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NATIONAL INCOME AND PRICE DETERMINATION
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Shifters of Aggregate Demand Change in C onsumer Spending Change in I nvestment Spending Change in G overnment Spending Net E X port Spending AD = C + I + G + X Shifters of Aggregate Supply AS = I + R + A + P Change in R esource Prices Change in A ctions of the Government Change in P roductivity (Investment) 2 Change in I nflationary Expectations
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B A D A D B A A C A major increase in productivity. A Answer and identify shifter: C.I.G.X or I.R.A.P 3
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Putting AD and AS together to get Equilibrium Price Level and Output 4
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How does this cartoon relate to Aggregate Demand? 5
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Macroeconomic equilibrium occurs at the intersection of aggregate demand and short-run aggregate supply. **Handout It can also happen that this occurs at the long-run equilibrium point, but not necessarily. Aggregate Price Level Aggregate Output LRAS SRAS AD
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As we have learned a Demand Shock can effect equilibrium: (demand shocks are shifts in the AD curve and Supply shocks are shifts in the SRAS)
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Shocks Demand shock causes Ag. Price Level and Ag. Output to move in the same direction Supply Shock causes them to move in opposite directions
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Shocks cont. Demand shocks have short-run effects on Ag. Output because the economy is self-correcting in the long run In a recessionary gap, an eventual fall in nominal wages moves the economy to long- run equilibrium (wages are sticky—slow to move-- in the SR) In an inflationary gap, an eventual rise in nominal wages moves the economy to long run equilibrium
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To sum it up… Shocks cause a shift in the Aggregate Demand or Supply and can also lead to Recessionary Gaps or Inflationary Gaps or Stagflation Stagflation is inflation and falling output and is caused by a negative supply shock
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What’s it look like?
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Price Level 14 AS Inflationary Gap GDP R LRAS QYQY AD 1 PL 1 Q1Q1 Output is high and unemployment is less than NRU Actual GDP above potential GDP
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Price Level 15 AD AS Example: Assume the government increases spending. What happens to PL and Output? GDP R LRAS QYQY AD 1 PL e PL 1 Q1Q1 PL and Q will Increase
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Price Level 16 AD GDP R QYQY PL 1 Q1Q1 LRAS AS 1 Recessionary Gap Output low and unemployment is more than NRU Actual GDP below potential GDP
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Price Level 17 AD AS GDP R QYQY PL e PL 1 Q1Q1 LRAS AS 1 Stagflation Stagnate Economy + Inflation Example: Assume the price of oil increases drastically. What happens to PL and Output?
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What about the long run? Baby Steps
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Price Level 19 AD AS Assume the government increases spending. What happens to PL and Output? GDP R LRAS QYQY AD 1 PL e PL 1 Q1Q1 PL and Q will Increase
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Price Level 20 AD AS Now, what will happen in the LONG RUN? GDP R QYQY AD 1 PL e PL 1 Q1Q1 LRAS Inflation means workers seek higher wages and production costs increase AS 1 PL 2 Back to full employment with higher price level
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Price Level 21 AD AS Assume consumers increase spending. What happens to PL and Output? GDP R LRAS QYQY AD 1 PL e PL 1 Q1Q1
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Price Level 22 AD AS Now, what will happen in the LONG RUN? GDP R QYQY AD 1 PL e PL 1 Q1Q1 LRAS Inflation means workers seek higher wages and production costs increase AS 1 PL 2 Back to full employment with higher price level
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Supply shocks and demand shocks can cause recessions
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Long Term Equilibrium To summarize how an economy responds to recessions/inflation we focus on Output Gap which is the % difference between actual aggregate output and potential output. Actual Aggregate Output-Potential Output x 100 Potential Output In the Long Run the economy is self-correcting but many times Governments are not willing to wait that long which brings about Macroeconomic Policy
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