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Chapter 14

ECON 1B03 Chapter Notes - Chapter 14: Aggregate Supply, Gdp Deflator, Money Supply

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Bridget O' Shaughnessy

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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
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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
- 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
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