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12.0 The Basic Macro Model

12.0 The Basic Macro Model. 12.1.1. Each micro concept has an analogous macro concept price : Price Level (P) quantity exchanged: real GDP (Y). The Macro Picture. In this picture,. Price level is on the vertical axis Real GDP is on the horizontal axis Y F is full employment or full GDP.

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12.0 The Basic Macro Model

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  1. 12.0 The Basic Macro Model

  2. 12.1.1 Each micro concept has an analogous macro concept price : Price Level (P) quantity exchanged: real GDP (Y)

  3. The Macro Picture

  4. In this picture, Price level is on the vertical axis Real GDP is on the horizontal axis YF is full employment or full GDP

  5. 12.1.2 AD - aggregate demand AS - aggregate supply The intersection of these curves represents the current conditions in the macroeconomy

  6. More inflation P Y More real GDP More employment Less unemployment

  7. 12.1.3 - A preview Great Depression caused by a great fall in AD More on the specifics later, but look what happens

  8. After Pearl Harbor war means big increase in AD, for reasons we’ll also see later

  9. Further, it is not just AD which can move AS moves due to changes in input prices, as you will see in greater detail later Ex. Oil shocks of the 1970’s

  10. This should give you some idea about how useful this macro picture can be in explaining the world We now need to look at each line in detail

  11. 12.2.1 Aggregate Demand (AD) is the sum of all the stuff that individuals and firms and governments are prepared to buy in a given year How much they actually demand depends on how much things cost The total amount planned to be spent is called Aggregate Expenditure (AE)

  12. AE is a nominal measure measured in current dollars

  13. The AD line represents the relationship between real GDP demanded and the price level for a given level of aggregate expenditure In functional form Y = AD (P | AE)

  14. AD slopes downward given constant AE because as price level (P) falls, constant AE buys more real GDP (Y) AE is the shift variable more AE shifts AD to the right

  15. 12.2.2 AE is a huge number There are six components of AE AE = C + I + G - T + X - M

  16. Consumption (C) nominal value of spending done by households (stuff you buy)

  17. Investment (I) nominal amount spent by firms on plants, equipment

  18. Government Spending (G) nominal amount government spends planes, tanks, schools, etc.

  19. Taxes (T) money taken out of hands of households by government this represents net taxation - doesn’t count transfer payments like Social Security where gov’t passes resources from one group to another (G-T) is the government budget position

  20. Exports (X) money spent by foreigners on U.S. products

  21. Imports (M) money spent by U.S. citizens on foreign goods (X-M) is the trade balance

  22. 12.2.3 Y = AD (P | AE) while AE = C + I + (G - T) + (X - M) so Y = AD (P | C, I, G, T, X, M) a change in any of these six variables shifts AD

  23. An increase in C, G, I, or X will move AD right if P stays the same, Y will increase as each of these three increases

  24. Ex. An increase in G P AD´ AD Y

  25. The same is true for an increase in C, I or X

  26. The reverse is true for T or M because they have a negative sign in front of them

  27. AD moves right when: Increase in C,G,I,X Decrease in T,M AD moves left when: Decrease in C,G,I,X Increase in T,M What moves AD?

  28. Example - Great Depression

  29. Decrease in I moves AD left, ceteris paribus

  30. 12.2.4 Outbreak of WWII after Pearl Harbor

  31. Huge increase in G moves AD right, ceteris paribus

  32. This push moved the economy beyond sustainable capacity people and machines can’t keep up that pace forever notice what happens to price level as you move further and further right inflation starts to become an issue

  33. 12.3.1 Aggregate supply line represents the relationship between the Price level and real GDP produced by the economy Actually, there are two different lines

  34. Long-run aggregate supply Represents situation when all micro adjustments have been completed under the nice assumptions Most efficient condition – biggest pie Full GDP – Full employment

  35. The LAS line Vertical line at full employment Full, sustainable capacity is determined by Initial endowment – that society’s natural resources, labor, and capital It is vertical because in the long-run, real GDP is independent of the price level

  36. 12.3.2 In the very long run endowment changes can shift LAS Population growth, new innovations, new natural resources can move LAS steadily rightward Natural disasters, war can move LAS leftward

  37. We will assume That the LAS remains stationary in order to focus on the long run macroeconomy We will use LAS as our orientation line for full employment

  38. 12.3.3 Short-run aggregate supply line (AS) In the short run, we assume that not all markets have had time to adjust Specifically, factor markets have not adjusted Along an AS line, factor prices (like wages) are constant

  39. 12.3.4 The AS line has three distinct segments They are labeled k, l, and m

  40. k-segment is significantly below full-employment real GDP large quantities of idle factors exist Under these circumstances, you can hire more people and increase production without the price level increasing

  41. 12.3.5 l-segment real GDP approaches, and then meets sustainable full employment GDP Bottlenecks may begin to occur, because not all industries might reach capacity at the same time Cost pressures might lead to higher output prices Shape of l-segment is important to understanding inflation

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