Transcript Chapter 12

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Economics for Managers
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Chapter 12, ECON125
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Chapter 12
Macroeconomic Models
and Analysis
Mastrianna, F.V. Basic Economics (14th
ed.) © 2007 Thomson South-Western.
ISBN 9780324400700
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Copyright Warning
This presentation is the intellectual property of the textbook
publisher Thomson South-Western 2007. Students are hereby
advised that they may not copy or distribute this work to any
third party
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Learning Objectives
Upon successfully completing this module, the student should be
able to:
Explain briefly the aggregate supply and aggregate demand framework
Explain the major ideas of classical economic doctrine and understand
Say’s law
Define aggregate expenditure and name its components
Demonstrate an equilibrium position according to Keynesian analysis
Explain the relationship between the multiplier and changes in income
resulting from a change in aggregate expenditures
Discuss the various options concerning the shape of the aggregate
supply curve
Distinguish between the monetarist and new classical theories
Describe the supply-side approach to expanding national output and
income
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Aggregate Demand (AD) Curve
The total amount of real output that buyers in an
economy will purchase at various alternate price levels
Real output
Output adjusted for changes in the price level
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Aggregate Demand (AD) Curve
Reasons for negative slope
Price level increases  increases in nominal income 
increases in income taxes
Higher price levels in the U.S. relative to price levels in the
rest of the world discourage exports and stimulate imports
A higher price level reduces the real purchasing power of
assets or wealth that people own
Higher price levels lead to higher interest rates  declines
in borrowing by businesses and spending by consumers
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Aggregate Supply (AS) Curve
A plot of the various quantities of total real output that
producers will offer for sale at various price levels
The shape of the aggregate supply curve is a matter of
much debate among economists
The difference between what AS looks like in the short
run and what it looks like in the long run, and about how
long the short run and the long run are
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Aggregate Supply (AS) and Aggregate
Demand (AD) Curves
P
AS
The intersection of AS and
AD determine the
equilibrium level of
average prices and total
output in the economy
P1
AD
0
Y1
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Y
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Classical Analysis
The most critical classical assumption is that the
economy can be in equilibrium only at full employment
If not, according to classical analysis, the situation will
correct itself
The market economy is self-regulating
Competition helps maintain or move the economy toward
equilibrium
If unsold inventory exists, prices decrease
All saving is invested because of interest rates are
forced down
Competition between workers eliminates
unemployment
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Classical Analysis
Say’s Law
The classical view that if supply creates its own demand,
then all goods offered for sale must be purchased
Alternatively, production creates supply and also creates
an equivalent amount of monetary purchasing power
(demand)
Because all income is spent, supply and demand are
always equal
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Keynesian Analysis
Economy can get stuck at equilibrium with significant
levels of unemployment
No automatic forces operate to solve this problems
Economy cannot take care of itself  the government
has a responsibility to pull the economy out of a
recession
Also known as income-expenditure analysis
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Keynesian Analysis
Purchasing power does not automatically become
demand for goods and services
Total demand for goods and services may be less than
the supply of goods produced
Focused on aggregate expenditure
Aggregate expenditures (AE)
Total planned spending for goods and services by
consumers, businesses, government, and foreign buyers
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Keynesian Analysis
Total output—and therefore total employment and
income—is determined by AE
The income derived from the output of goods and
services, in turn, determines AE
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A Two-Sector Economy
There are two sectors of AE:
Consumption
Investment
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Consumption
The largest component of spending
The amount consumers spend depends primarily on
their disposable income
Consumption function
Any equation, table, or graph that shows the relationship
between the income that consumers receive (disposable
income) and the amount they plan to spend on currently
produced final output
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Marginal Propensity to Consume (MPC)
The ratio of the change in consumption spending to the
change in disposable or after-tax income
The slope of the consumption function
0 < MPC < 1
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Saving
Keynes challenged the classical economic belief that
planned saving depended entirely on the interest rate
Keynes believed that consumers’ saving habits were
based primarily on their income
Saving function
The relationship between the amount of disposable
income consumers receive and the amount they save
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Marginal Propensity to Save (MPS)
The ratio of the change in planned saving to the change
in disposable income
The slope of the saving function
MPC + MPS = 1
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Investment
Classical economists believed that the most important
determinant of planned investment spending was the
interest rate
Keynes argued that profit expectations are the most
important single determinant of planned investment
spending by business
The Keynesian model treats planned investment as
having a given value that is determined by factors
outside of the model
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Expenditure
Consumption and Savings Functions
C = consumption function
Saving
C2
C1
Planned consumption =
total income and total output
45o
Saving
0
Y1
Y2
Real Income
S = saving function
S2
0
Saving
Y1
Y2
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Real Income
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Equilibrium Output when
Planned I Equals Planned S
Expenditure
Equilibrium 
AE equals total
output
Constant level of
planned investment
0
45o
Y1 Y2 Y3 Y4
Saving and
Investment
C+I
C
Real Income
S
I
0
I
Y1 Y2 Y3 Y4
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Real Income
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Equilibrium Output when
Planned I Equals Planned S
Expenditure
C+I
C
0
45o
Saving and
Investment
Y1
Y3
Real Income
S
I
0
I
Y1
Y3
Real Income
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At any output level
below Y3, for example
Y1, planned
investment > planned
saving  production
and output would
increase as firms
expanded supply to
meet the excess
demand
