1. EC102: Class 3 LT
Christina Ammon

2. 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

3. 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

4. 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.

5. 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?

6. 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

7. 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!

8. Question 2 In macroeconomics, the word “money” refers to Wealth. Cash.
A set of assets with certain characteristics.
Savings.

9. 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

10. 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

11. AD curve

12. 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.

13. 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

14. Essay Question a
Discuss the mechanism through which the following events translate into demands shocks:
A war

15. Essay Question a - war

16. Essay Question b
Discuss the mechanism through which the following events translate into demands shocks: An increase in the interest rate

17. Essay Question c
Discuss the mechanism through which the following events translate into demands shocks: An increase in income taxes