Download unit 1 the concepts of macroeconomics

Macroeconomic Principles and Issues
UNIT 1 THE CONCEPTS OF MACROECONOMICS
Contents
Page
1.1
Introduction to the Course
3
1.2
Introduction to this Unit
6
1.3
Gross Domestic Product
7
1.4
Demand, Supply and Equilibrium
11
1.5
Schools of Thought
15
1.6
Conclusion
16
Answers to Review Questions
17
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M ACROECONOMIC PRINCIPLES AND ISSUES
What this unit is about
This unit is an introduction to the course, Macroeconomic Principles and Issues. It indicates the
topics you will be studying throughout the course, and how these are organised. As well as
reviewing the ideas of the market, demand, supply and equilibrium, this unit provides an
overview of the different schools of thought within macroeconomics – the main theoretical
approaches to macroeconomic models. It introduces the idea of a simple economy and,
using a circular flow diagram, it derives the basic identities between income, expenditure
and output for a simple economy. It explains the basic concepts of national income
accounting and provides some examples of how GDP is calculated.
What you will learn
When you have completed this unit and its readings, you will be able to
• define the goods market
• derive the basic macroeconomic identities for the goods market of a simple
economy
• discuss the basic concepts of national income accounting
• explain how GDP is measured
• outline the key national accounting terms
• define the aggregate demand and aggregate supply and market clearing
equilibrium, and draw appropriate curves
• discuss the main schools of thought in macroeconomics and how they differ.
Reading for Unit 1
Textbook
Rudiger Dornbusch, Stanley Fischer and Richard Startz (2008) Macroeconomics: Chapters 1
and 2, and Chapter 5, Sections 5-1 to 5-3.
Course Reader
Two articles from The Economist ‘Grossly Deceptive Product’ and ‘Grossly Distorted
Picture’.
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1.1 Introduction to the Course
This course, Macroeconomic Principles and Issues, is concerned with the economic principles
used to model the economy as a whole. It is designed to teach you the tools and techniques
used for analysing aggregate economic behaviour and policy formulation in a market
economy. The course is comprised of the eight Course Units, which you will be studying in
the coming weeks.
This course focuses on the study of Macroeconomics, which is concerned with behaviour of
the economy as a whole or in aggregate. The types of questions you will consider in
studying this course are those relating to the headline economic issues of inflation,
unemployment, economic growth, money supply, government deficits and interest rates.
You will study economic models designed to answer such questions as:
• how do we explain inflation?
• what determines economic growth?
• why are there periods of sustained unemployment?
• what determines the rate of interest?
There are two further key questions that arise in macroeconomics, and these relate to how
the economy behaves in relation to other economies. These questions are:
• how are foreign exchange rates determined?
• why can there be persistent deficits or surpluses in the balance of payments?
In this course we will concentrate on the first four questions; that is, we will be focusing on
the economic behaviour and relationships of the domestic economy. Macroeconomics also
encompasses the study of an economy’s international relationships, as the last two questions
illustrate. Although your studies in this course will introduce some international
dimensions, we will defer most of our discussion of the economy’s international
relationships until the course on International Economics, which follows on from this one in
your Diploma programme.
Macroeconomics focuses on the overall level of prices and resource use for the economy as a
whole, while microeconomics is concerned with the analysis of price determination and the
allocation of scarce resources between alternative uses. For example, in your microeconomics course, you studied the determination of the relative prices of goods and services. In
macroeconomics, we are concerned with the overall price level, and we assume that relative
prices are unimportant. These two branches of economics focus on different aspects of the
same subject and are based on different assumptions.
In saying that, we may seem to be stating that the two are completely distinct, but that is
not necessarily so. Although there have been times when macroeconomic theories have not
been firmly linked to microeconomic principles, economics theoreticians usually try to
connect the two. In this course, your study will focus on macroeconomic theories and policy
but we will point out the links to microeconomics when this is relevant.
Macroeconomic theory is closely linked to the policies adopted by governments to deal with
the questions of inflation, unemployment, economic growth and so on. There is
considerable debate amongst economists about the economic principles and models that can
be used to analyse such phenomena. In Europe and North America, the most intense
debates over policy issues in the 1970s and 1980s concerned the relative merits of Monetarist
and Keynesian policies. Since then, the debates have moved to those between the New
Classicals and the New Keynesians. In this course, we will refer to these debates and analyse
the similarities and the differences between these different schools of thought.
So what topics will you be studying in this course, and how will you go about it?
