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1. Define AD & AS. AD – AQD [RGDP] desired by the private, public, & foreign sector at various PLs [inverse] [Everyone’s demand for everything] AS – AQS [RGDP] firms will supply at various PLs [direct] 2. Three reasons for the down-sloping AD curve a. interest rate effect b. real-balances effect c. foreign purchase effect 3. Know the three ranges of the AS curve. 4. Predict effects of an increase in AD in Keynesian, intermediate, & classical ranges. 5. Predict effects of an increase/decrease in AS on output and price level. 6. Know the four AD shifters [C+Ig+G+Xn]. 7. Know the three AS shifters [“REP”]. 8. Explain the ratchet effect of a decrease in AD. 9. Compare the Classical/Keynesian Schools of Economics. [Demand (AD) for everything by everyone] or [Amount of goods & services that will be demanded at various price levels by the private, public, and foreign sectors] [AQD will be greater at lower price levels] [amount of goods and services that will be produced by firms at various price levels] [AQS will be greater at higher price levels] Aggregation – combining all prices into a single aggregate price level and – combining all quantities into aggregate quantities [AQS or real GDP] Price Level ADCIG-XnLRAS SRAS [REP] [Production cost] PLe Ye RDO [Real Domestic Output] [C+Ig+G+Xn] When one of these variables change, either positively or negatively, the AD curve will move right or left. Caused by a “Change in PL” Macro Law of Demand [Inverse] AD PL1 Macro Law of Supply [DIRECT ] AS PL1 PL2 PL2 AQS2 AQS1 AQD2 AQD1 AQD or AQS is a point on the AD or AS curve [particular PL] AD or AS is the whole curve and represents all price levels. [Bunch of AQDS or AQS strung together on the same curve] AD PL1 PL2 PL AQD AQD1 AQD2 There go some of my profits! AS PL1 PL2 [DIRECT] AQS2 AQS1 AS PL2 PL1 [DIRECT ] AQS1 AQS2 PL CIG-X AD Shifters [C+Ig+G+Xn] Consumption Investment (gross) Government Spending [infrastructure, military spending, health care] Net eXports Y indicates 3 things: 1. Output[GDP] 2. Income 3. Unemployment YR – Recession gap YI – Inflation gap Y* – Full Employ. LRASSRAS2 SRAS1 AD 2 AD1 SRAS2 AD2 AS Shifters [REP] Resource cost Environment 103 YR Y* YI [legal-institutional] RGDP Aggregation – we are combining all prices into price level & combining all quantities into Real GDP(Y). 1. Subsidies, 2. Business taxes, 3. Business regs. Productivity Don’t confuse FE output with the economy’s maximum output, which is the larger output that would be produced if everyone were forced to work as much as possible. Price Level ADCIG-XnLRAS SRAS [REP] [Production cost] PLe Ye RDO [Real Domestic Output] [C+Ig+G+Xn] When one of these variables change, either positively or negatively, the AD curve will move right or left. • Short-Run – Period of time where input prices [wages] are sticky and do not adjust to changes in the PL – In the short-run, the level of Real GDP supplied is directly related to the PL • Long-Run – Period of time where input prices [wages] are completely flexible and adjust to changes in the PL – In the long-run, the level of Real GDP supplied is independent of the PL [caused by “C+Ig+G+Xn”] AD1 AD2 LRAS SRAS Increase in AD Price Level 1. Increase in Consumption 2. Increase in Investment 3. Increase in Gov. spending A. On military spending B. On the infrastructure C. On health care 4. Increase in Net exports [Xn] A. Dollar depreciates B. Trade partners Y’s rise YR YF Real Domestic Output, RGDP [caused by “C+Ig+G+Xn”] AD2 AD1 LRAS SRAS Price Level Decrease in AD 1. Decrease in Consumption 2. Decrease in Investment 3. Decrease in Gov. spending A. On military spending B. On the infrastructure C. On health care 4. Decrease in Net exports [Xn] A. Dollar appreciates B. Trade partners Y’s fall YR YF Real Domestic Output, GDP The amounts