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Study Guide ECON 301 Intermediate Macroeconomics Aggregate Demand, Aggregate Supply, Short Run and Medium Run Every statement on this Study Guide is TRUE (as far as I can tell). In the Quiz, you will have a bunch of True/False questions. See the longer study guide for tons of examples of seemingly‐true statements that are false. Aggregate Demand 1. To obtain the Aggregate Demand curve, we find the level of output that yields equilibrium in the money market (LM curve) and the goods market (IS curve) simultaneously, and then allow actual inflation ( ) to change exogenously to yield different levels of equilibrium output. The resulting inflation‐output combinations are graphed as the AD curve. 2. The aggregate demand curve is a relation between the inflation rate and output demanded: higher inflation, for a given rate of growth of nominal money supply, pushes down the real money supply, increases interest rates, reduces investment and output demanded, so that the AD curve is downward sloping. 3. The aggregate demand curve shifts to the left when money supply falls (if inflation is unchanged) because in that case the real money supply falls, raising interest rates, and lowering investment and output. 4. Any increase in spending that is not caused by changes in inflation shifts the AD curve to the right. 5. A reduction in any variable, other than inflation, that shifts the IS or LM curves to the left causes a shift of the AD curve to the left. 6. Lower inflation causes the LM curve to shift down (because the real money supply expands), raising output and lowering interest rates. Aggregate Supply 1. To derive the aggregate supply curve, we find the combinations of output and inflation that make workers’ decisions consistent with firms’ decisions, resulting in labor‐market equilibrium. True, False, or Uncertain? Explain with words and graphs 2. The aggregate supply curve is a relation between output and inflation: higher output reduces unemployment, which allows workers to demand faster raises – at a given expected inflation rate. Higher wages means higher costs of production, which raises inflation. 3. Because the AS curve has to go through the ,
point, higher expected inflation raises inflation at any level of output, which is represented as a shift up of the AS curve. The Short Run 1. In the short run, the AS curve must go through the ,
point. 2. Short‐run equilibrium is determined by the combination of the inflation rate and the level of output that is consistent with simultaneous money‐market equilibrium, goods‐market equilibrium, and labor‐market equilibrium. 3. If the economy is in short‐run equilibrium, it is where both the AD and the AS curves intersect; ,
this may happen away from the 4. If in short‐run equilibrium point or at the ,
, then it must be true that point. . The Medium Run 1. All three markets (goods, money, and labor) must be in equilibrium both in the short run and in the medium run. 2. If the economy is in medium‐run equilibrium, it is where both the AD and the AS curves intersect, at the ,
point. 3. The medium run is defined as the time when expected inflation has fully adjusted, and is now equal to actual inflation. 4. The medium run is defined as the time when actual output equal to the natural level of output. 5. The economy may be away from its medium‐run equilibrium for a while because expected inflation rates take a while to adjust; but adjustments in the expected inflation rate bring output back to the natural level of output. True, False, or Uncertain? Explain with words and graphs The Opening of an Output Gap 1. If AD shifts left, output will fall, leading to lower inflation. 2. If AS shifts left, output will fall, leading to higher inflation. 3. Suppose the economy starts from the ,
point. A leftward shift of either AD or AS opens a recessionary output gap, which means higher inflation if it is AS that shifted, and lower inflation if it is AD that shifted. 4. A monetary expansion raises equilibrium output in the short run. Because this is represented by a shift of the AD curve, the economy moves along the AS curve (higher output, lower unemployment, demands for larger wage raises, higher inflation). Higher inflation (shift up of the LM curve) counteracts the effect of the monetary expansion (larger shift down of the LM curve), but not fully, so that real money supply increases in the short‐run (net shift down of the LM curve), but by less than the increase in nominal money supply. 5. Suppose the economy starts from the ,
point. A shock that increases expected inflation (and changes nothing else) leads to lower output. In the short‐run, inflation rises, but by less than expected inflation. 6. Suppose the economy starts from the ,
point. A shock that increases the natural level of output (and changes nothing else) leads to lower inflation. In the short‐run, output rises, but by less than the increase in the natural level of output, so that . Adjustment to the Medium Run 1. If the economy’s short‐run equilibrium is away from the ,
point, medium‐run equilibrium will be restored by gradual adjustments in the expected inflation rate. 2. If the short‐run equilibrium inflation rate is below the expected inflation rate medium‐run equilibrium will be restored when the expected inflation rate falls. True, False, or Uncertain? Explain with words and graphs , , 3. If the short‐run equilibrium inflation rate is below the expected inflation rate equilibrium output will rise on its way back to medium‐run equilibrium. 4. If short‐run equilibrium output is above the natural level of output , then it must be true that the short‐run equilibrium inflation rate is above the expected inflation rate , so that expected inflation will rise on its way back to medium‐run equilibrium. Because the AS curve has to go through the ,
point, higher raises inflation. 5. If short‐run equilibrium output is below the natural level of output , then it must be true that the short‐run equilibrium inflation rate is below the expected inflation rate , so that expected inflation will fall on its way back to medium‐run equilibrium. Because the AS curve has to go through the 6. If ,
point, lower lowers inflation. , unemployment will encourage workers to accept smaller raises, which allows firms to pass on smaller price increases to consumers: inflation will be below expected inflation . Eventually, expected inflation will fall as workers revise their expectations. As expected inflation falls, workers accept smaller raises (of their wages and salaries), which allows firms to lower the inflation rate (the rate of their price increases). Lower inflation makes the real money supply larger (for any constant monetary policy), so that investment and expenditure rise: output rises. Expected inflation will keep falling as long as , raising output. The process continues until the natural level of output is reached. At this point, and the economy is in medium‐run equilibrium. Medium‐Run Effects of Shocks 1. In the medium‐run, inflation rises to fully offset a monetary expansion: comparing the initial point and the final medium‐run position, there is no change in real money supply, interest rates, output, or the components of expenditure. The only medium‐run effect of a monetary True, False, or Uncertain? Explain with words and graphs expansion (a shift right of the LM curve) is higher inflation (an identical shift left of the LM curve). 2. In the medium‐run, inflation rises to offset a fiscal expansion (a shift right of the IS curve), but comparing the initial point and the final medium‐run position, inflation rises and so real money supply falls (a shift left of the LM curve). The result is that, interest rates rise but output does not change, so that there is less investment in the medium‐run after a fiscal expansion. 3. There is no medium‐run effect of a shock to expected inflation on any variable (there is a short‐
run effect, however). For example, a decrease in expected inflation lowers inflation, causing expenditure to rise and opening an expansionary output gap. Higher output in the short run causes unemployment to fall below the natural rate of unemployment, so that inflation does not fall as much as expected inflation. In the transition to the medium run, expected inflation begins to rise (as workers realize inflation is higher than expected). Since a shock to expected inflation does not change any real (physical) variable, medium‐run equilibrium is regained when expected inflation returns to the original. 4. After an increase in production costs that reduces the natural level of output, inflation rises for any level of actual output. This contracts the real money supply, expenditure, and output, so that inflation does not rise by as much. As expected inflation adjusts upward to catch up with actual inflation, output keeps falling until its equal to the new, lower, level of natural output. True, False, or Uncertain? Explain with words and graphs