ECON10003 Chapter Notes - Chapter 9: Aggregate Supply, Aggregate Demand, Real Interest Rate

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orangemole587

25 May 2018

School

University of Melbourne

Department

Economics

Course

ECON10003

Professor

Nahid Khan, Lawrence Uren

For unlimited access to Textbook Notes, a Class+ subscription is required.

The aggregate demand (AD) curve shows the relationship between equilibrium real output, y, and

the rate of inflation, denoted pi

Also shows the relationship between inflation and spending

The RBA raises the real interest rate to control inflation and decrease planned spending and

output

The AD curve is downward sloping because an increase in the rate of inflation tends to reduce

equilibrium output

At high levels of inflation, purchasing power declines

○

Reduction in wealth reduces consumption spending and thus output

○

Wealth effect

People who are less well off (fixed incomes, minimum wage) are impacted more by

inflation

○

Less skilled at making financial investments and protect their savings against inflation

○

Wealthier individuals save more, so if money is redistributed towards the wealthy,

overall spending declines

○

Distributional effects

High inflation causes people to be less certain and makes planning more difficult

○

Households and firms become more cautious and reduce their spending

○

Uncertainty

Rise in domestic inflation causes prices of domestic goods in foreign markets to rise

more quickly

○

As domestic goods become relatively more expensive to foreign purchasers, export sales

decline

○

Prices of domestic goods and services sold abroad

Other reasons for the downward slope:

Exogenous increase in spending

> increases output

> shift right

○

Exogenous decrease in spending

> decreases output

> shift left

○

Exogenous changes in spending

Tighter monetary policy (higher real interest rate)

> upward shift of PRF

> reduces

output

> shift left

○

Easier monetary policy (lower real interest rate)

> downward shift of PRF

> increases

output

> shift right

○

Exogenous changes in the Reserve Bank's policy reaction function

Shifts of the AD curve:

Changes in the inflation rate

Changes in the real interest rate

Changes in equilibrium output

Movements along the AD curve:

Inflation, spending and output: Aggregate demand curve

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Inflation tends to be inertial as long as the economy is at full employment and there are no external

shocks to the price level

Expansionary output gap

> increase in inflation

○

Contractionary output gap

> decrease in inflation

○

Output gap

Shock that directly affects prices

○

Inflation shock

Sharp change in the level of potential output

○

Shock to potential output

3 factors that change the inflation rate:

Expectations of future inflation helps to determine the future inflation rate

○

The higher the expected rate of inflation the more nominal wages and cost of inputs will

tend to rise

○

People's expectations are influenced by their recent experience

○

Long

term wages and price contracts depend on inflation expectations at the time the

contracts were signed

○

Actual inflation rate = expected inflation rate + random error term

○

Inflation in period t = inflation in period t

1 + random error term

○

A scatter diagram of inflation in the current and immediate past periods can be plotted

to be a 45

degree line on average

○

Inflation expectations

If the output gap is zero, the rate of inflation will tend to remain the same

○

When an expansionary gap exists, the rate of inflation will tend to increase

○

When a contractionary gap exists, the rate of inflation will tend to decrease

○

Gamma = responsiveness of inflation to an output gap



Inflation in period t = inflation in period t

1 + gamma(yt

y*/y*) + random error term

○

Output gap

Two factors that determine the inflation rate

The aggregate supply (AS) curve shows the relation between output supplied by firms in the

aggregate and the rate of inflation

Increasing resources available

> increase in output

> shift right

○

Technological improvements

> increase in output

> shift right

○

Changes in available resources and technology

Increase in expected rate of inflation

> shift left

○

Changes in inflation expectations

Inflation shocks are sudden changes in the normal behaviour of inflation, unrelated to

the nation's output gap

○

An inflation shock is captured by the random error term

○

An inflation shock that increase inflation is a negative inflation shock and shifts the AS

curve left

○

An inflation shock that reduces inflation is a positive inflation shock and shifts the AS

curve right

○

Inflation shocks

Shifts in the AS curve:

Inflation and supply decisions

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Document Summary

The agg(cid:396)egate de(cid:373)a(cid:374)d (cid:894)ad(cid:895) (cid:272)u(cid:396)(cid:448)e sho(cid:449)s the (cid:396)elatio(cid:374)ship (cid:271)et(cid:449)ee(cid:374) e(cid:395)uili(cid:271)(cid:396)iu(cid:373) (cid:396)eal output, (cid:455), a(cid:374)d the (cid:396)ate of i(cid:374)flatio(cid:374), de(cid:374)oted pi. Also sho(cid:449)s the (cid:396)elatio(cid:374)ship (cid:271)et(cid:449)ee(cid:374) i(cid:374)flatio(cid:374) a(cid:374)d spe(cid:374)di(cid:374)g. The ad (cid:272)u(cid:396)(cid:448)e is do(cid:449)(cid:374)(cid:449)a(cid:396)d slopi(cid:374)g (cid:271)e(cid:272)ause a(cid:374) i(cid:374)(cid:272)(cid:396)ease i(cid:374) the (cid:396)ate of i(cid:374)flatio(cid:374) te(cid:374)ds to (cid:396)edu(cid:272)e e(cid:395)uili(cid:271)(cid:396)iu(cid:373) output. The rba (cid:396)aises the (cid:396)eal i(cid:374)te(cid:396)est (cid:396)ate to (cid:272)o(cid:374)t(cid:396)ol i(cid:374)flatio(cid:374) a(cid:374)d de(cid:272)(cid:396)ease pla(cid:374)(cid:374)ed spe(cid:374)di(cid:374)g a(cid:374)d output. At high le(cid:448)els of i(cid:374)flatio(cid:374), pu(cid:396)(cid:272)hasi(cid:374)g po(cid:449)e(cid:396) de(cid:272)li(cid:374)es. People (cid:449)ho a(cid:396)e less (cid:449)ell off (cid:894)fi(cid:454)ed i(cid:374)(cid:272)o(cid:373)es, (cid:373)i(cid:374)i(cid:373)u(cid:373) (cid:449)age(cid:895) a(cid:396)e i(cid:373)pa(cid:272)ted (cid:373)o(cid:396)e (cid:271)(cid:455) i(cid:374)flatio(cid:374) Less skilled at (cid:373)aki(cid:374)g fi(cid:374)a(cid:374)(cid:272)ial i(cid:374)(cid:448)est(cid:373)e(cid:374)ts a(cid:374)d p(cid:396)ote(cid:272)t thei(cid:396) sa(cid:448)i(cid:374)gs agai(cid:374)st i(cid:374)flatio(cid:374) Wealthie(cid:396) i(cid:374)di(cid:448)iduals sa(cid:448)e (cid:373)o(cid:396)e, so if (cid:373)o(cid:374)e(cid:455) is (cid:396)edist(cid:396)i(cid:271)uted to(cid:449)a(cid:396)ds the (cid:449)ealth(cid:455), o(cid:448)e(cid:396)all spe(cid:374)di(cid:374)g de(cid:272)li(cid:374)es. High i(cid:374)flatio(cid:374) (cid:272)auses people to (cid:271)e less (cid:272)e(cid:396)tai(cid:374) a(cid:374)d (cid:373)akes pla(cid:374)(cid:374)i(cid:374)g (cid:373)o(cid:396)e diffi(cid:272)ult. Households a(cid:374)d fi(cid:396)(cid:373)s (cid:271)e(cid:272)o(cid:373)e (cid:373)o(cid:396)e (cid:272)autious a(cid:374)d (cid:396)edu(cid:272)e thei(cid:396) spe(cid:374)di(cid:374)g. P(cid:396)i(cid:272)es of do(cid:373)esti(cid:272) goods a(cid:374)d se(cid:396)(cid:448)i(cid:272)es sold a(cid:271)(cid:396)oad. Rise i(cid:374) do(cid:373)esti(cid:272) i(cid:374)flatio(cid:374) (cid:272)auses p(cid:396)i(cid:272)es of do(cid:373)esti(cid:272) goods i(cid:374) fo(cid:396)eig(cid:374) (cid:373)a(cid:396)kets to (cid:396)ise (cid:373)o(cid:396)e (cid:395)ui(cid:272)kl(cid:455)

Related Questions

1) As the unemployment rate rises:

A) the separation rate decreases.

