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AGGREGATE DEMAND, AGGREGATE SUPPLY, AND EQUILIBRIUM

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msk2222's version from 2018-01-21 23:32

Section 1

Question Answer
Aggregate demand (AD)quantity of goods and services that households, businesses, government, and foreign customers want to buy at any given level of prices.
Aggregate supply (AS)quantity of goods and services producers are willing to supply at any given level of prices. It also reflects the amount of labor and capital that households are willing to offer into the marketplace at given real wage rates and cost of capital.
first conditionequality of planned expenditures and actual income/output—gives rise to what is called the IS curve.
second conditionequilibrium in the money market—is embodied in what is called the LM curve.
The IS CurveBalancing Aggregate Income and Expenditure:
Total expenditureC + I + G + (X – M)
aggregate income (Y)Y = C + S + T where T = (R – F) denotes net taxes and S = (SB + SH)-pvt sector spending
implications of government deficits and surpluses:G – T = (S – I) – (X – M)
[(G – T) > 0]private sector must save more than it invests [(S – I) > 0] or the country must run a trade deficit [(X – M) < 0] with corresponding inflow of foreign saving, or both.
consumption is a function C(·) of disposable income & GDP minus net taxesC=f(Y – SB – T, Y – T)
marginal propensity to consume (MPC)the proportion of an additional unit of disposable income that is consumed or spent.
marginal propensity to save (MPSMPS = 1 – MPC.
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Section 2

Question Answer
average propensity to consume (APC)ratio C/Y—rather than a measure of how the next unit of income would be divided between spending and saving, the MPC
definition of physical capitalany manmade aid to production.
gross investmentTotal investment, including replacement of worn-out capital,
net investmentonly the addition of new capacity
investment decisions may be modeled as a decreasing function I(·,·) of the real interest rate (I = I(r, Y)
exogenous policydetermined outside the macroeconomic model. In essence, this means that the adjustments required to maintain the balance among aggregate spending, income, and output must occur primarily within the private sector.-G and T
government’s fiscal balanceG − T = ¯¯¯ G − t ( Y )
automatic stabilizerThe fiscal balance decreases (smaller deficit or larger surplus) as aggregate income (Y) increases and increases as income declines. This effect is called an automatic stabilizer because it tends to mitigate changes in aggregate output.
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Section 3

Question Answer
Equilibrium in the Money Market: The LM CurveIn order to determine the interest rate and introduce a connection between output and the price level, we must consider supply and demand in the financial markets.
quantity theory of moneyMV = PY
V is the velocity of moneythe average rate at which money circulates through the economy to facilitate expenditure
quantity theory equation can be rewritten in terms of the supply and demand for real money balancesM/P = (M/P)D = kY
increasing function M(·,·) of real income and a decreasing function of the interest rateM/P = M(r,Y)
Aggregate Demand Curvenominal money supply (M) is held constant, then a higher or lower real money supply (M/P) arises because of changes in the price level. If the price level declines, the real money supply increases and, as shown in Exhibit 12, real income increases while the real interest rate declines. Conversely, an increase in the price level leads to a decline in real income and an increase in the real interest rate
The slope of the AD curve depends onthe relative sensitivities of investment, saving, and money demand to income and the interest rate.
AD curve will be flatter ifinvestment expenditure is highly sensitive to the interest rate; saving is insensitive to income; money demand is insensitive to interest rates; and money demand is insensitive to income.
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Section 4

Question Answer
aggregate supply curverepresents the level of domestic output that companies will produce at each price level.
The “long run”long enough that wages, prices, and expectations can adjust but not long enough that physical capital is a variable input. Capital and the available technology to use that capital remain fixed. This condition implies a period of at least a few years and perhaps a decade.
very short run, perhaps a few months or quarters, companies will increase or decrease output to some degree without changing priceVSRAS. If demand is somewhat stronger than expected, companies earn higher profit by increasing output as long as they can cover their variable costs
AS curve is upward sloping because more costs become variableshort-run aggregate supply (SRAS)
over the long run,when the aggregate price level changes, wages and other input prices change proportionately so that the higher aggregate price level has no impact on aggregate supply. This is illustrated by the vertical long-run aggregate supply (LRAS) curve
Y = F ( ¯¯¯¯ K , ¯¯¯ L ) = ¯¯¯ YThe position of the LRAS curve is determined by the potential output of the economy. The amount of output produced depends on the fixed amount of capital and labor and the available technology. This classical model of aggregate supply can be expressed as
long-run equilibrium level of output, Y1full employment, or natural, level of output. At this level of output, the economy’s resources are deemed to be fully employed and (labor) unemployment is at its natural rate. This concept of a natural rate of unemployment assumes the macroeconomy is currently operating at an efficient and unconstrained level of production.
The business cycle is a direct result of short-term fluctuations of real GDP.It consists of periods of economic expansion and contraction
expansionreal GDP is increasing, the unemployment rate is declining, and capacity utilization is rising
Shifts in the AD and AS curvesshort-run changes in the economy associated with the business cycle. In addition, the AD–AS model provides a framework for estimating the sustainable growth rate of an economy,
asset allocation perspectiveimportant to determine the current phase of the business cycle as well as how fast the economy is growing relative to its sustainable growth rate. In contrast, a decline in wealth will reduce consumer spending and shift the AD curve to the left. This is often referred to as the wealth effect
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Section 5