In this unit, the aim is to introduce you to the subject of macroeconomics and the basic
concepts required for your studies, including those of national income accounting. In
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microeconomics, the basic tool of analysis is the supply and demand framework. In
macroeconomics there is a similar framework known as the aggregate demand and
aggregate supply model. This will be introduced in Unit 1.
Units 2 and 3 cover the IS-LM model, which sets out the inter-relationship in an economy
between the market for goods and the market for money, and the role of interest rates as
the link between them. This model can then be used to show how the level of aggregate
demand in the economy can be determined. At the end of Unit 3 the aggregate demand
curve, which shows how changes in the price level affect aggregate demand, will be
derived from the IS-LM model.
Unit 4 will then explore further the behavioural functions that underpin the IS-LM model.
This will mean an examination of factors affecting consumption, investment, and the
demand for money.
Unit 5 focuses on the ways in which government monetary and fiscal policies can influence
aggregate demand.
In Unit 6 we will begin to explore the supply side of the economy and investigate how
output and the price level will react to a change in aggregate demand. The analysis of
aggregate supply is one of the most contentious areas of macroeconomics. The approach
that we will take in Unit 6 is based on the idea that output will be the first thing to alter
following a change in demand, and that this then affects the price level. Alternative
approaches to aggregate supply suggest that the price level is the first thing to respond to a
demand change, and that this then leads to output changes. These alternative approaches
are covered in Unit 7.
Finally, in Unit 8, we refocus on the economy and consider how economic models can be
used to analyse economic growth.
The textbook you will be using for this Course is Macroeconomics (tenth edition) by
Rudiger Dornbusch, Stanley Fischer and Richard Startz (hereafter referred to as DFS).
This is a widely used standard intermediate level macroeconomics textbook, which has a
traditional approach to the subject. In studying this course, you will be asked to read
assigned sections and chapters of DFS that deal with the material you are studying. The
course units are designed to help you understand these readings and to cover points we
think you might find difficult. There are other textbooks which cover the same material
and, while we will not be assigning you readings from those, you may refer to them for
additional exposition if you want to and have access to a library or bookshop that stocks
them. If you do decide to consult another textbook, we suggest you read the author’s
Introduction so you are aware of the approach being taken in presenting the theoretical
material. It may differ from that of DFS. Also, some textbooks are better on specific topics
than others in that the material is covered in more detail or set out more clearly. So you
should be aware of such differences.
Other textbooks you might want to consult include:
Olivier Blanchard (2009) Macroeconomics (Fifth Edition) New Jersey: Pearson/Prentice
Hall International
N Gregory Mankiw (2007) Macroeconomics (European Edition) Basingstoke UK:
Palgrave Macmillan
Michael Parkin (2008) Macroeconomics (Eighth Edition) Boston MA: Pearson Addison
Wesley.
At the end of each chapter of your set text, Dornbusch, Fischer and Startz have included a
Summary of the main topics and ideas covered and the Key Terms introduced. You will
find it useful to consult these. The authors also include a set of Problems, which are
designed to review the main concepts used in the chapter. Some of the problems are essaytype questions asking you to explain theoretical principles or economic concepts. Other
questions are numerical ones in which you have to use your theoretical knowledge in order
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to calculate the answers. We suggest that you look at these problems and try answering
some of them. Note that the textbook does not provide any answers to its problems, so you
will have to consult the chapter contents to check your replies.
During the course, we will occasionally ask you to read articles or extracts from economics
journals and from other books that we think are particularly good at explaining a specific
theoretical topic or at presenting arguments within one of the main macroeconomics
debates. Some of these articles will present a particular point of view. In reading such
articles and extracts, you should adopt a critical attitude to the arguments presented.
STUDY NOTE
Economists are famous for disagreeing amongst themselves. The main reason for this is
that economic analysis is invariably based on particular economic models, which in turn
are based on certain assumptions as to how the economy behaves. Different
assumptions will give rise to different results. It is very difficult in economics to judge
which models are the most accurate, because testing in any scientific sense is not
always possible. Therefore models are sometimes chosen on the grounds of simplicity or
because they are consistent with other views of how the economy behaves.
Some economic models are better than others in analysing and explaining some aspects
of economic behaviour. However, the best way to study is to learn each model on its own
terms and to evaluate its strengths and weaknesses. No model is perfect, and each one
you study will have strengths and weaknesses. In studying this course, we hope that you
will appraise critically all the materials that you read, including the course units like this
one, the textbook and the other readings. When you write essays for your assignments,
you will be expected not only to explain the relevant theories and models but also to set
out both their good points and weaknesses – that is, to analyse them critically.
