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551-10 - Chapter 10 ECONOMIC INSTABILITY In Ch 9 we focused...

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Chapter 10 – ECONOMIC INSTABILITY In Ch. 9, we focused on static, equilibrium conditions in the Aggregate Demand (AD) / Aggregate Supply (AS) model. We now look at dynamic changes in the macro model - e.g. acts of nature like droughts or earthquakes, important discoveries like the computer chip, shifts in consumer confidence, changes in the stock market, changes in foreign income or ex-rates, etc. We will still assume that fiscal and monetary policy are unchanged so that we can isolate private markets and see how they react to dynamic change. Then we can look later at the effects of macro policy (fiscal and monetary) on the economy. "Macroeconomics: Private and Public Choice." We distinguish between Anticipated and Unanticipated changes, because dynamic adjustment differs depending on whether changes are expected or not. An anticipated change gives people time to make adjustments, whereas an unanticipated changes catches people off guard. Example : inflation is 5% now and government announces that inflation will be 10% next year or that inflation will be 0% next year. That is different from inflation being 5% and unexpectedly going up to 10% or down to 0%. Or researchers develop a new high yield drought resistant hybrid seed that increases grain production by 10% (anticipated) vs. unusually favorable weather conditions resulting in a 10% increase in output (unanticipated). Unanticipated change is change that catches most people by surprise, so that decisions were already made that did not take the event into account. Most economic changes are unexpected , at least by the majority of the people. That is where the role of the entrepreneur becomes important. "Economics is largely about how people respond and markets adjust to change." FACTORS THAT SHIFT AD AD curve isolates the impact of the price level (P) on the AQ D of Goods/Services (Real GDP). Factors besides price level (P) changes also affect Real Output (Q) and those factors SHIFT the entire AD curve. Six factors: 1. Changes in Real Wealth - Changes in the price level affect real wealth by changing the real value of cash balances. Real wealth can also be affected by other factors. Examples: a) Stock prices doubled between 1995 and 1998 - this boom represents an increase in real wealth of households holding stocks, mutual funds, pension funds, IRAs, etc. (more than 50% of the population owns stock). b) The stock market crashed in 1987 by 20% in one day, a decrease in real wealth. AD shifts out (increases) from an increase in wealth, because there is an increase in demand for goods and services - people buy cars, go on vacation, etc. AD shifts back (decreases) from a decrease in real wealth, because people cut back on purchases. 2. Changes in the Real Interest Rate - Interest rates affect decisions of households and businesses in terms of their willingness and ability to borrow. A new vehicle and an auto loan are like MGT 551: BUSINESS ECONOMICS CH – 10 Professor Mark J. Perry 1
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complimentary goods, goods that are consumed jointly. Or houses and mortgages, furniture and credit card debt. If the cost of financing a car or house or furniture goes down, the cost of the joint purchase
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