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Chapter 7

Chapter 7. Short Run Aggregate Demand and Aggregate Supply. Aggregate Demand. Effects Real Balance Effect - Price falls, increases purchasing power, we buy more Interest rate Effect - As price falls, interest rates fall, we borrow and spend more

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Chapter 7

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  1. Chapter 7 Short Run Aggregate Demand and Aggregate Supply

  2. Aggregate Demand • Effects • Real Balance Effect - Price falls, increases purchasing power, we buy more • Interest rate Effect - As price falls, interest rates fall, we borrow and spend more • Foreign purchase Effect - As prices fall foreigner my more of our goods and we buy less of theirs

  3. Consumption • C = f(income, interest rates) • Characteristic • Largest • Most stable • Done by the households • MPC • MPS • MPC+MPS=1 • Determinants • Wealth • Price level • Expectations • Debt • Taxation

  4. Investment • I = f(interest rates, Expected profits) • Investment demand (MEI) – shows the relationship between interest rates and Investment • Real interest rate = nominal interest rate – inflation rate • Expected rate of return • Expected Profits – accelerator principle: GDP up, Profits up, I up • Characteristics • Done by the Business sector • Unstable – drastic change • Components: I = Ir + In • Ir = replacement investment: depreciation • In = new investment: growth • Types • Plant and equipment • Inventories • Residential construction

  5. Investment Continued • Determinants • Business conditions • Technology • Excess capacity • Business taxes • Capital costs • Capital stock

  6. Government Spending • G = f(Votes) • Characteristics • 2nd largest • Determinants • Policy • Unexpected events • War

  7. Net Exports • (X-M) = f(Exchange rates) • Characteristic • Smallest • Determinants • Income in other countries

  8. Short run Aggregate Supply • Nation’s total amount of goods produced for sale at various price levels • Ranges • Horizontal (Price is constant) • Intermediate (P and Y change) • Vertical - capacity (P increases, Y constant)

  9. AS Determinants (Shifts AS) • Changes in resource prices (quantity of resources) • Wages • Immigration • Unions • Minimum wage • Interest rates • Rent • Changes in productivity (quality of resources) • Education • Technology • Changes in legislation (institutional changes) • Taxes • Regulations • Laws • Government policy • Trade barriers • Supply shocks • Beneficial – shift the SRAS and LRAS outward • Good harvests • New resource discovery • Adverse - shift the SRAS and LRAS inward • Bad weather (Drought) • OPEC increases the price of oil • Natural disasters and war

  10. Short run Equilibrium • Period of time when at least one resource price is fixed by agreement

  11. Potential GDP • Maximum sustainable output level given set resources • Full employment - Natural Rate of Unemployment • No cyclical unemployment • NAIRU • Natural Rate of Unemployment – Rate that occurs at the natural output level • 4% to 6% (now 5.2%) • Cyclical unemployment is zero • Expected (Anticipated) price level • Capacity Utilization Rate is at 80%

  12. Short Run Equilibrium • No Gap: Actual GDP = potential GDP • Contractionary (recessionary) Gap = potentialGDP > Actual GDP • Underutilized resources - Idle workers, lower than capacity capital use, labor in great supply • Unemployment • Nominal wages are fixed by contracts • Causes • Decreased AD – Une up, inflation down • Decreased AS – Une up, inflation up • Remedy • Increasing AD and/or SRAS • Expansionary (inflationary) Gap = potential GDP < Actual GDP • Overutilized resources - Overtime work, Greater than capacity capital use, labor in short supply • Overemployment (possible inflation) • Nominal wages are fixed by contracts. • Causes • Increased AD – Une down, inflation up • Increased AS – Une down, inflation down • Remedy • Decreasing AD and/or SRAS

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