SUMMARY Chapters: 26-29

Chapter 26 interest The fee that borrowers pay to lenders for the use of their funds. The total quantity of money demanded in the economy is the sum: demand for checking account balances + cash by both households and firms. For both households and firms, the quantity of money demanded at any moment depends on the opportunity cost of holding money, a cost determined by the interest rate.

Chapter 26 Determinants of Money Demand 1The interest rate: r (The quantity of money demanded is a negative function of the interest rate.) 2Aggregate nominal output (income) P Y a. Real aggregate output (income): Y (An increase in Y shifts the money demand curve to the right.) b. The aggregate price level: P (An increase in P shifts the money demand curve to the right.) The demand for money depends negatively on the interest rate, r, and positively on real income, Y, and the price level, P.

The goods market and the money market do not operate independently. The links between goods and money markets: The money market determines the interest rate. The demand for money in the money market is affected by income (which is determined in the goods market). The goods market determines income, which depends on planned investment. Planned investment in turn depends on the interest rate (which is determined in the money market). The key link between the two markets is the interest rate… Chapter 26

policy mix is the combination of monetary and fiscal policies in use at a given time. Chapter 26

Refer to the information provided in table below to answer the questions that follow: A Hypothetical Investment Schedule 1. If the interest rate dropped from 10% to 4%, planned investment would __ by $ __ billion. A. Increase; 90B. Increase; 60C. decrease; 90D. decrease; =90 2. Suppose the expenditure multiplier is 3. A drop in the interest rate from 12% to 6%, ceteris paribus, would increase equilibrium output by $ ____ billion. A.180B. 120C. 270D. 160 Multiplier=∆Y/∆I ; ∆I = =90; ∆Y=90x3= Suppose the expenditure multiplier is 4 and the initial interest rate is 8%. A move to what interest rate will increase equilibrium output by 240 billion? A.4B. 6C. 10D. 12 ∆I = 240/4=60; =300 Interest rate % Planned Investment ($ Billion) Chapter 26

Chapter 28

Short run Aggregate Supply Curve In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. Long run Aggregate Supply Curve If wages fully adjust to prices in the long run, then the long run AS curve will be vertical. The level of aggregate output that can be sustained in the long run without inflation is called potential output or potential GDP. Chapter 28

CAUSES OF INFLATION Demand-pull inflation is inflation initiated by an increase in aggregate demand. Cost-push, or supply-side, inflation is inflation initiated by an increase in costs like energy prices. An increase in costs may also lead to stagflation the situation in which the economy is experiencing a contraction and inflation simultaneously. inflation targeting When a monetary authority chooses its interest rate values with the aim of keeping the inflation rate within some specified band over some specified horizon. Chapter 28

The Labor Market: Basıc Concepts Because the economy is dynamic, frictional and structural unemployment are inevitable and in some ways desirable. Times of cyclical unemployment are of concern to macroeconomic policy makers. In general, employment tends to fall when aggregate output falls and rise when aggregate output rises. Chapter 29

THE CLASSICAL VIEW OF THE LABOR MARKET Classical economists believe that the interaction of supply and demand in the labor market brings about equilibrium and that unemployment (beyond the frictional and structural amounts) does not exist. The classical view of the labor market is consistent with the theory of a vertical aggregate supply curve. Chapter 29

EXPLAINING THE EXISTENCE OF UNEMPLOYMENT Some economists argue that the unemployment rate is not an accurate indicator of whether the labor market is working properly. Those who do not subscribe to the classical view of the labor market suggest several reasons why unemployment exists. Sticky wages Efficiency wage theory Imperfect Information Minimum wage laws Chapter 29

THE SHORT-RUN RELATIONSHIP BETWEEN THE UNEMPLOYMENT RATE AND INFLATION There is a negative relationship between the unemployment rate (U) and aggregate output (income) (Y): When Y rises, U falls. When Y falls, U rises. The relationship between the unemployment rate and the price level is negative: As the unemployment rate declines and the economy moves closer to capacity, the price level rises more and more. Chapter 29

The Phillips Curve The Phillips Curve represents the relationship between the inflation rate and the unemployment rate. During the 1950s and 1960s, this relationship was stable and there seemed to be a predictable trade-off between inflation and unemployment. As a result of import price increases (which led to shifts in aggregate supply), the relationship between the inflation rate and the unemployment rate was erratic in the 1970s. Inflation depends on more than just the unemployment rate. Chapter 29

THE LONG-RUN AGGREGATE SUPPLY CURVE, POTENTIAL OUTPUT, AND THE NATURAL RATE OF UNEMPLOYMENT Those who believe that the AS curve is vertical in the long run also believe that the Phillips Curve is vertical in the long run at the natural rate of unemployment. The natural rate is generally the sum of the frictional and structural rates. The NAIRU (Nonaccelerating Inflation Rate of Unemployment) theory says that the price level will accelerate when the unemployment rate is below the NAIRU and decelerate when the unemployment rate is above the NAIRU. Chapter 29

Refer to the information provided in figure below to answer the question that follow. 1. The equilibrium wage rate is $________ and the equilibrium number of people employed is ________ million people. A.13; 100B. 7; 160C. 4; 130D. 13; At wage rate $13, there is a ________ of labor equal to ________ million people. A.Surplus; 100 B. Shortage; 100 C. Shortage; 120D.Surplus; At wage rate $4, there is a ________ of labor equal to ________ million people. A.Shortage; 120B. Shortage; 60C. Surplus; 120D. Surplus; 60 Chapter 29