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CSUN ECON 160 - macro8_0

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MacroeconomicsTopic 8: “Explain how slow price adjustments might affectthe short-run response of the economy to economic shocks.”Reference: Gregory Mankiw’s Principles of Microeconomics, 2nd edition, Chapter 19.IntroductionOne of the most important issues addressed in macroeconomics is the cause or causes ofshort-run fluctuations in aggregate economic activity. The role of slow price adjustmentsin explaining these short-run fluctuations will be addressed in this review. The aggregatesupply-aggregate demand model provides a framework which allows us to examine thisissue. We shall start our review by discussing aggregate demand. We will then discussboth the long-run and short-run aggregate supply curves. The important role of slow priceadjustments will become apparent in our discussion of the short-run aggregate-supplycurve. The review will end with some applications of this model.Aggregate DemandWhat is the definition of aggregate demand? What are the components of aggregatedemand? What relationship is expressed by the aggregate-demand curve? What does theaggregate demand curve have a negative slope? What are the shift variables for theaggregate-demand curve? These are the questions that will be covered in this section.• Defining Aggregate DemandAggregate demand refers to quantity of goods and services that households, firms, andthe government want to buy at each price level. Aggregate demand consists of realconsumption spending (C), real investment spending (I), real government spending ongoods and services, and net exports (NX). The aggregate-demand curve shows therelationship between the quantity of goods and services that households, firms, and thegovernment are willing to buy and the price level, as in Figure 1 (see next page).As can be seen in Figure 1, a decrease in the price level leads to an increase in theaggregate quantity of goods and services demanded—that is, the aggregate-demand curvehas a negative slope.• Slope of Aggregate DemandAs Figure 1 shows, when the price level rises, the quantity of real output demanded falls.This implies that the slope of Aggregate Demand is negative. Unlike ordinary demandcurves, it is not obvious why increasing the price level should reduce real output.Economists offer the following three reasons for negatively sloped Aggregate Demand.Wealth EffectThe nominal value of money is fixed (“it takes one dollar to buy one dollar”). It followsthat a fall in the price level increases the purchasing power of a given amount of dollars.This makes consumers feel wealthier, which in turn encourages consumers to spendmore. The increase in the spending means a larger quantity of goods and servicesdemanded.Interest-Rate EffectA decrease in the price level causes a decrease in the demand for money. The public willtherefore attempt to reduce their money holdings by purchasing other assets. Forexample, the public will convert some of their money into interest-bearing assets, whichwill lead to a drop in the interest rate (r). Lower interest rates, in turn, stimulateborrowing by firms that want to invest in new capital goods. The increase in investmentspending causes aggregate demand to rise.Exchange-Rate EffectAs discussed above, a lower domestic price level leads to a lower domestic interest rate.With the lower return on domestic assets, holding foreign assets becomes more desirable.The purchase of foreign assets requires the sale of dollars to acquire foreign currency inthe foreign-exchange market, the rise in the supply of dollars in the foreign exchangemarket causes the dollar to depreciate relative to other currencies (the real exchange rate,E, falls). This makes domestic goods cheaper abroad and foreign goods more expensivedomestically, which, in turn, causes an increase in net exports. The rise in net exportsmeans a rise in aggregate demand.• Events that shift the aggregate-demand curveShifts from ConsumptionAny event that changes how much people want to consume at a given price level shiftsthe aggregate-demand curve. Changes in expected-future income (“consumerconfidence”), wealth, and taxes would all affect current consumption spending. Forexample, suppose new information leads consumers to expect that their future incomewill fall (“drop in consumer confidence”). The resulting drop in consumption spendingwill cause the aggregate-demand curve to shift to the left. On the other hand, an increasein consumer confidence will cause the aggregate demand curve to shift to the right. Asanother example, suppose that a stock market boom makes people feel wealthier such thatconsumption spending rises. This would shift the aggregate demand to the right. As afinal example, suppose the government cuts taxes. This encourages spending whichincreases aggregate demand.Shifts from InvestmentAny event that changes how much firms want to invest at a given price level shifts theaggregate-demand curve. For example, changes in firms’ expectations about future cashflows from investment projects, changes in the tax rate on capital, and changes in themoney supply which lead to short-run changes in the interest rate will all have an impacton current investment spending. Thus, an increase in business confidence will encourageinvestment spending. This causes the aggregate demand curve to shift to the right.Likewise, a reduction in the tax rate on capital will also encourage investment spending.As a final example, consider the impact of an increase in the money supply. As explainedelsewhere, this will lower the interest rate in the short run. The lower interest rate willstimulate investment spending, thereby shifting out the aggregate-demand curve.Shifts from government spendingChanges in government spending on goods and services will also shift the aggregate-demand curve. For example, an increase in federal spending on national defense willlead to a rightward shift in the aggregate-demand curve. Changes in spending by otherlevels of government would also shift the aggregate demand curve.Shifts arising from net exportsAny event that changes net exports for a given price level also shifts the aggregate-demand curve. For example, a recession abroad would tend to lower the demand fordomestic goods, so net exports would fall. The fall in net exports would result in aleftward in the aggregate-demand curve. A change in the exchange rate (for reasons otherthan that given above in our discussion of the Exchange-Rate Effect) would also cause


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