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Outline for Lecture 12

Aggregate Demand

How do we define aggregate demand?

A schedule or curve that shows the total quantity of goods and services that would be demanded (purchased) at various price levels

How are the overall price level and aggregate output (real GDP) demanded related: positively or negatively? Explain.

There is an inverse, or negative, relationship between the economy’s overall price level (as measured by the price index) and the amount of real GDP that is demanded by households, businesses, and governments: When the price level rises, the quantity of real GDP demanded decreases; when the price level falls, the quantity of real GDP demanded increases.

Aggregate Demand Curve

Figure 32.1 illustrates the aggregate demand (AD) curve with its downward (upward or downward) slope, which can be justified in several ways. Of those, we focus on real balances.

How does the real-balances effect explain the slope of AD curve? Provide an example.

Real-Balances Effect A change in the price level produces a real-balances effect in which consumer spending (C) varies inversely with changes in the price level. To understand how it works, begin by noting that when people refer to the “balances” in savings and other financial accounts, they are referring to nominal balances, which are simply the nominal dollar values in each account.

Changes in Aggregate Demand

Changes in aggregate demand result from changes in the four components of aggregate demand (consumption, investment, government spending, net exports) and are illustrated by a shift of the AD curve.

Consumer Spending

How do we define consumer wealth? How do changes in consumer wealth affect consumption and aggregate demand? To which direction does the AD curve shift? Explain with an example.

Consumer wealth is the total dollar value of all assets owned by consumers less the dollar value of their liabilities (debts). expectations of lower future income or lower future prices may reduce current consumption and shift the aggregate demand curve to the left.

An unforeseen increase in the stock market is a good example.

How do changes in household borrowing affect consumption and aggregate demand? To which direction does the AD curve shift? Explain with an example.

Household Borrowing Consumers can increase their consumption spending by borrowing. Doing so shifts the aggregate demand curve to the right. By contrast, a decrease in borrowing for consumption purposes shifts the aggregate demand curve to the left. The aggregate demand curve also shifts to the left if consumers increase their savings to pay off their debts. With more money flowing to debt repayment, consumption expenditures decline, and the AD curve shifts left

How do changes in consumer expectations affect consumption and aggregate demand? To which direction does the AD curve shift? Explain with an example.

Changes in expectations about the future may alter consumer spending. When people expect their future real incomes to rise, they tend to spend more of their current incomes. Thus, current consumption spending increases (current saving falls), and the aggregate demand curve shifts to the right. For example, if my salary increased I will be able to spend and buy mor stuff, so if the income increase the spending increase as well.

How do changes in personal taxes affect consumption and aggregate demand? To which direction does the AD curve shift? Explain with an example.

A reduction in personal income tax rates raises take-home income and increases consumer purchases at each possible price level. Tax cuts shift the aggregate demand curve to the right. Tax increases reduce consumption spending and shift the aggregate demand curve to the left.

Investment Spending

How do changes in real interest rates affect investment and aggregate demand? To which direction does the AD curve shift? Explain with an example.

an increase in real interest rates will raise borrowing costs, lower investment spending, and reduce aggregate demand. A decline in investment spending at each price level shifts the aggregate demand curve to the left. For example, an increase in the money supply lowers the real interest rate, thereby increasing investment and aggregate demand. A decrease in the money supply raises the real interest rate, reducing investment and decreasing aggregate demand

What are the four determinants of expected returns on investment projects? How do changes in expected returns affect investment and aggregate demand? To which direction does the AD curve shift? Explain with an example.

Expectations about future business conditions, Technology, Changes in excess capacity, and Business taxes. Higher expected returns on investment projects increase the demand for capital goods and shift the aggregate demand curve to the right. Alternatively, declines in expected returns decrease investment and shift the aggregate demand curve to the left.

For example, new and improved technologies enhance expected returns on investment and thus increase aggregate demand. For example, recent advances in microbiology have motivated pharmaceutical companies to establish new labs and production facilities.

Government Spending

How do changes in government spending affect aggregate demand? To which direction does the AD curve shift? Explain with an example.

Government purchases are the third determinant of aggregate demand. An increase in government purchases (for example, more transportation projects) shifts the aggregate demand curve to the right, as long as tax collections and interest rates do not change as a result. In contrast, a reduction in government spending (for example, less military equipment) shifts the curve to the left.

