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How can we analyze economic fluctuations? Aggregate Demand and Aggregate Supply

Aggregate Demand and Aggregate Supply. Used to explain or predict the effects of macroeconomic events or policies on equilibrium price and output Effect:

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  • Slide 1
  • Aggregate Demand and Aggregate Supply
  • Slide 2
  • Used to explain or predict the effects of macroeconomic events or policies on equilibrium price and output Effect: Uncertainty causing less consumption and investment Lower price and gdp Event: Tsunamis Effect: More Governmental intervention to spend more money Higher price and gdp Event: Government Intervention
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  • Shows the relationship between PRICE LEVELS (y) And REAL GDP (X) the total demand for domestic goods in an economy GDP = C onsumption + I nvestment + G overnment Spending + E xports I mports
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  • 1) Foreign Sector Substitution effect: If prices rise domestically Look internationally If prices fall domestically Buy more domestically
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  • 2) Interest rate effect: If prices rise Need to borrow more Interest rates rise Investment falls Consumption falls If prices fall Need to borrow less Interest rates fall Investment increases Consumption increases
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  • 3) The Wealth effect: If price rises The purchasing power falls The quantity of domestic output demanded falls
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  • Changing any of the components: Consumption Investment Government Spending Exports Imports
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  • Consumption will Investment will Increase AD ifDecrease AD if More wealthLess wealth More optimisticLess optimistic Less taxesMore taxes Increase AD ifDecrease AD if Lower real interest rateHigher real interest rate Higher expected returnsLower expected returns Due to future expectations about profitability
  • Slide 10
  • GOVERNMENT SPENDING WILLNET EXPORTS Increase AD with more spending Decrease AD with less spending Increase AD if Decrease AD if Weak Domestic Currency (more exports, less imports) Strong Domestic Currency (less exports, more imports) Strong Foreign Economies (Export more) Weak Foreign Economies (we export less)
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  • INCREASE OF AD (RIGHT) DECREASE IN AD (LEFT)
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  • As a team of economists, you receive $1 million dollars to help bolster the Japanese economy. Strategize how you will use this money to increase your component of Aggregate Demand after the tsunami and earthquake in Japan. How will your response rebuild the economy?
  • Slide 13
  • MPC in Economics means Marginal Propensity to Consume. This refers to the means of measuring the proportion of how much is spent to how much is saved. This is known in business but is actually commonly used by individuals on their everyday lives and on how they budget.
  • Slide 14
  • Change to any component of AD (C + Ig + G + Xn) has a ripple effect Results in a multiplied effect on GDP Important as a small change in spending leads to a large change in GDP Calculated by: 1 or 1 MPS 1- MPC
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  • Examples: 1/MPS.25 MPS change = multiplier of 4.33 MPS change = multiplier of 3 MPC of.75 = 1/.25 (MPS) = multiplier of 4 If gov spending increases by $20 X 4 = GDP increases by $80
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  • PL (Y) And Real GDP (x) the summation of all individual supply curves in an economy or total output in an economy
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  • SHORT RUN: PD. OF TIME WITH STICKY PRICES AND WAGES LONG RUN: PD. OF TIME WHEN PRICES AND WAGES ARE FLEXIBLE Input $ do not adjust to changes in the Price Level Keynesian school Input $ are flexible and adjust to changes in Price Level Classical school
  • Slide 18
  • PL GDP R SRAS As prices increase: Firms produce more for a greater profit As prices decrease: sales will fall, and producers produce less
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  • P roductivity (technology) I nput Prices L aws, regulations, taxes E xpected Inflation
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  • Productivity will Input Prices will Increase SRAS ifDecrease SRAS if Improvements in technology Natural Disasters destroy resources Novel Techniques introduced Labor Force is reduced in size because of strikes or epidemics Increase SRAS ifDecrease SRAS if Lower cost of productionHigher cost of production
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  • Laws and Regulations will Expected Inflation will Increase SRAS ifDecrease SRAS if Lower taxesHigher taxes Lower wagesHigher wages Increase SRAS ifDecrease SRAS if Prices are expected to
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  • DECREASE IN INPUT COSTSINCREASE IN INPUT COSTS PL GDP R SRAS SRAS 1 PL GDP R SRAS SRAS 1 PL
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  • GDP R LRAS YfYf
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  • LIKE THE PPF In the Long run, we are at Full Employment (3-5% unemployment) CHANGE IN TECHNOLOGY CHANGE IN LABOR PRODUCTIVITY Increase the Human Capital, or skill level of the workers CHANGE IN CAPITAL
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  • NumberScenario 1The government increases expenditures on education. 2There is an increase in the price of oil. 3Businesses face a pollution tax for their externalities. 4The value of the yen increases. 5New technology and better education increase productivity. 6Interest rates fall with an increase in the money supply (show the effect on AD only) 7There is an increase in investment across the nation after the tsunami. 8Unions become more aggressive and wage rates increase. 9Consumers (not producers) become more confident about the future. 10Honda cars become extremely popular globally.
