Real GDP in the Long Run
When prices have time to fully adjust to changes in demand.
Real GDP in the Short Run
When prices don't yet have time to fully adjust to changes in demand. Prices don't change or don't change very much.
Aggregate Demand
Total demand for goods and services in an entire economy.
Aggregate Demand Curve (AD)
A curve that shows the relationship between the level of prices and the quantity of real GDP demanded.
Three ways Aggregate Demand curve is affected, Price levels fall.
1. Wealth Effect
2. Interest Rate Effect
3. International Trade Effect
Wealth Effect
Increase in spending that occurs because the real value of money increases when the price level falls.
Interest Rate Effect
Price levels go down leads to lower interest rates, cheaper to borrow money to make purchases. Demand for goods will increase. More money to consume.
International Trade Effect
Price levels go down, domestic goods (goods produced in the US) become cheaper, demand for domestic goods increase. Exports increase, imports decrease.
Reasons why AD shifts to the right, increases
1. Decrease in Taxes: More disposable income to use consumption or investments.
2. Increase in Government spending
3. Increase in money supply
Total Consumption is made up of what two things?
1. Consumption Function: Relationship between consumption spending and Level of income
2. Autonomous Consumption: Necessity Spending
Consumption function
The Marginal Propensity to Consume (MPC) slope
Marginal Propensity to Consume (MPC)
The fraction of additional income that is spent.
MPC= change in consumption
--------------------------
change in disposable income (DI)
MPC Example: If household receives additional $100 and consumes an additional $70. the other $30 went to savings.
MPC: $70
------- = 0.7
$100
Marginal Propensity to Save (MPS)
The fraction of additional income that is saved.
MPS = additional savings
---------------------
additional income
MPC and the MPS
The sum of the MPC and the MPS always equals one (100%). By definition additional income is either spent or saved.
Dis savings
When savings is negative. C>DI Consumption is greater than disposable income.
Two ways Dis savings is accomplished
1. Borrowing
2. Take out of previous savings-spend accumulated wealth
Multiplier
The ratio of the total shift in aggregate demand to the initial shift in aggregate demand. Basically the multiplier is the reciprocal of MPS.
Multiplier Example
Multiplier = 1
------------------
(1-MPC)
Aggregate Supply Curve (AS)
Curve that shows the relationship between the level of prices and the quantity of output supplied.
Long Run Aggregate Supply Curve
Vertical aggregate supply curve that reflects the idea that in the long run, output is determined solely by the factors of production and technology. Full employment. Prices go up.
Short Run Aggregate Supply Curve
Relatively flat aggregate supply curve that represents the idea that prices do not change very much in the short run and that firms adjust production to meet demand.
What happens to Aggregate Demand in Short run AS?
1. Output will increase
2. Small changes in price levels
3. Short Run AS curve slopes upwards.
Factors that determine cost of firms to produce
1. Input resources: wages, materials
2. Technology
3. Government Actions: taxes, subsidies, regulations
Supply Shocks
External factors that shift Aggregate Supply Curve. i.e. Increase in Oil Prices shifted to left.
Stagflation
A decrease in real output with increasing prices. High inflation + Unemployment.