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Equilibrium Output when
Planned I Equals Planned S
Expenditure
C+I
C
0
45o
Saving and
Investment
Y3 Y4
Real Income
S
I
0
I
Y3 Y4
Real Income
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Chapter 12, ECON125
At any output
level above Y3, for
example Y4,
planned
investment <
planned saving 
production and
output would
decrease
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Government Spending and Taxes
Government spending (G)
Causes increases in aggregate expenditures  injection
Assumed to be determined by factors other than income
Taxes (T)
Causes decreases in aggregate expenditures 
leakage
An increase (decrease) in T causes the saving function
to shift up (down) by the amount of the tax increase
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Taxes
Incorporated into the aggregate expenditure model
through the consumption function
An increase in taxes reduces disposable income 
consumption function shifts downward
A fall in taxes increases disposable income 
consumption function shifts upwards
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Net Exports
Exports (X)
Purchases by foreigners
Add to aggregate expenditures  injection
Imports (IM), spending of consumers, businesses, and
government on foreign output
Reduces aggregate expenditures  leakage
Both are assumed to be determined by factors outside
the model
Net exports (X – IM) can be regarded as a given constant
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Complete AE relationship
AE ≡ C + I + G + (X – IM)
Equilibrium
AE equals total output
Planned leakages = planned injections
Below equilibrium, injections > leakages  income and
output rise
Above equilibrium, injections < leakages  income and
output fall
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Equilibrium with Unemployment
Keynes argued that there may be no automatic
adjustment toward the full-employment level of output
Various measures must be used to stimulate the economy
Increased consumption
Increased net exports
Increased investment
Increased government spending
Discretionary government spending
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Discretionary Government Spending Used to
Increase Income and Output
Expenditure
C + I + G2 + (X – IM)
C + I + G1 + (X – IM)
C
If discretionary government
45o
Y1
Y*
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Chapter 12, ECON125
spending were used to fill the
vertical gap Y* between total
output and AE at full
employment  injections
equal leakages  equilibrium
occurs at a higher level of
output, income, and full
Real Income employment
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Equilibrium with Inflation
If AE continues to increase once full employment has
been attained, prices will be pushed upward as buyers
bid against each other for the use of scarce resources
To combat inflationary tendencies
Government spending can be decreased
Taxes can be increased
Interest rates can be pushed upward
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The Multiplier Effect
The relationship between a change in aggregate
expenditure and the resulting larger change in national
output or income
k = [1/(1 – MPC)] = (1/MPS)
The multiplier is related directly to the MPC and
inversely to the MPS
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Multiplier Effect Example
Net Increase
In Investment
$20
A
B
C
D
E
F
G
Increased
Income
$20.00
16.00
12.80
10.20
8.20
6.60
5.20
etc.
$100.00
Increased
Spending
(Spend 80%)
$16.00
12.80
10.20
8.20
6.60
5.20
4.20
etc.
$80.00
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Savings
(Save 20%)
$4.00
3.20
2.60
2.00
1.60
1.40
1.00
etc.
$20.00
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Deriving an Aggregate Demand Curve
from Aggregate Expenditure Curves
Expenditure
AE3
AE2
AE1
The AE function is drawn for
a given price level  a
unique equilibrium output 
AE1 is associated with P1, AE2
with P2, and AE3 with P3
where P1 > P2 > P3
45o
0
P
Y1
Y2
Y3
Y
The AD curve is derived by
plotting the various P and Y
combinations derived from
the set of AE curves
P1
P2
P3
AD
0
Y1
Y2
Y3
Y
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Aggregate Expenditure and Aggregate
Demand
Both the AE curve and the AD curve represent demand
for total output
AE shows the relationship between demand and income
AD shows the relationship between demand and price
level
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Classical and Keynesian Views of
Aggregate Supply
P
AS
P
P0
AS
AD2
AD2
AD1
AD1
0
Y*
Y
Equilibrium always occurs at the level
of output associated with full
employment  AS is vertical at full
employment  AD determines the
price level
0
Y
In the short term, equilibrium could be
reached at an output level involving
less than full employment  Keynes
suggested a horizontal AS curve
because of the unemployed resources
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Aggregate Demand and Composite
Aggregate Supply
P
AS
AD5
AD4
AD3
AD2
AD1
0
Y1
Y2
Y*
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The Monetarist School
Both wages and prices are highly flexible and adjust
quickly to supply and demand conditions
The economy automatically tends toward fullemployment equilibrium
Government intervention is not needed and worsens the
effects of the business cycle
Focus on the role of money as being the most important
variable in determining aggregate demand
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The Monetarist School
Changes in monetary policy can have a powerful impact
on the economy in the short run
The long-run effects are inflationary because increases
in the money supply do not increase employment or
output, only the price level
Ineffectiveness of monetary policy stem from time lags
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Time Lags
Recognizing that a problem exists in aggregate demand
and formulating a policy approach to correct it
The extensive amount of time required for the policy to
work its way through the economy
Result: Because of these two time lags, the economy
may actually be in a completely different situation than it
was when the problem was first recognized
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Monetarist Policy
Monetary and fiscal authorities should follow a fixed set of
rules
The government should balance its budget over the
business cycle
The Federal Reserve should maintain a constant rate of
growth in the money supply, regardless of interest rates,
the level of economic activity, or any other economic
variables
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The New Classical School
The economy is essentially stable and price and wage
flexibility are self-correcting properties
Active monetary policy has no place in the economy
because of rational expectations
Rational expectations
People learn from their past experiences and with access
to vast amounts of economic information available, are
able to correctly foresee the future
They will correctly anticipate changes in monetary and fiscal
policy
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Supply-Side Economics
The use of tax cuts for the purpose of encouraging
greater saving, investment, and work effort on the part of
individuals in order to stimulate economic growth
Shifts funds from the public into the private sector
Expansion in national output and income
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Supply-Side vs. Demand-Side Tax Cut
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