Aggregate Demand and Aggregate Supply Part 2 Flashcards
What happens when there is a demand side shock to the short run and long run equilibriums?
-In the short run, autonomous consumption goes down, which in turn reduces AE0. That shifts Aggregate Demand to the left. In the short run equilibrium, price and quantity drops.
-Since quantity supplied is less, firms must layoff employees.
-Unemployment rate will then rise.
-To reach long run aggregate supply, the short run aggregate supply must also then drop. At that point, quantity will rise to that level, but price will drop even further.
When Y is less than Y(FE), what happens?
-Wages drops
-Dropping wages lead to dropping per-unit production cost, which increases per-unit profit. That shifts the SRAS to the right.
-In the long run, Y increases back to Y(FE), prices drops farther, and the unemployment rate will drop to natural rate of unemployment.
What most often leads to aggregate supply shocks?
-Changes in commodity prices often shift aggregate supply.
When commodity prices rise, how does that affect aggregate supply and aggregate demand in the short and long run?
-Rising commodity prices increase per unit production costs.
-In turn that reduces per unit profit, and shifts SRAS to the left.
-In the short run, equilibrium price rises, and equilibrium quantity falls.
-The reduction in quantity leads to layoffs, which increases unemployment.
-Unemployment will be greater than NRU.
-Economists call this stag-flation, the simultaneous occurence of rising prices and falling output.
-Since Y1<Y(FE), there will be pressure for wages to drop.
-Wages drop, so per-unit production costs drop. Per-unit profit rises. SRAS shifts to the right, and back to SRAS.
-Y will rise back to Y(FE).
-P will drop back to (P0).
-Unemployment rate will drop back to NRU.
-The economy will self adjust in this case.
What shifts both the short run and long run aggregate supply?
Total factor productivity shifts the short run aggregate supply, as well as the long run aggregate supply.
When total factor productivity increases, what happens to the short and long run aggregate supply?
-As A rises, firms can produce more for the same amount of inputs, so per-unit production cost drops.
-Short run and long run aggregate supply both shift right because per-unit production cost falls, and per-unit profit rises.
-The initial short run equilbrium will shift right by a little bit, but in the long run, the “short run equilirium” will shift right by a lot.
What is fiscal policy?
Fiscal policy refers to the government’s choices on the level of spending on final goods and services, the amount of taxes they want to charge, and the amount of government transfers.
What is monetary policy?
-Monetary policy has to do with the central bank’s choice regarding the level of money supply.
-When there is a change in money supply, there will be a change in the interest rate.
-That will affect the cost of borrowing, which affects planned expenditure.
-When interest rates change, it affects household’s decision between whether to consume today, or whether to consume tomorrow.
-Interests affect capital flow, and capital flow affects the exchange rate, and affects the competitiveness of our goods in the market, and that affects our net exports.
-When money supply changes, interest rate changes, and that change in interest rate can cause autonomous expenditure, planned investment, and net exports.
What does autonomous expenditure (AE0) include? What does it relate to?
AE0=AC+AI+G+X0-IM0-MPCT0+MPCTR0-d*i
Autonomous expenditure is impacted by fiscal policy.
In the face of a demand shock, what are the options available to policy makers to stablize the economy?
1) Maintain the Status Quo
-Let the invisible hand do it’s work, setting into place the long run adjustment mechanism
-Since Y1<Y(FE), there will be pressure for wages to drop.
-Wages decreasing will decrease per-unit production cost, which will increase per-unit profit.
-SRAF shifts to the right to SRAS1.
2) Run Counter-Cyclical Stablization Policy in the Short Run
-They run a policy that increases output, and raises aggregate demand back to its initial starting point.
-They use expansionary fiscal or expansionary monetary policy, which has an expansionary effect on output.
What does expansionary fiscal policy involve?
1) Increasing government spending
2) Increasing government transfers
3) Reducing taxes
4) Increase in money supply which in turn drops interest rates.
What is more tricky for policy makers to deal with, a shock in aggregate supply, or a shock in aggregate demand?
-A shock in aggregate demand can quickly be changed by running counter-cyclical stabilization policy, which involves expansionary fiscal policy or expansionary monetary policy.
-A shock in aggregate supply is harder to account for.
In the face of a short-run supply shock, what are the options available to policy makers to stablize the economy?
1) Maintain the Status Quo
-Since Y1<Y(FE), there will be pressure for wages to drop.
-Wages drop, so per-unit production cost drops, which increases per-unit profit.
-SRAS shifts to the right, and back to SRAS0.
-But in the meantime, it takes a long time for this adjustment to occur. During that time, unemployment will be high.
2) Run Counter-Cyclical Stablization Policy in the Short Run
-They use expansionary monetary policy or expansionary fiscal policy.
-They run a policy that increases output, and shifts aggregate demand upwards.
-The tradeoff is that the economy will experience higher prices forever.
-Policy makers can increase government spending, government transfers, reduce taxes, or increase money supply.
-That wil increase autonomous expenditure, which increases AE0, AD shifts to the right.
What does monetary policy involve?
-Monetary policy has to do with the central bank’s choice regarding the level of money supply.
-When there is a change in money supply, there will be a change in the interest rate. That will affect the cost of borrowing, which affects planned expenditure. -When interest rates change, it affects household’s decision between whether to consume today, or whether to consume tomorrow.
-Interests affect capital flow, and capital flow affects the exchange rate, and affects the competitiveness of our goods in the market, and that affects our net exports.
-When money supply changes, interest rate changes, and that change in interest rate can cause autonomous expenditure, planned investment, and net exports.
What are stabilization policies?
Fiscal policy and monetary policy are often called stabilization policies because they are public policies aimed at reducing fluctuations in output in the short run. I.e. keeping Y close to Y(FE) in the short run.
