Week 6 Lecture 2 Flashcards
What are the three key facts about economic fluctuations?
1- Economic fluctuations are irregular and difficult to predict
2- Most macroeconomic quantities fluctuate together
3- As output falls, unemployment rises
When analysing economic growth, the financial system, interest rates, money and inflation in the long run, what are the two main building blocks we use to do so?
1- Classical dichotomy: This is the separation of variables into real and nominal variables
2- Money neutrality: This occurs when changes in the money supply affect nominal variables but not real variables
When analysing economic growth, the financial system, interest rates, money and inflation, how do we do so differently in the short run vs the long run?
- In the short run the assumption of money neutrality is no longer appropriate
- In the short run real and nominal variables are highly intertwined
What does the AD-AS model explain?
- The AD-AS model explains short-run fluctuations in economic activity
- It focuses on the relationship between prices and real GDP
- Under classical dichotomy there would be no relationship between these two variables
What does the aggregate demand curve show?
The AD curve shows the quantity of goods and services that households, firms, the government and customers abroad want to buy at each price level
Which way does the AD curve slope?
The AD curve slopes downwards
What does the aggregate supply curve show?
The AS shows the quantity of goods and services that firms are willing to produce and sell at each price level
Which way does the AS curve slope?
The AS curve slopes upwards
Draw a general AD-AS diagram and label the equilibrium point
See slide 17 in Week 6 Lecture 2
What are the three effects used to explain why the AD curve slopes downwards?
- Wealth effect (C)
- Interest rate effect (I)
- Exchange rate effect (NX)
These are all components of the AD equation:
Y = C + I + G + NX
Explain the wealth effect (C) in relation to why the AD curve slopes downwards
- A decrease in the price level increases the real value of money
- Consumers feel wealthier and increase their spending and so aggregate demand increases
Explain the Interest rate effect (I) in relation to why the AD curve slopes downwards
- A decrease in the price level reduces the interest rate
- This is because as the price level decreases real money balances/increases supply which makes the interest rate drop. This is required in order to induce households to increase money demand so that demand equals supply again
- This then stimulates spending on investment goods and so increases aggregate demand
Explain the Exchange rate effect (NX) in relation to why the AD curve slopes downwards
- A decrease in the UK price level reduces the interest rate similarly to the interest rate effect
- This causes the UK pound to depreciate in value as the supply of pounds on FX markets increases
- This stimulates UK exports (X) and suppresses UK imports (M)
- This increases net exports as NX = X-M and therefore AD also increases
Explain in terms of the wealth effect (C), interest rate effect (I) and exchange rate effect (NX) why a rise in the price level reduces the quantity of goods and services demanded?
- Wealth effect: Consumers are poorer so consumer spending decreases
- Interest-rate effect: There are higher interest rates so investment spending decreases
- Exchange rate effect: The currency appreciates so net exports decreases
Why might the AD curve shift?
The AD curve may shift because of exogenous changes in consumption, investment, government purchases or net exports which are the four components of real GDP
What does the Aggregate supply curve (AS) show?
The AS curve shows the total quantity of goods and services that firms produce and sell at a given price level
What does the shape of the AS curve depend on and give the different shapes and conditions for them
The shape of the AS curve depends on the time horizon:
- The Long run aggregate supply curve (LRAS) is a vertical line and the price level does not affect the long-run GDP
- The short run aggregate supply curve (SRAS) is upwards sloping like a regular supply curve
What four factors is GDP determined by in the long-run?
- Capital (physical and human)
- Labour
- Natural resources
- Technology
What is the relationship between LRAS and the price level?
The LRAS curve is not affected by the price level
How does LRAS not being affected by the price level uphold the classical dichotomy?
This upholds the classical dichotomy as it shows a real variable (long-run GDP) cannot be influenced by a nominal one (aggregate price level)
What does the LRAS curve show?
The LRAS curve shows the output level when all existing factors of production are fully utilized and unemployment is at its natural rate
Draw a general LRAS curve
See slide 30 in Week 6 Lecture 2
State which factors cause a shift in the LRAS curve and why
- As the LRAS curve represents the natural rate of output, any change in the natural rate of output will make the LRAS curve shift
- LRAS curve will shift if there is a change in the following variables:
- Changes in labour
- Changes in capital (physical or human)
- Changes in natural resources
- Changes in technological knowledge
How do AD and LRAS change in the long-run?
- Both the AD and LRAS curve shift to the right
- LRAS curve shifts right due to technological progress
- AD curve shifts right due to monetary policy (the central bank increases money supply over time)
- This results in continuing growth in output and inflation
Draw a diagram to show how LRAS and AD changes over time
See slide 34 of Week 6 Lecture 2
