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Chapter 20 Aggregate Demand and Supply • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2002 South-Western College Publishing 1 What is the aggregate demand curve? The curve shows the level of real GDP purchased by households, businesses, government, and foreigners at different price levels during a time period, ceteris paribus 2 What does the horizontal axis measure? The value of final goods and services included in real GDP measured in base year dollars 3 What does the vertical axis measure? It is an index of the overall price level, such as the GDP deflator or the CPI 4 Why does the aggregate demand curve slope downward to the right? • Real balance wealth effect • Interest rate effect • Net exports effect 5 What is the real balance effect? Consumers spend more on goods and services because lower prices make their dollars more valuable 6 What is the interest rate effect? Assuming fixed credit, an increase in the price level translates through higher interest rates into a lower real GDP 7 What is the net exports effect? A higher domestic price level makes U.S. goods more expensive compared to foreign goods, exports decrease, imports increase, decreasing real GDP 8 $200 $150 $100 Price Level The Aggregate Demand Curve A B AD $50 Real GDP 2 4 6 8 10 12 9 What can cause a shift in the aggregate demand curve? Consumption, investments, government spending and net exports can change 10 150 100 50 Price Level (CPI) 200 A Shift in the Aggregate Demand Curve A B AD2 AD1 Real GDP 2 4 6 8 10 12 11 What is the aggregate supply curve? The curve that shows the level of real GDP produced at different price levels during a time period, ceteris paribus 12 Why did Keynes assume fixed product prices and wages? During a deep recession or depression, there are many idle resources in the economy 13 Why do idle resources mean fixed prices? Producers are willing to sell additional output at current prices because there is plenty of resources to go around for everyone who wants them 14 Why do idle resources mean fixed wages? The supply of unemployed workers willing to work for the prevailing wage rate diminishes the power of workers to increase their wages 15 What kind of supply curve would explain fixed prices and wages? A horizontal supply curve 16 200 150 100 50 Price Level (CPI) The Keynesian Horizontal Aggregate Supply Curve E E2 1 AD2 AD1 Real GDP 2 4 6 AS 8 10 12 17 Price level remains constant, while real GDP and employment rise Government spending (G) increases Aggregate demand increases and the economy moves from E1 to E2 18 According to Keynes, what will a shift in aggregate demand do? It will restore a depressed economy to full employment 19 150 100 50 Price Level (CPI) 200 The Keynesian Horizontal Aggregate Supply Curve full employment E E2 AS 1 AD2 AD1 Real GDP 2 4 6 8 10 12 20 What is the Classical view of the aggregate supply curve? It is a vertical line at the full employment output 21 According to the Classical economists, where does the economy normally operate? The economy normally operates at its full employment level 22 How do the Classical economists view prices and costs? The price level of products and production costs change by the same percentage in order to maintain full employment 23 200 150 100 50 Price Level (CPI) The Classical Aggregate Supply Curve Surplus AS E1 E E2 Real GDP Full employment AD1 AD2 2 4 6 8 10 12 14 16 17 24 Three Ranges of the Aggregate Supply Curve Price Level AS Classical Range Intermediate Range Keynesian Range Real GDP YK Full Employment YF 25 Increasing Demand 150 Price Level 200 AS AD6 AD5 100 Full Employment 50 Real GDP 0 2 4 6 AD2 AD1 8 AD4 AD3 10 12 26 What factors can cause a shift in the aggregate supply curve? A change in • resource prices • technology • taxes • subsidies • regulations 27 AS1 150 100 50 Price Level 200 E1 A Rightward Shift in the Aggregate Supply Curve AS2 E2 full employment AD Real GDP 2 4 6 8 10 12 14 16 17 28 Increase in the aggregate supply curve Change in one or more nonpricelevel determinants: resource prices, technological change, taxes, subsidies, and regulations 29 What are the two types of inflation? • Cost push • Demand pull 30 What is cost push inflation? A rise in the general price level resulting from an increase in the cost of production 31 200 150 100 Price Level Cost Push Inflation 50 AS2 AS1 E2 E1 full employment AD Real GDP 2 4 6 8 10 12 14 16 17 32 What is demand pull inflation? A rise in the general price level resulting from an excess of total spending 33 150 Price Level 200 Demand Pull Inflation 100 AS E2 E1 50 Real GDP full employment AD2 AD1 2 4 6 8 10 12 14 16 17 34 What determines the business cycle? Shifts in the aggregate demand and aggregate supply curves 35 Key Concepts 36 Key Concepts • What is the aggregate demand curve? • Why does the aggregate demand curve slope downward to the right? • What can cause a shift in the aggregate demand curve? • What is the aggregate supply curve? • Why did Keynes assume fixed product prices and wages? • What kind of supply curve would explain fixed prices and wages? 