Chapter 14 - ECON.docx - Chapter 14 Aggregate Demand and Aggregate Supply Recession a period of declining real incomes and rising unemployment

Chapter 14 - ECON.docx - Chapter 14 Aggregate Demand and...

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Chapter 14: Aggregate Demand and Aggregate Supply Recession: a period of declining real incomes and rising unemployment. Depression: multiple periods of recessions. THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS Fact 1: Economic Fluctuations are Irregular and Unpredictable. o Fluctuations in the economy are known as the business cycle. This is because economic fluctuation responds o changes in business conditions. Fact 2: Most Macroeconomic Quantities Fluctuate Together. o Real GDP is the variable that is most commonly used to monitor changes in economy and the fluctuations. o Recession is an economy-wide phenomena, meaning that most macroeconomic variables will fluctuate together due fluctuations in the economy. o When economic conditions deteriorate, much of the decline is attributable to reductions in spending on new factories, housing and inventories. Fact 3: Output Falls, Unemployment Rises o When real GDP declines, un employment rises. This is hardly a surprise because as firms choose to produce smaller quantities of goods and services the less workers they need. o When recession ends and real GDP expand, the unemployment rate gradually decreases. EXPLAINING SHORT-RUN ECONOMIC FLUCTUATIONS Assumptions in Classical Economy: money does not matter in a classical economic world because the nominal changes would be affected but the real variables would remain the same. The Reality of Short-Run Fluctuations: o Most economists believe that classical theory describes the world in the long run but not short run. o In the short run, monetary changes affect nominal and real variables and they are highly intertwined. o Our new model focuses on how real and nominal variables interact. The Model of Aggregate Demand and Aggregate Supply: o The short-run economic fluctuations focus on two variables: Economy’s output of goods and services: Real GDP Overall price level measured by the CPI or the GDP Deflator o Model of aggregate demand and aggregate supply: model used to explain the short-run fluctuations along with the long-run trends. Aggregate demand curve: quantity of goods households want to buy at a given price level. Aggregate supply curve: quantity of goods and services that firms produce and sell at each price level.
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THE AGGREGATE-DEMAND CURVE The aggregate demand curve is downward sloping because the higher the price level the lower the quantity demanded and the lower the price level the higher the quantity demanded. Three reasons for the negative relationship – as price level falls: o Real wealth rises – increase in consumption o Interest rates fall – increase in investments o Exchange rate depreciates – increase in net exports. Why the Aggregate Demand Curve Slopes Downwards: o Recall: Y = C + I + G + NX .
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