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Lecture

Chapter 15 Summary.pdf

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Department
Economics
Course
ECON 1BB3
Professor
Bridget O' Shaughnessy
Semester
Winter

Description
Summary of Lecture Notes from Chapter 15 and Practice Questions. KEY POINTS: 1. All societies experience short▯run economic fluctuations around long▯run trends. These fluctuations are irregular and largely unpredictable. When recessions do occur, real GDP and other measures of income, spending, and production fall, and unemployment rises. 2. Economists analyze short▯run economic fluctuations using the model of aggregate demand and aggregate supply. According to this model, the output of goods and services and the overall level of prices adjust to balance aggregate demand and aggregate supply. 3. The aggregate▯demand curve slopes downward for three reasons. First, a lower price level raises the real value of households’ money holdings, which stimulates consumer spending. Second, a lower price level reduces the quantity of money households demand; as households try to convert money into interest▯bearing assets, interest rates fall, which stimulates investment spending. Third, a lower price level reduces the real exchange rate. This depreciation makes Canadian▯produced goods and services cheaper relative to foreign▯produced goods and services, and in this way stimulates net exports. 4. Any event or policy that raises consumption, investment, government purchases, or net exports at a given price level increases aggregate demand. Any event or policy that reduces consumption, investment, government purchases, or net exports at a given price level decreases aggregate demand. 5. The long▯run aggregate▯supply curve is vertical. In the long run, the quantity of goods and services supplied depends on the economy’s labour, capital, natural resources, and technology, but not on the overall level of prices. 6. Three theories have been proposed to explain the upward slope of the short▯run aggregate▯supply curve. According to the sticky▯wage theory, an unexpected fall in the price level temporarily raises real wages, which induces firms to reduce employment and production. According to the sticky▯price theory, an unexpected fall in the price level leaves some firms with prices that are temporarily too high, which reduces their sales and causes them to cut back production. According to the misperceptions theory, an unexpected fall in the price level leads suppliers to mistakenly believe that their relative prices have fallen, which induces them to reduce production. All three theories imply that output deviates from its natural rate when the price level deviates from the price level that people expected. 7. Events that alter the economy’s ability to produce output, such as changes in labour, capital, natural resources, or technology shift the short▯run aggregate supply curve (and may shift the long▯run aggregate supply curve as well). In addition, the position of the short▯run aggregate supply curve depends on the expected price level. 8. One possible cause of economic fluctuations is a shift in aggregate demand. When the aggregate▯ demand curve shifts to the left, for instance, output and prices fall in the short run. Over time, as a change in the expected price level causes perceptions, wages, and prices to adjust, the short▯run aggregate▯supply curve shifts to the right, and the economy returns to its natural rate of output at a new, lower price level. 1 2 ☞ Chapter 15/Aggregate Demand and Aggregate Supply 9. A second possible cause of economic fluctuations is a shift in aggregate supply. When the aggregate▯supply curve shifts to the left, the short▯run effect is falling output and rising prices―a combination called stagflation. Over time, as perceptions, wages, and prices adjust, the price level falls back to its original level, and output recovers. I. Economic activity fluctuates from year to year. A. Definition of recession: a period of declining real incomes and rising unemployment. B. Definition of depression : a severe recession. II. Three Key Facts about Economic Fluctuations A. Fact 1: Economic Fluctuations Are Irregular and Unpredictable 1. Fluctuations in the economy are often called the business cycle. 2. Economic fluctuations correspond to changes in business conditions. 3. These fluctuations are not at all regular and are almost impossible to predict. 4. Panel (a) of Figure 15.1 shows real GDP since 1966. The shaded areas represent times of recession. B. Fact 2: Most Macroeconomic Quantities Fluctuate Together 1. Real GDP is the variable that is most commonly used to monitor short▯run changes in the economy. 2. However, most macroeconomic variables that measure some type of income, spending, or production fluctuates closely together. 3. Panel (b) of Figure 15.1 shows how investment changes over the business cycle. Note that investment falls during recessions just as real GDP does. C. Fact 3: As Output Falls, Unemployment Rises 1. Changes in the economy’s output level will have an effect on the economy’s utilization of its labour force. 2. When firms choose to produce a smaller amount of goods and services, they lay off workers, which increases the unemployment rate. 3. Panel (c) of Figure 15.1 shows how the unemployment rate changes over the business cycle. Note that during recessions, unemployment substantially rises. Note also that the unemployment rate never approaches zero but instead fluctuates around its natural rate. Chapter 15/Aggregate Demand and Aggregate Supply ☞ 3 D. In the News: The Trash Indicator 1. When the economy goes into a recession, many economic variables fall together. 