Chapter 12 -- The Basic Macro Model

This chapter presents the first examination of our primary theory and model to describe the economy and predict effects.

The model itself is known as the Aggregate Demand - Aggregate Supply Model.

The Aggregate Demand-Aggregate Supply Model

Purpose -- seeks to examine the underlying behavior of what determines real GDP (Y) and the price level (P) (and therefore inflation) for the whole economy.

We can then use the theory/model to make concise predictions of how events and policies will affect the economy.

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) ADAggregate 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 is 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 is total net demand for US newly produced final goods and services by all “buyers”.

Aggregate Expenditure (AE): Variable Definitions

C = Consumption, consumer purchases of goods and services.

-- nondurable goods (e.g. food) -- durable goods (e.g. new cars, personal computers) -- services (e.g. auto mechanic, medical doctor) I = Investment, business purchases of new

plants and equipment + purchases of new residential housing + changes in inventories.

AE -- More Variable Definitions

G = Government purchases of goods and services.

T = Net Taxes, tax revenues minus transfer payments.

(T – G) is commonly known as the government budget.

(G – T), within AE is referred to as the government budget position.

AE – Even More Variable Definitions

X = Exports, foreign purchases of US produced goods and services.

M = Imports, US purchases of foreign produced goods and services.

(X – M) is commonly referred to as Net Exports, or the Balance of Trade.

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 is described as a shift the AD curve.

Increases in C, I, G, or X increase AE (and therefore increase AD).

Increases in T or M decrease AE (and therefore decrease AD).

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, in particular nominal wage rates (W).

Short-Run Aggregate Supply -- CausesPrice Level (P)

P ASPrice of Energy (PE)

PE ASThe Nominal Wage Rate (W)

W ASOther Production Related Causes (e.g.

labor productivity)

Short-Run Aggregate Supply: FormalizingGraph 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 any cause other than the price level (P) are described by a shift of the AS curve.

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 ultimately settle (what the model predicts).

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.This behavior within the model is

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

Business Pessimism and Investment, Continued

Decrease in Investment (I), ceteris paribus, necessarily decreases AE.

Within the model, this behavior is 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.

Market Failure in the Economy (AS Curve)

Market failure in the Economy -- W and PE stay constant, don’t move easily.

For institutional reasons (discussed later), factor markets don’t move to their equilibriums.

Describes the upward sloping Short-Run Aggregate Supply (AS) curve.

Implications of Market Failure in Economy

Economy not at General Competitive Equilibrium (GCE).

Equilibrium occurs where Y* is not necessarily 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 the nice assumptions (in particular, no market failure).

Characteristics of Long-Run Aggregate Supply (LAS)

Equilibrium under perfect competition with the nice assumptions satisfied (in particular, no market failure) the economy is in General Competitive Equilibrium (GCE).

GCE economy necessarily operates at the full sustainable level of output (YF).

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”. Economy is in GCE.

Curve shifts rightward (increase in LAS) or leftward (decrease in LAS).

Will consider what shifts the curve in a later chapter.

Putting The Model All Together -- Two “Teasers”

Teaser #1 – The Interventionist versus Non-interventionist positions on the economy – returning in a big way within macro.

Teaser #2 -- Spending gone too

far, the wage-price spiral.