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Chapter 12 -The Basic Macro Model
This chapter presents the first
examination of our primary theory
and model to describe the
economy and predict effects.
The model itself is known as the
Aggregate Demand Aggregate Supply Model.
The Aggregate DemandAggregate Supply Model
Purpose -- seeks to examine the
underlying behavior of what
determines real GDP (Y) and the price
level (P) (and therefore inflation) for the
whole economy.
We can then use the theory/model to
make concise predictions of how
events and policies will affect the
economy.
Aggregate Demand
Aggregate Demand (AD) -- the
sum of all the newly produced US
final goods and services that
consumers, businesses,
government, and foreigners intend
to purchase (i.e. real GDP
demanded).
Aggregate Demand: Causes
The Price Level (P)
P (ceteris paribus)  AD
Aggregate Expenditure (AE) -desire to purchase quantities of
newly produced final goods and
services, apart from price
considerations.
AE (ceteris paribus)  AD
Formalizing the Theory of
Aggregate Demand
Graph AD versus one of its causes
-- the price level (P).
Inverse relationship implies that
the curve is downward sloping.
Changes in P are described as a
movement along the curve.
Graph is drawn assuming that AE
is constant (ceteris paribus).
Describing Changes in One
of the “Other Causes”
AE changes (or changes in any
cause other than the price level)
are described by a shift of the
Aggregate Demand curve.
Contrast this with changes in P -movement along the curve.
Different descriptions occur only
because P is the cause that
appears on the graph.
Shifting the AD Curve
Changes -- other than P -- that
make AD increase are described
as a rightward shift of the curve, or
an increase in AD.
Changes -- other than P -- that
make AD decrease are described
as a leftward shift of the curve, or
a decrease in AD.
A Brief Look at
Aggregate Expenditure (AE)
AE = C + I + (G - T) + (X - M)
AE is total net demand for US
newly produced final goods and
services by all “buyers”.
Aggregate Expenditure
(AE): Variable Definitions
C = Consumption, consumer purchases of
goods and services.
-- nondurable goods (e.g. food)
-- durable goods (e.g. new cars,
personal computers)
-- services (e.g. auto mechanic,
medical doctor)
I = Investment, business purchases of new
plants and equipment + purchases of new
residential housing + changes in inventories.
AE -- More Variable Definitions
G = Government purchases of goods
and services.
T = Net Taxes, tax revenues minus
transfer payments.
(T – G) is commonly known as the
government budget.
(G – T), within AE is referred to as the
government budget position.
AE – Even More
Variable Definitions
X = Exports, foreign purchases of US
produced goods and services.
M = Imports, US purchases of foreign
produced goods and services.
(X – M) is commonly referred to as Net
Exports, or the Balance of Trade.
Aggregate Expenditure
(AE) -- Continued
AE = C + I + (G - T) + (X - M)
The causes of AE are the causes of
C, I, (G - T), and (X - M) -- next chapter.
A change in any of them is described
as a shift the AD curve.
Increases in C, I, G, or X increase AE
(and therefore increase AD).
Increases in T or M decrease AE (and
therefore decrease AD).
Short-Run Aggregate
Supply (AS)
Short-Run Aggregate Supply (AS)
-- the sum of all the newly
produced US final goods and
services that firms wish to
produce (real GDP supplied), given
inflexible input prices, in particular
nominal wage rates (W).
Short-Run
Aggregate Supply -- Causes
Price Level (P)
P  AS
Price of Energy (PE)
PE  AS
The Nominal Wage Rate (W)
W  AS
Other Production Related Causes
(e.g. labor productivity)
Short-Run Aggregate
Supply: Formalizing
Graph AS versus one of its causes
-- the price level (P).
Positive relationship implies that
the curve is upward sloping.
Changes in P are described as a
movement along the curve.
Graph is drawn assuming that PE,
W, and any other causes are
constant (ceteris paribus).
The Shape of the AS Curve
Describes different magnitudes of
response to increases in the price
level (P).
k segment -- P increase generates
large output response.
l segment -- P increase generates
moderate output response.
m segment -- P increase generates
small output response.
Describing Changes in One
of the “Other Causes”
Changes in PE, W, or any cause
other than the price level (P) are
described by a shift of the AS
curve.
Different descriptions occur only
because P is the cause that
appears on the graph.
Shifting the AS Curve
Changes -- other than P -- that
make AS increase are described as
a rightward shift of the curve, or an
increase in AS.
Changes -- other than P -- that
make AS decrease are described
as a leftward shift of the curve, or
a decrease in AS.
Equilibrium:
The Market in Action
Equilibrium (Y* and P*) -- The
values where real GDP and the
price level will ultimately settle
(what the model predicts).
Shifts and Changing the
Equilibrium -- Applications
Example 1 -- The effect of a war on the
economy.
War  (G - T)
Increase in (G - T) increases AE.
This behavior within the model is
described by shifting the AD curve
rightward.
Draw the picture and evaluate the
answer.
Another Application
Example 2 -- Firms become very
pessimistic about the economy,
decrease their purchases of new
plants and equipment (1930s).
Decreased purchases of new
plants and equipment  I
Business Pessimism and
Investment, Continued
Decrease in Investment (I), ceteris
paribus, necessarily decreases AE.
Within the model, this behavior is
described by shifting the AD curve
leftward.
Draw the graphical situation and
evaluate the answer.
Still Another Application
Example 3 -- The price of energy
(PE) increases (energy crisis in US,
1970s).
PE hinders production, reduces
Aggregate Supply.
Therefore the AS curve shifts
leftward.
Draw the graphs and evaluate.
Market Failure in the
Economy (AS Curve)
Market failure in the Economy -- W and
PE stay constant, don’t move easily.
For institutional reasons (discussed
later), factor markets don’t move to
their equilibriums.
Describes the upward sloping ShortRun Aggregate Supply (AS) curve.
Implications of
Market Failure in Economy
Economy not at General
Competitive Equilibrium (GCE).
Equilibrium occurs where Y* is not
necessarily equal to YF.
Characterizing the
Economy (Short-Run)
Y* < YF (sluggish economy,
demand deficient
unemployment)
Y* > YF (accelerating inflation)
Y* = YF (desired state of
the economy)
Long-Run
Aggregate Supply (LAS)
Long-Run Aggregate Supply (LAS)
-- the sum of all the newly
produced US final goods and
services that firms wish to
produce when all microeconomic
adjustments have been completed
under the nice assumptions (in
particular, no market failure).
Characteristics of Long-Run
Aggregate Supply (LAS)
Equilibrium under perfect competition
with the nice assumptions satisfied (in
particular, no market failure)  the
economy is in General Competitive
Equilibrium (GCE).
GCE  economy necessarily
operates at the full sustainable level of
output (YF).
Formalizing Long-Run
Aggregate Supply (LAS)
LAS curve is vertical when plotted against
the price level (P).
Vertical at the full sustainable level of real
GDP (YF), all adjustments completed under
the “nice assumptions”. Economy is in
GCE.
Curve shifts rightward (increase in LAS) or
leftward (decrease in LAS).
Will consider what shifts the curve in a later
chapter.
Putting The Model All
Together -- Two “Teasers”
Teaser #1 – The Interventionist
versus Non-interventionist
positions on the economy –
returning in a big way within
macro.
Teaser #2 -- Spending gone too far,
the wage-price spiral.
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