ECON 102 Lecture Notes - Lecture 23: Aggregate Demand, Autonomous Consumption, Root Mean Square

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Chapter23! output and prices in the short run! An increase in price reduces the real value of money(a fall in p raises the real value of money)! Changes in p also affect the wealth of bondholders and bond issuers. If p increases, the repayment to bondholders (lenders) is lower in real value. So bond issuers (borrowers) gain and lenders lose. An increase in p , reduces private-sector wealth and as a result: reduces desired consumption and shifts ae curve downwards ! Changes in p also affect net exports. higher domestic prices means domestic goods will be more expensive for the foreigners(and net exports fall). The aggregate demand (ad) curve relates equilibrium real gdp to the price level! For any given p, the ad curve shows the level of real gdp for which desired ae equals actual gdp (where ae curve and 450 line intersect).

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MBA502, Economics for Business

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You are responsible for economic policymaking in your country. Your desire is to eliminate inflation, keeping prices absolutely stable at P = 100, no matter what happens to output. Currently, the economy is in equilibrium at Q = 3200 (where Q = potential GDP) and P = 100. You can use monetary and fiscal policies to affect aggregate demand but you cannot affect aggregate supply in the short run. How would you respond to the following scenarios?

Explain and illustrate how each of these events would affect aggregate demand, aggregate supply, and prices, then explain how you would respond with economic policies.

1. A surprise increase in investment spending

In the short run, when investment spending increases, it results in an increase in Aggregate Demand (AD), which in turn pushes up both GPD and the price index.

To counterbalance this development, government might pursue contractionary fiscal policy by increasing taxes (to reduce consumption) or decreasing its own investment and spending so that the AD curve shifts back to its original position. Alternatively, the government can pursue contractionary monetary policy by reducing money supply and increasing interest rate to discourage economic activity.

2. Catastrophic floods that cause a sharp food price increase

In this case, sharp food shortages and consequent price increases cause a shock-type adjustment of the aggregate supply curve (it shift up and to the left). The result is a lower GDP and a higher price level.

The government cannot do anything to adjust AS in the short run. However, if the goal is to maintain the price level constant, the government can decide to do something to decrease the aggregate demand to force prices to come down, though it will be accompanies by another contraction in GDP and so it would not be a smart thing to do.

To cause AD to decrease, the government, similar to example above, can pursue fiscal policy (increase taxes, decrease spending) or monetary policy (reduce supply of money to the economy and thus increase interest rates).

3. A productivity decline that reduces potential output

In this case, AS shifts to the left, as was the case in example 2. As a result, price levels go up, as the same amount of money is chasing the reduced amount of goods and services, and GDP declines.

Government remedies here would be centered about causing AD to decrease through contractionary fiscal (higher taxes, lower spending) or monetary (reduce money supply and increase interest rates) policy. Again, this decision reduces inflation but at expense of GDP, as real output shrinks further.

4. A deep depression in East Asia that causes a sharp decrease in net exports to the United States

A decrease in exports of goods to from the United States to Asia will mean that the aggregate demand (which includes net exports

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In the AD-AS model, stagflation does not persist, because the working of the self-correcting mechanism of the economy _____ the level of output and _____ the price level until the economy eventually returns to a long-run equilibrium state, where actual output _____ potential output.

	decreases; decreases; falls short of
	increases; decreases; equals
	decreases; increases; exceeds
	decreases; increases; equals
	increases; decreases; exceeds

The LRAS curve is drawn as a vertical line at potential output (Y*) to indicate that

	Y* is independent of the price level and that actual output Y > Y* in the long run
	Y* equals actual output (Y) in the long run
	Y* is independent of the price level and that actual output Y = Y* in the long run
	Y* is independent of the price level
	Y* is independent of the price level and that actual output Y < Y* in the long run

Stagflation arises in the context of the AD-AS model when some external factor causes

	the LRAS curve to shift to the right
	the AD curve to shift leftwards
	the SRAS curve to shift downwards
	the SRAS curve to shift upwards
	the AD curve to shift rightwards

If the SRAS curve is positively sloped, then a decrease in the demand for Canadian-made goods in Europe will lead to _____ in the price level, in the short run.

	either an increase or a decrease
	no change
	an increase
	a decrease
	an initial increase, and then a decrease

Which of the following will shift the aggregate demand curve to the right?

	Consumers become pessimistic about the future
	A new technology is developed that will increase profits
	Income taxes are raised
	Foreign economies fall into recession, reducing their demand for domestic exports
	The government reduces purchases to balance the budget

Suppose a stock market crash decreases the stock of household wealth and therefore causes autonomous consumption to fall. Which of the following is the likely result?

