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Aggregate Demand, Aggregate Supply, and The Self-Correcting Economy

The document discusses key concepts in macroeconomics including: 1) The Keynes effect which shifts the LM curve due to changes in aggregate price levels and impacts real income, and the Pigou effect which shifts the IS curve due to changes in real wealth. 2) How shifts in aggregate demand (AD) curves from factors like fiscal policy, money supply, or investment affect price levels and output in both the short-run and long-run. 3) The relationship between aggregate supply curves and how price levels impact employment, output, and real wages in both the short-run and long-run.

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Prachi Tamta
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46 views11 pages

Aggregate Demand, Aggregate Supply, and The Self-Correcting Economy

The document discusses key concepts in macroeconomics including: 1) The Keynes effect which shifts the LM curve due to changes in aggregate price levels and impacts real income, and the Pigou effect which shifts the IS curve due to changes in real wealth. 2) How shifts in aggregate demand (AD) curves from factors like fiscal policy, money supply, or investment affect price levels and output in both the short-run and long-run. 3) The relationship between aggregate supply curves and how price levels impact employment, output, and real wages in both the short-run and long-run.

Uploaded by

Prachi Tamta
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Aggregate Demand, Aggregate

Supply, and the Self-Correcting


Economy

Chapter 7
Flexible Prices and the AD Curve
• What is meant by the “Keynes effect” of a change in
the aggregate price level? How does this shift the LM
curve for a given IS curve?
• What happens to real income due to the Keynes
effect?
• What is meant by the “Pigou effect” of a change in the
price level on real wealth? How does this shift the IS
curve for a given LM curve?
• What happens to the level of income when the price
level changes when (a) only the Keynes effect
influences real income versus (b) when both the
Keynes effect and the Pigou effect influence real
income?
• What happens to the slope of the AD curve when the
Pigou effect is added to the Keynes effect?
Shifts versus Movement Along the
AD Curve
• Why does a change in the price level result in a
movement along the AD curve even though it shifts the
LM (and possibly the IS) curve(s)?
• How does a change in the money supply, fiscal policy,
or any other autonomous spending affect the AD
curve?
• How does a flatter IS curve (higher multiplier or more
interest sensitive investment demand) affect the slope
of the AD curve?
• What is the slope of the AD curve if the economy
experiences a “liquidity trap?”
• Why does the effect of a change in AD on price versus
output depend on the slope of the AS curve?
Deriving the Short-run Aggregate Supply
Curve When the Nominal Wage is Rigid
• What is meant by an aggregate production
function that relates aggregate output as a
function of labor, capital, and technology?
• Why is technology a broad term that relates to
the development of ideas, organization,
managerial innovation, etc.?
• How is the demand for labor derived from the
production function under the assumption that
firms maximize profits? Why is the marginal
physical product of labor at each real wage
rate?
SAS continued

• How is the real wage related to the nominal


wage and the price level?
• What determines the supply of labor in the
economy? How does it relate to the real wage
in the economy?
• Why in the long-run will the labor market
“clear” toward equilibrium at full employment?
• But, why in the short-run is it possible for a
higher price level to lower the real wage and
increase employment and output?
The LAS and SAS Curves

• Why does a higher price level shift up the


short-run aggregate supply curve, SAS, as the
nominal wage rate adjusts to the higher price
level? (See figure 7-6)
• Although the SAS is upward sloping, why is the
long-run aggregate supply curve, LAS,
vertical?
• Why is the real wage unchanged along the
LAS curve?
• What determines employment and real wages
at the natural rate of employment and output?
Fiscal and Monetary Expansion in
the Short Run and Long Run
• How does the initial effect of fiscal policy on
expansion in AD that increases the price level
have on the real wage, employment, and
output for a given (sticky) nominal wage?
• Why does fiscal policy have no cyclical effect
on output in the long-run?
• Can the same conclusions also be reached
regarding the short-run versus long-run effects
of monetary policy?
Neoclassical Macroeconomics and the
Role of Keynes
• Why according to the neoclassical model would output
occur along the LAS curve at all times?
• Why according to the neoclassical school is fiscal
policy primarily a tool that affects the allocation of
resources?
• Why does the money supply determine the price level
in the long-run but not the rate of output and
employment?
• Why, according to the neoclassical school, is a change
in real output from full employment equilibrium only
due to a supply shock or an unexpected change in
demand?
The Keynes’s Revolution: The Failure of
Self-Correction (Three areas of dispute)
• In the goods market, why doesn’t a reduction
in planned investment automatically result in
less saving and more consumption as the
interest rate falls? (Say’s Law)
• In the money market, why isn’t the velocity of
money constant as predicted by the Classical
school? (The Quantity Theory of Money)
• In the labor market, why doesn’t the level of
employment always occur at the natural rate in
the short-run?
• Why did Keynes say that “in the long-run we
are all dead.”
The Effect of Lower Prices During
Recession
• How can the Pigou effect be offset by the
destabilizing effect on expectations when
prices are falling? (Effect of deflation on
postponing the purchase of goods.)
• What is the redistribution effect of lower
prices on aggregate demand?
• How has deflation deepened Japan’s
dilemma and recently led to concern that
it could impact the U.S. economy?
The Great Depression
• Why was aggregate demand so low during the
Great Depression?
• Is there any evidence that monetary policy was
ineffective during the Great Depression due to
a liquidity trap?
• Did the economy’s SAS curve shift downward
to provide self-correction or did it remain
stationary during the Great Depression?
• Were nominal wages rigid and did real wages
fluctuate counter cyclically as predicted by the
Keynesian model?

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