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Terms in this set (12)
Interest rate effect
The price level is one determinant of the quantity of money demanded.
• The lower the price level, the less money households need to hold to buy the goods and services that they want.
• When the price level falls households try to reduce their holdings of money → households try to convert some of their money into interest-bearing assets → banks use these funds to make more loans → this increases the supply of real money balances → interest rates fall.
• In turn, lower interest rates encourage borrowing from firms that want to invest in new factories and equipment → this increase in investment spending means a larger quantity of goods and services demanded.
What are the key facts about economic fluctuations?
Economic fluctuations correspond to changes in business conditions.
• When real GDP grows rapidly, firms find that customers are willing to buy their products and their profits increase. On the other hand, when GDP falls, many firms experience declining sales and decreasing profit.
How do most macroeconomic variables fluctuate?
Real GDP is the variable that is most often used to examine short-run changes in the economy → it measures the value of final goods and services produced within the economy in a given period of time.
• Most macroeconomic variables that measure some type of income or production fluctuate closely together → when real GDP falls, so do personal income, corporate profits, consumer spending, investment spending, industrial production and so on.
• Although many macroeconomic variables fluctuate together, they fluctuate by different amounts → investment spending in particular varies greatly over the business cycle.
As output falls what happens to unemployment?
Changes in the economy's output of goods and services are strongly correlated with changes in the economy's utilization of its labour force.
• The negative relationship between unemployment and real GDP is referred to as Okun's law.
• Okun's law states that in order to keep the unemployment rate steady, real GDP needs to grow at or close to its potential.
Most economists believe that classical theory describes the world in the long run but not in the short run.
What is the wealth effect?
Consider the money that you hold as cash and in your bank account.
• The nominal value of this money is fixed, but its real value is not.
• When prices fall, this money is more valuable because it can buy more goods and services.
• Thus, a decrease in the price level makes consumers feel more wealthy, which in turn encourages them to spend more.
• This increase in consumer spending means larger quantities of goods and services demanded.
What is the exchange rate effect?
A lower price lowers the interest rate → in response, some investors will seek higher returns by investing abroad.
• For example, as the interest rate on EU government bonds fall, an investment funds might sell EU government bonds to buy US government bods → as the investment fund tries to convert its euros into dollars in order to but US bonds, it increases the supply of euros in the market for foreign currency exchange.
• The increased supply of euros causes the euro to depreciate → the relative price of domestic and foreign foods change → real exchange rate changes → European exports increase, whereas European imports decrease.
• The increase in net export spending means a larger quantity of goods and services demanded.
Summary of why why a fall in the price level increases the quantity of goods and services demanded?
Consumers are wealthier, which stimulates the demand for consumption goods.
2. Interest rate falls, which stimulates the demand for investment goods.
3. The exchange rate depreciates, which stimulates the demand for net exports
How are shift caused by consumption?
Any event that changes how much people want to consume at a given price level shifts the AD curve.
When the government cut taxes, it encourages to spend more → AD curve shifts to the right
. • When the government raises taxes, people cut back on their spending → AD curve shifts to the left.
How does investment affect AD?
Any event that changes how much firms want to invest at a given price level shifts the AD curve.
An increase in the money supply lowers the interest rate in the short-run (the LM curve shifts to the right) → this makes borrowing less costly, which stimulate investment spending and, in turn, shifts the AD curve to the right at a given price level.
• A decrease in the money supply shifts the LM curve to the left and raises the interest rate → this discourages investment spending and, in turn, shifts the AD curve to the left at the given price level
How does government expenditure effect AD?
For example, suppose that the government starts building more motorways → the results is a greater quantity of goods and services demanded at any price level, and the AD curve shifts to the right.
How do next exports affect AD?
• Any event that changes net exports for a given price level also shifts the AD curve.
Net exports can also change because of movements in the exchange rate. • An appreciation of the euro makes goods produced in the Euro area more expensive compared to foreign goods, which depresses net exports and shifts the AD curve to the left.
• Conversely, a depreciation of the euro stimulates net exports and shifts the euro area AD curve to the right.
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