nominal wages, thus firms can hire more workers, which increases production and thus shifts the SRAS back to the long run equilibrium.
