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Explain how the static aggregate demand and aggregate supply model gives us misleading results about the price level, particularly with respect to decreases in aggregate demand. Describe how the aggregate demand curve is different in the dynamic model as compared to the static model. Describe how potential GDP is different in the dynamic model as compared to the static model.

The aggregate demand and aggregate supply model explains short-run fluctuations in
real GDP and the price level. The aggregate demand (AD) curve shows the relationship between
the price level and the quantity of real GDP demanded by households, firms, and the government
(both inside and outside of the country). The short-run aggregate supply (SRAS) curve shows
the relationship in the short run between the price level and the quantity of real GDP supplied
by firms. In the short run, real GDP and the price level are determined by the interaction of the
aggregate demand curve and the short-run aggregate supply curve.
The aggregate demand curve tells us the relationship between the price level and the
quantity of real GDP demanded, holding everything else constant. If the price level changes but
other variables that affect the willingness of households, firms, and the government to spend
are unchanged, the economy will move up or down a stationary aggregate demand curve. If any
variable changes other than the price level, the aggregate demand curve will shift.
Three variables shift the aggregate demand curve:
Changes in government policies. The federal government uses monetary policy and
fiscal policy to shift the aggregate demand curve. Monetary policy refers to the actions
the Federal Reserve take to manage the money supply and interest rates to achieve
macroeconomic policy objectives. Fiscal policy refers to changes in federal taxes and
purchases that are intended to achieve macroeconomic policy objectives.
Changes in the expectations of households and firms.
Changes in foreign variables.
Because changes in the price level do not affect the number of workers, the capital stock,
and the available technology in the long run, changes in the price level do not affect the level of
real GDP. The level of real GDP in the long run is called potential GDP or full-employment GDP.
The long-run aggregate supply (LRAS) curve shows the relationship in the long run between the
price level and the quantity of real GDP supplied. The LRAS curve is a vertical line. Because
potential GDP increases each year, the long-run aggregate supply curve shifts to the right each
year.
The short-run aggregate supply curve is upward sloping because, over the short run, as the
price level increases the quantity of goods and services firms are willing to supply increases. The
main reason firms behave this way is that as the prices of goods and services rise, prices of inputs
rise more slowly. Most economists believe that some firms and workers fail to accurately predict
changes in the price level. The reasons for this include:
contracts make some wages and prices sticky
firms are often slow to adjust wages
menu costs, the costs to firms of changing prices, make some prices sticky
The aggregate demand and aggregate supply model can be used to analyze changes in real
GDP and the price level. In the long run, the short-run aggregate supply curve and the aggregate
demand curve intersect at a point on the long-run aggregate supply curve, and the economy
produces its potential level of real GDP. At this point, firms are operating at their normal level of
capacity, and everyone who wants a job will have one, except for the structurally and frictionally
unemployed.
Summary
161
BAM 223 Principles of Economics
The basic aggregate demand and aggregate supply model leads to some misleading results
because of these assumptions: (1) the economy does not experience continuing inflation and (2)
the economy does not experience long-run growth. We can create a dynamic aggregate demand and
aggregate supply model by making changes to the basic model based on the following facts:
potential real GDP increases continually, shifting the long-run aggregate supply curve to
the right.
during most years, the aggregate demand curve shifts to the right.
except during periods when workers and firms expect high rates of inflation, the short-run
aggregate supply curve shifts to the right.
The dynamic aggregate demand and aggregate supply model provides a more accurate
explanation than the basic model of the source of most inflation. If total spending in the economy
grows faster than total production, prices rise. Inflation can also result when there is a shift to the
left of the short-run aggregate supply curve.

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