1 of 31 Principles of MacroEconomics: Econ101

 Aggregate Demand  Factors That Can Change AD  Short-Run Aggregate Supply  Short-Run Equilibrium  Long-Run Aggregate Supply and Long-Run Equilibrium  Case Study: 2008 Recession 2 of 31

Aggregate Demand Curve: Slopes downward, specifying an inverse relationship between the price level and the quantity demanded of Real GDP. Aggregate Demand: Ceteris paribus, the quantity demanded of all goods and services (real GDP) at different price levels. 3 of 31

Wealth Effect: The change in the purchasing power of dollar-denominated assets that results from a change in the price level. 4 of 31

Interest Rate Effect: Changes in household and business buying as the interest rate changes. 5 of 31

International Trade Effect: The change in foreign sector spending as the price level changes. 6 of 31

 A change in the quantity demanded of Real GDP is the result of a change in the price level.  A change in the quantity demanded of Real GDP is graphically represented as a movement from one point, A, on AD1 to another point, B, on AD1. 7 of 31

A change in Aggregate Demand is graphically represented as a shift in the aggregate demand curve from AD1 to AD2 8 of 31

Wealth ↓ → C ↓ → AD ↓ 1. Wealth - The value of all assets owned, both monetary and non- monetary Expect higher future prices → C↑ → AD↑ Expect lower future prices → C↓ → AD↓ 2. Expected Future Prices Wealth ↑ → C ↑ → AD ↑ 9 of 31

Expect lower future income → C↓ → AD↓ Expect higher future income → C ↑ →A D↑ 3. Expected Future Income Interest Rate ↑ → C↓ → AD↓ Interest Rate ↓ → C ↑ → AD↑ 4. Interest Rates 10 of 31

Income taxes ↑ → C↓ → AD↓ Income taxes ↓ → C ↑ → AD↑ 5. Income Taxes 11 of 31

Interest rates ↑ → I↓ → AD↓ Interest rates ↓ → I ↑ → AD↑ 1. Interest Rates Pessimistic about future sales → I↓ → AD↓ Optimistic about future sales → I ↑ → AD↑ 2. Expected Future Sales Business taxes↑ → I↓ → AD↓ Business taxes↓ → I↑ → AD↑ 3. Business Taxes 12 of 31

Foreign real national income ↓ → EX↓ → NX↓ →AD↓ Foreign real national income ↑ → EX↑ → NX↑ →AD↑ US $ appreciates → EX↓ and IM ↑ → NX↓ →AD↓ US $ depreciates → EX↑ and IM ↓ → NX↑ →AD↑ 2. Exchange Rates 1. Foreign Income 13 of 31

1. Explain the wealth effect. The Wealth Effect: a rise (fall) in the price level causes purchasing power to fall (rise), which decreases (increases) a person’s monetary wealth. As people become less (more) wealthy, the quantity demanded of Real GDP falls (rises). 2. Explain what happens to the AD curve if the dollar appreciates relative to other currencies. If the dollar appreciates, it takes more foreign currency to buy a dollar and fewer dollars to buy foreign currency. This makes U.S. goods (denominated in dollars) more expensive for foreigners and foreign goods cheaper for Americans. In turn, foreigners buy fewer U.S. exports, and Americans buy more foreign imports. As exports fall and imports rise, net exports fall. If net exports fall, total expenditures fall, ceteris paribus. As total expenditures fall, the AD curve shifts to the left. 3. Explain what happens to the AD curve if personal income taxes decline. If personal income taxes decline, disposable incomes rise. As disposable incomes rise, consumption rises. As consumption rises, total expenditures rise, ceteris paribus. As total expenditures rise, the AD curve shifts to the right. 14 of 31

Short-run Aggregate Supply curve (SRAS): Slopes upward, specifying a direct relationship between the price level and the quantity supplied of Real GDP. Aggregate Supply: Ceteris paribus, the quantity supplied of all goods and services (real GDP) at different price levels. 15 of 31

