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Principles and Policies I: Macroeconomics

Principles and Policies I: Macroeconomics. Chapter 9:Aggregate Demand, Aggregate Supply, and Modern Macroeconomics. Chapter 9 Learning Objectives You should be able to …. Discuss the historical development of macroeconomics.

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Principles and Policies I: Macroeconomics

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  1. Principles and Policies I: Macroeconomics Chapter 9:Aggregate Demand, Aggregate Supply, and Modern Macroeconomics Macroeconomics, Maclachlan 10/13/04

  2. Chapter 9 Learning ObjectivesYou should be able to … • Discuss the historical development of macroeconomics. • Explain the shape of the aggregate demand curve and what factors shift the curve. • Explain the shape of the short run aggregate supply curve and what factors shift the curve. • Explain the shape of the long-run aggregate supply curve. • Show the effects of shifts of the aggregate demand and aggregate supply curves on price level and output in both the short run and long run. • Discuss the limitations of the macro policy model. Macroeconomics, Maclachlan 10/13/04

  3. Classical Model Equilibrium in each market leads to equilibrium in the economy as a whole. Fallacy of composition. Macroeconomics, Maclachlan 10/13/04

  4. Considering the whole as more than sum of the parts. First major macroeconomist: John Maynard Keynes The General Theory of Employment, Interest and Money (1936) Macroeconomics, Maclachlan 10/13/04

  5. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.--John Maynard Keynes Macroeconomics, Maclachlan 10/13/04

  6. The Paradox of Thrift • This paradox of thrift is important to the Keynesian story. • Paradox of thrift – an increase in savings can lead to a decrease in expenditures, decreasing output and causing a recession. Macroeconomics, Maclachlan 10/13/04

  7. The Aggregate Demand Curve • The aggregate demand (AD) curve shows how a change in the price level changes aggregate expenditures on all goods and services in an economy. • It shows the level of expenditures that would take place at every price level in the economy. Macroeconomics, Maclachlan 10/13/04

  8. The Slope of the AD Curve • The AD is a downward sloping curve. • Aggregate demand is composed of the sum of aggregate expenditures. Expenditures = C + I + G +(X - M) Macroeconomics, Maclachlan 10/13/04

  9. The Slope of the AD Curve • The slope of the AD curve is determined by the wealth effect, the interest rate effect, the international effect, and the multiplier effect. Macroeconomics, Maclachlan 10/13/04

  10. The Wealth Effect • Wealth effect – a fall in the price level will make the holders of money and other financial assets richer, so they buy more. • Most economists accept the logic of the wealth effect, however, they do not see the effect as strong. Macroeconomics, Maclachlan 10/13/04

  11. The Interest Rate Effect • Interest rate effect – the effect a lower price level has on investment expenditures through the effect that a change in the price level has on interest rates. Macroeconomics, Maclachlan 10/13/04

  12. The Interest Rate Effect • The interest rate effect works as follows: a decrease in the price level  increase of real cash  banks have more money to lend  interest rates fall  investment expenditures increase Macroeconomics, Maclachlan 10/13/04

  13. The International Effect • Internationaleffect – as the price level falls (assuming exchange rates do not change), net exports will rise. Macroeconomics, Maclachlan 10/13/04

  14. The International Effect • The international effect works as follows: a decrease in the price level in the U.S. the fall in price of U.S. goods relative to foreign goods  U.S. goods become more competitive internationally  U.S. exports rise and U.S. imports fall Macroeconomics, Maclachlan 10/13/04

  15. The Multiplier Effect • Initial changes in expenditures set in motion a process in the economy that amplifies the initial effects. • Multiplier effect – the amplification of initial changes in expenditures. Macroeconomics, Maclachlan 10/13/04

  16. Price level Wealth, interest rate, and international effects P0 Multiplier effect P1 Aggregate demand Y0 Y1 Ye Real output The AD Curve Macroeconomics, Maclachlan 10/13/04

  17. Shifts in the AD Curve • Except for a change in the price level, anything that changes aggregate expenditures shifts the AD curve. Macroeconomics, Maclachlan 10/13/04

  18. Shifts in the AD Curve • The main shift factors of aggregate demand are: • Foreign income. • Expectations about future output or prices. • Exchange rate fluctuations. • The distribution of income. • Government policies. Macroeconomics, Maclachlan 10/13/04

  19. Fiscal Policy • Changing tax rates and/or government spending to influence aggregate demand. • Expansionary macro policy shifts the curve to the right. • Contractionary macro policy shifts it to the left. Macroeconomics, Maclachlan 10/13/04

  20. Price level Initial effect Multiplier effect 100 200 P0 Change in total expenditures AD0 AD1 300 Real output Effect of a Shift Factor on the AD Curve Initial effect Macroeconomics, Maclachlan 10/13/04

  21. The Short-Run Aggregate Supply Curve • The short-runaggregate supply (SAS) curve specifies how a shift in the aggregate demand curve affects the price level and real output in the short run, other things constant. Macroeconomics, Maclachlan 10/13/04

  22. Price level Real output The Short-Run Aggregate Supply Curve SAS Macroeconomics, Maclachlan 10/13/04

  23. The Slope of the SAS Curve • The SAS curve is upward-sloping. • The SAS curve reflects two different types of microeconomic markets in our economy. • Auctionmarkets – markets represented by the supply/demand model. • Posted-price markets – prices are set by the producers and change only infrequently. Macroeconomics, Maclachlan 10/13/04

