chapter 14 Flashcards
what are the 2 assumptions for the long run aggregate supply curve (LRAS)?
1) money neutrality, changes in nominal variables have no impact on real variables
2) output is given by Y= f(K,L)
what are the nominal variables in the long run (LRAS)?
money supply (M)
price level (P)
what are the real variables in the long run (LRAS)?
real interest rate (r)
income (Y)
investment (I)
consumption (C)
government spending (G)
how will an increase of money supply impact the IS-LM curve in the long run and the AD curve?
it will shift the LM curve to the right, but with the increase in M, causes an increase in P, causing the curve to shift back to the same level of r and y
AD will shift up, increasing price levels, Y unchanged
in the long run how does a change in money supply impact I,G and C?
I does not change because r did not change
G does not change because government policy did not change
C does not change because (Y-T) does not change
how will a tax cut impact the AD curve?
it will shift it to the right
how will a tax cut impact Y, C, P, M, G, r and I in the long run?
Y is unchanged because it is given as Y=f(K,L)
C increase due to higher disposable income (Y-T)
P increased due to right shift in AD curve
M is unchanged BoC did not change policy
G is unchanged due to no change in policy from Govt
r will increase from increase price level
I decreases from higher r
what does the aggregate supply curve show?
the relationship between quantity of goods and services supplied (Y) and price level
what does Y equal In the long run aggregate supply curve?
Y= F(K,L)
in the long run does output depend on price level?
no
why does output (Y) not depend on price level on the long run?
if real wage goes up so does real price, the consumer can still buy the same amount
what is the slope of the LRAS curve?
vertical up and down because price does not impact Y
in the short run, what causes output to temporarily deviate from long run levels?
market imperfections
what is Y a function of in the short run?
Y= Y (P-EP)
EP= expected price
how does a change in expected price level impact the SRAS curve?
it shifts it
how does an increase in expected price impact the SRAS curve?
it shifts it up
what are the 2 kinds are equilibrium in the aggregate supply and aggregate demand model?
short run equilibrium
long run equilibrium
what is the short run equilibrium?
short run equilibrium- when the price level deviates from expect price level and output deviates from the long run output (Y)
where is the short run equilibrium?
where AD curve crosses the SRAS curve
what is the long run equilibrium?
when the price level is equal to the expected price level, and output is at its natural level
where is the long run equilibrium?
where the AD curve, SRAS curve and LRAS curve all cross (see chap 14 slide 18)
how will an unexpected monetary expansion impact the aggregate supply aggregate demand model?
the increase in M will shift the AD curve to the right, the expected price will not change but the price will so the short run equilibrium will have higher prices and higher output than the natural level, the Long run expected price level rises and the SRAS shifts up to cross the AD curve along the LRAS bringing output back to normal level
what are the 2 theories that explain why the SRAS is up wards sloping?
the sticky price model
the imperfect information model
what is the short run aggregate Y?
Y= Y (P-EP)
what is the sticky price model?
it says that firms do not instantly adjust prices in response to changes in demand
what are the 3 reasons why firms cannot change prices?
contracts with buyers
frequency prices changes may annoy customers
once catalogues or price list are distributed, it is costly to change prices
what does the sticky price model assume?
that firms are price setters and have some market power
what are the 2 variables that price setting depends on?
overall price level, P. higher price level leads to higher costs for firms, so firms want to charge higher pries
level of national income,Y. higher income increases demand for firms product, encouraging firms to charge higher price
what is a firms desired price?
p= P+a(Y-Y bar)
what are the 2 types of firms?
firms with sticky prices
firms with flexible prices
how do firms with sticky prices set prices?
set prices as EP
how do firms with flexible prices set prices?
set prices to the desired price given by p= P+a(Y-Y bar)
if there are no sticky wage firms how does that impact the SRAS curve?
it makes it vertical like the LRAS curve
if there are all sticky wage firms how does that impact there SRAS curve?
it will be horizontal
what is the formula for price in the sticky price model?
P= EP+((1-s) a/s) (Y-Ybar)
what is the imperfect information model?
the confusion by producers and workers about what unexpected changes in prices imply about price level
what is the questions producers need to figure out in the imperfect information model?
does the in the price of their good mean there is an increase in the overall price level in the economy or just their good?
what are the 2 ways producers can react to an increase in the price of their good?
they will produce more if the overall price level increase
they will not produce more if it is just an increase in their good
when price level unexpectedly increases, how will the producer react?
they will mistake this for an increase in the relative price of goods they produce and they increase their output
in the imperfect information model, how does Y react when the expected price (EP) is higher than the price (P)?
the short run output (Y) is greater than long run output (Y bar)
in the imperfect information model, how does Y react when the expected price (EP) is Lowe than the price (P)?
the short run output (Y) is less than long run output (Y bar)
what is the short-run trade off that policy makers face?
between inflation an unemployment
if the central bank uses expansionary policy to increase aggregate demand, how will output, employment and price level react in the short run?
higher output
higher employment (lower unemployment)
higher price level
what is the Phillips curve?
the relationship between inflation and unemployment
what are the 3 things that the rate of inflation depends on?
expected inflation
deviation of unemployment rate from natural rate
supply shocks (v)
what is okun’s law?
the deviation of output form the natural rate is inversely proportional to the deviation of unemployment from its natural rate
how does the SRAS change when there is unexpected changes in price level?
it leads to changes in output
how does the Phillips curve change when there is unexpected changes in price level?
unexpected changes in inflation leads to changes in unemployment rate
when the bank of canada acts as predicted, how does it impact the aggregate supply and demand curve??
they both shift at the same time leading to the equilibrium on the LRAS
what are the 2 ways people form expectations?
adaptive expectations
rational expectations
what are adaptive expectations?
expectations that are based on recently observed inflation (expected inflation = last years inflation)
what is the only way to reduce inflation?
to temporarily increase unemployment
what is the cost of reducing inflation?
raising unemployment
what does the sacrifice ratio measure?
the percentage of a years GDP that is foregone to reduce inflation by 1%
if the sacrifice ratio is 3.5, how much will GDP fall by to reduce inflation by 4%?
14%
what does okuns law say the sacrifice ratio is?
a 1%rise in unemployment results in a 2% decline in GDP
what is rational expectations?
people optimally use all available information, including information on government policy to forecast the future
can you reduce inflation without the costs of the sacrafice ratio?
if policy makers are credible and publicly commit to a policy to reduce inflation it may be possible because people change their expectations
