ECON 304 Final Exam Study Guide Supplement Theory of Aggregate Demand I Consumption Function AD C I G NX a C f P i As price level increases our wealth coming from stock market and real estate wealth decreases ii Real wealth falls consumption falls b Cd c0 c1 Y T c2r c3CC c4W c5P i Y T disposable income ii This is the intercept equation c Intercept is c bar i A bar C I G NX d Slope c1 i Change in C change in Y MPC e Consumption C Income Y dissaving at those levels of income i US economy as a whole is dissaving Shifts in Consumption change in the intercept f i Decrease in taxes ii Increase in income iii Decrease in interest rate Increase in consumer confidence iv v Increase in wealth vi Decrease in price level g Equilibrium Income and Output i AD Y0 1 A c1Y ii When AD Y0 IU unplanned inventory investment 0 iii If AD does not equal Y0 inventories 1 Accumulate AD Y IU 0 falls 2 Or fall AD Y IU 0 rises II Change in AD and the Multiplier a Y AD i A c1Y ii A Y 1 c1 iii Y0 1 1 c1 x A iv Change in Y0 1 1 c1 x change A Change in income change in AD change in production b c The multiplier 1 1 c1 Chapter 9 pp 342 349 Business Cycles and Macroeconomic Policy I Why is AD negatively related to the price level a As the price level rises MS P falls and r rises i Affects real money supply Increase r Cd and Id decrease ii iii Occurs because P rising and simply just move along the demand curve b As the price level rises real wealth falls i Wealth real estate wealth financial crisis saw value of homes plummet equity in homes declined stock market wealth ii WRE P and WSM P price level increasing decreases both 1 Cd falls 2 Move along aggregate demand function c As the price level rises NX falls i As PL rises by more than foreign increase in PL NX are going to ii Our goods are relatively more expensive so as consumers we fall because exports decrease will import more from abroad II Aggregate Demand Curve a Change in the price level is always a movement along the demand b Curve relates aggregate quantity of output demanded to the general c price level If prices rise by an amount the price level also increases by that amount d The increase in the price level reduce aggregate quantity of goods e An increase in the price level reduces aggregate quantity of output curve demanded demanded f AD curve slopes downward because an increase in the price level reduces the money supply shifts LM curve up and to the left g Factors that Shift AD curve increase curve i Goods Market 1 An increase in consumption investment government spending and net exports will cause the AD curve to shift Increase in wealth Increase in expected future output 2 3 4 Decrease in taxes 5 6 Decrease in effective tax rate on capital Increase in expected future MPK ii Money Market 1 2 3 Decrease in nominal interest rate on money 4 Decrease in real money demand r falls Increase in nominal money supply Increase in expected inflation III Aggregate Supply Curve a Prices remain fixed in the short run In long run prices and wages adjust to clear all markets in economy b c Long Run Aggregate Supply i Vertical at full employment output ii As the price level rises output is unchanged iii When income Y full employment output Y bar the labor market is in equilibrium iv Y bar AF K N bar v GDP Deflator reflects the average level of prices of all output produced vi Completely independent of price changes vii Output remains unchanged as the price level rises because relative prices are unchanged d Factors that Shift LRAS curve i Beneficial supply shock technological innovation ii iii Increase in labor supply Increase in capital stock more output can be produced with the same amount of labor increase in productivity e Short Run Aggregate Supply i Horizontal because firms are willing to supply any amount of output at the particular price level IV Equilibrium in the AD AS Model a Short run equilibrium when prices are fixed i Intersection of AD and SRAS curve b Long run equilibrium when prices have fully adjusted Intersection of AD SRAS and LRAS curves i ii Output equals full employment level iii Same as general equilibrium V VI Monetary Neutrality in the AD AS Model a All real economic variables are unaffected in the long run b Variables Y bar MS P L r N bar w bar c Dynamic Adjustment Increase in AD a Increase in money supply has no long run affects i From SR to LR prices will rise as input prices increase and we move up along AD ii Demand shifts because of an increase in the MS for example Increase in MS decreases r Cd and Id increase leads to AD iii increase 1 2 Firms increase production and output rises IU 0 due to AD2 supply iv At price level AD2 is greater than LRAS 1 Prices must rise as wages and other input prices start to rise costs are going up and supply is being affected again In the money market v 1 MS P decreases because of an increase in P real money supply shifts back until prices rise by same amount as money supply increases vi AD shifts back to AD1 vii Move up along AD2 until prices rise by same amount as increase in money supply viii The adjustment stops when r returns to its original amount in money market b Decrease in AD i Decrease in MS increase r decrease Cd and Id AD shifts leftward down IU 0 unintended inventory accumulation due to Y AD2 ii 1 Firms cut production and lay off workers Y falls to Y2 iii At price level surplus and prices start to fall since AD2 Y bar firms accept lower prices and workers accept lower wages In the money market as the price level decreases MS increases 1 Real money supply begins to rise starts shifting back to the right until MS2 is equal to MS1 and percent change in money supply equals the change in the price level iv v AD shifts back up as r decreases in money market back to original state vi Price level decreases SRAS decreases until change in Price level equals change in MS and Y Y bar 1 Economy moves down along AD2 a Money neutrality money is neutral in the long run Chapter 8 The Business Cycle I Temporary Adverse Supply Shock increase in price of oil a Decrease in output and labor LRAS shifts left production function shifts down b AD LRAS2 shortage increase price level c As price level increases MS decreases and r increases i Cd Id ii Wealth decreases and NX decreases economy moves up along AD d Conclusions i …