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GWU ECON 1012 - Chapter 13: Aggregate Demand

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Chapter 13: Aggregate Demand and Aggregate Supply Analysis- In the short run, real GDP fluctuates around the long-run upward trend because of the business cycle- Fluctuations in GDP lead to fluctuations in employmentAggregate Demand- Aggregate demand and aggregate supply model: a model that explains short-run fluctuations in real GDP and the price level- Aggregate demand curve (AD): a curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government- Short-run aggregate supply curve (SRAS): a curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms- The aggregate demand curve is downward sloping because a fall in price level increases the quantity of real GDP demanded- The wealth effect:o As total household wealth rises, consumption riseso When price levels rise, the real value of household wealth declines, consumption declines, reducing the demand for goods and serviceso When price levels fall, the real value of household wealth rises, consumption rises, increasing the demand for goods and services- The interest rate effecto Higher price level increases the interest rate, reduces investment spending, reduces the quantity of goods and services demandedo Lower price levels decrease the interest rate, increases investment spending, increasing the quantity of goods and services demanded- The international trade effecto Price levels in the US rise relative to price levels in other countries, US exports will become more expensive, foreign imports will become lessexpensive, net exports will fall, reducing quantity of goods demandedo Lower price level in the US relative to other countries, net exports rise, increasing the quantity of goods and services demanded- Movement along curveo If the price level changes, but other variables that affect the willingness of households, firms, government to spend are unchanged,the economy will move up or down a stationary aggregate demand curve- Shifts of the aggregate demand curveo If any other variable other than the price level changes, the demand curve will shifto Variable that shift: Changes in government policies- Monetary policy: the actions the Federal Reserve takes to manage the money supply and interest rates to pursue macroeconomic policy objectives- Fiscal policy: changes in federal taxes and purchases that are intended to achieve macroeconomic policy objectives Changes in the expectations of households and firms- If households/firms become more optimistic about their future incomes, they are likely to increase their current consumption, shifting curve to the right- If households/firms become more pessimistic about their future incomes, demand curve will shift to the left  Changes in foreign variables- If firms and households in other countries buy fewer US goods or if firms and households in the US buy more foreign goods, next exports will fall, aggregate demand curve will shift to the left- Net exports will fall if the exchange rate between the dollar and foreign currencies rises because the price in foreign currency of US products sold in other countries will rise, and the dollar price of foreign products sold in the US will fall- A change in net exports that results from a change in theprice level in the US will result in a movement along the aggregate demand curveAggregate Supply- The effect of changes in the price level on the quantity of goods and services that firms are willing able to supply- In the long run, the level of real GDP is determined by the number of workers, the capital stock- In the long run, changes in the price level do not affect the level of real GDPo Level of real GDP in the long run is called potential/full employment GDP- Long run aggregate supply curve (LRAS): a curve that shows the relationship in the long run between the price level and the quantity of real GDP suppliedo Vertical curve- SRAS curve is upward slopingo Over the short run, as price level increases, the quantity of goods and services firms are willing to supply will increaseo As prices of final goods and services rise, prices of inputs rise more slowly (wages of workers, price of natural resources)o Higher price level leads to higher profits and increases the willingness o firms to supply more goods and serviceso A firm that is slow to raise its prices when the price level is increasing may find its sales increasing, therefore will increase productiono Some firms and workers fail to accurately predict changes in the price levelo Contracts make some wages and prices “sticky” When prices or wages do not respond quickly to changes in demand or supplyo Firms are often slow to adjust wages Wages of many union workers remain fixed by contract for several years If firms are slow to adjust wages, a rise in the price level will increase the profitability of hiring more workers and producing more output A fall in the price level will decrease the profitability of hiring more workers and producing more outputo Menu costs make some prices sticky Firms base their prices today partly on what they expect future prices to be Menu costs: the costs to firms of changing prices Unexpected increase in the price level, firm swill want to increase the prices they charge Low prices, firms will find sales increasing, increase output- Shifts of the Short Run Aggregate Supply curve vs. Movements along ito If price levels changes, but other variables are unchanged, the economy will move up or down a stationary aggregate supply curveo Variables that shift the short run aggregate supply curve Increases in labor force and in capital stock Technological change Expected changes in the future price level- If workers and firms expect the price level to increase by a certain percentage, the SRAS curve will shift by an equivalent amount Adjustments of workers and firms to errors in past expectations about the price level- If workers and firms across the economy are adjusting to the price level being higher than expected, SRAS curve will shift to the left- If they are adjusting to the price level being lower than expected, the SRAS curve will shift to the right Unexpected changes in the price of an important natural resource- Supply shock: an unexpected event that causes the short run aggregate supply curve to shiftMacroeconomic Equilibrium in the Long Run and the Short Run- The economy has


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