37 Key Concepts cont. • According to Keynes, what will a shift in aggregate demand do? • What is the Classical view of the aggregate supply curve? • According to the Classical economists, where does the economy normally operate? • What factors can cause a shift in the aggregate supply curve? • What are the two types of inflation? 38 Summary 39 The aggregate demand curve shows the level of real GDP purchased in the economy at different price levels during a period of time. 40 Reasons why the aggregate demand curve is downwardsloping include the following three effects: 41 (1) The real balances or wealth effect is the impact on real GDP caused by the inverse relationship between the purchasing power of fixed value financial assets and inflation, which causes a shift in the consumption schedule. 42 (2) The interest-rate effect assumes a fixed money supply, and, therefore, inflation increases the demand for money. As the demand for money increases, the interest rate rises, causing consumption and investment spending to fall. 43 (3) The net exports effect is the impact on real GDP caused by the inverse relationship between net exports and inflation. An increase in the U.S. price level tends to reduce U.S. exports and increase imports, and vice versa. 44 150 100 50 Price Level (CPI) 200 A Shift in the Aggregate Demand Curve A B AD2 AD1 Real GDP 2 4 6 8 10 12 45 The aggregate supply curve shows the level of real GDP that the economy will produce at different possible price levels. 46 The shape of the aggregate supply curve depends on the flexibility of prices and wages as real GDP expands and contracts. The aggregate supply curve has three ranges: 47 (1) The Keynesian range of the curve is horizontal because neither the price level nor production costs will increase when there is substantial unemployment in the economy. 48 (2) In the intermediate range, both prices and costs rise as real GDP rises toward full employment. Prices and production costs rise because of bottlenecks, the stronger bargaining power of labor, and the utilization of less productive workers and capital 49 (3) The classical range is the vertical segment of the aggregate supply curve. It coincides with the full-employment output. Because output is at its maximum, increases in aggregate demand will only cause a rise in the price level. 50 Three Ranges of the Aggregate Supply Curve Price Level AS Classical Range Intermediate Range Keynesian Range Real GDP YK Full Employment YF 51 Aggregate demand and aggregate supply analysis determines the equilibrium price level and the equilibrium real GDP by the intersection of the aggregate demand and the aggregate supply curves. 52 Stagflation exists when an economy experiences inflation and unemployment simultaneously. Holding aggregate demand constant, a decrease in aggregate supply results in the unhealthy condition of a rise in the price level and a fall in real GDP and employment. 53 Cost-push inflation is inflation that results from a decrease in the aggregate supply curve while the aggregate demand curve remains fixed. 54 Cost-push inflation is undesirable because it is accompanied by declines in both real GDP and employment. 55 150 Price Level 200 Cost Push Inflation 100 AS2 E2 AS1 full employment E1 50 AD Real GDP 2 4 6 8 10 12 14 16 17 56 Demand-pull inflation is inflation that results from an increase in the aggregate demand curve in both the classical and the intermediate ranges of the aggregate supply curve while the aggregate supply curve is fixed. 57 150 Price Level 200 Demand Pull Inflation 100 AS E2 E1 50 Real GDP full employment AD2 AD1 2 4 6 8 10 12 14 16 17 58 Chapter 20 Quiz ©2002 South-Western College Publishing 59 1. The aggregate demand curve is defined as a. the net national product. b. the sum of wages, rent, interest, and profits. c. the real GDP purchased at different possible price levels. d. the total dollar value of household expectations. C. Answers a, b, and c are not real GDP purchases at different possible price levels during a time period. 60 2. When the supply of credit is fixed, an increase in the price level stimulates the demand for credit, which, in turn, reduces consumption and investment spending. This argument is called the a. real balance effect. b. interest-rate effect. c. net exports effect. d. substitution effect. B. At a high price level, the demand for borrowed money increases and results in higher cost of borrowing (interest rates). 