Macroeconomics Chapter 12: Aggregate Demand & Aggregate Supply (Final)

How does the aggregate demand curve illustrate the relationship between the aggregate price level and the quantity of aggregate output demanded?

The aggregate demand curve is downward sloping for two reasons. The first is the wealth effect of a change in the aggregate demand - a higher aggregate price level reduces the purchasing power of households' wealth and reduces consumer spending. The second is the interest rate effect of a change in the aggregate price level - a higher aggregate price level reduces the purchasing power of households' and firms' money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending

How does the aggregate supply curve illustrate the relationship between the aggregate price level and the quantity of aggregate output supplied? Why is the aggregate supply curve different in the short run compared to the long run?

The short-run aggregate supply curve is upward sloping because nominal wages are sticky in the short run: a higher aggregate price level leads to higher profit per unit of output and increased aggregate output in the short run.

In the long run, all prices, including nominal wages are flexible and the economy produces at its potential output. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment and aggregate output, nominal wages will eventually fall in response to high unemployment and aggregate output will rise. So the long-run aggregate supply curve is vertical at potential output.

How is the AD-AS model used to analyze economic fluctuations?

In the AD-AS model, the intersection of the short-run aggregate supply curve and the aggregate demand curve is the point of short-run macroeconomic equilibrium. It determines the short-run equilibrium aggregate price level and the level of short-run equilibrium aggregate output

How can monetary policy and fiscal policy stabilize the economy?

The high cost - in terms of unemployment - of a recessionary gap and the future adverse consequences of an inflationary gap of inflationary gap lead many economists to advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. There can be drawbacks, however, because such policies may contribute to a long-term rise in the deficit and crowding out of private investment, leading to lower long-run growth. Also, poorly timed policies can increase economic instability.

Aggregate demand curve

A graphical representation that shows the relationship that shows the relationship between the aggregate price level and the quantity of aggregate output demanded by households, firms, the government, and the rest of the world.

The aggregate demand curve has a negative slope due to the wealth effect of a change in the aggregate price level and the interest rate effect of a change in the aggregate price level

Wealth effect of change in aggregate price level

The effect on consumer spending caused by the change in the purchasing power of consumers' assets when the aggregate price level changes. A rise in the aggregate price level decreases the purchasing power of consumers' assets, so consumers, decrease their consumption; a fall in the aggregate price level increasing the purchasing power of consumers' assets, so consumers increase their consumption

Interest rate effect of change in aggregate price level

The effect on consumer spending and investment spending caused by a change in the purchasing power of consumers' money holdings when the aggregate price level changes. A rise (fall) in the aggregate price level decreases (increases) , the purchasing power of consumers' money holdings. In response, consumers' try to increase (decrease) their money holdings, which drives up (down) interest rates, thereby decreasing (increasing) consumption and investment.

Aggregate supply curve

A graphical representation that shows the relationship between the aggregate price level and the total quantity of aggregate price level and the total quantity of aggregate output supplied

Nominal wage

The dollar amount of any given wage paid

Sticky wages

Nominal wages that are slow to fall even in the face of high unemployment and slow to rise even the face of labor shortage

Short-run aggregate supply curve

A graphical representation that shows the positive relationship between the aggregate price level and the quantity of aggregate output supplied that exists in the short run, the time period when many production costs, particularly nominal wages, can be taken as fixed. The short-run aggregate supply curve has a positive slope because a rise in the aggregate price level leads to a rise in profits, and therefore output, when production costs are fixed.

Long-run aggregate supply curve

A graphical representation that shows the relationship between the aggregate price level and the quantity of aggregate output supplied that would exist if all prices, including nominal wages, were fully flexible. The long-run aggregate supply curve is vertical because the aggregate price level has no effect on aggregate output in the long run; in the long run, aggregate output is determined by the economy's potential output

Potential output

The level of real GDP the economy would produce if all prices, including nominal wages , were fully flexible

AD-AS model

The basic model used to understand fluctuations in aggregate output and the aggregate price level. It uses the aggregate supply curve and the aggregate demand curve together to analyze the behavior of the economy in response to shocks or government policy

Short-run macroeconomic equilibrium

The point at which the quantity of aggregate output supplied is equal to the quantity demanded

Short-run equilibrium aggregate price level

The aggregate price level in short-run macroeconomic equilibrium

Short-run equilibrium aggregate output

The quantity of aggregate output produced in short-run macroeconomic equilibrium

Demand shock

An event that shifts the aggregate demand curve. A positive demand shock is associated with higher demand for aggregate output at any price level and shifts the curve to the right. A negative demand shock is associated with lower demand for aggregate output at any price level and shifts the curve to the curve to left.

Supply shock

An event that shifts the short-run aggregate supply curve. A negative supply shock raises production costs and reduces the quantity supplied costs and reduces the quantity supplied at any aggregate price level, shifting the curve leftward. A positive supply shock decreases production costs and increases the quantity supplied at any aggregate price level, shifting the curve rightward

Stagflation

The combination of inflation and falling aggregate output

Long-run macroeconomic equilibrium

The point at which the short-run macroeconomic equilibrium is on the aggregate supply curve; so short-run equilibrium aggregate output is equal to potential output

Recessionary gap

A gap that exists when aggregate output is below potential output

Inflationary gap

The gap that exists when aggregate output is above potential output

Output gap

The percentage difference between actual aggregate output and potential output

Self-correcting

Describes an economy in which shocks to aggregate demand affect aggregate output in the short-run but not in the long run

Stabilization policy

The use of government policy to reduce the severity of recessions and to rein in excessively strong expansions. There are two main tools of stabilization policy: monetary policy and fiscal policy