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ECON review

- Rise price level lowers value of money, therefore less wealth, less consumption, less GDP
- Fall in price level rises real value of money, more wealth, more consumption, GDP/AE increases
- Changes in price level, affects wealth of bond holders, and bond issuers – they offset the affect so no
change in total wealth.
- A rise in domestic price level reduces net exports – your country imports more (cheaper goods in other
countries), Other countries import less from you ( your goods more expensive) therefore there is a fall in
AE, shift downward.
- Fall in domestic price level = rise in AE
- AD curve shows the level of real GDP = desired AE
- Increase in expenditure shifts the AE curve up and AD curve to the right
- Fall in autonomous expenditure shifts the AE curve down, and the AD to the left.
- Simple multiplier measures the horizontal shift in the AD curve
- Factor prices and technology are exogenous
- Factor prices and technology are fixed for a given AS curve.
- Change in factor prices or technology shift the AS curve
- Anything that makes supply cheap (lower factor costs, increase in tech) shifts the AS curve to the right
- Anything that makes supply more expensive shifts the curve to the left
- Shocks – anything that shift the AS or AD curve
- Positive shock anything that increases equilibrium GDP
- Negative shocks decrease equilibrium GDP
- Ad shocks cause price level and GDP to change in the same direction – rise with an increase to AD
- Fall with a decrease to AD
- The more sloped the AS curve the less affect of the simple multiplier
- A variable price level reduces the value of the simple multiplier
- Flat range of AS is the Keynesian range firms with excess capacity can produce more output, without
increasing unit costs
- The effect of any shock on the AD curve will be distributed between the price level and the output.
- The steeper the slope of the AS curve the more affect a AD shock affects the price level, and less the
- Aggregate supply shocks cause the price level and output to change in opposite directions
- Negative shock increases price level and decreases output
- A positive shock decreases price level and increases output
Stagflation GDP falls, while price level rises
The short run
Factor prices exogenous
Tech and factor prices are constant
Short tun equilibrium is where AS intersects AD – fluctuates around Y*
The adjustment of factor prices
Factor prices adjust to output gaps
Technology and factor prices are constant so Y* is constant
The Long run
Factor prices have fully adjusted to any output gaps
Tech and factor prices are changing
- AS and AD curves intersect where real GDP exceeds potential GDP then we are in an inflationary gap
- This makes more demand for inputs, firms bid on inputs, and drives factor prices up.
- This increases firms units costs, driving price level up, and AS curve up and reducing GDP back to
potential GDP
- AS and AD curves intersect where real GDP is below Potential GDP
- This causes excess supply for inputs, driving factor prices down
- This causes unit costs to decrease, driving price level down, and AS curve down and output to increase
to potential GDP
- Downward wage stickiness – Both downward and upward adjustments to wages and unit costs occur,
but there are differences in the speed at which they operate. Booms cause wages to rise rapidly,
recessions however cause wages to fall slowly.
- The potential output acts as an anchor in the economy, as equilibrium will always shift back to it
- The adjustment of wages and other factor prices eventually eliminate any inflationary output gap
caused by an AD shock, real GDP returns to potential GDP.
- Flexible wages that fall quickly in a recessionary gap provide automatic adjustment process that
pushes the economy back quickly to potential output.
- If wages are downwardly sticky, the economies adjustment process is sluggish and thus will not quickly
eliminate a recessionary gap.
- Exogenous changes in the input prices cause the AS curve to shift, creating an output gap. The
adjustment process then reverses the initial AS shift and brings the economy back to potential output
and initial price level.
- In the long run real GDP is determined by Y*, AD only is used to determine the price level
- Empirical data in Canada show that inflationary gaps cause wages to rise, and recessionary gaps cause
wages to fall.
- In recession Policy makers can use expansionary fiscal policy
- In an inflationary gap policy makers can use contractionary fiscal policy
- When the economy’s adjustment process is slow to operate, or produces undesirable side effects such
as rising prices, there is a potential stabilization role for fiscal policy
- The paradox of thrift is only true in the short run – In the long run increased saving means there is an
increase in investment, and therefor increasing potential output.
- Even in the absence of discretionary fiscal policy, the governments tax – and transfer payment system
provides the economy with automatic stabilizers
Marginal Propensity to Spend (z) = MPC(1-t)-m
Simple multiplier =1/(1-z)
Limitations to discretionary fiscal policy
Decision and execution lag, temporary vs permanent tax changes, fine tuning vs gross tuning.
- Costs of econ grow
- Foregone consumption - Econ growth promises more goods and services tomorrow, is achieved by
consuming fewer goods today. This sacrifice of current consumption is an important cost of growth.
- Social costs – The process of economic growth renders some products and machines obsolete and
leaves some workers skills obsolete.
- Sources of econ growth – Growth in the labour force, Growth in human capital, Growth in physical
capital, technological improvement.
- Y = C+I
- I=Y-C OR S=I
- In the short run macro model, real GDP adjusts to determine equilibrium, in which desired savings
equals desired investment. In the model’s long run version, real GDP is equal to Y* and the real interest
rate adjusts to determine equilibrium.
- Private sector saving = Y*- T- C
- Public sector saving = T-G
- National saving = (Y* -T -C)+(T-G) = (Y*-C-G)
- In the long run – With GDP equal to Y*, the equilibrium interest rate is determined where national
savings is equal to desired investment
- In the long run, An increase of the supply of national savings reduces the interest rate and encourages
investment. The higher rate of investment leads to a higher growth rate of potential output.
- In the long run, an increase in the demand for investment pushes up the real interest rate and
encourages more savings by households, The higher rate of savings (and investment) leads to a higher
growth rate of potential output.
- Neoclassical model – You receive diminishing marginal returns when one is increased, and constant
returns when all are increases.
- In the neoclassical growth model with diminishing returns , Increases in the labour force increases GDP,
but results in an eventual decline in material living standards
- In the neoclassical growth model, capital accumulation leads to improvements in the material living
standards, but because of diminishing marginal returns, these improvements become smaller with each
additional increment of capital.
- If capital and labour grow at the same rate with CONSTANT tech, GDP will increase. But in the
neoclassical model with constant returns to scale, such balanced growth will not lead to increases in per
capita output and therefore will not generate improvements in material living standards.
- Many innovations are embodied in either physical or human capital. These innovations cause continual
changes in the techniques of production and in the nature of what is produced. Embodied technical
change leads to increases in potential output even if the amounts of labour and capital are held
-solow residual used to measure technological change