  • Slide 26
  • 1AD increase: Government 2AS decrease: Input Costs 3AS decrease: Legal Requirements 4AD decrease: Exports and Imports (NX) 5AS increase: Productivity 6AD increase: Consumption and Investment 7AD increase: Investment 8AS decrease: Input Costs 9AD increase: Consumption 10AS decrease: Expectations
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  • Intersection between SRAS and AD determines price level (PL) and the current output (GDP) GDP R PL AD SRASLRAS Yf P Full employment = Yf, any distance away from FE shows unemployment
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  • Equilibrium occurs to the right of full employment GDP R PL AD SRASLRAS YFYF P Y
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  • Equilibrium occurs to the left of full employment GDP R PL AD SRAS LRAS Yf P Y
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  • Basic Assumptions: 1) Inverse relationship between inflation and unemployment 2) If inflation demand pull 3) If deflation recession 4) Movement along curve changes during business cycle as represented by an increase or decrease of AD
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  • i u PC 4% 2% 7%5%....... Shows the relationship between inflation and unemployment
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  • Effect: Causes movements along the curve GDP R PL AD SRAS LRAS YFYF P Y AD 1 P1P1 SRPC i u i% u%unun i 1i 1 ....
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  • Effect: causes a rightward shift of the Short-run Phillips Curve Stagflation: Increase in Price and Decrease in Output (1970s) GDP R PL AD SRAS LRAS YFYF P Y1Y1 SRAS 1 P1P1 u% i SRPC LRPC unun i u1u1 SRPC 1 i1i1....
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  • i u SRPC 4% 2% 7%5%.............. SRPC 1 An increase in the SRPC arises from a leftward shift of the SRAS
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  • AD Slides it up or down, up or down, up or down, SRAS Shifts it in or out Inflation, Unemployment
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  • The economy can adjust to inflation in the long run due to real wages. The LRPC is vertical at the Natural Rate of Unemployment Increases in the unemployment rate because of more unemployment compensation rightward shift Decreases in the unemployment rate because of less unemployment compensation leftward shift
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  • SRPC 1 LRPC 1 % uN%uN% A BC 2 % u% SRPC 2 inflation unemployment A movement from A to B arises from a cyclical change. A shift from SRPC 1 to SRPC 2 arises from a decrease in the SRAS curve.
  • Slide 38
  • 1)Assume an economy is operating at full employment. A major political event stops the delivery of foreign oil to the country. a) Draw the Aggregate Model to show how this event affects macroeconomic equilibrium. (Include the SRAS, AD, and LRAS curves.) b) Show how this change affects the Short Run Phillips Curve. c) Because of this event, the government is unable to provide unemployment compensation for federal workers. Show the change on the LRPC. Use 4% as the original LRPC.