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ECON 1B03 (302)
Chapter 14

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McMaster University
Bridget O' Shaughnessy

Chapter 14 - Recession: a period of declining real incomes and rising unemployment - Depression: a severe recession - Three Key Fasts about the economy Fact 1: Economic Fluctuations Are Regular and Unpredictable - Business cycle: fluctuations in the economy o Economic fluctuations correspond to changes in business conditions o When real GDP grows rapidly-business is good- customers are plentiful and profits are growing o When real GDP falls during recessions- businesses have trouble- most firms experience declining sales and dwindling profits - Business cycle is NOT regular or predictable - Recessions do not come at regular intervals - Remember that when real GDP falls, it is a recession NOT a business cycle 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 recessions are economy-wide phenomena, they show up in many sources of macroeconomics data - Many macroeconomic variables fluctuate together, but by different amounts Fact 3: As Output Falls, unemployment Rises - When real GDP declines, the rate of unemployment rises - When recession ends and real GDP starts to expand, the unemployment rate gradually declines - Unemployment rate never approaches zero, but fluctuates around its natural rate Explaining short-run Economic Fluctuations The Assumptions of Classical Economics - Classical Dichotomy: the separation of variables into real variables (those that measure quantities or relative prices) and nominal variables (those measured in terms of money) - Classical Macroeconomic theory: changes in the money supply affect nominal variables but NOT real variables o Money does not matter(in a sense) o If the cost of everything doubles including your salary, it doesn’t matter because you care about how many goods you can buy with the money you have o Sometimes described as “money is a veil” , nominal variables are the first that we observe, but real variables are what really matter Reality of Short-Run Fluctuations - most economists believe that classical theory describes the world in the long run, but not in the short run - In the short-run, real and nominal variables are highly intertwined and changes in the money supply can temporarily pushes real GDP away from its long-run trend - We can no longer separate our analysis of real variables such as output and employment from our analysis of nominal variables such as money and the price level The Model of Aggregate-Demand and Aggregate-Supply - Model of short-run economic fluctuations focuses on the behaviour of two variables o Economies output of goods and services- as measured by Real GDP o The overall price level- as measured by the CPI or the GDP deflator - Output is a real variable, price level is a nominal variable - Model of aggregate demand and aggregate supply: The model that most economists use to explain short-run fluctuations in the 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 - Aggregate-supply curve: a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level - This model looks like market demand and market supply, BUT is very different The Aggregate-Demand Curve - tells us the quantity of all goods and services demanded in the economy at any given price level - A fall in the economy s overall price level tends to raise the quantity of goods and services demanded - An increase in the price level reduces the quantity of goods and services demanded Why the Aggregate-Demand Curve Slopes Downward - Y=C+I+G+NX - For now we say that the government spending is fixed by policy - There are three other components of spending depend on economic conditions and in particular… on the price level Why the aggregate- Demand Curve Might Shift - Downward slope of Aggregate-Demand shows that a fall in the price level raises the overall quantity of goods and services demanded The Aggregate-Supply Curve - The aggregate-supply curve tells us the total quantity of goods and services that firms produce and sell at any given price level - In the long-run, the aggregate supply curve is vertical, whereas in the short-run, the aggregate-supply curve is upward sloping Why the Aggregate-Supply Curve is Vertical in the Long-Run - In the long-run, an economies production of goods and services (its real GDP) depends on its supplies of labour, capital, natural resources and on the available technology used to turn these factors of production into goods and services - Because the price level does not affect long-run determinants of Real GDP, the long-run aggregate-supply is vertical - In the long-run, the economy’s labour, capital, natural resources and technology determine the total quantity of goods and services supplied, and this quantity supplied is the same regardless of what the price level happens to be Why the Long-Run Aggregate-Supply Curve Might Shift - Natural rate of output: the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate - Any change in the economy that alters the natural rate of output shifts
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