61 3. The real balance effect occurs because a higher price level will reduce the real value of people’s a. financial assets. b. wages. c. unpaid debt. d. physical investments. A. As price increase the dollars people receive in their paychecks and wealth are worth less. As a result, real GDP demand decreases. 62 4. The net exports effect is the inverse relationship between net exports and the _______of an economy. a. Real GDP. b. GDP deflator. c. Price level. d. Consumption spending. C. A higher domestic price level makes U.S. goods more expensive relative to foreign goods and vice versa. 63 5. Which of the following will shift the aggregate demand curve to the left? a. An increase in exports. b. An increase in investment. c. An increase in government spending. d. A decrease in government spending. D. Answers a, b, c shift the aggregate demand curve to the right. 64 6. Which of the following will not shift the aggregate demand curve to the left? a. Consumers become more optimistic about the future. b. Government spending decreases. c. Business optimism decreases.. d. Consumers become pessimistic about the future. A. Answers b, c and d shift the aggregate demand curve leftward. 65 7. The popular theory prior to the Great Depression that the economy will automatically adjust to achieve full employment is a. supply-side economics. b. Keynesian economics. c. classical economics. d. mercantilism. C. Supply-side economic concerns shifts in aggregate supply. Keynesians do not believe the economy automatically adjusts to full employment. Mercantilism is the idea that gold or silver is the source of a nation’s wealth. 66 8. Classical economists believed that the a. price system was unstable. b. goal of full employment was impossible. c. price system automatically adjusts the economy to full employment in the long run. d. government should not attempt to restore full employment. C. This is a key assumption for the vertical shape of the classical aggregate supply curve. 67 9. Which of the following is not a range on the eclectic or general view of the aggregate supply curve? a. Classical range. b. Keynesian range. c. Intermediate range. d. Monetary range. D. Answers a, b, and c are the three district ranges of the aggregate supply at a level of real GDP below full employment. 68 Three Ranges of the Aggregate Supply Curve Price Level AS Classical Range Intermediate Range Keynesian Range Real GDP YK full employment YF 69 10. Macroeconomic equilibrium occurs when a. aggregate supply exceeds aggregate demand. b. the economy is at full employment. c. aggregate demand equals aggregate supply. d. aggregate demand equals the average price level. C. Note that aggregate demand can equal aggregate supply at a level of real GDP below full employment. 70 11. Along the classical or vertical range of the aggregate supply curve, a decrease in the aggregate demand curve will decrease a. both the price level and real GDP. b. only real GDP. c. only the price level. d. real GDP and the price level. C. Along the vertical range of the aggregate supply curve, the economy is at full employment and only the price level changes. 71 12. Other factors held constant, a decrease in resource prices will shift the aggregate a. demand curve leftward. b. demand curve rightward. c. supply curve leftward. d. supply curve rightward. D. Changes in production costs do not affect the aggregate demand curve. 72 13. Assuming a fixed aggregate demand curve, a leftward shift in the aggregate supply curve causes a (an) a. increase in the price level and a decrease in real GDP. b. increase in the price level and an increase in real GDP. c. decrease in the price level and a decrease in real GDP. d. decrease in the price level and an increase in real GDP. A. 73 200 150 Price Level Cost Push Inflation AS2 AS1 E2 full employment E1 100 50 AD Real GDP 2 4 6 8 10 12 14 16 17 74 14. An increase in the price level caused by a rightward shift of the aggregate demand curve is called a. cost-push inflation. b. supply shock inflation. c. demand shock inflation. d. demand-pull inflation. D. 75 150 Price Level 200 Demand Pull Inflation AS E2 E1 100 50 Real GDP full employment AD2 AD1 2 4 6 8 10 12 14 16 17 76 15. Suppose workers become pessimistic about their future employment, which causes them to save more and spend less. If the economy is on the intermediate range of the aggregate supply curve, then a. both real GDP and the price level will fall. b. real GDP will fall and the price level will rise. c. real GDP will rise and the price level will fall. d. both real GDP and the price level will rise. A. A leftward movement of the aggregate demand curve along a downward sloping aggregate supply curve will result in lower prices and 77 less employment. END 78