HOMEWORK 5

HOMEWORK 5

1.       What are the three causes the aggregate demand curve to slope downward?

The first reason for the downward slope of the aggregate demand curve is Pigou's wealth effect. Recall that the nominal value of money is fixed, but the real value is dependent upon the price level. This is because for a given amount of money, a lower price level provides more purchasing power per unit of currency. When the price level falls, consumers are wealthier, a condition which induces more consumer spending. Thus, a drop in the price level induces consumers to spend more, thereby increasing the aggregate demand.

T he second reason for the downward slope of the aggregate demand curve is Keynes's interest-rate effect. Recall that the quantity of money demanded is dependent upon the price level. That is, a high price level means that it takes a relatively large amount of currency to make purchases. Thus, consumers demand large quantities of currency when the price level is high. When the price level is low, consumers demand a relatively small amount of currency because it takes a relatively small amount of currency to make purchases. Thus, consumers keep larger amounts of currency in the bank. As the amount of currency in banks increases, the supply of loans increases. As the supply of loans increases, the cost of loans--that is, the interest rate--decreases. Thus, a low price level induces consumers to save, which in turn drives down the interest rate. A low interest rate increases the demand for investment as the cost of investment falls with the interest rate. Thus, a drop in the price level decreases the interest rate, which increases the demand for investment and thereby increases aggregate demand.

The third reason for the downward slope of the aggregate demand curve is Mundell-Fleming's exchange-rate effect. Recall that as the price level falls the interest rate also tends to fall. When the domestic interest rate is low relative to interest rates available in foreign countries, domestic investors tend to invest in foreign countries where return on investments is higher. As domestic currency flows to foreign countries, the real exchange rate decreases because the international supply of dollars increases. A decrease in the real exchange rate has the effect of increasing net exports because domestic goods and services are relatively cheaper. Finally, an increase in net exports increases aggregate demand, as net exports is a component of aggregate demand. Thus, as the price level drops, interest rates fall, domestic investment in foreign countries increases, the real exchange rate depreciates, net exports increases, and aggregate demand increases.

2.       What is the difference between the causes of the shifts of the aggregate demand curve and movements along the aggregate demand curve?

A movement along the aggregate demand curve is the result of a change in price. As the law of demand states - all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease and vice versa.

A shift in the demand curve is if there is more demand - A shift in demand curve results from changes in demand - if all other factors that were held constant there is a change in price of other commodities, change in supply of the commodity in question, change in tastes and preferences of consumers, change in income of consumers etc., then the demand curve will shift (outwards if there is an increase in demand and inwards - to the left - if there is a decrease).

3.       Why is there a difference between LRAS curve and the SRAS curve?

In the long run (ceteris paribus), aggregate supply is perfectly inelastic, represented by a vertical line. No matter the inflation or deflation, there will be constant real product. However, in the short run, aggregate supply is much more elastic (and, according to Keynes, can become perfectly elastic (horizontal) if the economy gets into a rut). The real GDP will change because of the price level. But by definition, in the long run real variables are resistant to nominal changes, so real GDP will not be influenced by price level while in the short run it is not constant.

4.       What is the difference between the causes of the shifts of the aggregate supply curve and movements along the aggregate supply curve?

A movement along the aggregate demand curve is the result of a change in price. As the law of demand states - all other factors being equal, as the price of a good or service increases, consumer demand for the good or service will decrease and vice versa.

A shift in the demand curve is if there is more demand - A shift in demand curve results from changes in demand - if all other factors that were held constant there is a change in price of other commodities, change in supply of the commodity in question, change in tastes and preferences of consumers, change in income of consumers etc., then the demand curve will shift (outwards if there is an increase in demand and inwards - to the left - if there is a decrease).

1.        Why does the multiplier effect occur?

The multiplier effect occurs because:

as saving levels increase, a greater pool of loanable funds is available for investment spending by businesses.

increases in income cause a chain reaction of spending by many businesses and individuals.

increases in income cause tax revenues to increase, thereby stimulating increases in government spending levels.

businesses copy the spending decisions of their competitors.

2.        If the MPC is 0.75 and there is an increase in autonomous expenditure of $100 billion, what will the multiplier be?