Question Answer
Key factors that directly or indirectly influence the level of aggregate expenditures and cause the aggregate demand curve to shift include changes inhousehold wealth; consumer and business expectations; capacity utilization; monetary policy; the exchange rate; growth in global economy; and fiscal policy (government spending and taxes).
Household Wealthvalue of both financial assets (e.g., cash, savings accounts, investment securities, and pensions) and real assets (e.g., real estate).
Consumer and Business ExpectationsPSYCHOLOGY. Consumer spending declines and the AD curve shifts to the left when consumers become less confident. Similarly, when businesses are optimistic about their future growth and profitability, they spend (invest) more on capital projects, which also shifts the AD curve to the right.
Capacity Utilizationmeasure of how fully an economy’s production capacity is being used. Data from the OECD and the US Federal Reserve indicate that when aggregate capacity utilization reaches 82 to 85 percent, production blockages arise, prompting companies to increase their level of investment spending. This shifts the AD curve to the right.
Fiscal policy is the use of taxes and government spending to affect the level of aggregate expendituresAn increase in government spending, one of the direct components of AD, shifts the AD curve to the right, whereas a decrease in government spending shifts the AD curve to the left.
tax effect n GDPTaxes affect GDP indirectly through their effect on consumer spending and business investment. Lower taxes will increase the proportion of personal income and corporate pre-tax profits that consumers and businesses have available to spend and will shift the AD curve to the right. In contrast, higher taxes will shift the AD curve to the left.
Monetary PolicyMoney is generally defined as currency in circulation plus deposits at commercial banks. Monetary policy refers to action taken by a nation’s central bank to affect aggregate output and prices through changes in bank reserves, reserve requirements, or its target interest rate.
central bank can increase the money supply by1) buying securities from banks, 2) lowering the required reserve ratio, and/or 3) reducing its target for the interest rate at which banks borrow and lend reserves among themselves. In each case, the opposite action would decrease the money supply.
central bank buys securities from banks in an open-market operation, it pays for them with a corresponding increase in bank reservesThis increases the amount of deposits banks can accept from their customers—that is, the money supply. Similarly, cutting the required reserve ratio increases the level of deposits (i.e., money) consistent with a given level of reserves in the system. If the central bank chooses to target an interbank lending rate, as the Federal Reserve targets the federal funds rate in the United States, then it must add or drain reserves via open-market operations to maintain the target interest rate.
expansionary policyshift the AD curve to the right, from AD1 to AD2. In the very short run, output will expand from Y1 to Y2 without an increase in the price level.
Exchange Rateexchange rate is the price of one currency relative to another. Changes in the exchange rate affect the price of exports and imports and thus aggregate demand. lower euro should cause European exports to increase and imports to decline, causing the AD curve to shift to the right. Conversely, a stronger euro reduces exports and raises imports, and the AD curve shifts to the left.
Growth in the Global EconomyInternational trade is what links countries together and creates a global economy. Faster economic growth in foreign markets encourages foreigners to buy more products from domestic producers and increases exports.
What happens to interest rates when the AD curve shifts?In the case of an increase in the money supply, the interest rate declines at each price level because the increase in income (Y) increases saving and rates must decline to induce a corresponding increase in investment spending (I). In each of the other cases considered above, a rightward shift in the AD curve will increase the interest rate at each price level. With the real money supply held constant, the interest rate must rise as income increases. The increase in the interest rate reduces the demand for money at each level of expenditure/income and, therefore, allows expenditure/income to increase without an increase in the money supply. In terms of the quantity theory of money equation, this corresponds to a higher velocity of money, V.
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