Chapter 25

1. Chapter 25 Output And Prices in the Short-Run

2. What Happens to the equilibrium national income when the price level changes ? • There is a negative relationship between the price level and the Aggregate Expenditure . • A change in the price level have an effect on consumption , C and on net exports which in turn affect Aggregate Expenditure.

3. I. Change in Consumption, C • An increase in domestic price level , lower the real value of wealth or income which in turn decrease consumption and the decrease the Aggregate Expenditure , so AE function shift downward . • So as P rises , real W falls , C decreases,and AE Function shift downward . • A fall in the price level has the opposite effect .

4. II. Change in Net Exports ( X- M) • When domestic price level rises, then domestic goods become more expensive relative to foreign goods. Therefore, • Domestic consumers will buy less of domestic goods and more of foreign goods, so imports will rise . • Foreign countries will reduce their purchases of our domestic goods so Exports will decreaseand as a result Net Exports ( X- M ) will fall .

5. Change in Equilibrium National Income • Change in the price level change both Consumption and Net export . • A rise in the price level will decrease both C and ( X-M ) so AE function shift down and Y will decrease . • A fall in the price level has the opposite effect so as P falls , Y will rise .

6. The Aggregate Demand • The negative relationship between the price level and National income is called Aggregate Demand , AD . • AD curve is negatively slopped which means that : • As Price level decrease, Income will rise and as price level rises , Income will falls . • The change in price level , P, causes a movement along the AD curve .

7. Equilibrium National Income and The Price Level • So far, we have discussed how equilibrium National Income is determined using only the Aggregate Demand , AD . • To complete the picture, we need to add the Aggregate Supply to show the final market equilibrium .

8. The Aggregate Supply Curve • Shows the relationship between the quantity supplied by all firms and the price level . • Short-run Aggregate Supply, SRAS curve: relates the price level to quantity supplied by all firms with the assumption that prices of all factors of production remain constant. • Long-run aggregate supplied curve, LRAS: relates the price level to quantity supplied by all firms after the economy has fully adjusted to the change in the price level .

9. Short-Run Aggregate Supply • The SRAS curve shows a positiverelationship between the price level and the total output produced by all firms in the economy. • A change in the price level causes a movement along the SRAS curve from one point to another .

10. Shift in SRAS Curve or Aggregate Supply Shock • There are two reasons for SRAS curve to shift : • 1. Change in prices of inputs or cost of production . • 2. Increase in productivity .

11. I. Change in Prices of Inputs • If prices of inputs rise .. Cost of production will rise .. profit will decrease, therefore, for the same output to be produced , an increase in the price level is required , otherwise the firms will cut production and that shift the SRAS curve to the left . • If prices of inputs fall … it will have the opposite effect . (shift SRAS to the right )

12. II. Increase in Productivity • If labor productivity rises .. Unit cost of production will fall as long as the wage rate does not rise sufficiently to offset the productivity rise . This will shift the SRAS curve to the right . • If labor productivity falls it will have the opposite effect which means it will shift the SRAS curve to the left .

13. Macroeconomic Equilibrium • The intersection between the AD and SRAS curves give us the macroeconomic equilibrium of national income and the price level . • Any shift in either the AD or SRAS curves leads to change in the equilibrium value of the national income and the price level .

14. Aggregate Demand Shock • An increase in AD … shift the AD curve to the right , and this increase both the equilibrium national income and the price level . This increase in AD is called Expansionary Demand Shock. • A fall in AD … shift AD curve to the left, and this decrease both equilibrium national income and the price level . This is called Contractionary Demand Shock

15. Aggregate Supply Shock • An increase in aggregate supply will shiftthe SRAS curve to the right or downwardand this will lead to an increase in the equilibrium national income , but to a decrease in equilibrium price level . • A decrease in aggregate supply will shift the SRAS curve to the left or upward, and this decreases equilibrium national income , but increases the price level .

