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Flashcards in Aggregate Supply Deck (42):

Macroeconomic Goals

Goals - Framework - Policy Tools


Economic Growth (approximated by GDP growth)

Determines the prevailing standard of living in a country



Loss of potential value in output for the whole of society



Not all prices rise at the same time. If prices for goods increase faster than wages, then there will be unhappiness


Trade Imbalances

Source of macroeconomic disruption and instability


Aggregate Demand/Supply

-Model to explain economic growth tied to the unemployment rate
-Framework to study the connections and trade-offs between macro goals as well as the short-run fluctuations of GDP around long run trends



Period of falling real incomes and rising unemployment. Technical def. - Real GDP decreases in tow consecutive quarters



Severe Recession (very rare)


Business Cycle

Relatively short-term movement of the economy in and out of recession


Say's Law

Supply creates its own demand - a given value of supply must create an equivalent value of demand


Keynes' Law

Demand creates its own supply


Aggregate Supply

Positive relationship between the total quantity that firms choose to produce and sell and the price level for output holding the price of inputs fixed


Potential GDP

Maximum quantity that an economy can (sustainably) produce given its existing levels of labor, physical capital, technology, and institutions. The unemployment rate is at the natural rate.


Three Theories of AS-Curve

Actual output deviates from its natural rate (potential GDP) wen the actual price level deviates from the price level people expected


Sticky Wage Theory

Nominal wages are sticky in the short run; adjust sluggishly due to long-term labor contracts or social norms - Higher P causes Higher Y, so the AS-curve slopes upward


Sticky Price Theory

Many prices are sticky in the short run - due to menu costs (cost of printing new menues, the time required to change price tags) - Higher P is associated with higher Y, so the AS-Curve slopes upward


Misperceptions Theory

Firms may confuse changes in P with changes in the relative price of the products they sell
If P rises above Pe, a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, and may increase output and employment


Aggregate Supply Curve

Y = Yn + a (P-Pe)
Y: Actual output
Yn: Natural Rate of output (potential GDP)
a > 0: measures how much Y responds to unexpected changes in P
P: actual price level
Pe: expected price level


Aggregate Demand

The negative relationship between the total quantity of goods and services and the price level for output


GDP Equation

Y = C + I + G + NX


GDP Terms

C: Consumption, spending by households on goods and services (including education, but excluding new housing)
I: Investment, purchases of goods that will be used in the future to produce more goods and services (including new housing)
G: Government purchases, spending on goods and services by local, state, and federal governments (long form: government consumption expenditure and gross investment)
NX: Net Exports, foreign purchases of domestically produced goods (exports) minus the domestic purchases of foreign goods (imports).


Extrapolating Macro Curve from Micro

Wealth Effect (price level and consumption C)
Interest-Rate Effect (price level and investment I)
Exchange-Rate Effect or Foreign Price Effect (price level and next exports NX)


Wealth Effect

An increase in the price level lowers the real value of money and makes consumers less wealthy, which in turn discourages them to spend more. The decrease in consumer spending means a smaller quantity of goods and services demanded; vice versa


Interest Rate Effect

A higher price level increases the interest rate, discourages greater spending on investment goods, and thereby decreases the quantity of goods and services demanded, vice versa.


Foreign-Price Effect

When an increase in the US price level causes the relative price of US exports to increase and the relative price of imports from abroad to decrease, exports will decrease and imports will increase. Total net exports decrease and thereby decrease the quantity of goods and services demanded, vice versa.


Exchange-Rate Effect

What an increase in the US price level causes US interest rates to increase, the real value of the dollar increases in foreign exchange markets. This appreciation dampens US net exports and thereby decreases the quantity of goods and services demanded.



When an economy experiences stagnant growth and high inflation at the same time.


What shifts the long term AS-Curve?

Changes in the labor force or the natural rate of unemployment
Changes in physical or human capital
Changes in natural resources
Changes in technology


AS-AD Model - Growth and Recession

-Long run economic growth due to productivity increases are represented by gradual shift of AS to the right
-Potential GDP will gradually shift to the right as well
-Factors that determine the speed of long run growth are not in the model
-AS-AD model is a short run model: Recessions are illustrated in the AS-AD diagram when the equilibrium level of real GDP is substantially below potential GDP


AS-AD - Unemployment

-Cyclical unemployment bounces up and down according to the short run movements of GDP
- Diagram cyclical unemployment is shown by how close the economy is to potential (or full employment) GDP
-Factors determine the natural rate of unemployment are not shown in the AS-AD diagram; they are implicitly part of what determines potential GDP


AS-AD - Inflationary Pressure

AS-AD implies tow ways that inflationary pressure may arise
-AD pushes to the right when the equilibrium is already close to potential GDP; pushing the equilibrium is already clost to potential GDP; pushing the equilibrium into the steep portion of the AS-curve
- A rise in input prices (affecting many or most firms) causes AS-Curve to shift to the left


AS-AD- Inflationary Pressure 2

AS-AD shows on one-time shift in price level. Why is inflation persistent over time?
-Government continually attempts to stimulate economy by pushing AD up the AS-Curve
-Inflation expectations can become built into the annual increase in prices and wages


Review Questions on page 43 of slides

have you done them yet?


Keynesian Perspective

Focuses on explaining why recessions and depressions occur.
-Aggregate demand is not always automatically high enough to provide firms with the incentive to hire enough workers to reach full employment
- Economy adjusts slowly to changes in AD because of stickiness of wages and output prices


Keynesian Perspective - 2

A recession (equilibrium is to the far left of potential GDP) occures when AD is low far left). Importance of sticky wafes reflected by AS-curve that assumes constant (i.e. sticky) input prices. Sticky output prices reflected by a flat AS-curve. Changes in AD have little effect on price level (sticky output prices).


Phillips Curve

The phillips curve shows the short-run trade off between inflation and unemployment
Short Run: Fed Reserve can reduce unemploy rate below the natural unemply rate by making inflation greater than expected.
Long Run: Expectations catch up with reality, unemploy rate goes back to natural unemploy rate whether inflat. is high or low.


Phillips Curve Equations

Unemployment rate = Natural Rate of Unemployment - a( actual infl. - expected infl.)


Phillips Summary

Describes the short-run tradeoff between inflation and unemploy
Longrun: no tradeoff - inflation is determined by money growth, unemployment equals its natural rate
Short run: supply shocks and changes in expected inflation - shifting the short run curve - making tradeoff more of less favorable
Fed can reduce inflation by contracting the money suuply, which moves the economy along its short-run Phillips curve and raises unemployment. In the long run, expectations adjust and unemployment returns to its natural rate


Neoclassical Perspective

-Real GDPi is potential GDP and the AS-curve is vertical line drawn at the level of potential GDP
-Real GDP is equal to potential GDP regardless of AD
-Changes in AD can have an impact on output and employment on short run
-Over time, economic growth shifts protential GDP and the vertical AS (Long Run AS) gradually to the right
-Prices and wages may be sticky in the short run, but they are flexible in the long run


Rational Expectations

Theory that people form the most accurate possible expectations about the future that they can using all information available to them


Adaptive Expectations

Theory that people look at past experience and gradually adapt their beliefs and behavior as circumstances change


Answered Second Set of Questions at the end?

Done yet?