of real output that buyers [householders, businesses, government, & foreigners] desire to purchase at each possible price level. Or, the “demand for everything by everyone”. AD curve is downsloping due to: •Real Wealth [Money-balances] Effect [monthly flow of money and stock of accumulated savings balances like bonds & CDs “really” buy more] •Interest-Rate Effect - businesses invest more •Foreign Purchases Effect - foreigners buy more AD PL1 PL2 AQD1 AQD2 [There is no income or substitution effect.] [You can’t substitute for the whole economy] Macro Law of Demand [cause] [effect] PL decr; AQD incr. PL incr; AQD decr. “AD” refers to whole curve. “AQD” is a pt on the curve based on a particular PL. AD Reasons For Downsloping “AD” Curve [if PL decreases, this happens] 1. Interest Rate Effect – more Ig 2. Real Wealth Effect – more “C” 3. Foreign Purchase Effect - foreigners buy more PL1 Change in AQD PL AQD 1. Price Level change 2. Movement [up or down the AD curve 3. Pt to pt [along the AD curve] PL2 Inverse relationship 2 AQD 1 AQDcurve”. “AD” refers to the “whole [“all PLs”] “AQD” refers to a “point on the curve” based on a “particular price level.” C Consumption Mariah Carey Concert 1. “Non price Level” change-either C, Ig, G, or Xn 2. “Whole AD curve” shifts [There is a change in AQD but it is not caused by a change in price level.] AD2 AD 1 AD3 Ig G PL Let there be more military weapons XN Chevy Ferrari [Exports-Imports] AQD3 AQD1 AQD2 RDO AD1 AD2 PL Change in Consumer Spending Consumer Wealth [increases/decreases] [stocks/houses] [stable prices] Consumer Expectations [about future prices (increases/decreases) Consumer Expectations about future income [positive/negative] Consumer Indebtedness [low/high] Personal Taxes [increase/decrease] Real Interest Rate [stable prices] [increase/decrease] High Debt Change in Investment Spending Real Interest Rates [stable prices] [increase/decrease] [Positive/Negative] Profit Returns [Business taxes [increase/decrease] [Depleted/Excess] inventory stockpiles in the supply chain [continued] Government Spending [purchases] [either [increases/decreases] on [infrastructure, military, health care, etc.] Net Export Spending AD1 AD2 • National Income Abroad [either increases or decreases] PL • Exchange Rates [Depreciation-increases AD; Appreciation-decreases AD] More Exports Fewer Exports [Our products are cheaper] [Our products are more expensive] PL LRAS SRAS AD 103 Y* Real GDP 6% • While it may appear contradictory to talk about producing beyond the economy’s potential, remember that potential output does not mean zero unemployment. • Rather, it means that the actual unemployment rate equals the natural rate of unemployment, approximately 94%-96% of the labor force working. That is, even in an economy producing its potential output, there is some unemployed labor & unused production capacity. Potential GDP can be thought of as the economy’s normal capacity. LRAS SRAS PL2(106) AD1 AD2 AD3 PL1(103) PL3(100) YR Y*F Yi YA YP YA 9% 6% 3% Firms and workers are able, in the short run, to push output beyond the economy’s potential. *In the LR, the level of RGDP supplied is independent of PL. *In the SR, the level of RGDP supplied is dependent of PL. AD1 Price Level AD3 PL AQD SRAS AD2 CIG-X Surplus Shortage AQD Raise PL Y3 Y Y2 Real Domestic Output “AS” refers to the “whole AS curve” & refers to “all price levels” “AQS” refers to a “point on the AS curve” & refers to a “particular price level” Change in “AQS” PL2 1. Price Level change 2. Movement (up/down) “AS” curve) 3. Point to point (along “AS” curve) AS PL1 AQS1 AQS2 Reasons For Upsloping “AS” Curve 1. There is increasing opportunity cost if firms don’t produce. 