econ ch15-16 notes

Chapter 15 Textbook Notes: Aggregate Demand and Aggregate Supply

• Recession: a period of declining real incomes and rising unemployment
• Depression: a severe recession
• Gdp declines, unemployment rises

Three key facts

1. Economic fluctuations are irregular and unpredictable -the business cycle
2. Most macroeconomic quantities fluctuate together
3. As output falls, unemployment rises
4. Consumers become wealthier, stimulating the demand for consumption goods.
5. Interest rates fall, stimulating the demand for investment goods.
6. The currency depreciates, stimulating the demand for net exports.

Chapter 15:

Aggregate Demand & Aggregate Supply

When the economy contracts instead of expanding, firms find themselves unable to sell all the goods and services they have to offer. Therefore they reduce production and lay off workers, leading to more widespread unemployment idle factories

With economy producing fewer goods and services, real GDP and other measures of income decline

Recession: A period of declining real incomes and rising unemployment

Depression: A severe recession

Three key facts about economic fluctuation

1). Economic Fluctuations are Irregular and Unpredictable

Fluctuation in the economy are often called the business cycle

When real GDP grows rapidly, business is good

2). Most macroeconomic quantities fluctuate together

Real GDP is the variable most commonly used to monitor short-run changes in the economy

When real GDP falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on

3). As output falls, unemployment rises

When real GDP declines, unemployment rises

According to classical macroeconomic theory, changes in the money supply affect nominal variables but not real variables.

Model of aggregate demand and aggregate supply: The model that most economists use to explain short run fluctuations in economic activity around its long-run trend

On the vertical axis is the overall price level in the economy. On the horizontal axis is the overall quantity of goods and services produced in the economy.

Aggregate-demand curve: A curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level

Aggregate-supply curve: Shows the quantity of goods and services that firms produce and sell at each price level.

A decrease in the price level raises the real value of money and makes consumers wealthier, encouraging them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, reducing consumer spending and the quantity of goods and services demanded.

A lower price level reduces the interest rate, encourages spending on investment goods, and increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded.

The aggregate-supply curve is vertical only in the long run.

Natural level of output: The production of goods and services that an economy achieves in the long run when unemployment is at its normal rate

An increase in the economy’s capital stock raises productivity, thereby increasing the quantity of goods and services supplied. As a result, the long-run aggregate-supply curve shifts to the right. Conversely, a decrease in the economy’s capital stock reduces productivity and the quantity of goods and services supplied, shifting the long-run aggregate-supply curve to the left.

Technological progress enhances an economy’s ability to produce goods and services, and the resulting increases in output are reflected in continual shifts of the long-run aggregate-supply curve to the right.

Sticky-Wage Theory: the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions.

There are three explanations for the upward slope of the short-run aggregate-supply curve:

sticky wages,

sticky prices

misperceptions about relative prices.

Equation for this: Quantity of output supplied= natural level of output + a (actual price level -expected price level)

An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right.

In the short run, shifts in aggregate demand cause fluctuations in the economy’s output of goods and services.

In the long run, shifts in aggregate demand affect the overall price level but do not affect output.

Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations.

Stagflation: a period of falling output and rising prices

Chapter 16 Textbook Notes: The Influence of Monetary and Fiscal Policy on Aggregate Demand

The wealth effect:

A lower price level raises the real value of households’ money holdings, which are part of their wealth. Higher real wealth stimulates consumer spending and thus increases the quantity of goods and services demanded.

The interest-rate effect:

A lower price level reduces the amount of money people want to hold. As people try to lend out their excess money, the interest rate falls. The lower interest rate stimulates investment spending and thus increases the quantity of goods and services demanded.

The exchange-rate effect:

When a lower price level reduces the interest rate, investors move some of their funds overseas in search of higher returns. This movement causes the real value of the domestic currency to fall in the market for foreign-currency exchange. Domestic goods become less expensive relative to foreign goods. This change in the real exchange rate stimulates spending on net exports and thus increases the quantity of goods and services demanded.

These three effects work simultaneously to increase the quantity of goods and services demanded when the price level falls. And the opposite occurs when the price level rises.

For the U.S. economy, the most important reason for the downward slope of the aggregate-demand curve is the interest-rate effect.

Theory of Liquidity Preference

Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance

Monetary policy can be described either in terms of the money supply or in terms of the interest rate.

Fiscal Policy: the setting of the levels of government spending and taxation by government policymakers

The multiplier effect: the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending

Crowding-Out effect: the offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending

Automatic stabilizers: changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession but that occur without policymakers having to take any deliberate action