EC 111 1st Edition Lecture 19PREVIOUS LECTUREI. The Market for Loanable FundsII. How Net Capital Outflow Depends on the Real Interest RateIII. The Loanable Funds Market DiagramIV. The Market for Foreign-Currency ExchangeV. The Connection Between Interest Rates and Exchange RatesCURRENT LECTUREI. IntroductionII. The Model of Aggregate Demand and Aggregate SupplyIII. Why Aggregate Demand Curve Slopes DownwardIV. The Wealth Effect (Price and Consumption)V. The Interest Rate Effect (Price and Investment)VI. The Exchange Rate Effect (Price and Net Exports)VII. The Slope of the Aggregated Demand Curve SumVIII. Why the Aggregated Demand Curve Might ShiftIX. The Aggregated Supply CurvesX. The Long-Run Aggregated Supply Curve (LRAS)XI. Why the Long-Run Aggregated Supply Curve is VerticalXII. Why the Long-Run Aggregated Supply Curve ShiftsXIII. Using the Aggregated Demand and Aggregated Supply to Depict Long Run GrowthINTRODUCTION- Over the long-run, real GDP grows about 3% per year on average- In the short-run, GDP fluctuates around its trendo Recessions: periods of falling income and rising unemploymento Depression: serves recession (very rare)- Short-run economic fluctuations are often called business cycles- Investment is how we drive the economyo More jobs, business, technology, product, etc.- Before an economy hits recession, investment declines- Explaining there fluctuations is difficult, and the theory of economic fluctuations is controversial- Most economists use the model of aggregate demand- To study the short-run we use a new modelTHE MODEL OF AGGREGATE DEMAND AND AGGREGATESUPPLY- The model determines the equilibrium price level and equilibrium output (real GDP)- The aggregated demand curve shows the quantity of all goods and services demanded and any given price level at any specific timeWHY THE AGGREGATED DEMAND CURVE SLOPESDOWNWARD- Y=C+I+G+NX- Assume government purchases is fixed by the government policy- To understand the slope of the aggregated demand curve, we must determinehow a change in price effects C, I, and NXTHE WEALTH EFFECT (PRICE AND CONSUMPTION)- Suppose price goes upo The money people hold buy fewer goods and serviceso People feel poorer- Results: Consumption fallsTHE INTEREST RATE EFFECT (PRICE AND INVESTMENT)- Suppose price riseso Buying goods and services requires more dollarso To get these dollars people sell bonds or other assetso This drives up interest rates- Results: Investment falls (investment depends negatively on interest rates)- This is the strongest effectTHE EXCHANGE RATE EFFECT (PRICE AND NET EXPORTS)- Suppose price riseso US interest rates rises (the interest-rate effect)o Foreign investors desire more US bondso Increased demand for dollars in foreign exchange marketo US exchange appreciateso US exports are more expensive to people abroad, cheaper to US residents- Results: Net Exports fallsTHE SLOPE OF THE AGGREGATED DEMAND CURVE SUM- An increase in price reduces the quantity of goods and services demanded becauseo The wealth effect  Consumption fallso The interest rate Investment fallso The exchange rate Net export fallsWHY THE AGGREGATED DEMAND CURVE MIGHT SHIFT- Any event that changes C, I, G, or NX-except a change in price-will shift the aggregated demand curve- Changes in Consumptiono Stock market boom or crasho Preferences: consumption/saving tradeoffo Tax hikes/cuts- Changes in investmento Firms expanding: new computers, equipment factories etc.o Expectations: optimism/pessimismo Interest rateso Policy changes- Changes in government purchaseso Federal spending: defenseo State and local spending: school, roads etc.- Changes in Net Exportso Booms/Recessions in countries that buy our goodso Appreciation/depreciation resulting from interest speculation in foreign exchange marketTHE AGGREGATE SUPPLY CURVES- The aggregate supply curve shows the total quantity of goods and services firms produce and sell at any given price level- Aggregated supply is:o Upward slopingo Vertical in the long-runTHE LONG-RUN AGGREGATE SUPPLY CURVE (LRAS)- Natural Rate of Output (Y n ): the amount of output the economy produces when unemployment is at its natural rateo Yn is also called potential output oro Full-employment outputWHY THE LONG-RUN AGGREGATED SUPPLY CURVE ISVERTICAL- Ynis determined by the economy’s stocks of labor, capital, and natural resources, and level of technology- An increase in price does not effect any of these, so it does not affect Yn (classical dichotomy)WHY THE LONG-RUN AGGREGATED SUPPLY CURVE SHIFTS- Any event that changes any of the determinants of Ynwill shift the long-run aggregated supply curveo Immigration increases labor- Changes in labor or natural rate of unemploymento Immigrationo Baby boomers retiring o Government policies reduce the natural unemployment rate- Changes in Capital or Human Capitalo Investment in factories or equipmento More people get college degreeso Factories destroyed by natural disasters etc.- Changes in natural resourceso Discovery of new mineral depositso Reduction in the supply of imported oilso Changing weather patterns that affect agricultural production- Changes in technologyo Productivity improvements from technological progressUSING AGGREGATED DEMAND AND AGGREGATED SUPPLYTO DEPICT LONG-RUN GROWTH- Over the long-run, technological progress shifts long-run aggregated supply to the right and growth in money supply shifts aggregated demand to the right- Result: ongoing inflation and growth in