Page 257 - Krugmans Economics for AP Text Book_Neat

Section 4 Summary

Section 4 Review

Summary
1. The consumption function shows how an individual 9. Changes in commodity prices, nominal wages, and pro-
household’s consumer spending is determined by its ductivity lead to changes in producers’ profits and shift
current disposable income. The aggregate consump- the short -run aggregate supply curve.
tion function shows the relationship for the entire 10. In the long run, all prices, including nominal wages, are
economy. According to the life-cycle hypothesis, house- flexible and the economy produces at its potential out-
holds try to smooth their consumption over their life- put. If actual aggregate output exceeds potential out-
times. As a result, the aggregate consumption function put, nominal wages will eventually rise in response to
shifts in response to changes in expected future dispos- low unemployment and aggregate output will fall. If po-
able income and changes in aggregate wealth. tential output exceeds actual aggregate output, nominal
2. Planned investment spending depends negatively on wages will eventually fall in response to high unemploy-
the interest rate and on existing production capacity; it ment and aggregate output will rise. So the long -run
depends positively on expected future real GDP. aggregate supply curve is vertical at potential output.
3. Firms hold inventories of goods so that they can satisfy 11. In the AD–AS model, the intersection of the short -run
consumer demand quickly. Inventory investment is aggregate supply curve and the aggregate demand curve
positive when firms add to their inventories, negative is the point of short -run macroeconomic equilib-
when they reduce them. Often, however, changes in in- rium. It determines the short -run equilibrium aggre-
ventories are not a deliberate decision but the result of gate price level and the level of short -run equilibrium
mistakes in forecasts about sales. The result is un- aggregate output.
planned inventory investment, which can be either 12. Economic fluctuations occur because of a shift of the
positive or negative. Actual investment spending is aggregate demand curve (a demand shock) or the short -
the sum of planned investment spending and un- run aggregate supply curve (a supply shock). A demand
planned inventory investment. shock causes the aggregate price level and aggregate
4. The aggregate demand curve shows the relationship output to move in the same direction as the economy
between the aggregate price level and the quantity of ag- moves along the short -run aggregate supply curve. A
gregate output demanded. supply shock causes them to move in opposite direc-
5. The aggregate demand curve is downward sloping for tions as the economy moves along the aggregate de-
two reasons. The first is the wealth effect of a change mand curve. A particularly nasty occurrence is
in the aggregate price level—a higher aggregate price stagflation—inflation and falling aggregate output—
level reduces the purchasing power of households’ which is caused by a negative supply shock.
wealth and reduces consumer spending. The second is 13. Demand shocks have only short -run effects on aggre-
the interest rate effect of a change in the aggregate gate output because the economy is self -correcting in
price level—a higher aggregate price level reduces the the long run. In a recessionary gap, an eventual fall in
purchasing power of households’ and firms’ money nominal wages moves the economy to long -run macro-
holdings, leading to a rise in interest rates and a fall in economic equilibrium, in which aggregate output is
investment spending and consumer spending. equal to potential output. In an inflationary gap, an
6. The aggregate demand curve shifts because of changes eventual rise in nominal wages moves the economy to
in expectations, changes in wealth not due to changes in long -run macroeconomic equilibrium. We can use the
the aggregate price level, and the effect of the size of the output gap, the percentage difference between actual
existing stock of physical capital. Policy makers can use aggregate output and potential output, to summarize
fiscal policy and monetary policy to shift the aggre- how the economy responds to recessionary and infla-
gate demand curve. tionary gaps. Because the economy tends to be self -cor-
recting in the long run, the output gap always tends
7. The aggregate supply curve shows the relationship be-
toward zero.
tween the aggregate price level and the quantity of ag-
gregate output supplied. 14. The high cost—in terms of unemployment—of a reces-
sionary gap and the future adverse consequences of an
8. The short -run aggregate supply curve is upward slop-
inflationary gap lead many economists to advocate ac-
ing because nominal wages are sticky in the short run:
tive stabilization policy: using fiscal or monetary pol-
a higher aggregate price level leads to higher profit per
icy to offset demand shocks. There can be drawbacks,
unit of output and increased aggregate output in the
however, because such policies may contribute to a
short run.
long -term rise in the budget deficit, leading to lower
Summary 215