Remember that models are used to predict the impact of changes in certain variables on
the economy. When using a particular model you must work within the confines of that
model. Different models will give different predictions. Some models will be inconsistent
with others. Predictive accuracy is usually taken as the main way in which models and
theories can be judged. Sometimes different theories come up with the same prediction.
This makes theory choice very difficult.
All this means that you must remember that when you analyse a particular problem or
issue you will be expected to use a particular economic model. Your success on the
course will be based on your understanding and use of these models. Try not to rely on
common sense or ideas that you have picked up in the media. Your task is to show that
you can manipulate, understand and apply economic models.
1.1.1 How to approach the course
These units are designed to act as an aid to your understanding of the main macroeconomic
models as presented by DFS. We suggest that you work through the units with the
textbook open by your side. Periodically you will be asked to read particular sections of the
text, and to think about certain issues or questions. We know that there is a temptation to
ignore these questions (which are written in italics), but they have been designed to help
and further your understanding of the issues. A little time spent thinking about them will
pay dividends. The full benefit will be gained if you jot down your answers. The mere act
of writing out an answer forces you to focus on the issues. Just mentally coming to a
conclusion does not focus your ideas as clearly.
If you fail to answer the questions correctly, this is part of the learning process. Remember,
people learn from their mistakes and as long as you can understand the logic of the
solutions provided, you have furthered your understanding.
You will find that at times we have not followed the order in which a topic is covered in
DFS. This is because we feel that our structure gives a clearer explanation of the issues.
This means that you will cover the material in the text, but in a different order. It would be
a useful exercise if, after completing the unit you go back to the text and read the relevant
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chapters as identified at the beginning of the unit. This will give you DFS’s order of
presentation and will reinforce your grasp of the topic.
Over the scheduled weeks of this course, you must complete two assignments in which you
will be asked to write essays. The assignments will be marked by your tutor in the United
Kingdom and you will be sent comments and advice on your work. The grades you
receive on your two assignments will count for 30% of your final course grade. To complete
the course, you will take an examination according to the University of London
examination schedule. Your examination result will account for the other proportion of your
course grade.
Your essays, examination and study of the course should reflect its main themes and
reasoning. At this level of study it is not really enough to learn the various theories by
rote; you should aim also in your study and writing to be able to
• consider significant policy problems
• use appropriate theoretical models to analyse policy issues.
We will try to help you do this in the course texts by asking you to think about the theory
and its policy implications.
In general, we give great weight to the use you make of theoretical models in your essays,
and models presented in diagrams or equations are usually the clearest. However, the best
marks will be awarded to essays and examination answers that not only demonstrate your
knowledge of the theoretical concepts but also use these concepts to analyse economic
problems and their implications for policy.
Your work for each unit will be organised around one or two thematic questions relating to
the unit. The overall, broad questions which run through this course as a whole are the first
four set out at the very beginning of this unit; namely
• How do we explain inflation?
• What determines economic growth?
• Why are there periods of sustained unemployment?
• What determines the rate of interest?
STUDY NOTE
At this point, you might like to refer back to the Induction Course unit that you studied at
the very start of this programme, and review the concepts of economic theory, models
and policy that were discussed there.
1.2 Introduction to this Unit
In this first course unit on macroeconomic theory and policy, you will be introduced to the
basic concepts required to study macroeconomic models. The first topic looks at how
economists measure the level of economic activity in the economy at the macroeconomic
level. This involves examining how the value of output, known as Gross Domestic Product,
in the economy is estimated. This is important for two reasons.
• First of all, most of this course will be concerned with how the levels of output
and employment are determined. It is obviously sensible that you have a clear
idea of what the value of output means, and how the various components of
output are defined.
• Secondly, in showing how the value of output is determined you will come across
ideas that provide the basis for a large part of the analysis which is concerned
with how output is determined. As DFS put it (page 23), ‘national income
accounts provide the formal structure for our macrotheory models’.
The second topic is a review of the ideas of the market, demand, supply and equilibrium,
and you will see how to use these fundamental concepts in macroeconomics. At this point,
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we should also stress that you will be studying macroeconomic theories and models of
market economies. There are theories and models for command and developing economies
as well, but those topics will not be covered in this course.
In this unit, your study is focused on the following question:
• How can the concepts of market equilibrium and national income accounting be used to
explain the basic relationships of a simple economy?
1.3 Gross Domestic Product
Gross Domestic Product (GDP) is defined as the value of all final goods and services
produced in the economy within a given period of time.
