Week 10 chapter notes

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Published on 6 Dec 2010
School
UTSC
Department
Economics for Management Studies
Course
MGEB06H3
Chapter 9 Introduction to Economic Fluctuations Notes
x one way that economists arrive at their forecasts is by looking at leading indicators, which are variables that tend to fluctuate in
advance of the overall economy and that are used differently by each economist
x some of the most used leading indicators are new orders, inventory levels, number of new building permits issued, stock market
indexes, money supply data, the spread between short-term and long-term interest rates, and consumer confidence surveys
x these data are often used to forecast changes in economic activity about 6 to 9 months into the future
9.1 Time Horizons in Macroeconomics
How the Short run and the Long Run Differ
x in the long run, prices are flexible and can respond to changes in supply and demand
x in the short run, many prices are sticky” at some predetermined level
x because prices behave differently in the SR than in the LR, economic policies have different effects over different time horizons
x in the short run, many prices do not respond to changes in monetary policy
x this SR price stickiness implies that the SR impact of a change in the money supply is not the same as the LR impact
x during the time horizon over which prices are sticky, the classical dichotomy no longer holds: nominal variables can influence
real variables, and the economy can deviate from the equilibrium predicted by the classical model
The Model of Aggregate Supply and Aggregate Demand
x in classical macroeconomic theory, the amount of output depends on the economys ability to supply goods and services, which
in turn depends on the supplies of capital and labour and on the available production technology
x the theory posits that prices adjust to ensure that the quantity of output demanded equals the quantity supplied
x when prices are fixed, output also depends on the demand for goods and services
x demand, in turn, is influenced by monetary policy, fiscal policy, and various other factors
x because monetary and fiscal policy can influence the economys output over the time horizon when prices are sticky, price
stickiness provides a rationale for why these policies may be useful in stabilizing the economy in the short run
9.2 Aggregate Demand
x aggregate demand (AD) Æ the negative relationship between the price level and the aggregate quantity of output demanded that
arises from the interaction between the goods market and the money market
The Quantity Equation as Aggregate Demand
x M / P = (M / P)d = kY
where k = 1/V is a parameter determining how much money people want to hold for every dollar of income
x quantity equation states that supply of real money balances M/P equals demand (M/P)d and demand is proportional to output Y
x for any fixed money supply and velocity, quantity equation yields a negative relationship between the price level P and output Y
x this downward-sloping curve is called the aggregate demand curve
9.3 Aggregate Supply
x aggregate supply (AS) Æ the relationship between the price level and the aggregate quantity of output firms produce
x because the firms that supply goods and services have flexible prices in the long run, but sticky prices in the short run, the
aggregate supply curve relationship depends on the time horizon
The Long Run: The Vertical Aggregate Supply Curve
x according to the classical model, output does not depend on the price level
x to show that output is the same for all price levels, a vertical aggregate supply curve is drawn
x the intersection of the aggregate demand curve with this vertical aggregate supply curve determines the price level
x if the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not output
x the vertical AS curve satisfies the classical dichotomy, for it implies that the level of output is independent of the money supply
x this long-run level of output, Y-bar, is called the full-employment or natural level of output
x it is the level of output at which the economy’s resources are fully employed or at which unemployment is at its natural rate
The Short Run: The Horizontal Aggregate Supply Curve
x the classical model and the vertical aggregate supply curve apply only in the long run
x in the short run, some prices are sticky and, therefore, do not adjust to changes in demand
x because the price level is fixed in the SR, the situation is represented with a horizontal aggregate supply curve
x the short-run equilibrium of the economy is the intersection of the aggregate demand curve and this horizontal SRAS curve
x in this case, changes in aggregate demand do affect the level of output
From the Short Run to the Long Run
x over long periods of time, prices are flexible, the AS curve is vertical, and changes in AD affect the price level but not output
x over short periods of time, prices are sticky, the AS curve is flat, and changes in AD do affect the economy’s output
9.4 Stabilization Policy
x shocks Æ an exogenous change in an economic relationship, such as the aggregate demand or aggregate supply curve
x demand shocks Æ exogenous events that shift the aggregate demand curve
x supply shocks Æ exogenous events that shift the aggregate supply curve
x these shocks disrupt economic well-being by pushing output and employment away from their natural levels
x one goal of the model of aggregate supply and aggregate demand is to show how shocks cause economic fluctuations
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Document Summary

How the short run and the long run differ. The model of aggregate supply and aggregate demand. N when prices are fixed, output also depends on the demand for goods and services. N aggregate demand (ad)  the negative relationship between the price level and the aggregate quantity of output demanded that arises from the interaction between the goods market and the money market. The long run: the vertical aggregate supply curve. The short run: the horizontal aggregate supply curve. From the short run to the long run. N monetary policy is an important component of stabilization policy because the money supply has a powerful impact on ad. Summary: economies experience short-run fluctuations in economic activity, measured most broadly by real gdp. These fluctuations (business cycles) are evident in many macroeconomic variables. In particular, when gdp growth declines, the unemployment rate rises above its natural rate.