Macroeconomics Quiz on Aggregate Supply and Demand

Eco 1 Review of Aggregate Expenditure and Chapter 23: Analysis of Aggregate Demand and Aggregate Supply

• Aggregate demand and aggregate supply model: Explains short-run fluctuations in real GDP and the price level.
• Helps understand why real GDP, employment, and price levels fluctuate.
• In the short run, real GDP and price level are determined by the intersection of aggregate demand (AD) and short-run aggregate supply (AS) curves.
• Aggregate demand (AD) curve: Shows the relationship between price level and quantity of real GDP demanded by households, firms, and the government.
• Short-run aggregate supply (AS) curve: Shows the relationship between price level and quantity of real GDP supplied by firms.

Aggregate Demand

• Relationship between output and price level: Downward sloping, reflecting the inverse relationship between price level and level of planned aggregate expenditure.
• Change in price level: A decrease in price level shifts AD curve up, causing equilibrium GDP to rise; an increase in price level shifts AD curve down, causing equilibrium GDP to fall.

Aggregate Expenditure

• Relationship between spending and income: Upward sloping, reflecting the positive relationship between real GDP and aggregate expenditure.

The Four Components of Real GDP

• Real GDP has four components: Consumption (C), Investment (I), Government Purchases (G), and Net Exports (NX).
• Y = C + I + G + NX
• Government purchases are determined by policymakers.
• Other components depend on the price level.

The Wealth Effect

• Household consumption is primarily determined by income but also affected by wealth.
• Some wealth is held in nominal assets, so rising price levels decrease real value of household wealth, leading to reduced consumption.

Why is the AD Curve Downward Sloping?

• Interest-rate effect: Higher prices cause demand for money to rise, increasing interest rates and discouraging investment.
• International-trade effect: Higher U.S. prices make U.S. exports more expensive and imports cheaper, reducing net exports.
• Each effect decreases real GDP as price levels rises.

Shifts of the AD Curve vs. Movements Along It

• A change in price level causes a movement along the AD curve because the price level is a variable on the AD curve.
• A change in other components of aggregate demand (like government spending or investment) shifts the AD curve itself.

AD Shifts: Changes in Monetary Policy

• Federal Reserve actions to manage money supply and interest rates can shift AD.
• Higher interest rates reduce investment spending, shifting AD to the left.
• Lower interest rates increase investment spending, shifting AD to the right.

AD Shifts: Changes in Fiscal Policy

• Changes in federal taxes and purchases (fiscal policy) can shift the AD curve.
• Increased government purchases shift AD to the right.
• Increased taxes reduce disposable income, reducing consumption and shifting AD to the left.

AD Shifts: Changes in Expectations

• Optimistic expectations about the future increase consumption and investment shifting AD to the right, vice-versa.

AD Shifts: Changes in Foreign Variables

• Changes in foreign incomes and exchange rates affect net exports and thus shift the AD curve.
• Higher rates of domestic GDP relative to foreign GDP decrease net exports and shifts AD to the left.
• Increased value of the US dollar decreases net exports and shifts AD to the left.

Recessions and the Components of AD

• 2007-2009 recession: Low consumption, falling residential investment, increased net exports. Factors were unusually low and decreasing consumption and falling residential investment. A decline in the US dollar value increased net exports during this recession.

Aggregate Supply

• Aggregate supply refers to the quantity of goods and services firms are willing to supply.
• Long-run aggregate supply (LRAS) curve: A vertical curve at the level of potential GDP in the long run; unrelated to price level.
• Short-run aggregate supply (SRAS) curve: Upward sloping, not vertical like the long-run aggregate supply curve; relationship between price level and quantity of real GDP supplied in the short run.

Long-Run Aggregate Supply (LRAS) Curve

• Relationship between price level and quantity of real GDP supplied in the long run.
• Determined by factors unrelated to price level (number of workers, technology level, capital stock).
• Vertical because price level does not affect these factors in the long run.

Short-Run Aggregate Supply (SRAS) Curve

• Upward sloping because of sticky wages and prices.
• Contracts, menu costs, and slow wage adjustments result in firms and workers often failing to anticipate changing price levels.
• Sticky prices and wages affect SRAS differently than LRAS.

SRAS Shifts: Factors of Production and Technology

• An increase in the availability of labor, capital, or technology increases production at each price level, shifting short-run aggregate supply to the right.
• A decrease shifts SRAS to the left.

SRAS Shifts: Expected Future Prices

• If firms and workers expect higher prices, they raise wages and prices, shifting SRAS to the left.
• If firms and workers expect lower prices, shifts SRAS to the right

SRAS Shifts: Adjustments to Errors in Past Expectations

• Firms and workers adjust to errors in past expectations by changing prices and wages respectively, causing the SRAS curve to shift

SRAS Shifts: Unexpected Changes in Prices of Resources

• Unexpected increases in prices of resources (supply shock) decrease short-run aggregate supply.
• Unexpected decreases in prices of resources increases short-run aggregate supply.

Long-Run Macroeconomic Equilibrium

• Equilibrium occurs where AD and SRAS curves intersect on the LRAS curve.
• Explains why long-run macroeconomic equilibrium cannot occur at any other level of output.
• For simplicity, assumes no inflation and no long-run growth.

Long-Run Macroeconomic Equilibrium: Shifts

• When AD shifts, the economy moves to a new short-run equilibrium, and eventually, to a new long-run equilibrium.
• When SRAS shifts, the economy moves to a new short-run equilibrium, and eventually, to a new long-run equilibrium.
• Supply shocks affect the price level and output.

Dynamic AD and AS Model

• The dynamic AD and AS model allows for continually-increasing real GDP, so the LRAS curve shifts to the right, while SRAS and AD curves shift as well.

What Is the Usual Cause of Inflation?

• Inflation is often caused by AD shifting right more than anticipated changes to LRAS and SRAS, increasing prices and output in the equilibrium.

Test your knowledge on key concepts in macroeconomics, including the effects of exchange rates on U.S. exports and the determinants of aggregate supply and demand. This quiz covers important trends from the 2007-2009 recession and evaluates your understanding of real GDP and consumption spending.