ECON 1000 Chapter Notes - Chapter 14: Gdp Deflator, Classical Dichotomy, Aggregate Supply

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ECON 1000

Chapter 14: Aggregate Demand and Aggregate Supply

• Recession: a period of declining real incomes and rising unemployment

• Depression: a severe recession

Three Key Facts about Economic Fluctuations:

Fact 1: Economic Fluctuations Are Irregular and Unpredictable:

• Fluctuations in the economy are often called the business cycle

• Economic fluctuations correspond to changes in business conditions

• When real GDP grows rapidly, business is good, during such periods of economic

expansion, firms find that customers are plentiful and that profits are growing

• When real GDP falls during recessions, businesses have trouble, during such periods of

economic contraction, most firms experience declining sales and dwindling profits

• Economic fluctuations are not regular, and they are almost impossible to predict with

much accuracy

Fact 2: Most Macroeconomic Quantities Fluctuate Together:

• Real GDP is the variable that is most commonly used to monitor short-run changes in

the economy because it is the most comprehensive measure of economic activity

• Real GDP measures the value of all final goods and services produced within a given

period of time, it also measures the total income (adjusted for inflation) of everyone in

the economy

• For monitoring short-u flutuatios, it does’t atte hih easue of eooi

activity you choose, most macroeconomic variables that measure some type of income,

spending, or production fluctuate closely together, they fluctuate by different amounts

• When real GDP falls in a recession, so do personal income, corporate profits, consumer

spending, investment spending, industrial production, retail sales, auto sales, and so on

• Because recessions are economy-wide phenomena, they show up in many sources of

macroeconomic data

Fact3: As Output Falls, Unemployment Rises:

• Chages i the eoo’s output of goods and services are strongly correlated with

hages i the eoo’s utilizatio of its laou foe, when real GDP declines, the

rate of unemployment rises

• In each of the recessions, the unemployment rate rises substantially, when the

recession ends and real GDP starts to expand, the unemployment rate gradually

declines

• The unemployment rate never approaches zero; it fluctuates around its natural rate

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Explaining Short-Run Economic Fluctuations:

The Assumptions of Classical Economics:

• All of this previous analysis was based on two related ideas: the classical dichotomy and

monetary neutrality

• Classical dichotomy: the separation of variables into real variables (those that measure

quantities or relative prices) and nominal variables (those measure in terms of money)

• According to classical macroeconomic theory changes in the money supply affect

nominal variables but not real variables

• As a result of this monetary neutrality, were able to examine the determinants of real

variables (real GDP, the real interest rate, and unemployment) without introducing

nominal variables (the money supply and the price level)

• Money does not matter in a classical economic world

• If the quantity of money in the economy were to double, everything would cost twice as

uh, ad eeoe’s income would be twice as high

• The change would be nominal (in the sense of being nearly insignificant)

• The things that people really care about whether they have a job, how many goods and

services they can afford, and so on would be exactly the same

• Nominal variables may be the first things we see when we observe an economy because

economic variables are often expressed in units of money

The Reality of Short-Run Fluctuations:

• Most economists believe that classical theory describes the world in the long run but

not in the short run

• Most economists believe that, 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, just as classical theory says

• When studying year-to-year changes in the economy, the assumption of monetary

neutrality is no longer appropriate

• In the short run, real and nominal variables are highly intertwined, and changes in the

money supply can temporarily push real GDP away from its long-run trend

The Model of Aggregate Demand and Aggregate Supply:

• Our model of short-run economic fluctuations focuses on the behaviour of two variables

1. The eoo’s output of goods ad seies, as easued  eal GDP

2. The overall price level, as measured by the CPI or the GDP deflator

• Output is a real variable, whereas the price level is a nominal variable

• By focusing on the relationship between these two variables, we are departing from the

classical assumption that real and nominal variables can be studied separately

• 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

• 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

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• Aggregate-supply curve: a curve that shows the quantity of goods and services that

firms choose to produce and sell at each price level

• According to this model, the price level and the quantity of output adjust to bring

aggregate demand and aggregate supply into balance

The Aggregate-Demand Curve:

• A fall in the price level increases the quantity of goods and services demanded

• There are three reasons for this negative relationship; as the price level falls, real wealth

rises, interest rates fall, and the exchange rate depreciates

• These effects stimulate spending on consumption, investment, and net exports

• Increased spending on these components of output means a larger quantity of goods

and services demanded

Why the Aggregate-Demand Curve Slopes Downward:

• Each of the four components (consumption, investment, government purchases and net

exports) contribute to the aggregate demand for goods and services

• We assume that government spending is fixed by policy

• The other three components of spending (consumption, investment, and net exports)

depend on economic conditions and price level

The Price Level and Consumption: The Wealth Effect:

• A decrease in the price level makes consumers wealthier, which encourages them to

spend more

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Related Questions

1. Fiscal policy attempts to affect the level of overall spendingin the economy by changes in:
A) the interest rate.
B) the money supply.
C) banking regulations.
D) taxes and spending.

2. Economists have identified several consecutive months of fallingemployment and forecasts for the next few months are for more ofthe same. At what point in the business cycle is the economyapparently located?
A) recession
B) expansion
C) business cycle peak
D) business cycle trough

3. The onset of the Great Depression:
A) was not a shock to anyone since most economists predicted theâroaring 20sâ were bound to end in disaster.
B) created a disagreement between the Hoover administration andconventional economists because Hoover wanted the government tointervene much more quickly than most others.
C) came as a considerable shock to the conventional wisdom ofeconomics at that time and opened the door for critiques ofmainstream thought by economists like JM Keynes.
D) was in 1918 at the end of World War I.

4. When economists measure economic growth, they often use:
A) the inflation rate.
B) the unemployment rate.
C) nominal GDP.
D) real GDP.

5. In a typical business cycle, the business cycle peak isimmediately followed by the:
A) recession.
B) business cycle trough.
C) expansion.
D) depression.

6. Suppose an economy experiences rising total output accompaniedby increasing employment, this is generally known as:
A) stagflation.
B) recession.
C) inflation.
D) expansion.

7. Controlling interest rates is an example of:
A) fiscal policy.
B) tax policy.
C) monetary policy.
D) exchange rate policy.

8. The alternation between recessions and expansions is known asthe:
A) unemployment rate.
B) long-run economic growth.
C) business cycle.
D) macroeconomy.

9. A recession in America is typically associated with:
A) a falling unemployment rate.
B) a decrease in the number of people living in poverty.
C) a decrease in the percentage of Americans with healthinsurance.
D) an increase in corporate profits.

10. The purpose of macroeconomic policy is to:
A) bring unemployment closer to the natural rate.
B) reduce the severity of recessions.
C) rein in excessively strong expansions.
D) bring unemployment closer to the natural rate and to reduce theseverity of recessions.

11. The trade balance is the difference between the value ofthe:
A) trade deficit and the budget deficit.
B) goods and services that one country sells to other countries andthe value of the goods and services it buys in return.
C) exchange rates of two countries that are engaged ininternational trade.
D) national debt and the foreign debt.

12. Increasing the total amount of available productive resourcesis the focus of __________.
A) macroeconomics
B) fiscal policy
C) monetary policy
D) microeconomics

13. The point on a business cycle when real GDP stops rising andbegins falling is a(n):
A) peak.
B) trough.
C) expansion.
D) recession.

14. During a recession, one will often observe:
A) aggregate output rising.
B) unemployment rates will be increasing while aggregate output isfalling.
C) employment rates will be rising.
D) zero unemployment rates.

15. Monetary policy involves:
A) changes in government spending.
B) changes in government tax receipts.
C) changes in the quantity of money.
D) changes in tax rates.

16. The trough of the business cycle:
A) comes right after the expansion phase.
B) comes before the recession phase.
C) is a temporary maximum level of real GDP.
D) is a temporary minimum level of real GDP.

17. Which one of the following statements about the U.S. economy isnot accurate?
A) Since the Second World War, aggregate output grew at a ratelower than the average annual growth rate of population.
B) Since the Second World War, aggregate output grew at a ratehigher than the average annual growth rate of population.
C) Since the Second World War, macroeconomic policy has helped makethe economy more stable.
D) Long-run growth per capita is the key to higher wages and arising standard of living.

18. An economic recovery is all of the following except:
A) economic growth of a sustained nature.
B) a short-run increase in aggregate production in aneconomy.
C) a time of increasing employment.
D) the end of the business cycle.