16. Stagflation • An increase in the price level is called Inflation . • A decrease in output is called Stagnation. • The combination of inflation and • stagnation is called Stagflation

17. The Multiplier when the price level is held constant { Simple multiplier } • The simple multiplier measures the horizontal shift in AD curve in response to the change in autonomous expenditure. • If the price level is held constant, it means that firms are willing to supply all output demanded at the existing price.This leads to horizontal SRAS curve called “ Keynesian SRAS curve “ .

18. Keynesian SRAS Curve • Keynesian SRAS curve is horizontal . • Based on the Keynesian SRAS curve , firms will supply whatever they can sell at their existing price as long as they are operating below the normal capacity . • Therefore, based on the Keynesian SRAS curve, real national income is demand determined .

19. What happens in the case in which SRAS curveslope upward ? • In this case, a rise in national income caused by an increase in AD will be associated with a rise in the price level . • The multiplier effect when the price level is allowed to vary would be smaller than the simple multiplier .

20. The Importance of the Shape of SRAS curve • Over the horizontal range of SRAS curve any change in AD will change the equilibrium national income only. • Over the Intermediate range of SRAS : any change in AD will change both the equilibrium price level and income . • Over the steep range of the SRAS curve: any change in AD will cause large change in equilibrium price level ,but small change in equilibrium national income .

21. The Effect of Demand Shock when the SRAS curve is Vertical • When the SRAS curve is vertical, then any change in AD will change the price level only , and no change in equilibrium national income. • The multiplier in this case is zero .

22. Chapter 26 Output and Prices in the Long Run

23. Potential VS. Actual National Income • Potential National Income, or Y*: Is the total output that can be produced when all production resources are being used at their normal rate of utilization . Therefore, the potential National income represent what should be produced by the economy. • Actual National Income , or Y: Is the output actually produced given by the intersection between AD and SRAS curves .

24. The Output Gap • Is the difference between the potential and actual output . • Output Gap = Y* - Y • When Y* > Y we have Recessionary gap • When Y* < Y we have an Inflationary gap

25. Factor Prices and Output gap • Recessionary gap ( Y* > Y ) causes downward pressure on wages to fall . • Inflationary gap ( Y* < Y ) causes upward pressure on wages to rise . • When Y = Y* , so the GDP gap = 0 , there is neither downward nor upward pressure on wages to go up or down .

26. Long-Run Consequences of AD Shock 1.Expansionary AD Shock: increase in AD -A rise in AD .. Shift AD curve to the right. • This open an inflationary gap (Y > Y*) • The inflationary gap put pressure on wages to rise .. Increase cost of production .. Which shift SRAS curve to the left . This process will continue until the inflationary gap is eliminated. • This process is called “Self-Adjustment mechanism .

27. 2. Contractionary AD shock • Assume the economy is initially operating at full employment . Then , • A fall in AD shift the AD curve to the left and open a recessionary gap . • This gap , put pressure on wages to fall,so cost of production will fall . This encourage more production, so SRAS curve shift to the right until the gap is eliminated . This process is called ( Self-Adjustment mechanism )

28. Long-Run Equilibrium • The intersection between AD and LRAS curves give us the equilibrium P and Y in the long-run • Any shift in AD or LRAS curves will change the equilibrium value of P and Y . • Any change (shift) in AD in long-run will change the price level only . • Any change in LRAS will change both price level and national income , P and Y

29. Basic Theory of Fiscal Stabilization • Fiscal Policy: is the use of government expenditure ( G) and/or government revenue ( T ) to stabilize the economy at full-employment . Fiscal policy can be divided into two cases : • 1. Expansionary Fiscal Policy . • 2. Contractionary Fiscal Policy .

30. 1. Expansionary Fiscal Policy • A fall in T and/or a rise in G will shift AE function upward and shift AD curve to the right , and this will increase the national income or GDP . • Therefore, if the government would like to increase National income or GDP it should use the expansionary fiscal policy.

31. 2. Contractionary Fiscal Policy • A rise in Taxes and /or fall in government expenditure will decrease AE , and shift AE function downward and shift AD curve to the left , and this will decrease the equilibrium national income or GDP. • Therefore, if the government would like to decrease GDP , it should use the contractionary fiscal policy .