The total economy is very diverse and is comprised of a multitude of goods and services
being bought and sold by innumerable consumers, firms, the government and other
economic agents. This leads us to ask:
• How are we are going to focus on the output of the economy as a whole?
• How are we going to measure the total output of the economy?
1.3.1 Three approaches to GDP
To answer these questions, we need to have a way of combining apples, oranges, tractors,
turbines and all the various outputs of the economy. The easiest way to do this is to use
money as a numeraire. So we shall not be talking about the amount produced in terms of
quantities of apples, oranges, tractors and so on, but instead the monetary value of this
output. However, we will also need a method of adding up all this output that is useful for
analytical purposes. To do that, we will adopt the concepts of national income accounting,
which provides us both with a framework for describing the relationships and flows of the
key variables of the goods market and with a way of measuring them.
Let us start by assuming a simple economy consisting of two sectors – households and
firms. Households are where factors of production live and firms are where productive
activity takes place. National income accounting tries to measure the value of output in the
economy, the value of incomes earned in the economy and the value of goods produced in
the economy.
• Can you think of any relationship between these three values?
Take a minute to think about it before moving on.
In a simple economy of only households and firms, the total expenditure of households and firms
must equal the total income of the two, and it must equal the total value of output of goods and
services. This is an important identity:
aggregate income a aggregate expenditure a aggregate value of output.
STUDY NOTE
An identity exists when two terms are not just equal, but actually represent the same
concept. Thus in the example above, aggregate income does not only equal the value of
goods and services produced, it is the value of goods and services produced.
An identity is shown by the use of the symbol (a). It indicates that the terms on either side
of the symbol are the same concept and so must always be equal.
When an expression is expressed as an equation an equals sign (=) is used. This
indicates that the term on the left hand side is determined by the term on the right.
If we have an equation
C = cY
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we know that given values of Y we can calculate the value of C. Thus C depends upon Y.
There is a functional relationship between C and Y. Of course, we cannot solve this
equation because there are two unknowns and only one equation.
If we have an equation
100 = 2X
we can find values of X which solve this equation.
Thus, an equation specifies a relationship between two variables.
The aggregate value of the output, expenditure or income of an economy is called its Gross
Domestic Product (GDP) and is denoted as Y. Therefore, in our simple economy, this
identity can be written as
Y a Exp a GDP.
It is important that you understand the logic behind this conclusion.
Please read DFS pages 23–26 (Section 2-1), where the link between the value of
output and the value of incomes is explained and then answer the following question. Jot
down your answers before you continue.
• If the value of output is always received by someone in the form of income, would an increase
in the value of pensions paid by government to the elderly increase GDP? [Hint: GDP
measures the value of goods and services produced and so income should only be included if it
represents or reflects output produced.]
• Distinguish between GDP, GNP, NDP.
Pensions are not part of GDP because they do not represent incomes earned from a productive
activity. They are income transfers from one section of society (taxpayers) to pensioners. They are
therefore known as transfer payments.
Check your answer to the second question against DFS page 24.
The relationship between output and expenditure relies on the fact that all goods and
services produced must end up in someone’s possession. Consumption goods which are
produced for consumers will either be bought by consumers or remain unsold. Expenditure
by consumers is known as consumption (C).
Goods that are unsold will be acquired by firms as an increase in the level of stocks. This is
known as inventory investment. It can be thought of as unintended expenditure by firms
on their own production. Of course, some investment in inventories may be planned by
firms. Changes in inventories will therefore contain two elements, one planned and one
unplanned.
In a two sector economy, some goods and services will be produced because they are
required not by consumers, but by other firms. Both of these expenditures by firms are
classed as investment (I).
Please read DFS pages 31–33, just the section entitled ‘A Simple Economy’.
This yields the relationship
YaC+I
where I includes planned expenditure by firms on goods and services plus any unplanned
changes in inventories. Manipulation of this equation shows that
Y–CaI
If Y – C a S
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where S = saving,
Then
SaI
This suggests that savings are always equal to investment expenditure. This is only true if
investment expenditure includes expenditure on changes in inventories.
This is a significant result, since if firms experience unplanned changes in inventories
because planned expenditure is not equal to output, the economy will not be in
equilibrium since firms will alter their behaviour in order to prevent these unplanned
changes.
