CH 14 - Aggregate Supply & Demand

recession

period of falling incomes, rising unemployment

depression

a severe recession

economic fluctuations are:
1. regular and predictable
2. irregular and predictable
3. irregular and unpredictable
4. regular and unpredictable

irregular and unpredictable

most macroeconomic quantities fluctuate:
1. together
2. apart

1. together

as output falls, unemployment:
1. falls
2. rises

2. rises

what fluctuates the most during a recession?
C, I, G, or Nx

I - investment

(SR) model of aggregate demand and aggregate supply

- model used to explain short-run fluctuations around the long-run trend

explain the sections of the AD-AS model

AD curve: AD - P (price)
- downward sloping

AS curve: AS - P
- upward sloping

X axis: quantity of input
Y axis: price level

what does the AD curve show?

- displays quantity of goods/services households, firms, gov want to buy at each price level

what does the AS curve show?

- displays quantity of goods/services firms choose to produce and sell at each price level

why does the AD curve slope downward & decrease in price level?

- downward slope = decreased price, increased quantity demanded

C: when prices decrease....
- consumption increases
(wealth effect)

I: when prices decrease.....
- interest rates decrease
- borrowing costs are lowered
(interest rate effect)

NX: when prices decrease...
- goods/services produced in canada are cheaper, therefore...
- our country's exports INCREASE (higher incentive for other countries to buy)
- country's imports DECREASE (citizens buy cheap domestic products)
(TLDR: NX rate increases)
(real exchange-rate effect)

what is the GDP equation?

Y C + I + G + NX

what are reasons why the AD curve would shift?

- consumption changes
- investment changes
- government purchases
- NX changes

(all GDP factors)

what happens to the AD curve when..
1. a ten-yr old investment tax credit expires
2. canadian exchange rate falls
3. fall in prices increases real value of consumer wealth
4. prov. governments replace sales taxes w new interest, dividend, capital gain taxes

1. I falls, AD curve shifts left
2. NX falls, AD curve shifts right
3. P falls, point is moved down AD curve
4. C rises, AD shifts right

(AS) define natural rate of output

production of goods and services an economy achieves in the long run if unemployment rates are normal

what are reasons why the AS curve would shift?

- labour changes
- capital changes
- natural resource changes
- technological knowledge changes

(things needed to turn factors of production into goods and services)

(AS) what are the other names for natural rate of output and what does it mean again?

- potential output
- full-employment output

the level of real GDP the economy would produce if all its resources were used efficiently

(SRAS) why does the AS curve slope upward in the SHORT run?

- b/c price levels don't affect economy outputs
- price increases raises quantity of goods/services (moving UP the AS curve), so price decreases reduce goods/services (moving DOWN) the AS curve

what are the three theories explaining why the short-run AS curve slopes upward?

1. sticky-wage theory
2. sticky-price theory
3. misperceptions theory

what do all three short-run AS curve theories explain, and what are they?

- explains why SR AS curve is upward b/c output deviates from its usual rate when price levels deviate from the expected

what is the sticky-wage theory, how does it impact the upwards SR AS curve?

- nominal wages (wages in current monetary terms without inflation adjustment) are slow to adjust to changing economic conditions

- nominal wages are based on expected prices + don't immediately respond to actual prices
- THEREFORE, higher price levels = higher output b/c lower wages are "sticky" and don't immediately adjust, so firms hire more labour for cheap.

what is the sticky-price theory? how does it impact the upwards SR AS curve?

- prices of goods and services adjust slowly to changing economic conditions b/c of menu costs
- overall price levels drop when firms have high prices = depleted sales = firms reducing quantity of goods/services produced

- the opposite also occurs: overall price levels rise when firms have low prices = more customers = higher output = upwards SRAS curve

what is the misperceptions theory? how does it impact the upwards SR AS curve?

- overall price level changes mislead suppliers on the markets in which they sell their output
- if overall price levels rise, suppliers may mistake it for relative price rises = they think it's a good time to produce, therefore increasing quantity of goods and services supplied

(SRAS) what is the "quantity of output supplied" equation?

quantity of output supplied = natural level of output + a(actual price level - expected price level)

(a = # determining how much output responds to the unexpected price level changes)

(SRAS) what is quantity of output supplied equal to?

natural level of output

what are the effects of a shift in AD in the LR vs SR?

LR: AD shift affects overall price levels but doesn't affect output

SR: AD shifts cause outputs to fluctuate

define stagflation

period of falling output and rising prices

what are the steps for analyzing the impact of an economic event (ex: pessimism)?

1. does it affect AD or AS?
2. determine the shift direction
3. refer to the diagram to redetermine the AD and AS initial/new equilibrium
4. analyze the diagram's new SR and LR equilibriums together

can shift in SRAS cause stagflation? and how?

yes - if SRAS curve shifts left, new equilibrium shows that prices rise and output falls (which is the definition of stagflation)

FINAL REVIEW Q's
1.Is war good or bad for the economy?
2. What are the opportunity costs of using resources in wars?
3. How would a war affect aggregate supply?
4. Graph the shift in aggregate supply. What happens to output and the price level?
5. How would a war affect aggregate demand?
6. Graph the shift in aggregate demand. What happens to output and the price level?
7. Is peace good or bad for the economy?

[answer in booklet]