Unit Four: Aggregate Model

1. Unit Four: Aggregate Model Topic: Aggregate Model (hmm…)

2. Learning Targets • I will understand the aggregate model to the extent that I can explain how changes in AD and SRAS can create economic change. • I will understand how stagflation occurs in an economy. • I will be able to explain how policies can be instituted to fix GDP gaps.

3. REMEMBER • Short run: cannot change production capacity (represented by points on PPC). • Long run: must have a change in production capacity (how much you CAN produce); growth requires new and/or better resources.

4. Economic Fluctuations • Irregular and unpredictable • Most measures of macroeconomics (national income accounts) fluctuate together. • If output (GDPr or Y) falls, it means that unemployment (U) rises.

5. Short Run Variables • Output (real GDP) • Price level (changes are measured by CPI or deflator) • We will use the aggregate model as our short run model.

6. Aggregate Model • Def: shows equilibrium output (GDPr) and price level (PL) in the economy. • Explains short-run fluctuations in economic activity around long-run trends.

7. Short-Run Aggregate Model U.S. PL AS Pe AD Qe GDPr

8. Aggregate Demand (AD) • Def: shows the quantity of output (GDPr) that consumers desire at each and every price level (PL). • The relationship between AD and PL is an inverse relationship (like D and P), so the law of demand still applies.

9. Reasons for the Downward-Sloping AD Curve • Real-balances (wealth) effect: ↑ PL => ↓ purchasing power => ↓C • Interest-rate effect: (assume a fixed money supply) ↑ PL => ↑ D money => ↑ interest rates => ↓ Ig • Foreign purchases (exchange-rate) effect: U.S. ↑ PL relative to foreign PL, foreign demand for U.S. goods fall and Americans buy more foreign goods (reduces Xn).

10. Shifts in AD • The AD curve shifts like the D curve: • an increase in AD shifts the curve to the right • a decrease in AD shifts the curve to the left. • There are four factors (determinants) which can shift the AD curve.

11. Determinants of AD • Consumption (C) • Income, interest rates, wealth, expectations, debt, taxes • Investment (Ig) • Interest rates, taxes, expectations, money supply, loanable funds market • Government spending (G) • Tax revenue, borrowing, fiscal policy • Net exports (Xn) • National income abroad, exchange rates

12. AD Practice Questions For each of the following, state what happens to AD, PL and GDPr. • Americans are more concerned about saving for retirement. ↓ C=> ↓ AD => ↓ PL and ↓ GDPr • Government increases investment tax credits. ↑ Ig => ↑ AD => ↑ PL and ↑ GDPr • A recession occurs in Europe. ↓ Xn => ↓ AD => ↓ PL and ↓ GDPr

13. Aggregate Supply (AS) • Def: shows the quantity of output (GDPr) that producers will provide at each and every price level (PL). • The relationship between AS and PL is an direct relationship (like S and P), so the law of supply still applies.

14. Reasons for the Upward-Sloping AS Curve • Sticky-wage theory: nominal wages are slow to adjust to economic change (contracts, etc.) • Sticky-price theory: prices of some goods and services are slow to respond to economic change (menu costs) • Misperceptions theory: change in the overall PL can temporarily mislead suppliers about what is happening in their individual markets.

15. Shifts in AS • The AS curve shifts like the S curve: • an increase in AS shifts the curve to the right • a decrease in AS shifts the curve to the left. • There are four factors (determinants) which can shift the AS curve.

16. Determinants of AS • Expectations of price changes • Ex: Higher prices expected => higher nominal wages => decrease in AS (which actually creates higher prices) • Changes in resource cost • Ex: Minimum wage increases => increased resource cost => decreased AS • Change in productivity • Changes in legal requirements • Businesses taxes or gov’t regulations

17. AS Practice Questions For each of the following, state what happens to SRAS, PL and GDPr. • Minimum wage increases. ↑ labor cost => ↓ SRAS => ↑ PL and ↓ GDPr • Government increases environmental regulations. ↑ cost => ↓ SRAS => ↑ PL and ↓ GDPr • Businesses expect higher prices in the future. ↑nominal wages => ↓ SRAS => ↑ PL and ↓ GDPr

18. Long-Run Aggregate Supply • The AS curve is vertical in the LR because GDPr depends on the availability of resources (like full employment on the PPC). • Full employment is realized at the LRAS. LRAS = Q* = potential GDPr = full employment • Quantity of GDPr does not change with PL in the LR.

19. Long-Run Aggregate Model U.S. PL LRAS AS Pe AD Qe Y* GDPr

20. Shifts in LRAS • The LRAS curve (and full employment on PPC) ONLY shifts if: • Change in the amount of resources • Change in the productivity of resources • Change in technology • If there is economic GROWTH, the LRAS will shift RIGHT. • If there is economic DECLINE, the LRAS curve will shift LEFT.

21. LRAS Practice Questions For each of the following, state whether LRAS will increase or decrease. • Capital stock increases. ↑ LRAS • Immigration increases. ↑ LRAS 3. Immigrants are deported. ↓ LRAS 4. Fewer college degrees are awarded. ↓ LRAS

22. SR to LR Shifts • When there is a change in either SRAS or AD, the corresponding curve will shift, creating a short-run fluctuation. • In the long run, the economy will return to the natural rate of unemployment (full-employment at LRAS) either naturally or because of fiscal policy or monetary policy.

23. Important Note about LR • As resources increase, it creates economic growth. • The general trend in the money supply is growth (overall, the money supply is increasing). • As these two continuously grow, PL continuously rises.

24. Recession • Def (on the graph): actual GDPr is lower than Q*; there is unemployment. • Gov’t reaction: expansionary fiscal policy (↑ G and ↓ T); G will (hopefully) increase employment. • Fed reaction: expansionary monetary policy (buy bonds, ↓ discount rate, and ↓ reserve ratio); increasing the money supply means lower interest rates, which encourages Ig. • With these policies, the economy should return to Q*.

25. Inflation • Def (on the graph): actual GDPr is greater than Q*. • Gov’t reaction: contractionary fiscal policy (↓ G and ↑ T); hopefully discourages spending. • Fed reaction: contractionary monetary policy (sell bonds, ↑ discount rate, and ↑ reserve ratio); decreasing money supply causes an increase in interest rates, which decrease Ig. • With these policies, the economy should return to Q*.

26. Crowding-Out Effect • Def: increased gov’t spending crowds out investment spending. • ↑ G => ↑ AD => ↑D for money => ↑ i => ↓ Ig, partially offsetting the ↑ AD.

27. Stagflation • Def: a period of increasing unemployment AND inflation. • Usually occurs when there are supply shocks (decrease in SRAS)

28. Wage-Price Spiral • Def: higher prices leading to higher wages, which in turn leads to higher prices. • Can occur when SRAS decreases (expected higher prices lead to expected higher wages which create a decrease in SRAS which creates higher prices…whew!)

29. Decrease in AD or SRAS • ↓ AD => ↓ wages => ↑ SRAS • ↓ SRAS => expansionary policy => ↑ AD…OR…if there is no expansionary policy (or it doesn’t work), then economic decline.

30. Increase in AD or SRAS • ↑ AD => ↑ PL and ↑ GDPr => ↑ wages => ↓ SRAS (or contractionary policy) => back to Y* • ↑ SRAS => ↓ PL and ↑ GDPr => ↑ Y* (because of new capital investment, etc.)