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181

Case (1): A Contraction in Aggregate Demand

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Case (1): ECONOMIC FLUCTUATIONS: AD

Contraction (leftward shift) in Aggregate Demand (AD)

183

Case (1): ECONOMIC FLUCTUATIONS: AD

In the short run

output decreases,
the overall price level decreases, and
the unemployment rate increases

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Case (1): ECONOMIC FLUCTUATIONS: AD

In the long run

the overall price level decreases,
but output and the unemployment rate remain unchanged at their long-run levels

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Case (2): ECONOMIC FLUCTUATIONS: AS

A leftward shift in Short-Run Aggregate Supply
Output falls below the natural rate of employment
Unemployment rises
The price level rises
If the government does nothing, the SRAS will shift back to where it was.
The price level, total production and unemployment will be unaffected in the long run.

186

Case (2): An Adverse Shift in Aggregate Supply

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Stagflation

Adverse shifts in aggregate supply cause stagflation — a period of recession and inflation
Output falls and prices rise.

188

Accommodating an Adverse Shift in Aggregate Supply

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Why is the aggregate demand curve downward sloping

Inflation rate and investments (Interest rate effect)

Inflation rate and wealth (Pigou's wealth effect)

Inflation rate and net exports (Mundell-Flemings exchange rate effect)

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(Mundell-Flemings exchange rate effect)

A lower inflation rate lowers the interest rate. Investors will seek higher returns by investing abroad. The increase in net foreign investment raises the dollar supply, lowering the real exchange rate. Domestic goods become relatively cheaper compared to foreign goods. Net exports rise thereby increasing the quantity of goods and services demanded.

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(Interest rate effect)

A lower inflation rate induces the RBA to reduce the interest rate which encourages greater spending on investment goofs. It therefore increases the quantity of goods and services.

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(Pigou's wealth effect)

A decrease in the inflation rate (overall price level decreases) makes consumers feel wealthy. In turn it encourages them to spend more.

193

Why the aggregate supply curve is vertical in the long run

In the long run an economy's supply of goods and services depends on its supplies of resources along with the available production technology. Because the inflation rate does not affect the determinants of output in the long run, the LRAS curve is vertical at the natural rate of output.

194

The new classical mispercetions theory

Changes in the inflation rate (overall price level) can temporarily mislead suppliers about what is happening in the markets in which they sell their output. Suppliers respond to changes in the level of prices and thus the SRAS curve is upward sloping.

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The Keynesian sticky wage theory

Wages do not adjust to changes in prices in short run therefore real wages change and suppliers adjust their output levels. A lower rate of inflation makes employment and production less profitable leading firms to lower the quantity of goods and services supplied.

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The new Keynesian sticky price theory

The prices of some goods and services are also sometimes slow to respond to changes in the economy (menu costs). An unexpected fall in inflation rate leaves some firms with higher than desired prices which depresses sales and induces the firms to lower the quantity of goods and services supplied.

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Why the short run supply curve might shift

Events that shift long run

Inflation rate expectations

198

Events that shift long run

Events that shift the LRAS will shift the SRAS as well e.g. production costs, technology, minimum wages.

199

Inflation rate expectations

People's expectations of the inflation rate will affect the position of the SRAS curve even though it has no effect on the LRAS curve. A higher expected inflation rate will decrease the quantity of goods and services supplied and shift the SRAS curve to the left whereas a lower expected inflation rate increases the goods and services supplied and shifts the SRAS curve to the right.

200

If the world oil price increases

If the world oil prices rise, then short-run AS would decrease

201

Keynes attempted to explain:

short-run economic fluctuations and advocated policies to increase aggregate demand

The Keynesian school of thought argues that due to the multiplier effect, a relatively small increase in aggregate expenditures will have a larger final effect on total expenditures over time and therefore only a proportionally small boost to national spending is required to close a relatively large gap in GDP (being the gap between the actual level of GDP and the full employment level of GDP). Thus, Keynes advocated aggregate demand focused policies.

202

13. When an increase in the minimum wage raises the natural rate of unemployment:

both short-run and long-run aggregate-supply curves shift to the left

203

How fiscal policy influences aggregate demand

Changes in government purchases

Changes in taxes

Supply side economics

204

Changes in government purchases

When the government changes the level of its purchases it influences aggregate demand directly. A decrease in government purchases shifts the aggregate demand curve to the left. An increase in government purchases shifts the aggregate demand curve to the right.

The multiplier effect and the crowding out effect

205

The multiplier effect

The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

206

Expansionary fiscal policy

A planned decrease in the budget surplus (e.g. tax cut) to increase household's income and consumption.

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Contractionary fiscal policy

A planned increase in the budget surplus (e.g. reduced government spending without any reduction in taxes.)

208

The crowding out effect

The offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.

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The multiplier and crowding out effect

If the multiplier effect e.g. 3 billion is greater than the crowding out effect e.g. 2 billion, aggregate demand will rise by more than 1 billion and vice versa

210

Changes in taxes

Changes in taxes affect affect a households take-home pay. If the government reduces taxes, households income will increase which results in higher saving and consumption. The aggregate-demand curve will shift to the right and vice versa. The size of the shift in the aggregate demand curve will also depend on the sizes of the multiplier and crowding-out effect.