3.        How does the federal budget deficit impact private investment?

The rising federal budget deficit has garnered increased attention from policy makers and the public, who are concerned about its long-term effects. The Congressional Budget Office (CBO) projected in August 2011 that federal expenditures would exceed revenues by more than $1.2 trillion for the year, the third consecutive year the deficit will top $1 trillion. The CBO warns that the deficit can seriously impact economic growth and living standards in the U.S

1.       Which macroeconomic schools of thought believe that there is no difference between the short run and the long run aggregate supply curve?

Keynesian economics is a theory of total spending in the economy and its effects on output and price level. Keynesian economists believe that aggregate demand is influenced by a host of economic decisions-both public and private- and erratically. According to Keynesian economists, changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run effect on real output and employment, not on prices. Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending- consumption, investment, or government expenditures- cause output to fluctuate. Furthermore, Keynesians believe the rigidity of prices; especially wages causes periodic shortages and surpluses, especially of labor. Many Keynesians advocate stabilization policy to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems.

1.        Which economic schools of thought believe that the equilibrium level of real GDP per year is completely supply determined, and, that changes in aggregate demand affect only the price level, not real GDP?

Keynesian economics (/ˈkeɪnziən/ KAYN-zee-ən; or Keynesianism) is the view that in the short run, especially during recessions, economic output is strongly influenced by aggregate demand (total spending in the economy). In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy; instead, it is

2.        Which macroeconomic schools of thought believe that prices, especially the price of labor (wages), were inflexible downward due to the existence of unions and long-term contracts between businesses and workers?

3.        In whose model is increase in aggregate demand (AD) only leads to increase in real GDP and not the price level?

This is for the same reason that increased demand leads to higher prices in microeconomics.The idea is that there is greater demand, which means that there are more people who are willing to buy a given product.  When that happens, the people are typically willing to pay higher prices because they know that if they do not pay that price, someone else will and the product will be gone.So when there is more demand, there is more "money chasing goods" and the prices have to rise and you end up with demand-pull inflation.

4.In whose analysis does increase in AD lead to a lower short-run equilibrium increase than when the SRAS curve is horizontal, and to a higher price level that then causes planned purchases of goods and services to decline or rise to a level less than when the SRAS curve is horizontal?

The AD–AS or aggregate demand–aggregate supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply. It is based on the theory of John Maynard Keynes presented in his work The General Theory of Employment, Interest, and Money. It is one of the primary simplified representations in the modern field of macroeconomics, and is used by a broad array of economists, from libertarian, Monetarist supporters of laissez-faire, such as Milton Friedman, to Post-Keynesian supporters of economic interventionism, such as Joan Robinson.

Which macroeconomic school of thought said that when price level rises partially, real GDP can be expanded beyond the level consistent with its long-run growth path?

John Maynard Keynes issued the most telling challenge. He argued that wage rigidities and other factors could prevent the economy from closing a recessionary gap on its own. Further, he showed that expansionary fiscal and monetary policies could be used to increase aggregate demand and move the economy to its potential output. Although these ideas did not immediately affect U.S. policy, the increases in aggregate demand brought by the onset of World War II did bring the economy to full employment. Many economists became convinced of the validity of Keynes’s analysis and his prescriptions for macroeconomic policy.

4.        An increase in aggregate demand will not raise the price level, and a decrease in aggregate demand will not cause the firms to lower prices.

5.        Which macroeconomic schools of thought made this statements and why?

It is often cited that the aggregate demand curve is downward sloping because at lower price levels a greater quantity is demanded. While this is correct at the microeconomic, single good level, at the aggregate level this is incorrect. The aggregate demand curve is in fact downward sloping as a result of three distinct effects: Pigou's wealth effect, the Keynes' interest rate effect and the Mundell-Fleming exchange-rate effect. Additionally, the higher the price level is to be, the less demanded and thus it is downward sloping.[3]

1.       What is your prediction of what you are about to read?

I think it is a lot of work but I can digest it.

2.       How will you remember what you are about to read?

I will remember what I read by reading it more than one time and then putting it into my own understanding

3.       What are some things you are about to do to learn this information?

I compare it to other things I have learnt and try to interpret it in real life.

4.       As you read, did you put each passage in your own words?

Yes I did. I try to write the information out in bullet points in my own words so it is better understood.