Net Export Spending

How do changes in national income abroad affect net exports and aggregate demand? To which direction does the AD curve shift? Explain with an example.

National Income Abroad Rising national income abroad encourages foreigners to buy more products, some of which are made in the United States. U.S. net exports thus rise, and the U.S. aggregate demand curve shifts to the right. Declines in national income abroad do the opposite: They reduce U.S. net exports and shift the U.S. aggregate demand curve to the left.

How do we define the dollar’s exchange rate? How do changes in the exchange rate affect net exports and aggregate demand? To which direction does the AD curve shift? Explain with an example.

The rate at which another country's currency is converted into US dollars is known as the dollar rate. For example converting euro to US dollar.

Dollar depreciation increases net exports (imports go down; exports go up) and therefore increases aggregate demand. Which is shift to the right. Dollar appreciation has the opposite effects: Net exports fall (imports go up; exports go down) and aggregate demand declines. Which is shift to the left.

Outline for Lecture 13

Aggregate Supply

How do we define aggregate supply?

A schedule or curve showing the total quantity of goods and services that would be supplied (produced) at various price levels

Note that the shape of aggregate supply curve depends on the time horizon.

Aggregate Supply in the Short Run

How do we define short run? Are input prices fixed or flexible in the short run? How about output prices? Explain with examples.

Short-run: The period of time over which the level of wages in a nation are fixed. Also known as the fixed- wage period. More specifically, the short run is the period of time during which output prices are flexible but input prices are either totally fixed or highly inflexible.

Figure 32.4 illustrates the short-run aggregate supply curve AS with _ price level

___ measured on the vertical axis and __ Real domestic output,__ measured on the horizontal axis. The curve slopes __ upward __ (upward or downward). Explain why.

because, with input prices fixed, changes in the price level will raise or lower firms’ real profits.

Aggregate Supply in the Long Run

How do we define long run? Are input prices fixed or flexible in the long run? How about output prices? Explain with examples.

The aggregate supply curve associated with a time period in which input prices (especially nominal wages) are fully responsive to changes in the price level.

the long run is the time horizon over which both input prices and output prices are flexible.

Figure 32.5 illustrates the long-run aggregate supply curve ASLR, which is vertical at the economy’s full-employment output Qf. Explain why.

because in the long run wages and other input prices rise and fall to match changes in the price level. So price-level changes do not affect firms’ profits and thus they create no incentive for firms to alter their output.

Changes in Aggregate Supply

Changes in aggregate supply result from changes in factors that affect the unit cost, the average cost of producing one unit of output, and are illustrated by a shift of the AS curve.

Input Prices

How do changes in domestic resource prices affect the unit cost and aggregate supply? To which direction does the AS curve shift? Explain with an example.

decreases in wages increase profits by reducing per-unit pro-duction costs. So when wages fall, the aggregate supply curve shifts to the right. By contrast, increases in wages reduce profits by raising per-unit production costs. So when wages rise, the aggregate supply curve shifts to the left. For example Labor supply increases because of substantial immigration. Wages and per-unit production costs fall, shifting the AS curve to the right.

How do changes in prices of imported resources affect the unit cost and aggregate supply? To which direction does the AS curve shift? Explain with an example.

a decrease in the price of imported resources will raise U.S. profits and increase U.S. aggregate supply. Conversely, an increase in the price of imported resources will lower U.S. profits and reduce U.S. aggregate supply, other things equal. A good example is the oil price hikes of the 1970s. At that time, they decrease oil production and raise the price of oil. The tenfold increase in the price of oil that OPEC achieved during the 1970s drove per-unit production costs up and jolted the U.S. aggregate supply curve leftward.

Productivity

How do we define productivity? What are the main sources of productivity increases?

A measure of average output or real out-put per unit of input. For example, the productivity of labor is determined by dividing real output by hours of work.

improved production technology, a better-educated and better-trained workforce, improved forms of business enterprise, and the reallocation of labor resources from lower-productivity to higher-productivity uses

How do changes in productivity affect the unit cost and aggregate supply? To which direction does the AS curve shift? Explain with an example.

The doubled productivity has reduced the per-unit production cost by half.. By reducing per-unit production costs, an increase in productivity shifts the aggregate supply curve to the right.

