Aggregate Demand and Aggregate Supply Part 1 Flashcards
Why is aggregate demand downward sloping?
1) The wealth effect of a change in aggregate price level
-Holding all else constant, a rise in aggregate price, lowers the real value of existing assets, which leads to a reduction in the real value of wealth.
2) The interest rate effect of a change in aggregate price level
-Holding all else constant, interest rate rises when aggregate price increases because the purchasing power of our (existing) money holdings falls.
-To purchase the same amount of goods and services, we need to hold more money than before.
What is the formula for real value of wealth?
real value of wealth=$value of wealth/price
How does an increase in interest rate change investment, consumption, exports, imports, and net exports?
-When interest rates rise, the cost of borrowing rises, which reduces investment.
-When interest rate rises, current consumption becomes more expensive, which reduces consumption.
-An open economy also experiences more capital inflows, when interest rate rises. That causes the currency to appreciate, which reduces exports, but raises imports. But of those two things reduce net exports, so net exports reduce a lot.
What is the generic version of the aggregate demand curve.
The photo of the equation is on your phone.
What are five factors that shift aggregate demand to the right, and why?
1) Consumer confidence
-Households become more optimistic. They think jobs and money are plentiful, so they spend more for any given level of YD(disposable income)
2) Business confidence
-Firms become more optimistic, so they spend more on capital goods. That leads to autonomous expenditure at any given point(AE0)
3) Wealth
-Households feel that they become richer, which increases autonomous consumption, and by extension increases autonomous expenditure at any given point(AE0).
4) Size of the existing stock of physical capital is low.
-Incentive to invest increases. Firms have little room to increase production given the current state of things. To increase production, they need to increase autonomous investment which increases autonomous investment at any given point(AE0)
5) Government spending
-Government spending increases so AE0 increases. It’s called expansionary fiscal policy.
What are government related factors that shift aggregate demand to the right?
1) (Lump-sum) taxes decreases
2) (Lump-sum) transfer increases.
Why? YD=Y-T+TR.
3) Money supply goes up
4) A demand shift between foreign goods and domestic goods that favours domestic goods.
5) Trade policies such as import tariffs, import quotas.
How does expansionary fiscal policy via lump-sum tax and transfer payments shift aggregate demand to the right?
Consumption increases by MPC*T0, which leads AE0 to increase.
How does money supply increasing shift the demand to the right?
-Relates to expansionary monetary policy.
-When money supply goes up, we try to get rid of extra money holding, which puts a downward pressure on interest, which stimulates the demand for goods and services.
How does a demand shift between foreign goods and domestic goods that favours domestic goods shift aggregate demand to the right?
-E.g. a study shows that consuming more grains is good for your health. Foreigners buying grains from Canada increases our AE0.
-If foreign demand for domestic goods increases, exports rise, which increases AE0.
-If domestic demand for foreign goods falls, then imports fall which increases AE0.
How does trade policies such as import tariffs, import quotas dropping shift aggregate demand to the right?
-Import tariffs makes foreign goods become more expensive.
-That decreases demand for foreign goods, and by extension, it reduces imports, which increases AE0.
What two types of aggregate supply are there?
1) The short-run aggregate supply (SRAS)
2) The long-run aggregate supply (LRAS)
Why are prices and wages sticky in the short run?
1) Menu printing cost
2) Long-term contract
What is the formula for the short run supply curve in the short run?
The answer is on your phone.
In the short run supply curve, what is a?
A helps to capture other factors that affect firms willingness to supply.
What factors can lead to short run aggregate supply to shift to the right?
1) Commodity prices dropping
-Commodity is raw material. Per-unit production costs fall, which leads to a rise in per-unit profit. So firms want to supply more.
2) Nominal wages dropping
-Labour costs represent a lot of production cost. Firms will find that per-unit production cost drops, and per unit profit rises. So firms want to supply more.
3) Productivity increasing
-For the same amount of inputs, the firm can produce more. That drops per-unit production cost, and raises per-unit profit.
What is the formula for long-run supply curve? How does the long run average supply curve shift?
The formula for the long-run supply curve is the aggregate production function:
Y=A*F(K, L, H)
Changes in A, K, L and H will shift the LRAS curve.
When does long run equilibrium occur?
When short run equilibrium and long run equilibrium are both met.
When does an output gap occur?
-When short-run level of output is different than long run level of output, there is an output gap.
-When short run equilibrium level of output is greater than our long run equilibrium level of output, we experience an inflationary gap. That’s because there is pressure for prices to rise as we move closer to our long-run equilibrium.
What is the natural adjustmenet mechanism from the short run to the long run?
-The nominal wage will adjust over the long run to ensure that short run aggregate supply, long run aggregate supply, short run aggregate demand, and long run aggregate demand intersect.
-When the econoy is in a recessionary gap, the pressure will be on nominal wages to fall because the current level of unemployment is high.
-When the economy is in an inflationary gap, there will be pressure for wages to rise, because it’s hard for firms to find employees. E.g. employees asking firms to salary match their other offer.
