Chapter 6--Aggregate Demand/Aggregate Supply

Question 1

What is the classical dichotomy?

Answer 1

That, in the long run, there is a separation between real and nominal variables

Question 2

What is monetary neutrality?

Answer 2

That adjustments in the money supply only have effect on the nominal value of money, not its real value (which reflects the value people put on goods and services)

Question 3

What is aggregate demand?

Answer 3

The real GDP demanded by all groups in the economy at a given price level

Question 4

Does monetary neutrality apply to short-run changes to the economy?

Answer 4

No; real value appears to be affected by price level (ie. inflation and deflation) in the short-run. Aggregate demand and aggregate supply take this reality into account

Question 5

How is real GDP calculated?

Answer 5

(Nominal GDP/Price Level Index)*100

Question 6

When does the negative slope of the aggregate demand curve mean?

Answer 6

Price level and Real GDP demanded are inversely related

Question 7

What is the interest rate effect?

Answer 7

A reduction in the price level causes people to convert cash into interest-bearing assets.

Price level decrease–>deflation–>real value of cash increases–>cash buys more–>people have more cash–>demand for interest-bearing assets goes up–>interest rate goes down–>people invest more cash (I)–>Real GDP demanded increases

This is one of the reasons why the aggregate demand curve is negative

Question 8

What is the wealth effect?

Answer 8

A decrease in the price level makes consumers feel wealthier because each nominal dollar can purchase more goods and services.

Since more consumer items (C) are purchased, real GDP demanded increases

This is one of the reasons why the aggregate demand curve is negative

Question 9

What is the open economy effect?

Answer 9

When the price level falls, the real exchange rate depreciates.

The real exchange rate is the rate at which foreign-made goods can be bought or sold for domestic-made goods

Depreciation of the real exchange rate increases the quantity of exports and increases the quantity of imports, thus increasing next exports (NX) and the real GDP demanded

This is one of the reasons why the aggregate demand curve is negative

Question 10

What is aggregate supply?

Answer 10

The total quantity of goods and services the producers in the economy are willing and able to produce at a given price level

Question 11

How does the aggregate supply curve slope?

Answer 11

In the short-run: upward sloping

In the long-run: there is no slope; it is a vertical line located at the economy’s potential real GDP

Question 12

What is the profit effect?

Answer 12

That a company makes more profit (produces and sells more goods and services) when the price level increases, because of sticky wages: multi-year contracts with employees that do not fluctuate with price level.

Thus, when price level increases, the nominal amount of sticky wages stays the same though the real value of those wages decreases. Thus, employment and production become more profitable, since wage value is less.

One of the reasons why the short-run aggregate supply curve slopes upward

Question 13

What is the misperceptions effect?

Answer 13

In the short run, producers are temporarily fooled about what is really causing price changes in the markets they sell in.

Because of this, producers respond to increases in the price level by increasing production, even though there is no change in real price. Thus, production follows price level.

One of the reasons why the short-run aggregate supply curve slopes upward

Question 14

What is the menu cost effect?

Answer 14

Producers do not change their prices as often as they might, because it costs to update menus and they risk hurting customer goodwill by doing so.

For example, if there is a contraction in the economy (decrease in Real GDP), prices will stay the same for a period. This means the real price of the product has increased, and customers buy less of it. So, production relative to price level goes up.

One of the reasons why the short-run aggregate supply curve slopes upward

Question 15

What is the potential real GDP?

Answer 15

The maximum sustainable output level of an economy, given the amount of production factors available, state or technology, and formal or informal institutions that affect the economy.

Question 16

Why does the aggregate supply curve form a vertical line at the potential real GDP over the long-term?

Answer 16

Because, given enough time, producers will figure out changes in the economy and set their prices accordingly. Profit effect, misperceptions effect, and menu cost effect will vanish in the long-term, and the output of the economy will settle at its potential, regardless of price level

Question 17

What is natural unemployment? What is the natural unemployment rate?

Answer 17

Unemployment that exists when the real GDP of the economy has reached the potential real GDP.

This is made of frictional unemployment and structural unemployment, since these cannot be massaged out of the system.

Cyclical unemployment, however, does not exist in such a situation, since there are no current economic fluctuations.

The rate of natural unemployment is estimated between 4 and 5%

Question 18

What exogenous changes affect soft-term aggregate supply, but not long-term?

Answer 18

1) Short-term changes that reflect no actual alteration to capacity will shift the short-term curve, but not the long-term curve, while permanent changes to the factors of production affect both curves
2) Temporary supply shock–a temporary event that alters the availability of labor, but does not permanently change the production capacity of the economy

Question 19

What exogenous variables affect aggregate supply?

Answer 19

1) Changes in cost
2) Government policy
3) Economic growth or contraction
4) Favorable or unfavorable weather

Question 20

What is an inflationary gap?

Answer 20

A short-run effect that occurs after inflation. Workers eventually realize their wages have decreased in real value and demand higher wages. During the gap, production can exceed potential real GDP, since wages are artificially low

Question 21

What effect does a deflationary gap have?

Answer 21

Adds cyclical unemployment to the natural unemployment of the economy. This is because goods and services produced is less than the potential real GDP, so fewer workers are employed than the economy can sustain.

This causes workers to accept lower wages (since there are more people available to do work), which decrease input costs and increases profit maximizing quantities.

Question 22

How does fiscal policy stimulate aggregate demand when the economy is in a deflationary gap?

Answer 22

By the government purchasing more goods and services, cutting taxes, or increasing transfer payments. More money in the economy leads to a feeling of more wealth, and more demand for goods and services, thus raising aggregate demand and closing the gap.

This brings the economy back into equilibrium at the potential real GDP, but at a higher price level than would happen naturally (i.e.: with inflation)

Question 23

How does fiscal policy reduce aggregate demand when the economy is in an inflationary gap?

Answer 23

By the government purchasing fewer goods and services, raising taxes, or decreasing transfer payments. Less money in the economy leads to a feeling of less wealth, and less demand for goods and services, thus decreasing aggregate demand and closing the gap.

This brings the economy back into equilibrium at the potential real GDP, but at a lower price level than would happen naturally (i.e.: with deflation)

Question 24

What is the danger of fiscal policy solutions to economic fluctuations?

Answer 24

The time it takes to implement them may cause fiscal policy solutions to not be implemented until the economy has already corrected itself, which could lead to the government solution making things worse, not better.

Question 25

What are automatic stabilizers?

Answer 25

Those fiscal policies that are put in place to kick in immediately after certain economic benchmarks are met, that help solve the problem of fiscal policy lags.

They automatically stimulate the economy when it enters a deflationary gap, and automatically depress the economy when it enters an inflationary gap.

Examples include unemployment insurance, welfare benefits, and income taxes.