2. Current producers produce more [overtime/more shifts] 3. New producers are attracted to the market. Change in AS 1. “Non price level change”. Either R,Anything E, or P that lowers 2. “Whole AS curve” shifts. the cost of production 3. AQS changes but is not caused bywill a change PLright. shift in AS AS Shifters(REP) 1. Resource cost 2. Environment [legal-institutional Increase in environment for businesses change, the affecting availability of Resources production costs [subsidies, bus. taxes, regulations] 3. Productivity PL 1. Lower business taxes 2. Decrease in regulations 3. AS3 AS1 AS2 So – AS Shifters are REP You save money. We don’t require dental or medical insurance. You don’t have to pay us a pension and we don’t take sick days. And – we can dance. Increase in subsidies Environment [Legal-institutional] AQS3 AQS1 AQS2 Increase in Productivity [Recessionary Gap, Inflationary Gap, or no gap] AD1 110 LRASSRAS AD3 103 101 AD2 Recess Gap Inflat Gap [5%(“real”) cyclical unemployment] 10% (5x2%=10%) Recess. GDP Gap SR – output [product] 11% 6% 1% [10%(5x2%) Inflationary GDP Gap YR Y* YI YA YP YA $10 $11 $9 increase/decrease prices but input [wages] prices remain fixed in the presence of unanticipated inflation/disinflation [“sticky”] LR – both output [product] and input [wages] prices change. [caused by “REP”] Decrease in AS [“REP”] Resource Cost 1. Increase in resource cost AD SRAS3SRAS LRAS 1 SRAS2 Environment [legal-institutional] PL 2. Decrease in subsidies 3. Increase in bus. regulations 4. Increase in business taxes Productivity 5. Decrease in productivity Increase in AS [“REP”] Resource Cost 1. Decrease in resource price Environment [legal-inst.] Regulations place compliance costs on 2. Increase in subsidies businesses and reduce the SRAS. 3. Decrease RGDP in bus. regs. Real Domestic Output, RGDP Ex: To reduce sulfur dioxide emissions, factories 4. Decrease in bus. taxes have to pay for smokestack scrubbers which Productivity 5. Increase in productivity mean less money to increase output. AD SRAS2 SRAS1 PL2 PL1 Shortage Y2 Y 1 Real GDP AD SRAS1 SRAS2 PL1 Increase in Productivity Surplus PL2 Y2 Y2 Real GDP A 1% increase in productivity can eliminate 1.2 million jobs. LRAS Price Level SRAS AD2 AD PL2[106] [Production cost] E2 What if we have unanticipated inflation? What happens in SR to output, employment, and price level? PL1[103] Y YI RGDP Price Level PL2[106] LRAS AD2 AD E3 SRAS2 SRAS1 [Production cost] PL1[103] With unanticipated inflation what happens to output, employment and price level in the LR? RGDP Y There is a Short Run Equilibrium [AD=SRAS] and a Long Run Equilibrium [AD = LRAS]. LRAS Price Level AD1 SRAS [Production cost] With unanticipated disinflation, what happens to output, employment, and price level in the SR? AD2 PL1[103] PL3[101] E2 YR Y RGDP LRAS AD SRAS1 [Production cost] SRAS2 PL1[103] PL3[101] E3 Y With unanticipated disinflation, what happens to output, employment, and price level in the LR? RGDP LRAS AD SRAS The LRAS curve is not influenced by PL. 103 PL Output at Full Employment The SRAS curve is influenced by PL and slopes upward because of sticky-wages and sticky-prices. Y* Quantity of Output LRAS Price Level SRAS AD1 AD2 PLe Surplus PL2 YR Ye Quantity of Output [Stagflation] Price Level AD LRAS SRAS2 SRAS 1 110 This created cognitive dissonance among many. Ple[103] 10% 6% YR YF RDO 1. The process of combining all individual product prices and quantities into a single unit is (deduction/conglomeration/aggregation). 2. The AD curve shows the amount of (real/nominal) domestic output which will be purchased at each possible (price/price level). 3. The AD curve is always (up/down) sloping & shows a(an) (direct/inverse) relationship between output & (price/price level). 