AD1 AD2 Shifts in Aggregate Demand PriceLevel AD0 Goods & Services(real GDP)
1. Explain how and why each of the following factors would influence current aggregate demand in the United States: (a) An increased fear of recession. (b) An increased fear of inflation. (c) The rapid growth of real income in Canada and Western Europe. (d) A reduction in the real interest rate. (e) A higher price level (be careful). (f) A stock market decline. Questions for Thought:
SRAS2 LRAS2 YF2 Shifts in Aggregate Supply PriceLevel PriceLevel SRAS1 LRAS1 Goods & Services(real GDP) Goods & Services(real GDP) YF1
Indicate how the following would influence U.S. aggregate supply in the short run: (a)An increase in real wage rates. (b) A severe freeze that destroys half of the orange crop in Florida. (c) An increase in the world price of oil. (d) Abundant rainfall during the growing season of agricultural states. Questions for Thought:
Questions for Thought: Which of the following would be most likely to shift the long run aggregate supply curve (LRAS) to the left? a. Unfavorable weather conditions that reduced the size of this year’s grain harvest. b. An increase in labor productivity as the result of improved computer technology and expansion in the Internet. c. An increase in the cost of security as the result of terrorist activities.
LRAS2 SRAS2 Growth in Aggregate Supply LRAS1 PriceLevel SRAS1 P100 P95 AD Goods & Services(real GDP) YF2 YF1
Questions for Thought: 1. Suppose consumers and investors suddenly become more pessimistic about the future and therefore decide to reduce their consumption and investment spending. How will a market economy adjust to this increase in pessimism? 2. If the general level of prices is higher than business decision makers anticipated when they entered into long-term contracts for raw materials and other resources, profit margins will be abnormally low and the economy will fall into a recession. Is this statement true?
Questions for Thought: 3. Which of the following would be most likely to throw the U.S. economy into a recession? a. A reduction in transaction costs as the result of the growth and development of the Internet. b. An unanticipated reduction in the world price of oil. c. An unanticipated reduction in AD as the result of a sharp decline in consumer confidence. 4. During 2000 there was a sharp reduction in stock prices and a sharp increase in the world price of crude oil. Within the framework of the AD/AS model, how would these two changes influence the U.S. economy?
Real interest rates fall (because of weak demand for investment) r Real resource prices fall(because of weak demand and high unemployment) Pr Unemployment greaterthan Natural Rate Changes in Real Interest Rates and Resource Prices Over the Business Cycle LRAS PriceLevel Goods & Services(real GDP) YF
Real interest rates rise (because of strongdemand for investment) r Real resource prices rise (because of strong demand and low unemployment) Pr Unemployment lessthan Natural Rate Unemployment greaterthan Natural Rate Changes in Real Interest Rates and Resource Prices Over the Business Cycle LRAS PriceLevel Real interest rates fall (because of weak demand for investment) r Real resource prices fall(because of weak demand and high unemployment) Pr Goods & Services(real GDP) YF
three reasons economy adjusts to long-run equilibrium • data show that consumption, the largest component of aggregate demand, is relatively stable over the business cycle and behaves according to the permanent income hypothesis -- the assumption that consumption depends on long-run expected income rather than on current income. • the movement of interest rates exerts a stabilizing influence on the economy. Lower real interest rates during recessions can help stimulate investment and aggregate demand, while higher real interest rates during booms can help restrain aggregate demand by discouraging investment. • resource prices directly affect aggregate supply, which can redirect the economy to long-run equilibrium, depending on the level of current output relative to the economy's potential capacity.
SRAS2 Higher resource prices reduce SRAS In the short-run, output may exceed or fall short of the economy’s full-employment capacity (YF). Higher real interest rates reduce AD AD2 The Self-Correcting Mechanism PriceLevel LRAS SRAS1 P100 AD1 Goods & Services(real GDP) YF Y1 YF
Lower resource prices increase SRAS SRAS2 In the short-run, output may exceed or fall short of the economy’s full-employment capacity (YF). AD2 Lower real interest rates increase AD The Self-Correcting Mechanism PriceLevel LRAS SRAS1 P100 AD1 Goods & Services(real GDP) Y1 YF YF