Transcript The Basic Macro Model

The Basic Macro Model
The first examination of our
primary theory and model to
describe the economy and predict
effects.
The model itself is known as the
Aggregate DemandAggregate Supply Model.
Theories and Models
Theory -- An assertion about the
major causes of observed
behavior, done in order to predict
outcomes.
Model -- A formalization of a
theory, done to make concise
predictions.
The Aggregate DemandAggregate Supply Model
Purpose -- seeks to predict the
behavior of real GDP (Y) and the
price level (P) (and therefore
inflation).
Aggregate Demand
Aggregate Demand (AD) -- the
sum of all the newly produced US
final goods and services that
consumers, businesses,
government, and foreigners intend
to purchase (i.e. real GDP
demanded).
Aggregate Demand: Causes
The Price Level (P)
P (ceteris paribus)  AD
Aggregate Expenditure (AE) -desire to purchase quantities of
newly produced final goods and
services, apart from price
considerations.
AE (ceteris paribus)  AD
Formalizing the Theory of
Aggregate Demand
Graph AD versus one of its causes
-- the price level (P).
Inverse relationship implies that
the curve is downward sloping.
Changes in P are described as a
movement along the curve.
Graph is drawn assuming that AE
(and any other causes) are
constant (ceteris paribus).
Describing Changes in One
of the “Other Causes”
AE changes (or changes in any
cause other than the price level)
are described by a shift of the
Aggregate Demand curve.
Contrast this with changes in P -movement along the curve.
Different descriptions occur only
because P is the cause that
appears on the graph.
Shifting the AD Curve
Changes -- other than P -- that
make AD increase are described
as a rightward shift of the curve, or
an increase in AD.
Changes -- other than P -- that
make AD decrease are described
as a leftward shift of the curve, or
a decrease in AD.
A Brief Look at
Aggregate Expenditure (AE)
AE = C + I + (G - T) + (X - M)
AE: close to definition of real GDP.
except that it subtracts out taxes.
Increases in C, I, G, or X increase
AE (and therefore increase AD).
Increases in T or M decrease AE
(and therefore decrease AD).
Aggregate Expenditure
(AE) -- Continued
AE = C + I + (G - T) + (X - M)
The causes of AE are the causes
of C, I, (G - T), and (X - M) -- next
chapter.
A change in any of them will shift
the AD curve.
Short-Run Aggregate
Supply (AS)
Short-Run Aggregate Supply (AS)
-- the sum of all the newly
produced US final goods and
services that firms wish to
produce (real GDP supplied), given
inflexible input prices.
Short-Run
Aggregate Supply -- Causes
Price Level (P)
P  AS
Price of Energy (PE)
PE  AS
The Nominal Wage Rate (W)
W  AS
Other Production Related Causes
(e.g. labor productivity)
Short-Run Aggregate
Supply: Formalizing
Graph AS versus one of its causes
-- the price level (P).
Positive relationship implies that
the curve is upward sloping.
Changes in P are described as a
movement along the curve.
Graph is drawn assuming that PE,
W, and any other causes are
constant (ceteris paribus).
The Shape of the AS Curve
Describes different magnitudes of
response to increases in the price
level (P).
k segment -- P increase generates
large output response.
l segment -- P increase generates
moderate output response.
m segment -- P increase generates
small output response.
Describing Changes in One
of the “Other Causes”
Changes in PE, W, or changes in
any cause other than the price
level are described by a shift of the
AS curve.
Like Aggregate Demand, different
descriptions occur only because P
is the cause that appears on the
graph.
Shifting the AS Curve
Changes -- other than P -- that
make AS increase are described as
a rightward shift of the curve, or an
increase in AS.
Changes -- other than P -- that
make AS decrease are described
as a leftward shift of the curve, or
a decrease in AS.
Equilibrium:
The Market in Action
Equilibrium (Y* and P*) -- The
values where real GDP and the
price level will settle, given that the
strategies of demands and
suppliers play out.
Properties of Equilibrium
If the price level is anywhere else,
natural market forces bring it to
equilibrium.
P* and Y* represent the actual
price level and real GDP predicted
by the theory.
Shifts in either the AD or AS
curves change the equilibrium.
Shifts and Changing the
Equilibrium -- Applications
Example 1 -- The effect of a war on
the economy.
War  (G - T)
Increase in (G - T) increases AE,
described by shifting the AD curve
rightward.
Draw the picture and evaluate the
answer.
Another Application
Example 2 -- Firms become very
pessimistic about the economy,
decrease their purchases of new
plants and equipment (1930s).
Decreased purchases of new
plants and equipment  I
Decrease in I also decreases AE,
described by shifting the AD curve
leftward.
Draw the graphical situation and
evaluate the answer.
Still Another Application
Example 3 -- The price of energy
(PE) increases (energy crisis in US,
1970s).
PE hinders production, reduces
Aggregate Supply.
Therefore the AS curve shifts
leftward.
Draw the graphs and evaluate.
The “Nice Assumptions” -Market Efficiency
No market power -- advantages in
the market are transitory and can
be eliminated by competition.
-- equal access to information
-- equal access to markets
No market failure -- markets
function smoothly and quickly to
coordinate choices.
Market failure in the economy -nominal wage rates and energy
prices do not adjust flexibly to
macroeconomic conditions.
Market Failure in Macro
Market failure in Macro -- P
changes, but W and PE stay
constant.
Describes the upward sloping
Aggregate Supply (AS) curve.
Main implication -- In the AD-AS
model, Y* does not have to be
equal to YF.
Characterizing the
Economy (Short-Run)
Y* < YF (sluggish economy,
demand deficient
unemployment)
Y* > YF (accelerating inflation)
Y* = YF (desired state of
the economy)
Long-Run
Aggregate Supply (LAS)
Long-Run Aggregate Supply (LAS)
-- the sum of all the newly
produced US final goods and
services that firms wish to
produce when all microeconomic
adjustments have been completed
under our nice assumptions (in
particular, no market failure).
Characteristics of Long-Run
Aggregate Supply (LAS)
Unaffected by the price level.
P  W and PE as well
 no incentive for firms to change
production plans.
Affected by production-oriented
variables as well as peoples’
attitudes toward work (will study
more later).
Formalizing Long-Run
Aggregate Supply (LAS)
LAS curve is vertical when plotted
against the price level (P).
Vertical at the full sustainable level
of real GDP (YF), all adjustments
completed under the “nice
assumptions”.
Will consider shifts of the curve in
a later chapter.
Putting The Model All
Together -- Two “Teasers”
Teaser #1 -- The role of Economic
Policy, getting Y* closer to YF.
Teaser #2 -- Spending gone too far,
the wage-price spiral (nominal
wage rates reacting to spendinginduced inflation).