Section 8 Review

Summary

Aggregate Demand

• 1. The aggregate demand curve shows the relationship between the aggregate price level and the quantity of aggregate output demanded.
• 2. The aggregate demand curve is downward sloping for two reasons. The first is the wealth effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending. The second is the interest rate effect of a change in the aggregate price level—a higher aggregate price level reduces the purchasing power of households’ and firms’ money holdings, leading to a rise in interest rates and a fall in investment spending and consumer spending.
• 3. The aggregate demand curve shifts because of changes in expectations, changes in wealth not due to changes in the aggregate price level, and the effect of the size of the existing stock of physical capital. Policy makers can use fiscal policy and monetary policy to shift the aggregate demand curve.

Aggregate Supply

• 4. The aggregate supply curve shows the relationship between the aggregate price level and the quantity of aggregate output supplied.
• 5. The short-run aggregate supply curve is upward sloping because nominal wages are sticky in the short run: a higher aggregate price level leads to higher profit per unit of output and increased aggregate output in the short run.
• 6. Changes in commodity prices, nominal wages, and productivity lead to changes in producers’ profits and shift the short-run aggregate supply curve.
• 7. In the long run, all prices, including nominal wages, are flexible and the economy produces at its potential output. If actual aggregate output exceeds potential output, nominal wages will eventually rise in response to low unemployment and aggregate output will fall. If potential output exceeds actual aggregate output, nominal wages will eventually fall in response to high unemployment and aggregate output will rise. So the long-run aggregate supply curve is vertical at potential output.

The AD–AS Model

• 8. In the AD–AS model, the intersection of the short-run aggregate supply curve and the aggregate demand curve is the point of short-run macroeconomic equilibrium. It determines the short-run equilibrium aggregate price level and the level of short-run equilibrium aggregate output.
• 9. Economic fluctuations occur because of a shift of the aggregate demand curve (a demand shock) or the short-run aggregate supply curve (a supply shock). A demand shock causes the aggregate price level and aggregate output to move in the same direction as the economy moves along the short-run aggregate supply curve. A supply shock causes them to move in opposite directions as the economy moves along the aggregate demand curve. A particularly nasty occurrence is stagflation—inflation and falling aggregate output—which is caused by a negative supply shock.
• 10. Demand shocks have only short-run effects on aggregate output because the economy is self-correcting in the long run. In a recessionary gap, an eventual fall in nominal wages moves the economy to long-run macroeconomic equilibrium, in which aggregate output is equal to potential output. In an inflationary gap, an eventual rise in nominal wages moves the economy to long-run macroeconomic equilibrium. We can use the output gap, the percentage difference between actual aggregate output and potential output, to summarize how the economy responds to recessionary and inflationary gaps. Because the economy tends to be self-correcting in the long run, the output gap always tends toward zero.
• 11. The high cost—in terms of unemployment—of a recessionary gap and the future adverse consequences of an inflationary gap lead many economists to advocate active stabilization policy: using fiscal or monetary policy to offset demand shocks. There can be drawbacks, however, because such policies may contribute to a long-term rise in the budget deficit, leading to lower long-run growth. Also, poorly timed policies can increase economic instability.
• 12. Negative supply shocks pose a policy dilemma: a policy that counteracts the fall in aggregate output by increasing aggregate demand will lead to higher inflation, but a policy that counteracts inflation by reducing aggregate demand will deepen the output slump.