Essentials of Economics - Chapter 15 Flashcards

Definition: The aggregate demand (AD) curve illustrates the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.
Components of Real GDP:
- Consumption (C)
- Investment (I)
- Government purchases (G)
- Net exports (NX)
Equation: $Y = C + I + G + NX$
Wealth Effect:
- As price levels increase, the real value of household wealth (held in nominal assets) decreases, leading to reduced consumption.
- Higher price level => lower consumption
Interest-Rate Effect:
- Rising prices increase the demand for money, causing households and firms to borrow more.
- This raises interest rates, discouraging investment.
- Higher price level => lower investment
International-Trade Effect:
- Increased U.S. price levels make U.S. exports more expensive and imports cheaper.
- Net exports decrease.
- Higher price level => lower net exports
Slope of Aggregate Demand Curve: The aggregate demand curve slopes downward due to the wealth effect, the interest-rate effect, and the international-trade effect.
Movements Along vs. Shifts of the AD Curve:
- Movement along: Occurs when the price level changes, without the change being caused by a component of real GDP changing.
- Shift: Occurs when a component of real GDP changes (e.g., government purchases).

Factors that Shift the Aggregate Demand Curve:
- Interest Rates:
  - Increase in interest rates shifts AD curve left.
  - Higher interest rates increase the cost of borrowing, reducing consumption and investment spending.
  - Influenced by monetary policy.
- Government Purchases:
  - Increase in government purchases shifts AD curve right.
  - Government purchases are a direct component of aggregate demand.
  - Related to fiscal policy.
- Personal and Business Taxes:
  - Increase in taxes shifts AD curve left.
  - Higher personal taxes reduce consumption; higher business taxes reduce investment.
  - Related to fiscal policy.
- Household Expectations:
  - Increased expectations of future income shift AD curve right.
  - Higher expectations lead to increased consumption and residential investment.
- Firm Expectations:
  - Increased expectations of future profitability shift AD curve right.
  - Higher expectations lead to increased investment spending.
- Relative GDP Growth:
  - Faster domestic GDP growth relative to foreign GDP shifts AD curve left.
  - Imports increase faster than exports, reducing net exports.
- Exchange Rate:
  - Increase in the value of the dollar shifts AD curve left.
  - Imports increase, and exports decrease, reducing net exports.

Definition: Aggregate supply represents the quantity of goods and services that firms are willing and able to supply.
Long-Run Aggregate Supply (LRAS) Curve:
- Shows the relationship between the price level and the quantity of real GDP supplied in the long run.
- In the long run, real GDP is determined by the number of workers, the level of technology, and the capital stock.
- The LRAS curve is vertical at the level of potential or full-employment GDP.
- Not affected by the price level.
Short-Run Aggregate Supply (SRAS) Curve:
- Shows the relationship between the price level and the quantity of real GDP supplied in the short run.
- The SRAS curve is upward-sloping.
- Reasons for Upward Slope:
  - Sticky wages and prices due to contracts.
  - Firms being slow to adjust wages (e.g., annual salary reviews).
  - Menu costs making some prices sticky.

Factors that Shift the SRAS Curve:
- Labor Force and Capital Stock:
  - Increase shifts SRAS curve right.
  - More output can be produced at every price level.
- Productivity:
  - Increase shifts SRAS curve right.
  - Production costs decrease.
- Expected Future Price Level:
  - Increase shifts SRAS curve left.
  - Workers and firms increase wages and prices.
- Adjustment to Previous Underestimation of Price Level:
  - Shifts SRAS curve left.
  - Workers and firms attempt to catch up to a higher price level.
- Price of Natural Resources:
  - Increase shifts SRAS curve left.
  - Production costs rise.
Supply Shock:
- An unexpected event that shifts the SRAS curve.
- Example: Sudden increase in oil prices.

Long-Run Macroeconomic Equilibrium:
- Occurs when the AD and SRAS curves intersect at the LRAS level.
- The economy is in short-run equilibrium, and GDP is at its full-employment level.
Short-Run Effects of a Decrease in Aggregate Demand:
- AD shifts left (e.g., due to rising interest rates).
- Results in a recession.
Long-Run Adjustment to a Decrease in Aggregate Demand:
- Workers accept lower wages, and firms expect lower prices, shifting SRAS to the right.
- Restores long-run macroeconomic equilibrium with a lower price level.
Short-Run Effects of an Increase in Aggregate Demand:
- AD shifts right (e.g., due to increased firm optimism).
- Unemployment falls below its natural rate, raising wages and prices.
Long-Run Adjustment to an Increase in Aggregate Demand:
- Firms and workers raise expectations about the price level, shifting SRAS to the left.
Supply Shock: Stagflation, a combination of inflation and recession, usually resulting from a supply shock.

Incorporates:
- Continually increasing real GDP, shifting LRAS to the right.
- AD also ordinarily shifting to the right.
- SRAS shifting to the right except when workers and firms expect high rates of inflation.

Keynesian Economics:
- Inspired by John Maynard Keynes' The General Theory of Employment, Interest, and Money.
New Keynesian Economics:
- Emphasizes the stickiness of wages and prices.
Monetarism:
- Associated with Milton Friedman.
- Advocates for increasing the quantity of money at a constant rate (monetary growth rule).
- Based on the quantity theory of money.
New Classical Macroeconomics:
- Associated with Robert Lucas.
- Emphasizes rational expectations.
Real Business Cycle Model:
- Focuses on real (rather than monetary) causes of the business cycle.
- Argues that temporary productivity shocks are the main source of fluctuations in real GDP.
Austrian Model:
- Associated with Carl Menger, Ludwig von Mises, and Friedrich von Hayek.
- Argues for the superiority of the market system over economic planning.
- Hayek: only the price system could make use of all the dispersed information to achieve efficiency.
- Central bank-induced low interest rates cause overinvestment and the business cycle.
Marxist Economics:
- Karl Marx believed in the labor theory of value.
- Argued that the market system would eventually be replaced by a Communist economy.