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UB ECO 181 - Exam 2 Study Guide

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ECO 181 1nd EditionECO 181TEST 2 STUDY GUIDE:Chapter 10:Real GDP and the Price Level in the Long RunI. Aggregate Supply / Aggregate Demand Model- Aggregate supply: total of all planned production in the economy (RGDP)- Aggregate Supply (AS) Curve: Whether or not the supply of goods produced in the economy is dependent on the price level will depend on the time frame (short run vs. long run). AS curve shows the total quantity (real GDP) of goods and services firm produce at any given price levels- In the long – run the LRAS (long run aggregate supply) curve is vertical at YN- The full employment or natural rate of output (Yn) is the amount of output the economy produced when unemployment is at its natural rate- Yn is also called potential output (Yp) or full – unemployment output (Yfe). When Y=Yn U=UnII. Why LRAS Vertical?- Yn is determined by the economy’s stocks of labor, land, capital and natural resources, and on the level of technology- An increase in P does not affect any of these, so it does not affect Yn- This shows the level of output after input prices have fully adjusted to changes in output prices. If prices increase by 10% then input prices will also increase by 10% - thus suppliers have no incentive to increase outputIII. Growth- Growth is shown by outward shift of both the production possibilities curve and the LRAS curve caused by:o 1. Innovation: improvement in technologyo 2.More equipment, factories, stores… (Increase K)o 3. More skilled and educated workers …(increase H)o 4. More workers (immigration and population growth) … (increase L)o 5. Discovery of new mineral deposits …(increase N)o Y = AF(L,K,H,N)  N DOES NOT AFFECT GROWTHIV. Aggregate Demand- Total quantity og all planned expenditures on goods and services by households, firms, government and rest of the worldo AD = RDGP = C + I + G + X-M (NX)V. The AD Curve- The AD: curve shows the quantity of all RGDP demanded in the economy at any price level- (draw graph from notes)  As P increases AD __________, shown by -________________________- If the average price level (P) is low AD will be ________- If the average price level (P) is high AD will be ________- To understand the negative slop of AD, must determine how a change in P affects C+I+G+NXo Inversely related o Assume government spending is not related to NXVI. Reasons for negatively sloped AD- 1. The Real Balance (Wealth) Effect (P and C) – If P rises, The dollars people hold buy fewer g&s , so real wealth (purchasing power) is lowero People feel less wealthy Result: C decreases and AD decreases- 2. The Interest Rate Effect (P and I) If P rises; buying g&s requires more dollars. To get these dollars, people save less or borrow more. This drives up interest rates (less money in banks)o Since r is the cost of borrowing moneyo Interested rates can be the cost of borrowingo Increase IR  less borrowing, less investment spending Result: I decreases and AD decreases- 3. The International Substitution Effect (P and NX) – If P rises, domestic goods are relatively moreexpensive, while foreign goods are cheaper. Thus exports decrease, imports increase and NX decreaseso Result: NX decreases and AD decreasesVII. The Slope of the AD Curve: Summary- An increase in P reduces the quantity of Goods and Services demanded because:o The Real Wealth Effect (C Falls) (From Y1 to Yc)o The Interest Rate Effect (I Falls)o The International/Substitution Effect (NX Falls)VIII. Why the AD Curve Might Shift- Any event that changes C, I, G, or NX – except a change in price – will shift the AD curveo Ex) Consumption A stock market boom makes households feel more wealthy, C increase, the AD curve shifts outward to AD2- If AD is greater at all price levels then the curve will shift outward to AD2- If AD is lower at all price levels then the curve will shift inward to AD3- Changes in Consumption Spendingo 1) Changes in wealtho 2) Changes in preferences in terms of the savings/consumption trade off Savings  Consumption o 3) Changes in expectation of the future (consumer confidence)o 4) Government policy – changes in taxes or the interest rateso 5) Changes in the money supply  Money  Consumption - Changes in Investment Spendingo 1) Significant changes in technologyo 2) Change in expectations (optimism; I , pessimism; I)o 3) Changes in the interest rate {cost of borrowing} (monetary policy)o 4) Changes in taxes {investment tax credit} (fiscal policy)- Changes in Government Spendingo 1) Fiscal Policy – International changes in spending directly aimed at change in AD and Real GDPo 2) Unintentional Changes in government spending to deal with unexpected changes like war or natural disasters- Changes in Net Exportso 1) Changes in income either foreign or domestico 2) Changes in the exchange ratesIX. In View of Demand:- If the value o the $ increases (it appreciates/gets stronger) the $ gets more foreign goods abroad. Thus imports are cheaper- However more foreign currency must be given up for each $ so exports are more expensive, thusX, M, NX, ADX. Long Run Equilibrium and the Price Level- Real GDP has been increasing; this can be shown by outward shifts in the LRAS. Due to more andbetter resources and innovation Solely supply factors (no demand)- Before 1940,we experiences a # of periods of continuing deflation. How can we explain this?o Falling average price leveloXI. Long Run Equilibrium- Pl = GDP Deflator = Nominal / Real X 100- For the economy as a whole, long run equilibrium occurs at the price level where the aggregate demand curve (AD) intersects the long-run aggregate supply curve (LRAS)- Meaning that equilibrium, o Planned expenditures = planned production (RGDP)- If AD > LRARS then prices are too low, inventories would be depleted, prices would rise until Planned Expenditures = Planned Production o Suppose P = P low- If AD < LRAS then prices are too high, inventories would pile up, prices would fall, until Planned Expenditures = Planned Production- Equilibrium long run output (Yn) is determined by supply factors (LRAS)o But the equilibrium price level and inflation is determined by both LRAS and ADXII. Using LRAS/AD to explain the change in the price level-- During the late 1800’s industrial revolution resulted in larger in production - Falling prices could be caused by economic growth cause by more


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