19. Which of the following would NOT be classified as amacroeconomic question?
A) How many people are employed in the economy as a whole?
B) What determines the overall level of prices in the economy as awhole?
C) What determines the overall trade in goods, services, andfinancial assets between the United States and the rest of theworld?
D) What determines the cost to a university or college of offeringa new course?

20. Which of the following statements regarding price level orinflation is correct?
A) Supply and demand can not explain why a particular good orservice becomes more expensive relative to other goods andservices.
B) Inflation affects only the more advanced countries whereas lessadvanced countries face deflation.
C) Prices of most goods and services remained stable during thegreat depression.
D) In general, when the economy is in recession and jobs are hardto find, inflation tends to fall.

21. If wages grew at a 5% rate last year and average prices grew ata 3% rate, then the average worker is:
A) better off.
B) worse off.
C) no better or worse off.
D) unaffected.

22. In an open economy:
A) the exchange rate is determined by the government.
B) specialization in activities with a comparative advantage is notpossible.
C) trade is only beneficial to the relatively larger economy.
D) there is trade in goods, services, or assets with othercountries.

23. Changes in government spending and taxes in an effort to changeoverall spending in an economy is:
A) fiscal policy.
B) monetary policy.
C) investment.
D) the stock market.

24. If an economy is open, this means that:
A) anyone can immigrate to the country.
B) trading with other countries makes up a portion of itseconomy.
C) it does not trade with other countries.
D) it will experience a drop in its real GDP.

25. Inflation is a situation where:
A) the average price level falls.
B) the average price level increases.
C) the average price level becomes negative.
D) the real price level falls.

26. The topics studied in macroeconomics include:
A) the price of a motorcycle.
B) the wages of engineers.
C) the average price level in the economy.
D) how much ice cream consumers buy.

27. A period of rising real GDP is a(n):
A) peak.
B) trough.
C) expansion.
D) recession.

28. The modern tools of macroeconomic policy are:
A) tax policy and antitrust policy.
B) fiscal policy and monetary policy.
C) monetary policy and exchange rate policy.
D) capital policy and labor policy.

29. A ârubber neckingâ traffic jam is an example of:
A) microeconomics in action.
B) individual behavior that has a large aggregate impact.
C) the paradox of thrift.
D) an outcome smaller than the sum of its parts.

30. The most painful consequence of a recession is:
A) rising unemployment.
B) increasing inflation.
C) increasing aggregate output.
D) higher interest rates.

31. Per capita economic growth is:
A) economic growth per unit of capital.
B) economic growth per person.
C) economic expansion over the business cycle.
D) sustained increase in aggregate output.

32. Keynesian economics stressed:
A) total spending.
B) the self-regulating power of free markets.
C) the long run.
D) that the Depression should run its course to bring down the highcost of living.

33. When an economy's overall production grows faster than itspopulation, this is referred to as:
A) long-run growth per capita.
B) an increase in nominal GDP.
C) deflation.
D) the paradox of thrift.

34. Fiscal policy attempts to affect the overall level of spendingin the economy through:
A) changes in the inflation rate.
B) changes in the quantity of money or the interest rate.
C) changes in tax policy or government spending.
D) discretionary regulation of profits and wages.

35. With regard to the aggregate price level, economists generallybelieve:
A) price stability is a desirable goal.
B) inflation is worse than deflation.
C) deflation is worse than inflation.
D) inflation actually benefits most retired people.

36. Recessions are periods when:
A) output rises.
B) the aggregate price level rises.
C) the unemployment rate is falling.
D) output and employment are falling.

37. Monetary policy attempts to affect the overall level ofspending in the economy by changes in:
A) taxes.
B) taxes and spending.
C) taxes and interest rates.
D) interest rates and the quantity of money.

38. The basic difference between an economic recession and economicdepression is that:
A) the latter is a shorter economic downturn than the former.
B) during recessions output falls faster than duringdepressions.
C) during depressions employment falls faster than duringrecessions.
D) the former is a longer economic downturn than the latter.

39. The central mission of modern macroeconomics is to prevent_____ from happening again.
A) recessions
B) inflation
C) deflation
D) anything like the Great Depression

40. Fiscal policy refers to:
A) the control of interest rates.
B) the control of government spending and taxations.
C) the control of the quantity of money.
D) the control of interest rates and of government spending.

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ECON 1000 Chapter Notes - Chapter 14: Gdp Deflator, Classical Dichotomy, Aggregate Supply

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