1.3.2 The measurement of GDP
As noted above, aggregate income equals aggregate expenditure equals the aggregate
value of output in the economy. So we should be able to measure GDP in three ways, and
we should get the same answer each time. In theory, this is correct. In practice, it is not –
because some types of data required to compile GDP figures for some of the measures are
harder to come by than others. This means that GDP figures cannot be relied upon to give
a definitive figure for Gross Domestic Product. Each method of measurement will give a
slightly different result. If different countries experience different degrees of difficulty in
obtaining accurate figures, international comparisons of GDP are likely to be inaccurate.
This problem is made worse by two important factors. First, in order to compare GDP
figures they need to be put into a common currency. This requires conversion at a
particular exchange rate. This means that exchange rate changes can affect relative GDP
figures.
Second, some economies have a large informal sector where economic activity takes place
but where such economic activity is impossible to measure. GDP figures can only include
economic activity where goods and services are bought and sold. If a country has a large
agricultural sector, but the farmers are self-sufficient and crops are consumed by the people
who grow them, this output will not show up in GDP figures.
Three approaches to measuring GDP
• The expenditure approach measures GDP by adding together the expenditure of all
sectors in the final product market. That is, consumers’ expenditure, firms’
investment, government expenditure of goods and services and the net of exports
minus imports. From a statistician’s point of view, this is the easiest way to
calculate GDP.
• The income approach measures GDP by aggregating all the incomes paid by firms
and government to households for factors of production, and this includes wages
and salaries, interest on capital, rent for land and profits. GDP is calculated using
this approach, although some figures, such as income earned by the selfemployed, have to be imputed as they are difficult to measure directly.
• The output approach measures GDP by adding together the value added of each
sector of the economy, such as agriculture, manufacturing, transport, banking
and finance and so on. This measure of GDP is conceptually straightforward but
is in fact difficult to calculate.
The two extracts from The Economist, ‘Grossly Deceptive Product’ and ‘Grossly
Distorted Picture’, provided in your Course Reader, give you the flavour of the debate
about the accuracy of GDP figures. You should read them now because they illustrate the
important point that economists cannot always accurately measure important concepts that
they are quite happy to define.
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STUDY NOTE
In studying national income accounting it is very easy to become bogged down in the
maze of detail of the calculations for each of these approaches to measuring GDP. At
this stage, it is important that you understand the concepts and step back from all the
detail. If you want to learn more about national income accounts, then please do feel free
to study the details.
From the point of view of this course, it is important to understand and feel comfortable in
using the main concepts and the components of the expenditure approach,
Y = C + I + G + (X – M).
1.3.3 GDP, identities and equilibrium
As was noted above, the expenditure approach to measuring GDP is the simplest way to
calculate GDP from the point of view of a statistician. It is also the most significant approach
because it provides a framework within which economists can analyse changes in GDP.
We have seen that when changes in inventories are classed as investment expenditure
output must be the same as total expenditure. This gives the identity
Y=C+I
Output must either be bought be consumers (C) or other firms (I) or remain unsold and so
add to inventories that are included in I.
However if unplanned changes in inventories have occurred, it is unlikely that firms will
continue producing the same level of output. Firms will react to the unplanned changes in
inventories. If firms are changing their behaviour, the economy cannot be in an
equilibrium position, since this implies a state of rest where there are no forces of change at
work.
This means that when I represents the amount of expenditure on inventories and other
goods and services that firms want or plan to make, the expression can be interpreted as an
equilibrium condition for the economy. If I is defined as planned investment then (C + I) is
classed as planned expenditure. In this case if
Y=C+I
firms can sell all they want to sell, and there will be no unplanned change in inventories.
Therefore, firms will have no incentive to change their level of output. The economy is said
to be in equilibrium. This relationship is expressed as an equation because we have said
that Y is determined by planned expenditure, and that when planned expenditure just
equals output, the economy will be in equilibrium. It is no longer an identity because
planned expenditure does not have to equal output.
In economics, the idea of the economy being in equilibrium when planned expenditure is
just equal to output is the cornerstone of macroeconomic analysis.
1.3.4 GDP, government and the foreign sector
We can now expand the two-sector economy seen in the previous section to a four sector
economy by adding in expenditure from the government sector and the foreign sector.
Please read DFS Section 2-2, pages 26-30.
Make sure that you can identify all the terms in equation (3) on page 26.
This is a fundamental equation as far as macroeconomics is concerned.
Y = C + I + G + NX
If investment includes unplanned changes in inventories, this equation is an identity.
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It becomes an equilibrium condition if it is interpreted as saying that the economy will be
in equilibrium when (C + I + G + NX) constitutes planned expenditure and when this is just
equal to the level of output in the economy (Y).
