Week 8 Flashcards
Business cycle
Fluctuations in the economy are often called the business cycle
Three key facts about economic fluctuations
Economic fluctuations are irregular and unpredictable.
Most macroeconomic variables (that measure some types of income or production) fluctuate together
Do they do so by the same amounts?
As output falls, unemployment rises
Why?
Explaining short-run economic fluctuations
Most economists believe that classical theory describes the world in the long run but not in the short run
The basic model of economic fluctuations
Two main macroeconomic variables, output and prices, are used to develop a model to analyze the short-run fluctuations.
The economy’s output of goods and services measured by …?
The overall price level measured by…?
The model looks at the aggregated behaviour of households and firms, how it is affected by Y and P and how these in turn affect the behaviour
AD
The aggregate-demand curve (AD) shows the quantity of goods and services that households, firms, and the government want to buy at each price level
An important note AD
it is also possible to present the model in terms of inflation rather than the price level, with the intuition slightly changed (inflation rate used in a textbook)
Components of AD
The aggregate demand for goods and services has four components:
Aggregate Demand = C + I + G + NX
Aggregate Supply = Y
In equilibrium, supply = demand
Therefore, in equilibrium Y = C + I + G + NX
The aggregate-demand curve illustrated
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The demand curve for an individual commodity is downward sloping because of two effects:
Substitution effect: when ice cream becomes cheaper people buy more ice cream because they are switching from frozen yogurt (a substitute)
Income effect: when price of ice cream falls and income is unchanged, people feel richer and, therefore, buy more ice cream
The demand curve for an individual commodity is downward sloping because of two effects:
EXTRA NOTES
But the AD curve can consider only changes in the overall price level. If all prices decrease, there can be no substitution effect
It is inconsistent to talk about changes in aggregate demand while assuming unchanged income, because aggregate income must be equal to aggregate demand. Therefore, the income effect can’t be applied to the aggregate economy.
Shifts in the Aggregate Demand Curve
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Why the Aggregate-Demand Curve Might Shift
Shifts arising from
Consumption: consumer optimism, tax rates, prices of assets (stocks, bonds, real estate)
Investment: technological progress, business confidence, tax rates, money supply
Government Purchases
Net Exports: foreign GDP, expectations about exchange rates
The aggregate-supply curve
The aggregate-supply curve (AS) shows the quantity of goods and services that firms choose to produce and sell at each price level.
In the long run (LR), is Y affected by P?
What is then the slope of LRAS?
The long-run aggregate-supply curve
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Why the Long-Run Aggregate-Supply Curve Might Shift
Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.
Any change in the economy that alters the natural rate of output will shift the long-run aggregate-supply curve.
Labor: population growth, immigration, natural rate of unemployment
Capital, physical or human
Natural Resources: price of imported oil
Technology
Laws, government policies
The short-run aggregate-supply curve
We empirically observe that in the SR, unlike the LR, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.
A decrease does the opposite
Put differently, P has temporary but not permanent positive effect on Y
The short-run aggregate-supply curve
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WHY does a nominal variable like M or P have effect on a real variable like Y???
There are 3 main theories
All have something to do with some imperfections in the adjustment process
All lead to an upward sloping SRAS
There are 3 main theories
All have something to do with some imperfections in the adjustment process
All lead to an upward sloping SRAS
(1) the misperceptions theory
(2) the sticky-wage theory
(3) the sticky-price theory
How the SRAS curve shifts
SRAS1 shows the aggregate supply curve for 2010
the expected price level and the natural rate of output, must be on the SRAS curve
If either Pe↓ or YN↑, the green dot moves down or to the right
When the green dot shifts, so must the AS curve
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The long-run equilibrium
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Two causes of recession
In some LR equilibrium (called the steady state) all the main variables are either constant or change by a certain (unchanging) percentage
For example: inflation is 2% each year, output growth is 3% each year etc.
New economic developments (shocks) however may shift the three curves further and this leads to SR fluctuations
The economy then has a tendency to go back to some LR equilibrium (either the original one or a new one).
This works through the supply side and is called the self-correcting mechanism
Case (1): A Contraction in Aggregate Demand
3 photos
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