  24. Shifts in the SAS Curve • The AS curve shifts when a shift factor changes – other things are not constant: • Changes in input prices. • Changes in expectations of inflation. • Productivity. • Excise and sales taxes. • Import prices. Macroeconomics, Maclachlan 10/13/04

  25. The Long-Run Aggregate Supply Curve • The LAS is vertical crossing output axis at POTENTIAL OUTPUT. • At potential output, a rise in the price level means that all prices, including input prices rise. Macroeconomics, Maclachlan 10/13/04

  26. The Long-Run Aggregate Supply Curve Long-run aggregate supply (LAS) Price level Real output Macroeconomics, Maclachlan 10/13/04

  27. Real output A Range for Potential Output and the LAS Curve LAS P C B SAS A Underutilized resources Overutilized resources Low-level potential output High-level potential output Macroeconomics, Maclachlan 10/13/04

  28. Shifts in the LAS Curve • The LAS curve will shift whenever there is a changes in: • Capital. • Available resources. • Growth-compatible institutions. • Technological development. • Entrepreneurship. Macroeconomics, Maclachlan 10/13/04

  29. Equilibrium in the Aggregate Economy • Changes in the SAS, AD, and LAS curves affect short-run and long-run equilibrium. Macroeconomics, Maclachlan 10/13/04

  30. Short-Run Equilibrium • Short-run equilibrium is where the AS and AD curves intersect. Macroeconomics, Maclachlan 10/13/04

  31. Price level Real output Short-Run Equilibrium:Shift in Aggregate Demand SAS P1 F P0 E AD1 AD0 Y0 Y1 Macroeconomics, Maclachlan 10/13/04

  32. Price level Real output Short-Run Equilibrium:Shift in Aggregate Supply SAS1 G P1 SAS0 E P0 AD Y1 Y0 Macroeconomics, Maclachlan 10/13/04

  33. Long-Run Equilibrium • Long-run equilibrium is where the AD and long-run aggregate supply curves intersect. • In the long run, output is fixed and the price level is variable. Macroeconomics, Maclachlan 10/13/04

  34. LAS Price level H P1 E P0 AD1 AD0 Y0 Real output Long-Run Equilibrium:Shift in Aggregate Demand Macroeconomics, Maclachlan 10/13/04

  35. Integrating the Short-Run and Long-Run Frameworks • The economy is in both short-run and long-run equilibrium when all three curves intersect in the same location. Macroeconomics, Maclachlan 10/13/04

  36. Integrating the Short-Run and Long-Run Frameworks • The ideal situation is for aggregate demand to grow at the same rate as aggregate supply and potential output. • Unemployment and growth are at their target rates with no inflation. Macroeconomics, Maclachlan 10/13/04

  37. LAS Price level SAS E P0 AD YP Real output Long-Run Equilibrium Macroeconomics, Maclachlan 10/13/04

  38. The Recessionary Gap • A recessionary gap is the amount by which equilibrium output is below potential output. Macroeconomics, Maclachlan 10/13/04

  39. The Recessionary Gap • If the economy remains at this level for a long time, there would be an excess supply of factors of production. • Costs and wages would tend to fall. Macroeconomics, Maclachlan 10/13/04

  40. The Recessionary Gap • As factor prices fall, the SAS curve will shift down to eliminate the recessionary gap. Macroeconomics, Maclachlan 10/13/04

  41. Price level Real output The Recessionary Gap LAS SAS0 A P0 B SAS1 P1 AD Recessionary gap Y1 YP Macroeconomics, Maclachlan 10/13/04

  42. The Inflationary Gap • The inflationarygap occurs when the economy is above potential that exists at the current price level. • Factor prices rise causing the SAS curve to shift up. • The price level rises, and the inflationary gap is eliminated. Macroeconomics, Maclachlan 10/13/04

  43. The Inflationary Gap LAS SAS2 D Price level P2 C SAS0 P0 AD Inflationary gap YP Y2 Real output Macroeconomics, Maclachlan 10/13/04 (c)

  44. The Economy Beyond Potential • When the economy operates below its potential, firms can hire additional factors of production without increasing production costs. • Once the economy reaches its potential output, that is no longer possible. Macroeconomics, Maclachlan 10/13/04

  45. The Economy Beyond Potential • As firms compete for resources, costs rise beyond productivity increases. • The short-run AS curve shifts up and the price level rises. Macroeconomics, Maclachlan 10/13/04

  46. The Economy Beyond Potential • The economy will slow down by itself or the government will step in with a policy to contract output and eliminate the inflationary gap. Macroeconomics, Maclachlan 10/13/04

  47. Price level Real output Expansionary Fiscal Policy LAS AS P1 P0 AD1 A AD0 Y0 YP Macroeconomics, Maclachlan 10/13/04

  48. Price level Real output Contractionary Fiscal Policy LAS B AS P2 AD0 AD2 YP Y2 Macroeconomics, Maclachlan 10/13/04

  49. Some Additional Policy Examples • Unemployment is 12 percent and there is no inflation. • What policy would you recommend? • Use expansionary fiscal policy to shift the AD curve out to its potential income. Macroeconomics, Maclachlan 10/13/04

  50. Price level Real output Expansionary Fiscal Policy LAS SAS B P1 P0 AD1 A AD0 Y0 YP Macroeconomics, Maclachlan 10/13/04

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