Chapter 14 Flashcards
Recession and Depression
Recession is a period of falling incomes and rising unemployment. Note that real GDP has to be falling multiple times in succession. So if it drops in quarter one and quarter two, then we know we’re entering a recession. If it’s a severe recession, so it keeps dropping, we’re entering a depression.
Depression is a severe recession.
3 Economic Facts
FACT 1: Economic fluctuations are irregular and unpredictable.
* Business cycles
FACT 2: Most macroeconomic quantities fluctuate together.
FACT 3: As output falls, unemployment rises.
The Assumptions of Classical Economics
The classical view is sometimes described by saying, “Money is a veil.”
What is important, however, are the real variables and the economic forces that determine them.
So money is a veil means money needs to be peeled back to see what’s going on. And remember, classical economics looks at the long run of things. What’s important is the real variables and the economic forces that determine them. So in the long run. Change in money supply does not affect real variables, it’s only affecting nominal variables like price. Or real variable is the actual output, the Y of it all.
The Model of Aggregate Demand and Aggregate Supply
Most economists believe that classical theory describes the world in the long run but not in the short run.
Model of aggregate demand and aggregate supply is the model most economists use to explain short-run fluctuations in economic activity around its long-run trend.
Aggregate-demand curve is a curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level.
Aggregate-supply curve is a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level.
Why the Aggregate-Demand Curve Slopes Downward
The price level and consumption: The wealth effect
* When prices fall, consumers have more purchasing power and feel wealthier, which leads to increased spending. As consumption goes up, Y goes up.
The price level and investment: The interest-rate effect
* When prices fall, interest rates tend to drop, which encourages more investment and borrowing.So as I goes up. Y goes up
The price level and net exports: The real exchange–rate effect
* When prices fall, domestic goods and services become cheaper relative to foreign goods, which increases net exports and demand for domestic goods and services. For a lot of foreigners buy it. This stimulates net exports, causing more demand for goods and services.
Why the Aggregate-Demand Curve Might Shift
Changes in consumption
Changes in investment
Changes in government purchases
Changes in net exports
Postive changes shift it right
Negtative changes shift it left
Aggregate Supply Curve
Supply curves tells us the total quantity of goods and services the firms produce and sell at any given price level.
The formula is the same as the long run. Supply curve which is just. Y = AF (K,L,H,NR). The formula is the same, however the visual of it is not the same.
Why the aggregate supply curve is vertical in the long run?
In the long run, an economy’s production of goods and services, its real GDP, depends on supplies of labour, capital, natural resources and on the available technology it used to turn these factors of production to goods and services.
Natural rate of output is the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate.
This is also known as potential output or full employment output or natural level of output.
What might cause the long run aggregate supply curve to shift? Y = Af(L,K,H,NR)
A change in any of these will cause it to shift to the right.
For Labour, think if we get more workers or the natural rate of unemployment. For capital thinking increasing economies capital stock increases productivity and thereby the quantity of goods and services supplied. For changes in natural resource is a discovery of a new mineral deposit or other natural resource is shift the long run aggregate supply to the right. Changes in technological knowledge Advances in technological knowledge is probably one of the major reasons we can produce more today than we did in the past.
Using aggregate demand and aggregate supply to depict long run growth and inflation.
We can use AD and LRAS to determine long run trends, this is the graph with the 3 LRAS moving from left to right and the 3 AD line moving with it.
- Overall, as we get more advanced so any of the production formula is posotive then the LRAS moves to the right,
- That move causes growth in the money supply and it shifts the aggregate demand to the right as well
- That move leads to growth in output
- And a growth happens it leads to growth in output
Aggregate-Supply Curve Slopes Upward in the Short Run
In the short run, the price level (y-axis) does affect the economy’s output.
An increase in the overall level of prices tends to raise the quantity of goods and services supplied and vice versa. As they get more money for each unit they sell.
Why the Aggregate-Supply Curve Slopes Upward in the Short Run
The sticky-wage theory: Wages fall slowly druing in a recession as they are sticky and people don’t like wage cuts. If they got cut it would end the recession quicker but they don’t and the recession continues. As an example, imagine that a year ago, a firm expected the price level to be 100 and, based on this expectation, it signed a contract with its workers agreeing to pay them $20 per hour. In reality the price level turns out to be only 95. As a result of the fall in prices, the firm gets 5 percent less than expected for each unit of its product that it sells. The cost of labour is stuck at $20 per hour and production is less profitable, so firms hire fewer workers and the quantity of output supplied declines.
The sticky-price theory: The sticky-price theory emphasizes that the prices of some goods and services also adjust sluggishly in response to changing economic conditions. The slow adjustment of prices is often the result of the existence of menu costs. Suppose that each firm in the economy announces its prices in advance based on the economic conditions it expects to prevail over the coming year. Then, after the prices are announced, the economy experiences an unexpected contraction in the money supply, which reduces the overall price level in the long run. Some firms may reduce their prices immediately while other firms may lag in adjusting prices because of the existence of menu costs. Their prices are relatively higher and as a result sales decline, leading to cutbacks on production and employment and thus reducing the quantity of goods and services produced by these firms.
The misperceptions theory: According to this theory, changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their product. As a result of these short-run misperceptions, suppliers respond to changes in the level of prices, and this response leads to an upward-sloping aggregate-supply curve.
SUMMARY (Short run Supply)
All three theories suggest that output deviates from its natural rate when the price level deviates from the price level that people expected.
Quantity = Natural Level of output + a(Actual Price - Expected Price)
Where a is the number that determines how much output responds to unexpected changes in the price level.
SUMMARY (Long Run Supply)
In the long run, wages and prices are flexible rather than sticky and people are not confused about relative prices.
Qauntity of Output Supplied = Natural Rate of Output
In the long run, wages and prices are more flexible rather than sticky, and people are not confused about relative prices. So in the long run you don’t have those problems of the sticky prices, the sticky wages and things like that. Remember, that’s the short run. Aggregate supply curve that has sticky wages, sticky price. And misperceptions.
Why the short run aggregate supply curve might shift?
We can think of the short-run aggregate-supply curve as similar to the long-run aggregate-supply curve but made upward sloping by the presence of sticky wages, sticky prices, and misperceptions.
Increase in the economies capital stock increases productivity. Therefore both the long run and short run aggregate supply curves shift to the right. An increase in the minimum wage raises the natural rate of unemployment. Both the long run and short run aggregate supply curve shift to the left. As remember minimum wage causes the price level to increase in the price level increasing Causes workers to have to layoff people. As more people are laid off, the unemployment rate rises, and if that rises, you’re producing less.
