Test #3 (chapter 12) Flashcards
What is the aggregate demand curve?
Describes the relationship between the aggregate price level and the quantity of aggregate output
- Horizontal axis = total quantity of domestic goods and services demanded (aka Real GDP / aggregate output)
- Vertical axis = aggregate price level, measured by the GDP deflator
Why does the AD curve slope downward?
- Wealth affect:
- increase in aggregate price level = lower purchasing power of wealth (feel poorer) = lower consumption - Interest rate effect:
- rise in aggregate price level = HH hold more money = reduces the funds available for lending to other borrowers = higher interest rates = lower I and C
Explain how the AD curve & the income-expenditure model are related
(what happens on the income-expenditure graph if the price level drops?)
- AD curve is the application of the income expenditure model at different prices
We can ask what the aggregate expenditure would be at any given aggregate price level, which is just what the aggregate demand curve shows
- if the price level drops, planned spending rises at all output levels (new higher equilibrium point and RGDP point)
**economists often use the income-expenditure model to analyze short-run economic fluctuations
How is the AD curve different form the individual demand for a good?
Individual demand for a good → depends on the price of that good, holding the prices of other goods and services constant
*if a consumer decides to buy fewer clothes but more cars, this doesn’t necessarily change the total quantity of final goods and services they demand
Aggregate demand curve → considering a simultaneous change the prices of all final goods and services
A rise in the aggregate price level leads to a fall in the quantity of ALL domestically produced final goods and services demanded
What causes shifts of the AD curve?
- Changes in expectations
- When consumers and firms become more optimistic about the future, aggregate demand increases - Changes in wealth:
- When the real value of household assets rises, aggregate demand increases - Size of the existing stock of physical capital:
- When the existing stock of physical capital is relatively small, aggregate demand increases
Ex. if a large number of houses have been built in recent years, this will depress the demand for new houses and will tend to reduce residential investment spending - Fiscal policy:
- When the government increases spending or cuts taxes, aggregate demand increases
- changes in G have a direct effect, changes in T or TR have an indirect effect - Monetary policy:
- When the central bank increases the quantity of money supplied = interest rate decreases = aggregate demand increases
Does a change in wealth move us along the AD curve (wealth effect) or shift it?
*it depends:
- movement along the AD if wealth changes due to aggregate prices cause the price to change (ex. rapid inflation shrinks wealth)
- shift in AD if wealth changes due to other factors (ex. housing market crashes)
What is the aggregate supply curve?
It shows the relationship between the aggregate price level and the quantity of aggregate output in the economy (GDP)
Why is the short-run aggregate supply curve upward sloping?
- because of STICKY WAGES (nominal wages that are slow to fall even in the face of high unemployment and slow to rise even in the face of labour shortages) –> because of contracts or informal agreements
- lower aggregate price level –> lower firm profits = firms lower output to maximize profit
- higher aggregate price level –> higher profits = increased aggregate output
**all about producers thinking about maximizing profit - since wages are typically inflexible they have to instead change how much they produce
What is an integral component of what distinguishes the short run from the long run?
How long it takes for nominal wages to become flexible
How are prices set differently in different kinds of markets?
Perfectly competitive - producers take prices as given
- Ex. price falls → costs are fixed in the short run → profit per unit of output declines → reduce quantity supplied in the short run
- Producers look for ways to limit the decline in output → only way they can do this is by laying off workers (law of diminishing marginal productivity)
Imperfectly competitive - producers have some ability to choose the price (pricing power)
- Ex. rise in demand for product → able to raise prices and output to increase profit
- Ex. fall in demand → firms will lower prices to limit the fall in sales
What causes shifts in the short-run aggregate supply curve?
- commodity prices
- increase in the price of a commodity = raises production costs = reduces the quantity of output supplied at any given price level = SRAS shifts left
*commodity prices can change drastically and have large impacts on production costs - nominal wages
- when contracts and informal agreements are renegotiated (ex. Rise in health care insurance premiums paid by employers as part of employees’ wages → increases production costs = supply decreases) - productivity
- Increase in productivity → worker can produce more units of output with the same quantity of inputs = supply increases
- Ex. introduction of bar-code scanners in retail stores → shifted SRAS to the right
*hardest and slowest to change
Why can the SRAS curve shift?
factors besides the aggregate price level can affect profit per unit, and in turn, aggregate output (these factors cause shifts)
Explain the significance of the long-run aggregate supply curve
The long-run aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied in the long run (is a completely vertical line on the graph)
- in the long run all prices (including nominal wages) are fully flexible and will fully adjust to changes in the aggregate price level
**in the long run, the aggregate price level has NO effect on the quantity of aggregate output supplied because changes in the aggregate price level, which is composed of prices of final goods and services, will be accompanied by equal proportional changes in ALL input prices, including nominal wages
In the long run, aggregate output is determined by the economy’s _______________
potential output
What is the horizontal intercept on the LRAS curve
What are the other names for this point?