The idea that the economy is in equilibrium when planned expenditure equals output is
the macroeconomic analogy to the idea that you learned in microeconomics – that a market
is in equilibrium when demand (planned expenditure) equals supply (output). It is no
surprise, therefore, that macroeconomics makes use of a demand and supply framework of
analysis, and it is this that you will study next.
1.4 Demand, Supply and Equilibrium
The market can be defined as the means by which buyers and sellers of goods and services
interact, which presents the opportunity of exchange or trade taking place. In your study of
microeconomics, you considered the market for one good or one type of output. In
macroeconomics, we will be talking about the market for all goods and services; that is, the
total output of the economy.
We can also define the market more formally as ‘a model in which there are a demand
function, a supply function (that is, there are both buyers and sellers) and an equilibrium
point’.
The demand function for a good is expressed as the total amount that buyers want to
purchase as a function of its price, the price of other goods, the income level and other
variables. For the economy as a whole, we refer to aggregate demand, which is a function for
the whole of the economy’s output.
The supply function for a good is expressed as the amount a seller wants to sell as a function
of its price, the price of other goods, the income level and other variables. In a similar way,
we can talk about the aggregate supply of the total output of the economy.
The third defining characteristic of a market is the equilibrium point, which is a point where
there is no tendency to change. It is a point of rest and in terms of a market it is achieved
when demand equals supply. This is a market clearing equilibrium as it occurs when both
buyers’ demand is fully satisfied and sellers have sold all they want to supply to the
market.
Figure 1.1 is the familiar demand and supply model that you studied in Microeconomic
Theory and Applications. A market clearing equilibrium is as illustrated by point E in Figure
1.1. That is, the market mechanism works to ensure that there are no surpluses or shortages
of goods to be bought or sold. It is in equilibrium because there is no reason why the
market should move to any other point, and it is market clearing because demand and
supply are equal. In Figure 1.1, the market would not clear at any other point. If the price
is P1 , then it is said to be in disequilibrium as supply, point B, is greater than demand, point
A, and there is pressure for the price to fall until demand equals supply. Therefore,
disequilibrium is defined as not being a point of rest, or a point at which equilibrium has
not been achieved.
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Figure 1.1
Equilibrium of Demand and Supply
Price
D
S
A
P
B
●
●
1
E
P
●
E
Quantity
1.4.1 Aggregate demand and supply
In macroeconomics, we will be concerned with the determination of the aggregate demand
and aggregate supply of output in the economy and the general price level. When using
graphical analysis, the horizontal axis of a graph of aggregate demand and supply
functions is the aggregate quantity of the economy’s output, while the vertical axis is the
general price level which is a measure of the prices of all goods and services in the
economy. Such a model is shown in Figure 1.2 below.
Figure 1.2
Aggregate demand and supply
Price
Level
AD
AS
A
P
B
●
●
1
E
P
0
●
Y0
Output
The aggregate demand (AD) curve shows the total planned expenditure on goods and
services in the economy as a function of the price level. A higher price level will reduce
total planned expenditure. (You will examine the reasons for this in Unit 3.) The aggregate
supply (AS) curve shows the quantity of output which firms are prepared to supply at
various price levels. The AS curve in Figure 1.2 suggests that firms are only prepared to
supply more if the price level rises. (You will see the reason for this in Unit 6.)
This model will be in equilibrium where AD equals AS, at point E. In terms of the
equations you saw in the earlier section, planned expenditure (C + I + G + NX) just equals
output Y or:
Y = C + I + G + NX
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Suppose that the economy is not in equilibrium because the price level is at P1 . At this
price level planned expenditure (AD) is less than output (Y). However, the identity
Y = C + I + G + NX
will still hold because inventories equal to the distance AB will be added to firms’
inventory holdings. There will be unintended investment of AB. Thus actual expenditure
(including unintended inventory accumulation) will equal output.
This cannot be an equilibrium position because firms will react to their lack of sales. As you
will see in later units there are convincing reasons why these reactions will force the
economy towards E.
An increase in planned expenditure would shift the AD curve to the right. E would no
longer be an equilibrium position. Stop now and jot down your answers to the following
questions.
• What would be the nature of the disequilibrium if AD increased?
• What would you expect to happen to inventories?
• How would you expect firms to respond?
The increase in AD would cause an excess demand.
Inventories will fall as firms satisfy the excess demand from their stocks.
It is likely that firms will increase output (or prices).
The extent to which firms will react, by increasing prices or output, depends upon the slope
of the AS curve. The slope will depend crucially on the time period under consideration.