B) the young and unskilled experience lower-than-average increases in unemployment.

C) the young and skilled experience larger-than-average increases in unemployment.

D) the young and unskilled experience larger-than-average increases in unemployment.

E) the proportion of the unemployed finding a job increases.

2) The natural level of employment will increase when which of the following occurs?

A) a decrease in the markup of prices over costs

B) an increase in the natural level of output

C) an increase in the actual unemployment rate

D) an increase in unemployment benefits

E) an increase in the markup of prices over costs

3) Suppose workers and firms expect the overall price level to increase by 4%. Given this information, we would expect that:

A) the real wage will decrease by 4%.

B) the real wage will increase by 4%.

C) the nominal wage will increase by less than 4%.

D) the nominal wage will increase by more than 4%.

E) the nominal wage will increase by exactly 4%.

4) An increase in the minimum wage will cause:

A) a reduction in the equilibrium real wage.

B) an increase in the natural rate of unemployment.

C) an increase in the equilibrium real wage.
D) a decrease in the natural rate of unemployment.

E) no change in the natural rate of unemployment.

5) In the aggregate demand relation, a reduction in the price level causes output to increase because of its effect on:

A) firms' markup over labor costs.

B) the nominal wage.

C) the interest rate.

D) the expected price level.

E) government spending.

6) The short-run aggregate supply curve (AS) is upward sloping because:

A) an increase in output causes an increase in employment, a reduction in unemployment, an increase in the nominal wage, and an increase in the price level.

B) a reduction in the aggregate price level causes a reduction in nominal money demand and a reduction in the interest rate.

C) a reduction in the aggregate price level (P) will cause a reduction in the interest rate and an increase in output.

D) an increase in the aggregate price level will cause an increase in the interest rate and a reduction in output.

E) an increase in the nominal wage causes a reduction in the amount of output that firms are willing to produce.

7) Assume that the economy is initially operating at the natural level of output. A simultaneous expansionary monetary policy and an increase in oil prices will cause which of the following?

A) an increase in output and a reduction in the interest rate in the short run

B) a reduction in output and an increase in the interest rate in the short run

C) a reduction in output and a reduction in the interest rate in the short run

D) an ambiguous effect in output and an increase in the price level in the short run

E) an ambiguous effect in output and a reduction in the price level in the short run

8) Assume that the economy is initially operating at the natural level of output. A one-time 4% reduction in the nominal money supply will cause:

A) a 4% increase in the price level in the medium run.

B) a 4% reduction in the price level in the medium run.

C) a 4% increase in the real money supply in the medium run.

D) a 4% increase in the interest rate (i) in the medium run.

E) a 4% reduction in investment in the medium run.

9) The original Phillips curve implied that:

A) the markup over labor costs is zero.

B) the expected inflation rate is equal to last year's inflation rate.

C) a lower rate of unemployment causes an increase in the rate of inflation.

D) the inflation is always zero.

E) the expected inflation is always zero.

10) In the Phillips curve equation, which of the following will NOT cause a rise in the current inflation rate?

A) a rise in the minimum wage

B) a rise in the expected inflation rate

C) a rise in the employment insurance

D) a drop in the markup

E) a fall in the unemployment rate

2. Using the AS and AD, WS and PS, and IS-LM graphs, illustrate and explain the short run and medium run effects of less stringent enforcement of existing antitrust legislation (Monopolist market power increased) . Explain what happens to P, Y, I, W/P, I and u.

