Aggregate Demand and Aggregate Supply Read Chapter 7 pages 145-165

1. Aggregate Demand and Aggregate Supply Read Chapter 7 pages 145-165 I Aggregate Demand A) Basic definitions • Aggregate demand is the relationship between the total quantity of goods and services demanded and the price level, all other determinants of spending unchanged. 2) The aggregate demand curve is a graphical representation of aggregate demand.

3. B) The slope of the aggregate demand curve is negative. This reflects the following effects. • The wealth effect is the tendency for a change in the price level to affect real wealth and thus alter consumption. • The interest rate effect is the tendency for a change in the price level to affect the interest rate and thus the quantity of investment demanded. 3) The international trade effect is the tendency for a change in the price level to affect net exports.

4. C) Change in the quantity demanded versus a change in demand • A movement along an aggregate demand curve is a change in the aggregate quantity of goods and services demanded. 2) A change in the aggregate quantity of goods and services demanded at every price level is a change in aggregate demand.

5. D) Factors that can change aggregate demand. • Changes due to consumption • Consumer confidence. • Tax and transfer policy. 2) Changes due to investment • Expectations about profits for firms. b) Changes in interest rates due to things other than a change in the general price level. (I.e. not the same as the interest rate effect.)

6. 3) Changes in government purchases. 4) Changes in exports. • Change in a foreign countries income • Change in the exchange rate. A countries exchange rate is the price of its currency in terms of another currency or currencies, e.g. yen/$. A rise in the exchange rate makes U.S. goods more expensive and fewer are purchased.

7. E) The multiplier • The multiplier is the ratio of the change in the quantity of real GDP demanded at each price level to the initial change in one or more components of aggregate demand that produce it. • Multiplier = change in real demand / initial change in demand component 3) The multiplier occurs due to a domino effect.

9. II Aggregate Demand and Aggregate Supply • Basics of the long run and the short run. • The short run in macroeconomic analysis is a period in which wages and some other prices do not respond to changes in economic conditions. 2) A sticky price is a price that is slow to adjust to its equilibrium level, creating sustained periods of shortage or surplus. 3) The long run in macroeconomic analysis is a period in which wages and prices are flexible.

10. B) The long run • The long-run aggregate supply (LRAS) curve relates the level of output produced by firms to the price level in the long run. • This curve is vertical at the economy’s potential output level. 3) Note, although there is a single real wage that clears the labor market, the price level and the nominal wage rate can take a range of values.

12. 3) The long run equilibrium occurs where the long run aggregate supply and the aggregate demand curves intersect.

14. C) The Short Run • The short-run aggregate supply (SRAS) curve is a graphical representation of the relationship between production and the price level in the short run. 2) Factors held constant in the short run: • Capital stock. • Stock of natural resources. • Level of technology. d) Prices of factors of production.

16. 3) A change in the price level produces a change in the aggregate quantity of goods and services supplied and is illustrated by the movement along the short-run aggregate supply curve. 4) A change in the quantity of goods and services supplied at every price level in the short run is a change in short-run aggregate supply.

17. D) Reasons for Wage and Price Stickiness • Wage Stickiness due to: • labor contracts; • minimum wages. 2) Price Stickiness due to: • induced from labor stickiness; • reluctance by a firm to jeopardize; customer relations c) long term contracts.

18. E) Equilibrium Levels of Price and Output in the short run. Two examples: 1) A change in health care costs.

20. 2) A change in government purchases.

22. III Recessionary and Inflationary Gaps and the Achievement of Long-Run Macroeconomic Equilibrium • Terminology • The gap between the level of real GDP and potential output, when real GDP is less than potential, is called a recessionary gap. 2) The gap between the level of real GDP and potential output, when real GDP is greater than potential, is called an inflationary gap.

25. B) Restoring Long Run Macroeconomic Equilibrium 1) An increase in Aggregate Demand. a) Consider an economy initially at long run equilibrium given by subscripts of “1”. b) Next, suppose government spending increases.

27. 2) A decrease in Aggregate Supply • Consider an economy initially at long run equilibrium given by subscripts of “1”. b) Next, suppose that health care costs rise.

29. C) Gaps and Public Policy • A nonintervention policy is one in which there is no policy choice taken to try to close a recessionary or an inflationary gap. 2) A stabilization policy is one in which a policy choice is taken in an attempt to move the economy to its potential output. 3) A stabilization policy designed to increase real GDP is known as expansionary policy. 4) A stabilization policy designed to reduce real GDP is a contractionary policy.

30. 5) Fiscal policy is the use of government purchases, transfer payments and taxes to influence the level of economic activity. 6) Monetary policy is the use of central bank policies to influence the level of economic activity.