	A leftward shift the AD curve
	There will be no movement of the AD curve
	A movement down the AD curve
	A movement up the AD curve
	A rightward of the shift the AD curve

An economy is characterized by the AD equation P = 200 ? 0.02Y, SRAS equation P = 100 and LRAS equation Y* = 5000. In the absence of any change in policy or exogenous shocks, this economy will achieve a long-run price level of

	100
	110
	120
	90
	105

The AD-AS model depicts a self-correcting economy. This means that the price level in the model adjusts automatically in response to a(n) _____ gap, so as to eliminate the _____ gap in the long run, without requiring any help from government policies.

	recessionary; recessionary
	recessionary; expansionary
	expansionary; expansionary
	output; output
	expansionary; recessionary

The aggregate demand curve shows

	the amount of planned aggregate expenditure (and output) at the current price level
	the amount of planned aggregate expenditure (and output) at an average price level
	the amount of planned aggregate expenditure (and output) at a constant price level
	the amount of planned aggregate expenditure (and output) at various price levels
	the amount of planned aggregate expenditure (and output) at last year's price level

Consider an economy initially at long-run equilibrium with output (Y) equal to potential output (Y*). If the SRAS is positively sloped, then a shift to the right of the AD curve will lead to _____ in the price level, in the short run. In the long run, the SRAS curve will shift to the _____ and the equilibrium will be at __________.

	an increase; left; Y = Y*
	a decrease; right; Y > Y*
	an increase; right; Y = Y*
	a decrease; left; Y > Y*
	no change; left; Y = Y*

1. According to the Solow model, an increase in the capital-labor ratio will a. always increase steady state consumption per worker b. reduce steady state consumption per worker if the capital-labor ratio is below the Golden rule capital stock c. always reduce steady state consumption per worker d. increase steady state consumption per worker if the capital-labor ratio is below the Golden rule capital stock

2. In a steady state a. capital and labor, by definition, are inversely related to one another b. both consumption per worker and the capital-labor ratio are constant c. consumption per worker can change, but the capital-labor ratio is constant d. consumption per worker is constant, but the capital-labor ratio can change

3. Which of the following changes would lead, according to the Solow model, to a higher level of long-run output per worker? a. An increase in the saving rate b. A lower level of capital per worker c. A decrease in productivity d. A rise in the rate of population growth

4. In the long run, a reduction in productivity will cause a. an increase in the capital-labor ratio and a decrease in consumption per worker b. a decrease in the capital-labor ratio and a decrease in consumption per worker c. a decrease in the capital-labor ratio and an increase in consumption per worker d. an increase in the capital-labor ratio and an increase in consumption per worker

5. An increase in the growth rate of population in a steady-state economy would cause a. a pivot down and to the right in the investment line b. a parallel shift downward in the investment line c. a pivot up and to the left in the investment line d. a parallel shift upward in the investment line 1 2

6. In the efficiency wage model, an increase in productivity would a. have no effect on either output or the real wage b. increase output but have no effect on the real wage c. decrease the real wage but have no effect on output d. increase output but decrease the real wage

7. Keynesian economists believe that in the short run, a. money neutrality does not exist and prices adjust rapidly b. money neutrality does not exist and prices do not adjust rapidly c. money neutrality exists and prices adjust rapidly d. money neutrality exists and prices do not adjust rapidly

8. If the expected inflation rate is unchanged, a fall in the natural rate of unemployment would a. not shift the Phillips curve b. shift the Phillips curve to the left c. shift the Phillips curve to the right d. shift the Phillips curve to the left and shift the long-run Phillips curve to the right

9. Classical economists believe that in the short run, a. money neutrality does not exist and prices adjust rapidly b. money neutrality does not exist and prices do not adjust rapidly c. money neutrality exists and prices do not adjust rapidly d. money neutrality exists and prices adjust rapidly

10. The fact that the long-run Phillips curve is vertical implies that a. money canât affect inflation in the long run b. money is neutral in the long run c. monetary policy canât affect unemployment d. there is a natural rate of inflation

1. Briefly explain the shape of the per-worker production curve in the Solow model. If investment per worker initially exceeds saving per worker, how is the steady state capital-labor ratio achieved?

2. Describe the effects of a rise in the domestic real interest rate on the exchange rate and on both domestic and foreign net exports.

3. For each of the following changes, what happens to the real interest rate and output in the short run, before the price level has adjusted to restore general equilibrium? a. Wealth declines b. Money supply declines c. The future marginal productivity of capital declines d. Expected inflation rises e. Future income rises

ECON 102 Lecture Notes - Lecture 23: Aggregate Demand, Autonomous Consumption, Root Mean Square

ECON 102 Full Course Notes

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