DFS identify three models of aggregate supply – a short run model, a medium term model
and a long run model.
1.4.2 Short-run aggregate supply
Let us start by examining the short-run model, where the AS curve is assumed to be flat.
Equilibrium will be at the point where AD equals AS. Given a flat AS curve, the level of
output in the economy is determined solely by the level of aggregate demand. Changes in
aggregate demand will only affect output, with no impact on prices.
Please read pages 8–9 of DFS, the section headed ‘The short run’, and then answer
the following question.
• Under what circumstances will firms be able to satisfy an increase in demand without this
having any impact on the price level? Write down your ideas.
If firms can increase output without increasing their prices, this means that they can increase
output without increases in their average costs of production. This must imply that they can obtain
additional resources, especially labour, without experiencing higher costs. This is most likely to be
true in periods of high unemployment, or when there are barriers to costs increasing.
This view of aggregate supply is sometimes referred to as the Keynesian view of aggregate
supply because it is a view associated with John Maynard Keynes who argued that the
deep economic recession which was experienced in the 1930s was the result of a lack of
demand and that the way to boost output was to expand aggregate demand. This was
based on the idea that spare resources were plentiful and that firms could easily increase
output without this putting pressure on the price level. Keynesian economics came to be
associated with policies aimed at boosting aggregate demand, and at heart they are based
on the view that the AS curve is flat.
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M ACROECONOMIC PRINCIPLES AND ISSUES
This view of aggregate supply emphasises the importance of aggregate demand in the
determination of output in the economy. Aggregate demand is explored in Units 2, 3, 4
and 5.
1.4.3 Long-run aggregate supply
In the long run, the aggregate supply curve is vertical. This means that, in the long run,
any change in aggregate demand will only affect the price level and will have no impact
on output.
Please read DFS pages 4–8 and then, using Figure 1-2 on page 6, answer the
following question,
• If there was an increase in aggregate demand, what would Figure 1-2 predict would happen
to the economy?
The model predicts that output would not change, but that the price level would rise.
• Can you think of any reasons why the AS curve might be vertical?
A vertical AS curve means that output does not expand when there is an increase in aggregate
demand. This is usually explained by saying that the economy is operating under some sort of
capacity constraint and that firms are unable to increase output. The constraint that is usually
assumed is the constraint of full employment. Y0 in Figure 1-3 is potential GDP, or the level of
output associated with full employment.
This view of aggregate supply is known as the Classical aggregate supply curve. Classical
economics therefore is associated with the idea that changes in aggregate demand only
affect the price level and have no impact on the level of output in the economy.
Please read DFS, pages 101–02, the section headed ‘The classical supply curve’, and
then answer the following question.
• What does Figure 1-2 on page 6 of DFS suggest would result from an increase in the level of
output associated with full employment. i.e., an increase in productive potential?
An increase in productive potential would shift the AS curve to the right. This would increase
output and reduce the price level. The long run behaviour of productive potential is explored in
Unit 8 when we investigate growth theory.
1.4.4 Aggregate supply in the medium run
Most economists accept that the short run AS curve is flat and the long run AS curve is
vertical. However, this leaves open the question of how long is the short run, and what is
the process by which the AS curve becomes vertical?
Please read the section headed ‘The medium run’ from page 9 of DFS, and then
answer the following question.
• If firms adjusted prices more rapidly what would happen to the slope of the AS curve?
The faster prices adjust the steeper the AS curve will be. Since one of the major factors influencing
prices will be the cost of labour, wages, the slope of the AS curve also depends upon how quickly
wages adjust to an increase in output.
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UNIT ONE
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Please read Box 5-3 on page 107 of DFS where the authors suggest that factors other
than time will be important in determining the slope of the AS curve. When you have
finished, answer the following question.
• If output in an economy expands because of increased expenditure, and prices fail to rise,
what does this imply about the level of unemployment in the economy?
If increased output can be produced without prices rising, firms must be able to secure extra
workers without putting pressure on wages. Hence there must be unemployed resources available.
Unemployment must exist in the economy. In terms of the figure in Box 5-3 of DFS, output must
be low and the economy is operating on the left hand portion of the AS curve.
The mechanism through which output changes affect wages and prices forms the basis of
Units 6 and 7. It is in those two units that you will study various views of how the price
level and the output level respond to increases in aggregate demand in the medium term.
In order to test your grasp of these ideas please draw AD/AS models to answer the
following questions.
