Transcript Short Macro Review

Spending  Output  Income  Spending
Aggregate Demand and Aggregate Supply
Y = C + I + G + NX
Why AD slopes downward
Why AD might shift
Why Short-run AS (SRAS) slopes upward
Vertical LRAS
Why AS might shift—Recall: CostsSupply
“Long-run” (Medium run) AS-AD Equilibrium
Expectations Augmented Phillips Curve
Okun’s Law
Money Supply—Money multiplier
Money Demand—Money market equilibrium
Response to monetary expansion
Response to fiscal expansion
Spending multiplier/Crowding out
Automatic stabilizers
Rules vs. discretion
Spending  Output  Income  Spending


$GDP: The market value of all final goods and services
produced in our economy in a year
GDP Deflator (=P): The dollar value of a year’s outputs
relative to what it would have been had prices
remained constant at base year prices.
• In practice, the increase in a year’s prices over the prior year’s (for all
the things produced this year – C,I,G, and X) chained to the base year.

Real GDP (= Y): $GDP measured at base year prices
Real GDP = $GDP/Price Deflator
Y = $GDP/P
Aggregate Demand and
Aggregate Supply...
Price
Level
Aggregate
supply
Equilibrium
price level
Aggregate
demand
0
Equilibrium
output
Quantity of
Output
The Aggregate Demand Curve
 The
four components of GDP (Y)
contribute to the aggregate demand for
goods and services.
Y = C + I + G + NX
The Aggregate-Demand Curve...
Price
Level
P1
1. A
decrease
in the price
level...
P2
Aggregate
demand
0
Y1
Y2
2. …increases the quantity of goods
and services demanded.
Quantity of
Output
Why the Aggregate Demand
Curve Is Downward Sloping
 Price
Level and Consumption:
Wealth
Effect
…the purchasing power of money balances
 Price
Level and Investment:
Interest
 Price
Rate Effect
Level and Net Exports:
Substitution
effect
The Exchange-Rate Effect via real balances and
interest rate
Why the Aggregate Demand Curve Might Shift
 Shifts
arising from Consumption
Changes in wealth
House prices
Stock prices
 Shifts
arising from Investment
Responses to interest rate
New technologies
Animal Spirits
 Shifts
arising from Government Purchases
 Shifts arising from Net Exports
The Aggregate Supply Curve
 In
the long run, the aggregatesupply curve is vertical.
 In the short run, the aggregatesupply curve is upward sloping.
The Short-Run Aggregate
Supply Curve...
Price
Level
Short-run
aggregate
supply
P1
1. A decrease
in the price
level
P2
0
2. reduces the
quantity of goods and
services supplied in
the short run.
Y2
Y1
Quantity of
Output
Why the Aggregate Supply Curve Slopes
Upward in the Short Run
 Sticky
 High
– wages  Profit Up when Prices Up
output  Low Unemployment
 Wages Up  Prices Up
The Long-Run AggregateSupply Curve...
Price
Level
P1
Long-run
aggregate
supply
2. …does not
affect the quantity
of goods and
services supplied
in the long run.
P2
1. A change
in the price
level…
0
Natural rate
of output
Quantity of
Output
Why the Aggregate Supply Curve Might Shift:
Recall: Supply reflects costs
 Shifts
arising from Labor
Higher wages  higher costs
 given output can/will only be supplied at higher price
 Shifts
arising from Capital
Increase in capacity  increase in supply
 Shifts
arising from Natural Resources
Increase in resource price  increased costs
 Shifts
arising from Technology.
 Shifts arising from the Expected Price Level.
The Long-Run Equilibrium
Price
Level
Equilibrium
price
0
Short-run
aggregate
supply
Long-run
aggregate
supply
A
Natural rate
of output
Aggregate
demand
Quantity of
Output
A Contraction in Aggregate Demand...
Price
Level
2. …causes output to
fall in the short run…
Long-run
aggregate
supply
Short-run aggregate
supply, AS1
AS
2
A
P1
P2
B
P3
1. A decrease in
aggregate demand…
C
AD
0
Y2
Y1
3. …but over time,
the short-run
aggregate-supply
curve shifts…
Aggregate
demand, AD1
2
4. …and output returns
to its natural rate.
Quantity of
Output
Money Supply
Means of Payment:
Currency + Demand Deposits
= Money multiplier x Monetary Base
= Money multiplier x (Currency + Reserves)
The
money supply is controlled by the Fed
through:
 Open-market
operations
 Changing reserve requirements
 Changing the discount rate
 The
public’s willingness to deposit money in
banks and bank willingness to lend matter as well
Money Demand
 The
opportunity cost of holding money is the
interest that could be earned on interest-earning
assets—bonds
 An increase in the interest rate raises the
opportunity cost of holding money.
 As a result, the quantity of money demanded is
reduced
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
Equilibrium in the Money
Market...
Interest
Rate
Money
supply
r1
Equilibrium
interest rate
r2
0
Money
demand
M 1d
Quantity fixed
by the Fed
M 2d
Quantity of
Money
The Money Market and the Slope of the
Aggregate Demand Curve...
(a) The Money Market
Interest
Rate
(b) The Aggregate Demand Curve
Price
Level
Money
supply
2. …increases
the demand for
money…
r2
1. An increase in the
price level…
P2
Money demand at
price level P2, MD2
Aggregate
demand
P1
r1
Money demand at
price level P1, MD1
0
Quantity fixed
by the Fed
3. …which increases the
equilibrium equilibrium rate…
Quantity
of Money
0
Y2
Y1 Quantity
of Output
4. …which in turn reduces the
quantity of goods and services
demanded.
Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.
A Monetary Injection...
(a) The Money Market
Interest
Rate
Money
supply,
MS1
MS2
(b) The Aggregate-Demand Curve
3. …which
increases the
quantity of goods
and services
demanded at a
given price level.
Price
Level
1. When
the Fed
increases
the money
supply…
P
r1
r2
AD2
Aggregate
demand, AD1
0
2. …the equilibrium
interest rate falls…
Quantity
of Money
0
Y1
Y2
Quantity
of Output
Changes in Government Purchases
Macroeconomic effects from change in
government purchases:
The
multiplier effect
The crowding-out effect
The Multiplier Effect...
Price
Level
2. …but the multiplier effect can amplify
the shift in aggregate demand.
$20 billion
AD3
1. An increase in government
purchases of $20 billion
initially increases aggregate
demand by $20 billion…
0
AD2
Aggregate demand, AD1
Quantity
of Output
Formula for the Simpler Spending Multiplier
Multiplier = 1/(1 - MPC)
 MPC
 It
is the marginal propensity to consume
is the fraction of extra income that
households consume rather than save.
 The greater the MPC, the more total output (Y),
income and spending results from an initial
increase in spending
The Crowding-Out Effect...
(a) The Money Market
Interest
Rate
Price
Level
Money
supply
r2
(b) The Shift in Aggregate Demand
2. …the increase
in spending
increases money
demand…
$20 billion
AD2
r1
MD2
AD3
Aggregate demand, AD1
Money demand, MD1
0
4. …which in turn
partly offsets the
initial increase in
aggregate
demand.
Quantity fixed
by the Fed
Quantity
of Money
3. …which increases the equilibrium
interest rate…
0
Quantity of Output
1. When an increase in government
purchases increases aggregate demand…
Automatic Stabilizers
Automatic
stabilizers are changes in fiscal
policy that stimulate aggregate demand
when the economy goes into a recession
without policymakers having to take any
deliberate action.
Automatic
stabilizers include the tax
system and some forms of government
spending.
The Case for Active Stabilization Policy
The Employment Act has two implications:
 The government should avoid being the cause
of economic fluctuations.
 The government should respond to changes in
the private economy in order to stabilize
aggregate demand, e.g., the Bush tax rebate
and Obama’s stimulus package
Obama insisted that only government could
“break the vicious cycles that are crippling our
economy,” prevent “the catastrophic failure of
financial institutions,” restart the flow of credit
and restore the regulations needed to prevent
such a crisis in the future. January 8, 2009
The Case Against Active Stabilization Policy
 Active
monetary and fiscal policies may
destabilize the economy.
 Monetary and fiscal policies affect the
economy with a substantial lag.
 They suggest the economy should be left to
deal with the short-run fluctuations on its
own.
Avoid monetary mischief