CH 11 Aggregate Demand and Aggregate Supply
1. Define potential GDP
The maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions. Also known as LRAS Long Run Aggregate Supply and the Natural Unemployment level or Full Employment
2. Aggregate demand/aggregate supply model - a model that shows what determines total supply or total demand for the economy, and how total demand and total supply interact at the macroeconomic level.
3. Aggregate supply (AS) - the total quantity of output (i.e. real GDP) firms will produce and sell.
4. Aggregate supply (AS) curve - shows the total quantity of output (i.e. real GDP) that firms will produce and sell at each price level.
Short run aggregate supply (SRAS) curve - positive short run relationship between the price level for output and real GDP, holding the prices of inputs fixed
5. Long run aggregate supply (LRAS) curve - vertical line at potential GDP showing no relationship between the price level for output and real GDP in the long run.
Long Run Aggregate Supply is at Potential GDP or Full Employment GDP
● Potential GDP - the maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions.
● Full-employment GDP - another name for potential GDP, when the economy is producing at its potential and unemployment is at the natural rate of unemployment.
6. What is Aggregate Demand?
The total spending on domestic goods and services at each price level
7. What do Neoclassical economists emphasize?
The importance of aggregate supply in determining the size of the macroeconomy over the long run.
8. Describe stagflation
Is when an economy experiences stagnant growth and high inflation at the same time.
9. What is Keynes’ law?
“demand creates its own supply”
10. What is Say’s law?
“supply creates its own demand”
11. Long run Aggregate Supply Curve
The vertical line at potential GDP showing no relationship between the price level for output and real GDP in the long-run.
12. Shift factors for SRAS curve and how they affect the SRAS (Short Run Aggregate Supply)
Wages
Input Prices
Productivity
Supply Shocks (adverse and beneficial)
An increase in Wage or Input prices, a decrease in productivity or an Adverse Supply Shock will cause the SRAS curve to shift to the left.
A decrease in Wages or Input prices, an increase in Productivity or a Beneficial Supply Shock will cause the SRAS curve to shift to the right.
13. Components of Aggregate Demand include:
Consumption, investment, government spending, and net exports
The components are also the shift factors for AD
Shift factors for AD and how they affect AD
Consumptions
Investment
Government Spending
Net Exports
An increase in Aggregate Demand (shift right) is caused by an increase in Consumption, Investment, Government Purchases or Net Exports.
A decrease in Aggregate Demand (shift left) is caused by a decrease in Consumptions, Investments, Government Purchases or Net Exports.
14. Rate of unemployment and it’s relation to a recession or inflation
The AD/AS graph illustrates an inflationary gap when the equilibrium level of real GDP is substantially to the right of potential GDP or the LRAS curve. The actual rate of unemployment is lower than the natural unemployment rate.
The AD/AS graph illustrates a recessionary gap when the equilibrium level of real GDP is substantially to the left of potential GDP or the LRAS curve. The actual rate of unemployment is higher than the natural unemployment rate.
An economy is in long run equilibrium if we are at full employment and the actual rate of unemployment is equal to the natural rate of unemployment.
CH 12 Keynesian economics
15. Keynesian economist are focused on aggregate demand and the short run. They believe that the government has enough power to change government spending (a component of aggregate demand) enough to pull the economy out of a recessionary gap or slow an economy down if it is in an inflationary gap.
Keynesian economics focuses on explaining why recessions and depressions occur and offering a policy prescription for minimizing their effects.
16. The Keynesian view of recession is based on two key building blocks.
• Aggregate demand is not always automatically high enough to provide firms with an incentive to hire enough workers to reach full employment.
• *The macroeconomy may adjust only slowly to shifts in aggregate demand because of sticky wages and prices.
17. What is Expansionary fiscal policy
Tax cuts or increases in government spending designed to stimulate aggregate demand and move the economy out of recession
18. What is Contractionary fiscal policy
Tax increases or cuts in government spending designed to decrease aggregate demand and reduce inflationary pressures
19. Expenditure multiplier
Keynesian concept that asserts that a change in autonomous spending causes a more than proportionate change in real GDP.
