Principles and Policies I: Macroeconomics

1
Principles and Policies I Macroeconomics

• Chapter 9Aggregate Demand, Aggregate Supply, and
  Modern Macroeconomics

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.

3
Classical Model

• Equilibrium in each market leads to equilibrium
  in the economy as a whole.
• Fallacy of composition.

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)

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

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.

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.

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)

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.

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.

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.

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
13
The International Effect

• International effect as the price level falls
  (assuming exchange rates do not change), net
  exports will rise.

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
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.

16
The AD Curve

17
Shifts in the AD Curve

• Except for a change in the price level, anything
  that changes aggregate expenditures shifts the AD
  curve.

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.

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.

20
Effect of a Shift Factor on the AD Curve
Initial effect
21
The Short-Run Aggregate Supply Curve

• The short-run aggregate 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.

22
The Short-Run Aggregate Supply Curve
SAS
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.
• Auction markets markets represented by the
  supply/demand model.
• Posted-price markets prices are set by the
  producers and change only infrequently.

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.

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.

26
The Long-Run Aggregate Supply Curve
Long-run aggregate supply (LAS)
Price level
Real output
27
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
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.

29
Equilibrium in the Aggregate Economy

• Changes in the SAS, AD, and LAS curves affect
  short-run and long-run equilibrium.

30
Short-Run Equilibrium

• Short-run equilibrium is where the AS and AD
  curves intersect.

31
Short-Run EquilibriumShift in Aggregate Demand
SAS
P1
F
P0
E
AD1
AD0
Y0
Y1
32
Short-Run EquilibriumShift in Aggregate Supply
SAS1
G
P1
SAS0
E
P0
AD
Y1
Y0
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.

34
Long-Run EquilibriumShift in Aggregate Demand
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.

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.

37
Long-Run Equilibrium
38
The Recessionary Gap

• A recessionary gap is the amount by which
  equilibrium output is below potential output.

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.

40
The Recessionary Gap

• As factor prices fall, the SAS curve will shift
  down to eliminate the recessionary gap.

41
The Recessionary Gap
LAS
SAS0
A
P0
SAS1
B
P1
AD
Recessionary gap
YP
Y1
42
The Inflationary Gap

• The inflationary gap 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.

43
The Inflationary Gap
LAS
SAS2
D
Price level
P2
C
SAS0
P0
AD
Inflationary gap
Y2
YP
Real output
(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.

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.

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.

47
Expansionary Fiscal Policy
LAS
AS
P1
P0
AD1
A
AD0
YP
Y0
48
Contractionary Fiscal Policy
LAS
B
AS
P2
AD0
AD2
YP
Y2
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.

50
Expansionary Fiscal Policy
LAS
SAS
B
P1
P0
AD1
A
AD0
Y0
YP
51
Some Additional Policy Examples

• Unemployment is at its target rate and it is
  likely that consumer expenditures will rise.
• What policy would you recommend?
• Use contractionary fiscal policy to shift the AD
  curve inward to counteract the expected increase
  in AD.

52
Contractionary Fiscal Policy
LAS
SAS
B
P1
AD0
AD2
YP
Y1
53
Some Additional Policy Examples

• What would have happened if the government didnt
  institute a contractionary fiscal policy?
• There would be an inflationary gap which would
  increase factor prices.
• The SAS curve would shift up until it intersects
  the AD curve at YP.

54
Economy Above Potential
LAS
SAS1
E
P1
SAS0
D
P0
C
AD1
AD0
YP
Y1
55
The Problem of Implementing Fiscal Policy

• There is no guarantee that government will do
  what the economy needs to be done.
• Implementing government spending and tax changes
  is a slow legislative process.
• Government spending and tax decisions are made
  for political rather than for economic reasons.

56
The Problem of Estimating Potential Output

• One way of estimating potential output is to
  estimate the target rate of unemployment.

• Target rate of unemployment the rate below
  which inflation began to accelerate in the past.
• Target rate is not constant. Its hard to tell
  whats structural and whats cyclical.

57
The Problem of Estimating Potential Output

• Another way to determine potential output is to
  add the normal growth factor (3) the economys
  previous level.

• Estimating the economys potential from past
  growth rates is complicated by potentially
  dramatic changes in regulations, technology, and
  expectations.

58
Problem 9-3

• Explain what will likely happen to the slope or
  position of the AD curve in the following
  circumstances.
• The exchange rate changes from fixed to flexible.
• When the price level changes the exchange rate
  will change so the international effect wont be
  as strong. The curve will get steeper.

59
9-3 cont.

• b) A fall in the price level doesnt make people
  feel richer.
• The wealth effect will be weaker curve will be
  steeper.
• c) A fall in the price level creates expectations
  of a further falling price level.
• The curve shifts downward.
• d) Income is redistributed from rich people to
  poor people.
• Since poor people consume a greater percentage of
  their income, the curve shifts to the right.
• e) Autonomous exports increase by 20.
• Curve shifts to the right.
• f) Government spending decreases by 10.
• Curve shifts to the left.

60
Problem 9-5

• Congratulations! You have been appointed an
  economic policy adviser to the United States.
  You are told that the economy is significantly
  below potential output, and that the following
  will happen next year World income will fall
  significantly and the price of oil will rise
  significantly. (The United States is an oil
  importer.)
• What will happen to the price level and real
  output?
• What policy might you suggest to the government?