4. The income & substitution effects (do/do not) apply to the AD curve. The 3 explanations for the downsloping AD curve are the interest rate effect, foreign purchase effect, & (econ/real-balances) effect. AD Change in AQD Price Level Change Point to Point movements PL1 PL AQD PL2 AQD1 AQD2 AD PL1 Real Wealth [Money-balances] Effect – PL2 economy’s monetary wealth. If we buy QD1 QD2 a fixed bundle of goods & services every month (food/clothing/ shelter), at lower prices, it now takes less money. money. Our accumulated savings balances [401k, CDs, bonds] will purchase more. Market Basket Interest Rate Effect – lower interest rates increase investment and consumption. Foreign Purchase Effect – with lower U.S. prices, both Americans & foreigners buy more American goods. 5. The interest rate effect suggests that an increase in the PL will (incr/decr) the demand for money, (incr/decr) interest rates and (increase/decrease) consumption and investment which would cause a(an) (increase/decrease) in (AD/AQD). 6. The real-balances effect indicates a higher price level will (increase/decrease) the real value of money, (increase/decrease) consumption, and therefore (increase/decrease) (AD/AQD). 7. The foreign purchase effect suggests that an increase in PL relative to other countries (increase/decrease) our exports and (incr/decr) our imports which would (incr/decr) (AD/AQD). AD PL2 PL1 Lower PL Higher PL AQD2 AQD1 AD1 110 SRAS2 SRAS SRAS3 LRAS AD3 AD2 103 101 Recess Gap [5%(“real”) cyclical unemployment] 10% (5x2%=10%) Recess. GDP Gap 11% YR YA $9 Inflat Gap 6% Y* YP $10 1% [10%(5x2%) Inflationary GDP Gap YI YA $11 Input prices have responded to unanticipated changes in output prices in LR. [They respond to unanticipated inflation or disinflation. Two sets of prices are changing in LR - output and input. [C+Ig+G+Xn] Consumer Spending Increases AS 1. Aggregate wealth increases independent of PL [stocks, bonds, land, houses, etc.] 2. 3. 4. 5. Expectations of surging future inflation Consumer indebtedness is fairly low Consumer taxes are decreased PL Interest rates are decreased [independent of PL] Investment Spending Increases 1. 2. 3. 4. AD1 AD2 Y1 Y2 Interest rates are decreased [independent of PL] Positive profit expectations Factory inventories are down 100 Bases May *Business taxes are reduced [*will also shift AS]Face Closure Government Spending Increases Military base cuts Government spending increases on health care, would start in 2010. Health care, infrastruc., military military bases, infrastructure, etc. 100 of the nation’s 425 bases would be Net Export Spending Increases 1. Foreign incomes increase [will buy more there andclosed, here] saving over $75 billion annually. 2. Dollar depreciates [our exports are cheaper] Resource Cost Decrease (domestic) 1. Land – new raw materials (oil) are found. 2. Labor–labor force increases or wages decrease. 3. Capital stock or entrepreneurial ability increases. 4. The number of sellers of resources increase. AD AS1 AS2 PL1 PL2 Resource Cost Decrease (overseas) 1. Imported resources decrease in price. 2. Dollar appreciates [foreign inputs are cheaper]. 3. OPEC nations cheat by producing more oil. Environment [Legal-Institutional Environment for businesses change] 1. Subsidies are increased. 2. Regulations on businesses are decreased. 3. *Business taxes decrease. Productivity Increases Technological breakthrough leads to an increase in productivity [more outputs from same inputs]. *Notice that a decrease in business taxes increases both AD & AS. Y1 Y2 Change in AS 1. “Non price level change”. Either R, Anything E, or P that lowers 2. “Whole AS curve” shifts. the cost of production shiftinAS 3. AQS changes but is not caused by will a change PL right. AS Shifters(REP) 1. Resource cost 2. Environment [legal-institutional environment for businesses change, Increase in the affecting availability of Resources production costs. [subsidies, bus. taxes, regulations] 3. Productivity PL 1. Lower business taxes 2. Decrease in regulations 3. AS3 AS1 AS2 So – AS Shifters are REP You save