32. How a Recessionary gap can be eliminated ? • 1. SRAS curve shift to the right as a result of decrease in prices of input and the cost of production ( self-adjustment mechanism process ) . • 2. AD curve shift to the right as a result of a rise in G /and or a fall in T which will restore full employment at Y* , but at a higher price level .

33. Advantages VS Disadvantages of Fiscal Policy • Advantage: The use of fiscal policy will shorten the period of recession . • Disadvantage: the use of fiscal policy may cause the economy to overshoot its potential output .

34. How an Inflationary gap can be eliminated ? • 1. SRAS curve may shift to the left as a result of an increase in prices of factors of production (self-adjustment mechanism ) . • 2. AD curve shift to the left as a result of fall in G and/or a rise in T (contractionary fiscal policy ) .

35. Built in Stabilizers • These policies specify that government spending or tax changes will take place automatically in response to upturn and downturn in economic activities . • Example of automatic measures are : • 1. Unemployment compensation . • 2.various welfare programs . • 3. Progressive income tax .

36. The effect of Fiscal Policy that is not revesed • If the economy overshoot its potential level of output, it is possible to stabilize the economy at full employment if the fiscal policy can be quickly reversed. • But, if the fiscal policy can not be reversed quickly , then the output gap will exist for longer period, and eventually will be closed through the self-adjustment mechanism .

37. Chapter 27 The Nature of Money and Monetary Institutions

38. Definition of Money • Economists define money as : • Anything that is generally accepted in payment for goods or services or in the repayment of debts . • Barter economy is defined as: an economy where one good is being exchanged directly for another good.

39. Wealth and Money • Wealth is all assets (including money) that are owned by an individual such as Bonds , Stocks , Land, Furniture, Cars, Houses , etc. • Money is just one asset of the total wealth of the individual . • Wealth is much broader concept than money .

40. Income VS. Money • Income is f Flow of earning per period of time . • Money is a stock i.e. certain amount of at a given point in time .

41. Functions of Money • 1. Act as a medium of exchange . • 2. Act as a unit of account . • 3. Act as store of value .

42. 1. Money act as a medium of exchange • This means that money is used to pay for goods and services . • This act promotes economic efficiency by reducing transaction cost . • It eliminates much of the time spent in exchanging goods and services in the Batter economy .

43. Barter Economy • Exchanging one good for another good • In this economy, the transaction cost is very high . • In this economy people have to satisfy “ Double Coincidence of wants “

44. 2. Money act as a unit of account • We measure the value of goods and services in terms of money . • In money economy , the number of prices needed equal to the number of goods and services to be exchanged . • In barter economy, the number of prices needed equal to n ( n-1 ) 2 where n = number of goods to exchanged

45. 3. Money act as a store of value • Money is a store of purchasing power over time . • You can sell what you have for money, and then store your money until you have the time and desire to buy . • Money is not the only asset that has this function , but it is the most liquid asset . • Money losses value during inflation period .

46. Money Supply • Is the total stock of money in the economy at any moment in time . • There are different definitions for the money supply . These definitions vary in terms of what deposits are included .

47. Definitions of Money Supply • 1. Narrow definition of money supply or M1 • Broader definition of money supply or M2 and M3

48. Narrow definition of money supply • M1 = currency in + deposits that can be circulation used as a medium of exchange • Therefore : • M1 = C + DD + NOW D + ATS D + any checkable deposits . • NOW D = Negotiable Order of Withdrawal • ATS D = Automatic Transfer Service

49. Broader Definition of Money Supply or M2 and M3 • M2 = M1 + SD + Small TD • M3 = M2 + Large denomination of TD • Where : SD = Saving deposits TD = Time deposits

50. Near Money & Money substitutes • Near Money: Are assets that satisfy the store of value function and can be converted into a medium of exchange, but they are not themselves a medium of exchange . Example: Treasury Bills that mature in 30 days