….because over the short-run, as the price level increases, the quantity of goods and services firms are willing to supply will increase. As prices of final goods & services rise, prices of inputs, such as the wages of workers or the price of a natural resources, rise more slowly. Profits rise when the prices of the goods & services firms sell rise more rapidly than the prices they pay for inputs. 16 of 31

 Wage rates  Productivity  Supply shocks  Adverse  Beneficial 17 of 31

1. If wage rates decline, explain what happens to the short-run aggregate supply (SRAS) curve. As wage rates decline, the cost per unit of production falls. In the short run (assuming prices are constant), profit per unit rises. Higher profit causes producers to produce more units of their goods and services. In short, the SRAS curve shifts to the right. 2.Give an example of an increase in labor productivity. Last year, 10 workers produced 100 units of good X in 1 hour. This year, 10 workers produced 120 units of good X in 1 hour. 18 of 31

 At P 1, the quantity supplied of Real GDP is greater than the quantity demanded. As a result, the price level falls and firms decrease output.  At P 2, the quantity demanded of Real GDP is greater than the quantity supplied. As a result, the price level rises and firms increase output.  Short-run equilibrium occurs at point E, where the quantity demanded of Real GDP equals the (short-run) quantity supplied. 19 of 31

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 The Real GDP that is produced at the natural rate of unemployment* at which the economy’s resources are fully utilized.  The Real GDP that is produced when the economy is in long-run equilibrium. *Unemployment caused by frictional and structural factors in the economy. 21 of 31

 The LRAS curve is a vertical line at the level of Potential/Natural Real GDP.  It represents the output the economy produces when all economy wide adjustments have taken place and workers do not have any relevant misperceptions. 22 of 31

………...at the intersection of the AD, SRAS and LRAS curves. …………when wages and prices have adjusted to their (final) equilibrium levels and workers do not have any relevant misperceptions. 23 of 31

1.What is the difference between short-run equilibrium and long-run equilibrium? In long-run equilibrium, the economy is producing Potential/Natural Real GDP. In short-run equilibrium, the economy is not producing Potential/Natural Real GDP, although the quantity demanded of Real GDP equals the quantity supplied of Real GDP. 24 of 31

 Draw the AD-SRAS-LRAS diagram for the U.S. economy starting in a long-run equilibrium.  A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment. 25 of 31

LRAS YNYN P Y AD 2 SRAS 2 AD 1 SRAS 1 P1P1 P3P3 C P2P2 Y2Y2 B A Event: Boom in Canada 1. Affects NX, AD curve 2. Shifts AD right 3. SR eq’m at point B. P and Y higher, unemp lower 4. Over time, P E rises, SRAS shifts left, until LR eq’m at C. Y and unemp back at initial levels. 26 of 31

 From 12/2007 to 6/2009, real GDP fell about 4%  Unemployment rose from 4.4% in 5/2007 to 10.1% in 10/2009  The housing market played a central role in this recession… 27 of 31

Rising house prices during 2002–2006 due to:  low interest rates  easier credit for “sub-prime” borrowers  government policies to increase homeownership  securitization of mortgages: ◦ Investment banks purchased mortgages from lenders, created securities backed by these mortgages, sold the securities to banks, insurance companies, and other investors. ◦ Mortgage-backed securities perceived as safe, since house prices “never fall” 28 of 31

Consequences of 2006–2009 housing market crash:  Millions of homeowners “underwater”—owed more than house was worth  Millions of mortgage defaults and foreclosures  Banks selling foreclosed houses increased surplus and downward price pressures  Housing crash badly damaged construction industry: 2010 unemployment rate was 20.6% in construction vs. 9.6% overall 29 of 31

Consequences of 2006–2009 housing market crash:  Mortgage-backed securities became “toxic,” heavy losses for institutions that purchased them, widespread failures of banks and other financial institutions  Sharply rising unemployment and falling GDP 30 of 31

The policy response:  Federal Reserve reduced Fed Funds rate target to near zero.  Federal Reserve purchased mortgage-backed securities and other private loans.  U.S. Treasury injected capital into the banking system, to increase banks’ liquidity and solvency in hopes of staving off a “credit crunch”  Fiscal policymakers increased government spending and reduced taxes by $800 billion 31 of 31