money. We don’t require dental or medical insurance. You don’t have to pay us a pension and we don’t take sick days. And – we can dance. Increase in subsidies Environment [Legal-institutional] AQS3 AQS1 AQS2 Productivity increase Increase in AD [caused by “C+Ig+G+Xn”] Increase in AD 1. Increase in Consumption a. aggregate wealth increases AD1 b. expected increase in inflation AD2 LRAS c. positive future income Price Level d. low consumer debt e. decrease in consumer taxes f. decrease in interest rates 2. Increase in Investment a. decrease in interest rates b. positive profit expectations c. inventories are low d. *business taxes are reduced 3. Increase in Government spending a. on the military b. on the infrastructure c. on health care 4. Increase in Net exports [Xn] A. Dollar depreciates B. Trade partners incomes rise YR YF Real Domestic Output, GDP SRAS Decrease in AD [caused by “C+Ig+G+Xn”] Decrease in AD 1. Decrease in Consumption a. aggregate wealth decreases AD2 b. expected decrease in inflation AD1 LRAS c. negative future income Price Level d. large consumer debt e. increase in consumer taxes f. increase in interest rates 2. Decrease in Investment a. increase in interest rates b. negative profit expectations c. excess inventories d. *business taxes are increased 3. Decrease in Government spending a. on the military b. on the infrastructure c. on health care 4. Decrease in Net exports [Xn] A. Dollar appreciates B. Trade partners incomes fall YR YF Real Domestic Output, GDP SRAS Increase in AS [caused by “REP”] Increase in AS [“REP”] AD Resource Cost [domestic] a. More land, labor, capital & entrepreneurs b. # of sellers increase c. Hiring fewer union PL workers Resource Cost [overseas] c. Imported input prices decrease d. Dollar appreciates Environment [legal-institutional] a. Increase in subsidies b. Decrease in bus. regulations c. *Decrease in business taxes Productivity Increase in productivity AS1 AS2 RGDP Decrease in AS [caused by “REP”] Decrease in AS [“REP”] Resource Cost [domestic] AD AS3 AS1 a. Land, labor, & capital become more scarce b. Hiring more union workers c. Number of sellers decrease PL Resource Cost [overseas] c. Imported input prices increase d. Dollar depreciates Environment [legal-institutional] a. Decrease in subsidies b. Increase in bus. regulations c. *Increase in business taxes Productivity Decrease in productivity RGDP 2 2 2 2 [“REP”] D ___33. Decrease in the availability of key natural resources (R)? C ___34. Increase in resource productivity (P)? A ___35. Increase in foreign spending on our products (Xn)? B ___36. Substantial reduction in government spending (G)? C ___37. Declines in the prices of imported resources (R)? B ___38. Declines in the incomes of our trading partners (Xn)? A ___39. Improvement in business profit expectations (Ig)? B ___40. Stock market plunge affects consumer wealth (C)? B ___41. There is an increase in interest rates [stable prices] (C & Ig)? A ___42. Consumer indebtedness is very low (C)? Extra: D ___43. Increased government regulations are forced on businesses (E)? C ___44. The government increases subsidies to all farmers (E)? Points of Emphasis for AD/AS Questions 1. Wages (labor), this is resource cost, so AS shifter. 2. Increase/decrease in union workers hired – they get paid more – so labor, so AS shifter. 3. Appreciation/depreciation of a currency [either AD or AS] a. Resource cost is part of REP, so it is AS shifter. b. Exports are part of C+Ig+G+Xn, so it is AD shifter. 4. Regulations and subsidies [legal-institutional Environment], part of REP, so they are AS shifters. 5. For all C+Ig+G+Xn, does the situation result in an increase or decrease in AD & therefore GDP? 6. For REP, think of production costs – if producers make more money, there is an increase in AS, if producers make less money – there is a decrease in AS.