EC102: CLASS 3 LT
Christina Ammon
Overview
New Topic: Economic Fluctuations
 Before: What determines the total output an economy can
produce in the long run?
•
Focus on supply
 Now: How does the Economy fluctuate in the short run?
• Focus on demand ( and short run supply)
Will cover:
 Essay question d, a, b, c
 E,F, G will be covered next week
 Quiz 3 wherever it fits
Question 4
The phrase “economic fluctuations” refers to
 Changes in the level of income from one quarter to another
 The correlation between consumption and income over time
 Changes in the level of prices from one quarter to another
 Changes in the rate of growth of income from one quarter to
another
Question 1
The following is an argument against believing that supply
shocks are the main source of fluctuations:
 Investment is more volatile than consumption.
 Unemployment rises in recessions.
 GDP growth is often negative.
 GDP growth is often below its long-run average.
Essay Question d
What is the aggregate demand curve and why is it downward
sloping?
 The aggregate demand curve shows the relationship between
aggregate demand and the price level
 AD curve shows us the equilibrium in the goods market and
the money market
 Components of the AD curve?
Demand shocks
Demand shocks:
 • An increase in government spending G
 • An increase in desired investment I
 • An increase in desired consumption C
 • An increase in net exports NX
Why is the demand curve downward sloping?
 Why does high price levels imply low demand?
• Careful: not a micro reason!
• In principle, should have no effect!
Because:
 there is a positive relationship between between prices and
interest rates
 and a negative relationship between interest rates and
consumption/investment
Only effect through the interest rate!
Question 2
In macroeconomics, the word “money” refers to
 Wealth.
 Cash.
 A set of assets with certain characteristics.
 Savings.
Positive relationship between P and i
•
i= nominal interest rate
Consumer make a portfolio choice: choose what share of wealth
to store in money/cash instead of bonds
•
•
Money – liquid, can be used for consumption
Bonds – earn interest rate I
 The higher the interest rate – the bigger the share of bonds
 The higher the price level – the more money is needed to cover
desired consumption – money demand higher
 In model: Central Bank fixes the money supply
 If price level increases: nominal money demand increases /
real money supply decreases => interest rate is increased
Negative relationship between i and I,C
Consumption
 If interest rate is high – if we save now, can consume more in
future
 More likely to save now and consume more tomorrow
 Desired consumption now decreases
 Note: short run effect – in the long run the same
Investment
 Cost of investment = interest rate
 Investment financed through bonds i.e. firms borrow from
consumers
 Cost of investment increased => desired investment decreased
AD curve
Question 3
An increase in the price level will induce consumers to:
 Consume less to avoid the higher prices.
 Sell bonds to replenish their real balances.
 Work harder to make up for the higher prices.
 Hold less money to avoid the loss in value.
Question 5
An increase in interest rates
 Makes firms want to invest more
 Makes consumers want to consume more
 Makes consumers want to hold less money
 All of the above
Essay Question a
Discuss the mechanism through which the following events
translate into demands shocks:
A war
Essay Question a - war
Essay Question b
Discuss the mechanism through which the following events
translate into demands shocks:
An increase in the interest rate
Essay Question c
Discuss the mechanism through which the following events
translate into demands shocks:
An increase in income taxes