2. This is an article from The Chicago Tribune discussing how the volume of trash generated by consumers is related to the health of the economy. III. Explaining Short▯Run Economic Fluctuations A. How the Short Run Differs from the Long Run 1. Most economists believe that the classical theory describes the world in the long run but not in the short run. 2. Beyond a period of several years, changes in the money supply affect prices and other nominal variables, but do not affect real GDP, unemployment, or other real variables. 3. However, when studying year▯to▯year fluctuations in the economy, the assumption of monetary neutrality is not appropriate. In the short run, most real and nominal variables are intertwined. B. The Basic Model of Economic Fluctuations 1. Definition of 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. 2. We can show this model using a graph. a. The variable on the vertical axis is the overall price level in the economy. b. The variable on the horizontal axis is the overall quantity of goods and services. c. Definition of aggregate-demand curve : a curve that shows the quantity of goods and services that households, firms, and the government want to buy at each price level. d. Definition of aggregate-supply curve : a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level. 3. In this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance. 4 ☞ Chapter 15/Aggregate Demand and Aggregate Supply IV. The Aggregate▯Demand Curve A. Why the Aggregate▯Demand Curve Is Slopes Downward 1. Recall that GDP (Y) is made up of four components: consumption (C), investment (I), government purchases (G), and net exports (NX). Y = C + I + G + NX 2. Each of the four components is a part of aggregate demand. a. Government purchases are assumed to be fixed by policy. b. This means that to understand why the aggregate▯demand curve slopes downward, we must understand how changes in the price level affect consumption, investment, and net exports. Table 15.3 Chapter 15/Aggregate Demand and Aggregate Supply ☞ 5 3. The Price Level and Consumption: The Wealth Effect a. A decrease in the price level makes consumers feel wealthier, which in turn encourages them to spend more. b. The increase in consumer spending means a larger quantity of goods and services demanded. 4. The Price Level and Investment: The Interest▯Rate Effect a. The lower the price level, the less money households need to buy goods and services. b. When the price level falls, households try to reduce their holdings of money by lending some out (either in financial markets or through financial intermediaries). c. As households try to convert some of their money into interest▯bearing assets, the interest rate will drop. d. Lower interest rates encourage borrowing by firms that want to invest in new plants and equipment and by households who want to invest in new housing. e. Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods, and therefore increases the quantity of goods and services demanded. 5. The Price Level and Net Exports: The Real Exchange▯Rate Effect a. For a given nominal exchange rate, a lower price level reduces the real exchange rate by making Canadian▯produced goods and services cheaper relative to foreign▯produced goods and services. b. The depreciation of the real exchange rate causes exports to rise, imports to fall, and net exports to increase. 6. All three of these effects imply that, all else equal, there is an inverse relationship between the price level and the quantity of goods and services demanded. B. Why the Aggregate▯Demand Curve Might Shift 1. Shifts Arising from Consumption a. If Canadians become more concerned with saving for retirement and reduce current consumption, aggregate demand will decline. b. If the government cuts taxes, it encourages people to spend more, resulting in an increase in aggregate demand. 6 ☞ Chapter 15/Aggregate Demand and Aggregate Supply 2. Shifts Arising from Investment a. Suppose that the computer industry introduces a faster line of computers and many firms decide to invest in new computer systems. This will lead to an increase in aggregate demand. b. If firms become pessimistic about future business conditions, they may cut back on investment spending, shifting aggregate demand to the left. c. An investment tax credit increases the quantity of investment goods that firms demand, which results in an increase in aggregate demand. d. An increase in the supply of money lowers the interest rate in the short run. This lead to more investment spending, which causes an increase in aggregate demand. 3. Shifts Arising from Government Purchases a. If Parliament decides to increase purchases of new equipment for Canada’s armed forces, aggregate demand will rise. b. If provincial governments decide to spend less on highway construction, aggregate demand will shift to the left. 4. Shifts Arising from Net Exports a. When the U.S. experiences a recession, it buys fewer Canadian goods, which lowers net exports. Aggregate demand will shift to the left. b. If the value of the Canadian dollar increases, Canadian goods become more expensive to foreigners. Net exports fall and aggregate demand shifts to the left. V. The Aggregate▯Supply Curve A. The relationship between the price level and the quantity of goods and services supplied depends on the time horizon being examined. B. Why the Aggregate▯Supply Curve Is Vertical in the Long Run 1. In the long run, an economy’s production of goods and services depends on its supplies of resources along with the available production technology. Chapter 15/Aggregate Demand and Aggregate Supply ☞ 7 2. Because the price level does not affect these determinants of output in the long run, the long▯run aggregate▯supply curve is vertical. C. Why the Long▯Run Aggregate▯Supply Curve Might Shift 1. The position of the aggregate supply curve occurs at an output level sometimes referred
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