EC102: Class 3 LT Christina Ammon

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

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

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.

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?

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

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!

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

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

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

AD curve

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.

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

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

Essay Question a - war

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

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