ECN202: Macroeconomics

1. ECN202: Macroeconomics Circular Flow & Aggregate Supply-Aggregate Demand

2. Circular Flow Diagram The Circular flow diagram is comparable to a wiring or plumbing diagram for a house. Here is shows the flow of money in a modern economy, and in it you can see the four key players (Households, Firms, Government, and Foreigners) and the four macro markets in which these players conduct their business (labor, output, capital, and foreign exchange). For each market there is a S & D curve and price and quantity measures that we look into later. In the circular flow you just need to “follow the money” to understand how the macro economy functions and how shocks in any market spread to the other markets.

3. Macro Markets, Players, & Indicators

4. Each Market has one of these Supply Price Headlines are about Price & Output changes P* Demand Q* Quantity

6. Foreigners Four Players

7. Four Markets

8. An overview of macro environment

9. Foreign ExchangeMarket (US $s) Price = Exchangerate Supply P* Demand Q* Quantity = units of currency

10. What is happening to the value of the US $ in these two graphs

12. An overview of macro environment

13. LaborMarket Supply Price = wage P* Demand Q* Quantity = Employment

15. An overview of macro environment

16. CapitalMarket Supply Price = Interestrate P* Demand Q* Quantity = Funds $s

17. What is happening here to interest rates?

18. OutputMarket Supply P* Demand Q*

19. An overview of macro environment

21. What is happening to real GDP growth rate?

22. How does WW II seem to divide the two periods?

24. Aggregate Supply & Aggregate Demand You have now looked at the labor and output markets, and now we are going to look at the “picture” of the output market more carefully. This is the market for ALL goods and services – cars, lawyers, school, milk – and while it looks like the S&D graph, it is not. One thing is the same – if you follow the rules you will be OK. Now we will look at the AS-AD model economists use to understand the macro economy.

25. AS-AD AnalysisCookbook Approach Identify the participants AS: Suppliers (firms…) AD: Demanders ( firms, households, government, foreigners) Identify the determinants of behavior Identify the appropriate curves KNOW the AXES (variables) Identify any special situation

26. Determinants of aggregate supply (AS) Number of inputs Capital, labor, resources Costs of production Price of inputs / resources Productivity / efficiency of resources Price level

27. Aggregate Supply Curve AS has positive slope since higher prices coax out more supply AS (depends on # and price of inputs & their productivity Price Level P1 P0 Q1 Q0 GDP

28. What shifts the Aggregate Supply curve? Change in any of the factors (other than price level) that affect Aggregate Supply will change the AS curve.

29. Aggregate Supply Curve When productivity increases @ each price Aggregate Supply has increased and curve shifts to the right Price Level AS P1 P0 Q1 Q0 Quantity = GDP

30. Components of aggregate demand (AD) Who buys American “stuff” in the output market? (Households) Consumption Spending (Firms) Investment spending (Government) Government spending (Foreigners) Export & Import spending

31. Determinants of aggregate demand (AD) What affects demand for American “stuff”? Consumption Spending (Households) Income, expectations, interest rate… Investment spending (Firms) Profit, expectations, interest rate… Government spending (Government) Policies, state-of-economy, interest rate… Export spending (Foreigners) Income, expectations, exchange rate in ROW Import spending (US firms & Householde) Income, expectations, exchange rate in US

32. Aggregate Demand Curve AD has negative slope since higher prices mean there is less money to purchase “stuff” P1 P2 AD = C+I+G+X-M Q2 Q1

33. Aggregate Demand Curve When interest rates fall and demand for cars increases @ each price = increases Aggregate Demand and the curve shifts to the right P1 P2 AD = C+I+G+X-M Q2 Q1

34. AS-AD Model of Output Market AS(# and price of inputs, productivity) P* AD (C+I+G+X-M) Q*

35. We now have a model that helps us understand changes in the price level (CPI) and national output (GDP). We can use it to explain past changes or forecast future changes in these variables and it looks very much like the analysis of S&D. We need to look at how the economy adjusts to “shocks” to the system using the same technique.

36. Use AS-AD model to explain the following headlines a decrease in US consumer confidence that pushes consumption spending lower a significant expansion in Asia that raises Asian demand for US exports an increase in the productivity of American workers China growth pushes oil prices higher Get out that pad and draw the diagrams for each question before reading on

37. a. Impact of decrease in US confidence that pushes consumption spending lower. AS AD Cookbook approach • Identify the participants - US consumers = AD • Identify the determinants of behavior – Consumer confidence decrease reduced consumption spending • Identify the appropriate curves - AD curve shifts in • Result: lower GDP (recession) and lower inflation (price level)

38. b. a significant expansion in Asia that raises Asian demand for US exports. AS AD Cookbook approach • Identify the participants - Asian demand for US exports = AD • Identify the determinants of behavior – Expansion in Asia means more income = more demand for US exports • Identify the appropriate curves - AD curve shifts out • Result: higher GDP and higher inflation (price level)

39. c. an increase in the productivity of American workers. AS AD Cookbook approach • Identify the participants - productivity of workers = AS • Identify the determinants of behavior – Increase productivity = lower costs of production – increase AS • Identify the appropriate curves - AS curve shifts out • Result: higher GDP and lower inflation (price level)

40. d. China growth pushes oil prices higher. AS AD Cookbook approach • Identify the participants - oil prices = AS • Identify the determinants of behavior – higher oil prices raise costs of production – reduces AS • Identify the appropriate curves - AS curve shifts in • Result: lower GDP (recession) and higher inflation (price level)

41. Note on oil price shock In a more complete analysis you need to account for the fact the US imports a good deal of its oil and that demand for oil is inelatic so when the price goes up we do not cut demand much. In this case if the price of oil rises then US imports rise so we get the inward shift of the AS curve from higher production costs AND an inward shift in the AD curve because imports rise. In exams you should not worry about the more detailed analysis.

42. Here are a few more examples A rise in the value of the US $ pushes US imports higher A rise in interest rates slows housing sales Rise in housing prices raises household wealth Business confidence falls lower spending on new equipment Get out that pad and draw the diagrams for each question before reading on

43. A rise in the value of the US $ pushes US imports higher

44. b. A rise in interest rates slows housing sales

45. c. Rise in housing prices raises household wealth

46. d. Business confidence falls lower spending on new equipment

47. See how you did A rise in the value of the US $ pushes US imports higher – higher US imports affects AD – but be careful since Imports have a negative sign so higher imports reduces demand for US “stuff” – so AD decreases and shifts left. A rise in interest rates slows housing sales- higher interest rates reduce demand for housing = reduce home building = reduce investment spending = shift AD in Rise in housing prices raises household wealth-households feeling wealthier increase consumption spending = shift AD out Business confidence falls lower spending on new equipment-lower equipment spending = lower I spending = shift AD in

48. Generalization: Single Shift Based on what you have done, fill in the following table

49. Questions a. What happens when oil prices rise and war spending rises? Get out that pad and draw the diagram before reading on

50. Questions b. What happens when productivity rises and exports rise due to growth in China? Get out that pad and draw the diagram before reading on