L7-9: Aggregate Supply, Prices, and Adjustment to Shocks

Flashcards based on Macroeconomics Lecture Notes

What is the assumption of the classical model regarding output and deviations from potential output?

Output is at its long-run equilibrium level, and deviations are swiftly corrected by price and wage adjustments.

What happens in the short run when prices and wages are not completely flexible?

Prices and wages may not be completely flexible, leading to aggregate demand determining output.

What is the real interest rate?

Nominal interest rate minus the inflation rate.

How does a central bank influence the real interest rate?

The central bank forecasts inflation and sets nominal interest rates to achieve the desired real interest rate.

According to the aggregate demand schedule, how does inflation affect aggregate demand?

Higher inflation reduces aggregate demand by inducing the central bank to raise real interest rates. As inflation increases, consumers and businesses expect higher prices, leading to reduced spending and investment.

When is the aggregate demand (AD) schedule flat?

AD is flat when interest rate changes have a big impact on demand, like in a liquidity trap, reducing monetary policy effectiveness.

What causes the AD curve to shift up and to the right?

An increase in aggregate demand can be caused by factors such as rising consumer confidence, higher government spending, tax cuts, or a decrease in interest rates, all of which stimulate more spending in the economy.

What primarily determines potential output?

Determined by available quantities of factors of production (physical capital, human capital, land, energy) and the efficiency with which resources are utilized in the economy.

In the context of flexible wages and prices, why is a worker's real purchasing power unchanged with rising inflation?

With flexible wages and prices, a worker's real purchasing power remains constant as wages and consumer prices increase proportionally. This means that if inflation causes prices to rise by, say, 5%, wages also increase by 5%, maintaining the worker's ability to purchase the same amount of goods and services.

How does the central bank ensure that equilibrium inflation coincides with the inflation target?

The central bank adjusts the interest rate (height of the rr schedule) to influence aggregate demand and ensure equilibrium inflation coincides with the inflation target.

What is the impact of positive and negative supply shocks on inflation?

A positive supply shock is deflationary, whereas a negative supply shock is inflationary. Positive supply shocks increase supply, reducing prices, while negative supply shocks decrease supply, leading to higher prices.

How does the central bank respond to a demand shock that increases inflation above the target?

The central bank raises the interest rate until AD is back to its original position. This adjustment reduces aggregate demand, helping to bring inflation back to the target level.

What are the assumptions about price and wage flexibility in the short run aggregate supply curve (SRAS)?

Prices are somewhat flexible over the short run, while money wages are rigid.

Each SRAS schedule is drawn for a given rate of what?

The rate of nominal wage growth.

Following an aggregate demand shock caused by a tighter monetary policy, what happens to inflation expectations and the SRAS curve in the short run?

Inflation expectations typically decline, causing the Short-Run Aggregate Supply (SRAS) curve to shift to the right, leading to lower prices in the short run.

How does the central bank respond to a permanent positive supply shock?

The central bank permanently lowers the interest rate, and the AD curve shifts out/right.

This response can lead to increased investment and spending, stimulating economic growth and helping to maintain full employment.

How do higher oil prices affect the SRAS curve?

Higher oil prices cause firms to charge a higher price for any output level which implies a shift of the SRAS curve up and to the left.

With supply shocks, what is no longer possible for the central bank to stabilize?

It is no longer possible to stabilize both output and inflation. This is because adjusting interest rates to control inflation can negatively impact output, leading to a trade-off between the two. The central bank must choose between stabilizing inflation or output, as both cannot be achieved simultaneously without causing adverse effects.