The idea that not only does spending affect the equilibrium level of GDP, but that spending is powerful.
The reason for the expenditure multiplier is that one person’s spending becomes another person’s income, which leads to additional spending and additional income
The cumulative impact on GDP is larger than the initial increase in spending.
20. Disposable income is income after taxes.
Income – Taxes = Disposable Income
21. Menu costs - The costs of changing prices that businesses must consider. This is one of the reasons that prices and wages are sticky.
22. Sticky wages and prices
The Keynesian economic framework is based on an assumption that prices and wages are sticky and do not adjust rapidly. This will cause the macroeconomy to adjust only slowly to shifts in aggregate demand.
23. Inflationary Gap
When the AD curve is crossing the SRAS curve on the vertical portion of the Keynesian Curve. Equilibrium is at a level of output above potential GDP
24. Recessionary Gap
When the AD curve is crossing the SRAS curve on the horizontal portion of the Keynesian Curve below Potential GDP. Equilibrium is at a level of output below potential GDP
25. Keynesian economics focuses on
Keynesian economics is considered a "demand-side" theory that focuses on changes in the economy over the short run. Keynes focused on Aggregate Demand
26. The Keynesian economic framework is based on an assumption that
prices and wages are sticky and do not adjust rapidly.
27. A country is more likely to face a trade deficit if it has strong economic growth.
28. Keynesian Phillips Curve supports the macroeconomic theory that high unemployment may be accompanied by low inflation, and low unemployment may be accompanied by high inflation.
29. Describe the Keynesian Aggregate Supply curve
The Keynesian aggregate supply curve is horizontal at levels below Potential GDP and then vertical at Potential GDP
30. Who should increase spending or cut taxes to help pull the economy out of a recession?
Government (according to Keynes)
31. When will an increase in AD only affect the price level and not total output?
Keynes believed that increases in aggregate demand at points on the vertical portion of the Aggregate Supply curve only increase the price level and do not add to Real GDP
CH 13 Classical and Neoclassical economics
32. Neoclassical perspective
the philosophy that, in the long run, the business cycle will fluctuate around the potential, or full-employment, level of output. The belief that the economy is self-regulating without interference from government (laissez-faire approach)
33. Classical and Neoclassical economist are focused on the long-run and aggregate supply. They believe that any changes in Aggregate Demand only changes the price level in the long run.
34. Physical capital per person
Amount and kind of machinery and equipment available to help a person produce a good or service
35. Neoclassical perspective emphasizes that
in the long run, the economy seems to rebound back to its potential GDP and its natural rate of unemployment.
36. Building blocks of neoclassical economics
• Potential GDP determines the economy's size.
• Wages and prices will adjust both upward and downward in a flexible manner,so that the economy will adjust back to its potential GDP level of output.
37. The neoclassical view holds that long-term expansion of potential GDP due to economic growth will determine the size of the economy
38. Will aggregate demand affect output or unemployment in the long run?
In the neoclassical view, changes in Aggregate Demand can only have a short-run impact on output and on unemployment; and in the long-run, only affect the price level.
39. According to Neoclassical economists, what underpins long run productivity growth in the economy?
GDP growth can be explained by increases and investment in
• physical capital per person (equipment to help a person produce a good or service)
• human capital (knowledge, skills and training)
• advances in technology
40. In the Classical/ Neoclassical model, what happens if the economy is in a recessionary gap?
Wages and input prices will drop and the SRAS curve will shift right
41. In the Classical / Neoclassical model, what happens if the economy is in an inflationary gap?
Wages and input prices will increase and the SRAS curve will shift left
42. Laissez-faire
A public policy of not interfering with market activities in the economy.
43. Adam Smith and the invisible hand
Adam Smith is considered a classical economist who described an invisible hand to explain why the indirect or unintended benefits for society that result from the unobservable market force that helps the demand and supply of goods in a free market to reach equilibrium automatically without government interference. This explains the view that an economy is self-regulating.
Recognize and Describe for Exam
Recessionary Gap in the Classical model
Keynesian aggregate supply curve and a recessionary gap at E1