Ch 20: Aggregate Demand and Eggregate Supply

Question 1

What happens when an economy contracts?

Answer 1

Firms unable to sell all the goods and services they have to offer, so productions is reduced, workers are laid off, unemployment grows, factories left idle. The economoy produces less, so real GDP and other measures of income decline. Period of falling incomes and rising unemployment is called a recession if relatively mild and a depression if it is more severe.

Question 2

Example of Recession

Answer 2

The Great Recession (2008-2009):
- real GDP fell by 4.0 percent
- unemployment rose from 4.4 percent to 10.0 percent
- hard for graduating students to find jobs

Question 3

Model of aggregate demand and aggregate suppy

Answer 3

use to analyze the short-run effects of various events and policies

Question 4

Three key facts about economic fluctuations

Answer 4

1. Economic fluctuations are irregular and unpredictable
2. Most macroeconomic quantities fluctuate together
3. As output falls, unemployment rises

Question 5

What is the business cycle?

Answer 5

Fluctuations in the economy that correspond to changes in business conditions

Question 6

RealGDP

Answer 6

variable most commonly used to monitor short-run changed in the economy; it measures the value of all final goods and services produced within a given period of time, also measures the total income (adjusted for inflation) of everyone in the economy

Question 7

Why do most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together?

Answer 7

When real GDP falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on. Because recessions are economy-wide phenomena, they show up in many sources of macroeconomic data.

Question 8

Do the macroeconomic variable fluctuate by the same amount? Why?

Answer 8

No

Question 9

What happens to unployment as real GDP declines

Answer 9

Unemployment rises; when firms produce less, they lay off workers

Question 10

How do classical dichotomy and money neutrality correlate?

Answer 10

Classical dichotomy is the separation of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money). Money neutrality says that changes in the money supply affect nominal variables but not real variables

Question 11

Examples of real variables and nominal variables

Answer 11

Real: Real GDP, the real interest rate, unemployment

Nominal: the money supply, the price level, GDP deflator

Question 12

Why is it said that in a sense, money does not matter in a classical world— “Money is a veil”?

Answer 12

If quantity of money doubled, everything costs twice as much and income would be twice as high. The change would be nominal because the things people really care about (a job, how many goods and services they can afford, and so on) would be exactly the same.

Question 13

Describe the model of aggregate demand and aggregate supply.

Answer 13

X-Axis = quantity of output
Y-Axis = price level
Supply curve = aggregate-supply curve shows the quantity of g&s that firms produce and sell at each price level
Demand curve = aggregate-demand curve shows quantity of g&s that households, firms, the gov. and cust. abroad want to buy at each price level

Intersection = output and price level adjust to bring aggregate demand and aggregate supply into balance

Question 14

Most economists believe that classical macroeconomic theory is valid only in the long run or short run?

Answer 14

long run because

Question 15

Why is the aggregate-demand curve downward sloping?

Answer 15

Three reasons:
As price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. This leads to more spending on consumption, investment, and net exports. Increased spending on any or all of these components of output means a larger quantity of g&s demanded.

Question 16

Explain the Wealth Effect

Answer 16

Price level falls, real value of money rises and consumers are wealthier, thereby encouraging them to spend more. More consumer spending means a larger quantity of g&s demanded. The reverse is true.

Question 17

Explain the Interest-Rate Effect

Answer 17

Price level is one determinant of the quantity of money demanded. When price level is low, household reduce holdings of money by lending some of it out into interest-bearing assets, which drive down interest rates. Lower interest rate makes borrowing less expensive and encourages firms to borrow more to invest in new plants ad equipment and encourages households to (1) borrow more to invest in new housing and (2) spend more on large durable purchases like cars, which are often bought on credit.

A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of g&s demanded. The reverse is true.

Question 18

Explain the Exchange-Rate Effect

Answer 18

Lower price level = lower interest rate, which makes investors seek out higher returns in foreign investments. Such foreign investments increases the supply of dollars in the market for foreign-currency exchange as investers need to convert its dollars into euros or the other country’s currency. This increased supply of dollars causes the dollar to depreciate relative to the euro, altering the real exchange rate. Because each dollar buys fewer units of foreign currencies, foreign goods become more expensive relative to domestic goods so imports go down and foreigners buy more from the U.S.

When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of g&s demanded. The reverse is true.