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Chapter #14 ECN.doc

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Ryerson University
ECN 204
Christopher Gore

Chapter #14  Over the long run, real GDP grows about 2% per year on average.  In the short run, GDP fluctuates around its trend.  Recessions: periods of falling real incomes and rising unemployment  Depressions: severe recessions (very rare)  Short-run economic fluctuations are often called business cycles  Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial.  Most economists use the model of aggregate demand and aggregate supply to study fluctuations.  This model differs from the classical economic theories economists use to explain the long run. Classical Economics—A Recap  Most economists believe classical theory describes the world in the long run, but not the short run.  In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate).  To study the short run, we use a new model. The Basic Model of Aggregate Demand and Aggregate Supply  Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.  The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.  The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level. The Wealth Effect (P and C ) Suppose P rises.  The dollars people hold buy fewer g&s, so real wealth is lower.  People feel poorer. Result: C falls. The Interest-Rate Effect (P and I ) Suppose P rises.  Buying g&s requires more dollars.  To get these dollars, people borrow more  This drives up interest rates. Result: I falls. (Recall, I depends negatively on interest rates.) The Exchange-Rate Effect (P and NX ) Suppose P rises.  Real exchange rate = e x P P*  It increases the real exchange rate  Canadian exchange rate appreciates.  Canadian exports more expensive to people abroad, imports cheaper to Canadian residents. Result: NX falls. Why the AD Curve Might Shift  Changes in C • Stock market boom/crash • Preferences re: consumption/saving tradeoff • Tax hikes/cuts  Changes in I • Firms buy new computers, equipment, factories • Expectations, optimism/pessimism • Interest rates, monetary policy • Investment Tax Credit or other tax incentives  Changes in G • Federal spending, e.g., defense • Provincial & municipal spending, e.g., roads, schools  Changes in NX • Booms/recessions in countries that buy our exports, e.g. recession in the U.S. • Appreciation/depreciation resulting from international speculation in foreign exchange market Active Learning #1 What happens to the AD curve in each of the following scenarios? • A ten-year-old investment tax credit expires. o I falls, AD curve shifts left • The Canadian exchange rate falls. o NX rises, AD curve shifts right • A fall in prices increases the real value of consumers’ wealth. o Move down along AD curve (wealth- effect) • Provincial governments replace sales taxes with o C rises, AD shifts right Why the LRAS Curve Might Shift  Changes in L or natural rate of unemployment • Immigration • Baby-boomers retire • Govt policies reduce natural u- rate  Changes in K or H • Investment in factorie
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