Outline for Lecture 14

Equilibrium in the ADAS Model

Figure 32.7 illustrates the macroeconomic equilibrium in the ADAS model, which occurs at the intersection of __ Price Level__ and __ Real domestic output.

Changes in Equilibrium

Increases in AD: Demand-Pull Inflation

Suppose that the economy is initially operating at full-employment level, as illustrated by Figure 32.8, producing the potential GDP Qf at price level P1.

Suppose further that a positive demand shock (i.e. increase in aggregate demand) occurs. Provide an example of a positive demand shock. To which direction does the AD curve shift?

In the late 1960s. The escalation of the war in Vietnam resulted in a 40 percent increase in defense spending between 1965 and 1967 and another 15 percent increase in 1968. The rise in government spending, on top of an already growing economy, shifted the economy’s aggregate demand curve to the right

What is the impact on equilibrium output? How about the impact on equilibrium price level? What type of inflation do we observe: demand-pull or cost-push? Explain.

inflation reduced the increase in real output—and thus the multiplier effect—by about one-half. Price-level flexibility weakens the realized multiplier effect. the increase in the price level, real output increases only from Qf to Q1 and the multiplier effect is reduced.

demand-pull

Decreases in AD: Recession and Cyclical Unemployment

Suppose that the economy is initially operating at full-employment level, as illustrated by Figure 32.9, producing the potential GDP Qf at price level P1.

Suppose further that a negative demand shock (i.e. decrease in aggregate demand) occurs. Provide an example of a negative demand shock. To which direction does the AD curve shift?

for example, in 2008, U.S. investment spending greatly declined because of sharply lower expected returns on investment. These lower expectations resulted from the prospect of poor future business conditions and high degrees of unused production capacity. the resulting decline in aggregate demand as a leftward shift.

Note that deflation, a decline in the price level, is not the norm in the American economy; we see in the data that prices are often downwardly inflexible.

Given downward price stickiness, what is the impact on equilibrium price level? How about the impact on equilibrium output?

a decline of real output , decline in the price level

Decreases in AS: Cost-Push Inflation

Suppose that the economy is initially operating at full-employment level, as illustrated by Figure 32.10, producing the potential GDP Qf at price level P1.

Suppose further that a negative supply shock (i.e. decrease in aggregate supply) occurs. Provide an example of a negative supply shock. To which direction does the AS curve shift?

Suppose that a major terrorist attack on oil facilities severely disrupts world oil supplies and drives up oil prices by, say, 300 percent. Higher energy prices will spread throughout the economy, driving up production and distribution costs on a wide variety of goods and services. The U.S. aggregate supply curve would shift to the left

What is the impact on equilibrium output? How about the impact on equilibrium price level? What type of inflation do we observe: demand-pull or cost-push? Explain.

price level rising and real output declining , cost-push. A leftward shift of aggregate supply raises the price level and produces cost-push inflation. Real output declines and a recessionary GDP gap occurs

Increases in AS: Full Employment with Price-Level Stability

Suppose that the economy is initially producing the output Q1 at price level P1, as illustrated by Figure 32.11.

Suppose further that a relatively large positive demand shock (i.e. increase in aggregate demand) and a relatively small positive supply shock (i.e. increase in aggregate supply) occur at the same time. Provide an example in each case. To which direction(s) do AD and AS curves shift?

In the late 1960s. The escalation of the war in Vietnam resulted in a 40 percent increase in defense spending between 1965 and 1967 and another 15 percent increase in 1968. The rise in government spending, on top of an already growing economy, shifted the economy’s aggregate demand curve to the right

Suppose that a major terrorist attack on oil facilities severely disrupts world oil supplies and drives up oil prices by, say, 300 percent. Higher energy prices will spread throughout the economy, driving up production and distribution costs on a wide variety of goods and services. The U.S. aggregate supply curve would shift to the left

What is the combined impact on equilibrium output? How about the impact on equilibrium price level? Are these predictions consistent with the behavior of the U.S. economy in the late 1990s? Explain.

During the late 1990s, the United States experienced a combination of full employment, strong economic growth, and very low inflation. The unemployment rate fell to 4 percent and real GDP grew nearly 4 percent annually, without igniting inflation.

Real out-put increased from Q1 to Q3, and the price level rose only modestly (from P1 to P2).

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