ECON 1202 INTRODUCTION TO MACROECONOMICS CHAPTER 13 14 STUDY GUIDE Aggregate Demand and Aggregate Supply Monetary Policy Actions the Federal Reserve takes to manage the money supply and interest rates to achieve macroeconomic policy goals Fiscal Policy Changes in federal taxes that are intended to achieve macroeconomic policy objectives Aggregate Demand The Aggregate Demand curve shows the negative relationship between the price level and the quantity of Real GDP demanded The AD curve is downward sloping because of the wealth effect the interest rate effect and the international trade effect It is not downward sloping for the same reasons as the demand curve for a single product The Wealth Effect A higher price level reduces the real value of household wealth The Interest Rate Effect A higher price level raises interest rates which in turn which in turn decreases consumption decreases investment and consumption The International Trade Effect A higher price level makes U S exports more expensive and foreign imports less expensive which in turn decreases net exports The general equation for GDP is Y C I G X M An increase or decrease in the price level merely causes a movement along the curve rather than a shift of it The cause of shifts in the AD curve include the following Causes a rightward shift of the AD curve A decrease in interest rates An increase in government purchases A decrease in personal taxes or business taxes An increase in household s expectations of their future incomes An increase in future profitability of investment spending A decrease of domestic GDP relative to foreign GDP or A decrease in the exchange rate imports will decrease faster than exports increasing net exports Causes a leftward shift of the AD curve An increase in interest rates A decrease in government purchases An increase in personal taxes or business taxes A decrease in household s expectations of their future incomes A decrease in future profitability of investment spending An increase of domestic GDP relative to foreign GDP or an increase in the exchange rate imports will increase faster than exports decreasing net exports Aggregate Supply In the Long Run price level does not have an affect on the quantity of real GDP supplied At potential GDP firms operate at their normal level of capacity and unemployment is at it s natural level regardless of the price level As such the Long run aggregate supply curve is vertical The LRAS curve will shift right as the capacity of the economy increases and technological change occurs which can be facilitated by protecting property rights subsidizing research and development loosening up trade barriers and subsidizing education In the Short Run the Aggregate Supply Curve is upward sloping because as the price level increases the quantity of goods and services firms are willing to produce increases This occurs mainly because price of inputs and wages are sticky meaning that their price rises more slowly when compared to the price of final goods and services Menu costs can also be sticky and can potentially contribute to the upward slope Some firms and workers fail to accurately predict the price level and this is why certain prices are slower to change than others If everyone s predictions of the price level were perfect the SRAS would be exactly the same as the LRAS vertical at the potential GDP An increase or decrease in the price level merely causes a movement along the SRAS curve rather than a shift of it The cause of shifts in the SRAS curve include the following Causes a rightward shift of the SRAS curve An increase in the labor force or capital stock An increase in productivity A decrease in the expected future price level Causes a leftward shift of the SRAS curve A decrease in the labor force or capital stock A decrease in productivity An increase in the expected future price level A decrease in the expected price of an important natural resource Adjustments by workers to having previously over estimated the price level An increase in the expected price of an important natural resource Adjustments by workers to having previously under estimated the price level Menu Costs The costs to firms of changing prices With the advent of the internet these costs have decreased Supply Shock An unexpected event that causes the SRAS to shift usually caused by an increase or decrease in the price of important natural resources Equilibrium In Long Run Macroeconomic Equilibrium the AD and SRAS curves intersect at a point on the LRAS curve However in the short run the economy is not necessarily performing at it s normal level of capacity and thus is not in long run economic equilibrium Therefore Short Run changes in Aggregate Demand and Aggregate Supply may cause the economy to move to a new Short Run Macroeconomic Equilibrium Yet market forces will eventually push the economic equilibrium back to Potential GDP although it will not usually happen instantly and there will most likely be either an increase or decrease in the price level If there is a Short Run decline in aggregate demand the AD curve will shift left and the economy will move to a new Short Run Macroeconomic Equilibrium where it intersects with the SRAS curve with a lower level of Real GDP Eventually the SRAS curve will shift right to counteract this returning to a new Long Run Macroeconomic Equilibrium with a lower price level If there is a Short Run increase in aggregate demand the AD curve will shift right and the economy will move to a new Short Run Macroeconomic Equilibrium where it intersects with the SRAS curve with a higher level of Real GDP Eventually the SRAS curve will shift left to counteract this returning to a new Long Run Macroeconomic Equilibrium with a higher price level Inflation occurs when the price level increases Disinflation occurs when the price level increases by less that it has before Deflation occurs when the price level decreases Recession occurs when the economy is producing below the level of Potential GDP Expansion occurs when the economy is producing above the level of Potential GDP Stagflation is a combination of inflation and recession If the inflation rate for one year is greater than that of previous years it is likely that a recession would be caused by a negative supply shock rather than an increase in aggregate demand Deflation hasn t happened in the U S since the great depression Dynamic Model vs Basic Model The dynamic model of aggregate supply and aggregate