1 In the short run, how will the economy react to a fall in aggregate demand?
2 In the Classical case, how will the economy react to an increase in aggregate demand?
3 In the Keynesian case, how will the economy react to an increase in aggregate supply?
4 In the medium term, how will the economy react to an adverse supply shock?
5 On one diagram show the medium term impact of an increase in aggregate demand as well as
the long run impact.
Answers are provided at the end of the unit .
1.5 Schools of Thought
In studying macroeconomics you will come across various schools of thought. We have
already mentioned Keynesian and Classical models. You may also come across such terms
as Monetarist, New Classical and New Keynesian. The key distinction between these
schools of thought concerns whether or not market forces can be relied upon to achieve full
employment or whether government intervention via fiscal and monetary policy is
necessary to generate sufficient aggregate demand to secure full employment.
This debate hinges on whether or not markets, left to their own devices, will achieve an
equilibrium position. This can be summarised as
• one school argues that markets work best where left to themselves, with as little
intervention from government as possible
• the other argues that government intervention can improve the operation of the
economy and thus it should take an active role in policy terms.
These two views are fundamentally based on assumptions about the aggregate supply
curve. If the AS curve is vertical, or if the long run is a short period of time, the economy
will always revert back to the original level of output because price changes will quickly
restore equilibrium. This is known as the market clearing school of thought, which sees
price changes as restoring equilibrium in all markets.
Suppose that there is a drop in the demand for oranges. If the orange market is
competitive, the excess supply of oranges will reduce the price of oranges, until supply and
demand are again equalised. The market will always clear so that the excess supply of
oranges will be eliminated. Now consider what will happen in the labour market when
there is a fall in aggregate demand. There will be an excess supply of goods in the
economy. Firms will reduce their demand for labour. There will be an excess supply of
labour in the labour market. The excess supply of labour will reduce wages and prices. The
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M ACROECONOMIC PRINCIPLES AND ISSUES
price level will fall, stimulating aggregate demand until equilibrium is again restored. In
terms of the AS curve, this suggests that the AS curve is very steep and becomes vertical
very quickly.
The non-market clearing view suggests that this process will not work and that markets
may operate out of equilibrium for a long time. In particular, the labour market may be
characterised by excess supply for a long period of time. Firms will respond to a fall in
demand by reducing output, not prices. Excess supplies can persist. In terms of the AS
curve, this view suggests that the AS curve is flat and it may take a long time for wages
and prices to adjust. Output may be depressed and unemployment may persist for a long
period of time.
1.6 Conclusion
We have seen that GDP can be measured in three ways, by the expenditure, income and
output methods. The expenditure method tells us that aggregate expenditure is always
equal to aggregate output (GDP) if unsold goods are included in expenditure as inventory
accumulation. Older economics texts referred to this as ex post expenditure, always
equalling output by definition.
The expenditure approach also gives rise to an equilibrium condition for the economy,
when unintended investment is zero, which will be when planned, or ex ante,
expenditure, equals output.
This then permits equilibrium to be examined in terms of aggregate demand and
aggregate supply curves. The message you have learned from these is that the impact of
changes in demand on the economy depends crucially on the slope of the AS curve. This
will depend on the time period under consideration, but also on the way in which firms
react to a change in demand.
In this unit we have seen the main building blocks of macroeconomic analysis. To fill
in the background, and to see the whole picture as presented by DFS, please read all the
remaining sections of Chapters 1 and 2.
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UNIT ONE
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Answers to Review Questions
Question 1
In the short run, a fall in aggregate demand will cause a fall in output, but will leave the
price level unaffected.
Figure 1.3
Price
Level
AD1
AD
P1
AS
Y2
Y1
Output
Question 2
In the Classical case, an increase in aggregate demand will increase the price level but
leave the output level unaffected. See DFS page 111, Figure 5-10, where the increase in
aggregate demand is caused by a fiscal expansion.
Question 3
In the Keynesian case, an increase in aggregate supply would have no impact on the
economy.
Figure 1.4
Price
Level
AS
AS1
AD
P1
Y1
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Output
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M ACROECONOMIC PRINCIPLES AND ISSUES
Question 4
In the medium term, an adverse supply shock will cause the output level to fall and the
price level to increase. See DFS page 100, Figure 5-3.
Question 5
In the medium term, the level of output and the price level would both rise. In the long
run the output level would revert to the original level and the price level would rise
further.
Figure 1.5
Price
Level
AD
AS (Long Term)
AD1
AS (Medium Term)
P3
●
P2
P1
●
●
Y1
Y2
C ENTRE FOR FINANCIAL AND M ANAGEMENT STUDIES
Output