| UNIT THREE |
CHAPTER 10
The Classical AS/AD MacroEconomic Model
I.
Anticipated and Unanticipated Changes
A.
Anticipated changes are foreseen by economic participants. Decision
makers have time to adjust to them before they occur.
B.
Unanticipated changes catch people by surprise.
II.
Factors That Shift Aggregate Demand
A.
An increase (decrease) in real wealth.
B.
A decrease in
the real rate of interest.
C.
An increase in
the optimism (pessimism) of businesses and consumers about the future economic
conditions
D.
An increase
(decline) in the expected rate of inflation.
E.
Higher (lower)
real incomes abroad.
F.
A reduction
(increase) in the exchange rate value of the nation’s currency.
III. Unanticipated
Changes in Aggregate Demand
A.
In the short run, output will deviate from full employment capacity when
prices in the goods and services market deviate from the price level that people
expected.
B.
Impact of an Unanticipated Increases in Aggregate Demand
1.
Initially, the strong demand and higher price level in the goods and
services market will temporarily improve profit margins.
2.
Output will increase; the rate of unemployment will drop below the
natural rate and output will temporarily exceed the economy's long-run
potential.
3.
With time, however, contracts will be modified and resource prices will
rise and return to their competitive relation with product prices.
4.
Once this happens, output will recede to the economy's long-run
potential.
C. Impact of an Unanticipated
Reductions in Aggregate Demand
1.
Weak demand and lower prices in the goods and services market will reduce
profit margins. Many firms will incur losses.
2.
Firms will reduce output; the rate of unemployment will rise above the
natural rate and output will temporarily fall short of the economy's long-run
potential.
3.
With time, long-term contracts will be modified. Eventually, lower
resource prices and interest rate will direct economy back to long-run
equilibrium, but this may be a lengthy and painful process.
IV. Shifts in
Aggregate Supply
A. Changes in Long‑Run
Aggregate Supply
1. An increase
(decrease) in the supply resources.
2.
An improvement (deterioration) in technology and productivity.
3.
Institutional changes that increase (reduce) the efficiency of
resource use.
B. Changes in Short‑Run
Aggregate Supply
1.
A decrease (increase) in resource prices—that is, production costs.
2.
A reduction
(increase) in the expected rate of inflation.
3.
Favorable
(unfavorable) supply shocks, such as good (bad) weather or a reduction
(increase) in the world price of an important resource.
V.
Impact of Changes in Aggregate Supply
A.
Economic Growth and Anticipated Shifts in Long‑Run Aggregate
Supply
1.
Increases in LRAS will make it possible to produce and sustain a larger
rate of output.
2.
Both LRAS and SRAS will shift to the right and output will
increase.
3.
These changes generally take place slowly and therefore they need not
disrupt long-run equilibrium.
B.
Impact of an Unanticipated Increase in SRAS
1.
SRAS shifts to the right—temporarily output will exceed the
economy's long-run potential.
2.
Since the temporarily favorable supply conditions cannot be counted on in
the future, the economy s long-term production capacity will not be altered.
3.
Recognizing that they will be unable to maintain their current high level
of income, individuals will generally save a substantial portion of it for use
at a future time that is not nearly so prosperous.
4.
The increased saving with reduce interest rates, which will encourage
investment (capital formation).
C.
Impact of an unanticipated reductions in SRAS
1.
If an unfavorable supply shock is expected to be temporary, long-run
aggregate supply will be unaffected.
2.
Households will reduce their current saving level (and dip into past
savings) to maintain a current consumption level more consistent with their
longer-term perceived opportunities.
3.
The reduction in saving will lead to higher real interest rates and
retard current investment.
VI.
The Business Cycle Revisited
A.
Recessions occur because prices in the goods and services market are low
relative to costs of production (and resource
prices). There are two reasons for this:
1. unanticipated reductions
in aggregate demand and
2. unfavorable supply
shocks.
B. An unsustainable
economic booms occurs when prices in the goods and services market are high
relative to costs (and resource prices). The
two causes of booms are:
1.
unanticipated increases in aggregate demand and
2.
favorable supply shocks.
VII. Does the Market
Have a Self-Corrective Mechanism that will Keep it on Track?
A. There are three reasons
to believe that it does.
1.
Consumption demand is relatively stable over the business cycle.
2.
Changes in real interest rates will help to stabilize aggregate demand
and redirect economic fluctuations. Interest rates will tend to fall during a
recession and rise during and economic boom.
3.
Changes in real resource prices will redirect economic fluctuations. Real
resource price will tend to fall during a recession and rise during an economic
expansion.
IX. The Great Debate:
How Rapidly Does the Self-Corrective Mechanism Work?
A.
Many economists believe that the self-corrective mechanism works slowly:
if this is the case, then market economies will still experience prolonged
periods of abnormally high unemployment and below-capacity output.
B.
Many other economists believe that is work fairly rapidly if it is not
disrupted by perverse monetary and fiscal policy.
