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A recession is a period of declining real
GDP, falling incomes, and risingunemployment.
A depression is a severe recession.
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Economist use the model of aggregatedemand and aggregate supply to explain
short-run fluctuations in economic
activity around its long-run trend.
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The aggregate demand curveshows thequantity of goods and services that
households, firms, and the government
want to buy at each price level.
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The aggregate supply curve shows the
quantity of goods and services that
firms produce and sell at each price
level.
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Equilibrium
output
Quantity of
Output
PriceLevel
0
Equilibriumprice level
Aggregate
supply
Aggregatedemand
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The four components of GDP (Y)
contribute to the aggregate demand for
goods and services.
Y = C + I + G + NX
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The Price Level and Consumption: The
Wealth Effect
The Price Level and Investment: The
Interest Rate Effect
The Price Level and Net Exports: TheExchange-Rate Effect
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Shifts arising from Consumption
Shifts arising from InvestmentShifts arising from Government
Purchases
Shifts arising from Net Exports
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Quantity ofOutput
PriceLevel
0
Aggregatedemand, D1
P1
Y1
D2
Y2
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In the long run, the aggregate-
supply curve is vertical.
In the short run, the aggregate-
supply curve is upward sloping.
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In the long-run, an economys production of
goods and services depends on its supplies of
labor, capital, and natural resources and on
the available technology used to turn these
factors of production into goods and services.
The price level does not affect these variables
in the long run.
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Quantity ofOutputNatural rateof output
PriceLevel
0
Long-run
aggregatesupplyP1
P22. does not
affect the quantityof goods and
services supplied
in the long run.
1. A change
in the price
level
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The long-run aggregate supply curve
is vertical at the natural rate of
output.
This level of production is also
referred to as potential output orfull-employment output.
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Shifts arising from Labor
Shifts arising from CapitalShifts arising from Natural
Resources
Shifts arising from TechnologicalKnowledge
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The Misperceptions Theory
The Sticky-Wage Theory
The Sticky-Price Theory
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Changes in the overall price level temporarily
mislead suppliers about what is happening in
the markets in which they sell their output:A lower price level causes misperceptions
about relative prices.
These misperceptions induce suppliers to
decrease the quantity of goods and services
supplied.
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Nominal wages are slow to adjust, or are
sticky in the short run:
Wages do not adjust immediately to a fall inthe price level.
A lower price level makes employment
and production less profitable.
This induces firms to reduce the quantity of
goods and services supplied.
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Prices of some goods and services adjust
sluggishly in response to changing economic
conditions:An unexpected fall in the price level leaves
some firms with higher-than-desired prices.
This depresses sales, which induces firms to
reduce the quantity of goods and services
they produce.
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Shifts arising from Labor
Shifts arising from CapitalShifts arising from Natural Resources.
Shifts arising from Technology.
Shifts arising from the Expected PriceLevel.
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In the short run, shifts in aggregate
demand cause fluctuations in the
economys output of goods and services.
In the long run, shifts in aggregate
demand affect the overall price level but
do not affect output.
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Adverse shifts in aggregate supply
cause stagflationa combination of
recession and inflation.
Output falls and prices rise.
Policymakers who can influence aggregate
demand cannot offset both of these adverseeffects simultaneously.
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Policymakers may respond to a recession
in one of the following ways:
Do nothing and wait for prices and wages toadjust.
Take action to increase aggregate demand by
using monetary and fiscal policy.
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