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Chapter Objectives
Says law Classical equilibrium Real balance, interest rate, and foreign exchange effects Aggregate demand Aggregate supply in the long run and short run
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Objectives
The Keynesian critique of the classical system Equilibrium at varying price levels Disequilibrium and equilibrium Keynesian policy prescriptions
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GDP = C + I
GDP = C + S
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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C+I=C+S
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7.0 AS
Firms
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AS=7.0
C=6.5
Firms
Their savings are borrowed by investors who spend this money on investment goods 11-12 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
I=0.5
AS=7.0
C=6.5
I=0.5
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7 D 2 4 6 8 Quantity 10 12 14
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If the wage rate is set too high ($9 an hour),the quantity of labor supplied exceeds the quantity of labor demanded. The wage rate falls to the equilibrium level of $7; at that wage rate, the quantity of labor demanded equals the quantity supplied
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The level of aggregate demand varies inversely with the price level. As the price level declines, people are willing to purchase more and more output. Alternatively, as the price level rises, the quantity of output purchased goes down
180 160 140 120 100 80 60 40 20 0 0 1 2 3 4 5 6 7 8 Real GDP (in trillions of dollars) 9 10 Aggregate demand
Aggregate demand is the total value of real GDP that all sectors of the economy are willing to purchase at various price levels
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Thus, American net exports (exports minus imports) component of GDP declines When the price level declines, the net exports component (and GDP) rises
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Why is the curve a vertical line? The classical economists made two assumptions: (1) In the long run, the economy operates at full employment; (2) In the long run, output is independent of prices
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Why does the short-run aggregate supply curve sweep upward to the right? Because business firms will supply increasing amounts of output as prices rise
140 120 100 80 60 40 20 0 0 1 2 3 4 5 6 7 8 9 10 Real GDP (in trillions of dollars) Full-employ ment GDP
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The long-run aggregate supply curve, the short-run aggregate supply curve, and the aggregate demand come together at full-employment
S-RAS
Aggregate demand
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John Maynard Keynes asked, If supply creates its own demand, why are we having a worldwide depression?
John Maynard Keynes advocated massive government intervention to bring an end to the Great Depression
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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As an economy works its way out of a depression, output can be raised without raising prices, so the aggregate supply curve is flat.
160 140 120 100 80 60 40 20 0 0 1 2 3 4 5 6 7 8 Real GDP (in trillions of dollars) 9 10 L-RAS
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However, as resources becomes more fully employed and bottlenecks develop, costs and prices begin to rise. When this happens the aggregate supply curve begins to curve upward.
160 140 120 100 80 60 40 20 0 0 1 2 3 4 5 6 7 8 Real GDP (in trillions of dollars) 9 10 L-RAS
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When we reach full employment (at a real GDP of $6 trillion), output cannot be raised any further
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Real GDP
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9 8 7 6 5 C +I C
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By doing this, aggregate supply is raised relative to aggregate demand and equilibrium is restored
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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In the meantime, aggregate supply has fallen back into equilibrium with aggregate demand
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Because recessions are self-correcting, the role of government is to stand back and do nothing
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Keynes would have prescribed lowering aggregate demand to bring down inflation
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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