The horizontal intercept is the economy’s potential output (Yp) → the level of real GDP the economy would produce if all prices, including nominal wages, were perfectly flexible
- Not maximum level of output but the level of real output the economy would produce when all the factors of production are effectively and fully utilized
AKA, natural rate level of output, full employment level of output, and long run equilibrium output
What is an output gap?
the percentage difference between actual aggregate output and potential output → when the output gap is negative, the actual real output is below the long-run potential level
*always tends towards zero
The economy is always in one of two states: (what are they? in relation to the LRAS and SRAS curves)
- economy can be on both LR and SR curves simultaneously (at point where the curves cross and where actual aggregate output and potential output roughly coincide)
- It can be on the short-run aggregate supply curve but not the long-run aggregate supply (where the actual aggregate output and potential output do not coincide) = output gap
***if the economy finds itself at a price and output level away from the LRAS, wages will adjust and the SRAS curve will shift toward equilibrium
a rise in nominal wages shifts SRAS __________ and a fall in nominal wages shifts SRAS ___________
leftward
rightward
What is the AD-AS model?
AD-AS model = the basic model used to understand fluctuation in aggregate output and the aggregate price level → uses the ASC and the ADC together to analyze the behaviour of the economy in response to shocks or government policy
What is the point at which the AD and SRAS curves intersect on the AD-AS model?
Esr = the short-run macroeconomic equilibrium –> assume the economy is always in Esr
Aggregate price level at Esr = PE –> the short-run equilibrium aggregate price level
Level of aggregate output at Esr = YE → the short-run equilibrium aggregate output
What is the long-term trend in the aggregate output and aggregate price level?
In reality there is a long-term upward trend - so you calculate the fall in either variable as a fall compared to the long-run trend (ex. Price level normally rises 4% per year, one year it only rises 3%, that’s a 1% decline)
What are demand shocks and supply shocks? Which are more common?
Demand shock = an event that shifts the aggregate demand curve *more common
Supply shock = an event that shifts the short-run aggregate supply curve
What do negative and positive demand shocks do? (important features)
**prices and output move in the same direction and govt. can create demand shocks through policy
Negative demand shock: leads to a lower aggregate price level and lower aggregate output
- negative output gap - creates a recession
Positive demand shock: leads to a higher aggregate price level and higher aggregate output
What do negative and positive supply shocks do? (important features)
**prices and output move in opposite directions and it’s much harder for the government to shift the AS curve
Negative supply shock: leads to lower aggregate output and a higher aggregate price level ** this is the WORST - creates two problems = STAGFLATION (the combination of inflation and falling aggregate output)
Positive supply shock: leads to higher aggregate output and a lower aggregate price level - the BEST - more output and lower prices
When is the economy is long-run macroeconomic equilibrium?
LRME is the point at which the short-run macroeconomic equilibrium is on the long-run aggregate supply curve; so short-run equilibrium aggregate output is equal to potential output (*the intersection of all three curves- LRAS, SRAS, and AD)
a negative demand shock creates a _________ gap and a positive demand shock creates a __________ gap
recessionary
inflationary
What is a recessionary gap and inflationary gap?
What happens to the price level in each case once the economy self-corrects?
recessionary gap: when aggregate output is below potential output - corresponds to high unemployment
- Once the economy self-corrects back to potential output, the price level has decreased
inflationary gap: when aggregate output is above potential output - low unemployment but higher prices (leads to rising nominal wages and other sticky prices)
- Once the economy self-corrects back to potential output, the price level has increased
What does self-correcting mean?
Describes an economy in which shocks to aggregate demand affect aggregate output in the short run but not in the long run
- the process of self-correction can take a decade or more
What mainly causes recessions?
recessions are mainly caused by demand shocks, but it’s especially severe when a negative supply shock happens
What is stabilization policy?
The use of government policy to reduce the severity of recessions and to rein in excessively strong expansions –> through monetary and fiscal policy
- can push economy back to potential output quicker
What is the negative supply shock policy dilemma?
To stabilize aggregate output requires increasing aggregate demand - will lead to inflation
To stabilize prices requires reducing aggregate demand - will deepen a recession