sangriaskunk963

MACROECONOMICS

1. Which one of the following is not a determinant of aggregate demand?

a. Investment expenditure

b. Technology

c. Consumption expenditure

d. Net exports

2. An improvement in technology will?

a. Decrease aggregate demand

b. Increase aggregate demand

c. Increase aggregate supply

d. Decrease aggregate supply

3. Oil price changes in the mid 80's are an example of?

a. An exiernal supply shock increasing prices and reducing real income

b. An external supply shock decreasing prices and raising real income

c. An external supply shock increasing prices and reducing real in come

d. An external demand shock inceasing prices and reducing real in come

4. The oil shock in 1979-80 was an example of?

a. An external supply shock decreasing prices and increasing real income

b. An external supply shock increasing prices and decreasing real income

c. An external demand shock decreasing prices and real income

d. An external demand shock increasing prices and real income

5. Which one of the following does not cause the aggregate demand curve to slop downward?

a. Changes in relative prices between foreign and domestic goods

b. Wealth effect

c. Changes in real output

d. Changes in interest rate

6.Which one of the following is not determinant of aggregate supply?

a. Productivity

b. Disposal income

c. Capacity and investment plan

d. Cost and availability of resources

7. Which of the following relationship is correct?

a. Equilibrium employment and full employment may not be the same

b. Equilibrium employment and full employment are not related

c. Equilibrium employment and full employment are always the same

d. Equilibrium employment and full employment are never the same

8. Which of the following was not a factor limiting the severity of effects of the oil sopply shock of 1979-80?

a. Increase in use of alternative sources of energy

b. More efficient use of energy

c. Increased supplies of non-OPEC oil

d. More rapid worldwide economic growth

9. Which one of following does not cause the aggregate demand curve to slop downward?

a. Changes in relative prices between foreign and domestic goods

b. Interest rate changes

c. Wealth effect

d. Chnages in real output

10. With aggregate demand shocks?

a. teh aggregte supply curve moves up the aggregate demand curve and increases price and reduces real income

b. the aggregate demand curves moves up the aggregate supply curve and increases prices and real income

c. the aggregate demand curves moves down the aggregate supply curve and increases both prices and real income

d. the aggregate supply curve moves down the aggregate demand curve and reduces prices and increases in real income

MBA502, Economics for Business

Apply and Discover 7.2

You are responsible for economic policymaking in your country. Your desire is to eliminate inflation, keeping prices absolutely stable at P = 100, no matter what happens to output. Currently, the economy is in equilibrium at Q = 3200 (where Q = potential GDP) and P = 100. You can use monetary and fiscal policies to affect aggregate demand but you cannot affect aggregate supply in the short run. How would you respond to the following scenarios?

Explain and illustrate how each of these events would affect aggregate demand, aggregate supply, and prices, then explain how you would respond with economic policies.

1. A surprise increase in investment spending

In the short run, when investment spending increases, it results in an increase in Aggregate Demand (AD), which in turn pushes up both GPD and the price index.

To counterbalance this development, government might pursue contractionary fiscal policy by increasing taxes (to reduce consumption) or decreasing its own investment and spending so that the AD curve shifts back to its original position. Alternatively, the government can pursue contractionary monetary policy by reducing money supply and increasing interest rate to discourage economic activity.

2. Catastrophic floods that cause a sharp food price increase

In this case, sharp food shortages and consequent price increases cause a shock-type adjustment of the aggregate supply curve (it shift up and to the left). The result is a lower GDP and a higher price level.

The government cannot do anything to adjust AS in the short run. However, if the goal is to maintain the price level constant, the government can decide to do something to decrease the aggregate demand to force prices to come down, though it will be accompanies by another contraction in GDP and so it would not be a smart thing to do.

To cause AD to decrease, the government, similar to example above, can pursue fiscal policy (increase taxes, decrease spending) or monetary policy (reduce supply of money to the economy and thus increase interest rates).

3. A productivity decline that reduces potential output

In this case, AS shifts to the left, as was the case in example 2. As a result, price levels go up, as the same amount of money is chasing the reduced amount of goods and services, and GDP declines.

Government remedies here would be centered about causing AD to decrease through contractionary fiscal (higher taxes, lower spending) or monetary (reduce money supply and increase interest rates) policy. Again, this decision reduces inflation but at expense of GDP, as real output shrinks further.

4. A deep depression in East Asia that causes a sharp decrease in net exports to the United States

A decrease in exports of goods to from the United States to Asia will mean that the aggregate demand (which includes net exports

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ECON10003 Chapter Notes - Chapter 9: Aggregate Supply, Aggregate Demand, Real Interest Rate

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