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LECTURE 1 INCREASE IN INVESTMENT PROSPECTS THE MACRO ECONOMIC MODEL Introduction to Economics Charles R. Plott California Institute of Technology I a Spending I1+a1 I1 Y1 i i I1 a1 I UNKNOWNS .Y income .C consumption .I investment .i interest rate .P price level .L employment .MD money demand .MDT transaction demand P for money .MDS speculative demand for money .w nominal wages level GIVENS G Government spending X net exports M nominal money supply b marginal propensity to consume EQUATIONS .Y=C+I+G+X .C=a(i)+bY .I=I(i) .M/P = MD .MD=MDT+MDS .MDT = MDT(Y) .MDS = MDS(i) .DL(w/P)-SL(w/P)=0 .L=SL(w/P) .Y=F(L,..) Y2 Y i i a Y MD MDT P M/P T Y M/P P P* W /P Y Y M*/P * M/P Lecture 1 THERE IS A SHIFT IN INVESTMENT EXPECTATIONS EXPECTATIONS BECOME MORE OPTIMISTIC I a Spending I1+a1 I1 Y1 i i I1 Y2 Y i I a1 i a Y MD MDT P P M/P T Y M/P P P* W /P Y Y M*/P * M/P AGGREGATE DEMAND EXCEEDS AGGREGATE SUPPLY AND PRICES BEGIN TO DRIFT UPWARD I a Spending I1+a1 I1 Y1 i i I1 Y2 Y i I a1 i a Y MD MDT P P M/P T Y M/P P P* W /P Y Y M*/P * M/P THE LABOR MARKET AND AGGREGATE SUPPLY RESPOND AS LABOR PERCEPTIONS AND EXPECTATIONS OF PRICE INCREASES LAG THE ACTUAL INCREASES AGGREGATE SUPPLY TEMPORARILY EXCEEDS THE POTENTIAL GDP I a Spending I1+a1 I1 Y1 i i I1 Y2 Y i I a1 i a Y MD MDT P P M/P T Y M/P P P* W /P Y Y M*/P * M/P NOMINAL WAGE INCREASES WITH LAGGING KNOWLEDGE OF PRICE INCREASES HAVE CREATED AGGREGATE SUPPLIES ABOVE THE POTENTIAL GDP. AS EXPECTATIONS ARE BROUGHT INTO LINE WITH REALITY THE REAL WAGE RETURNS TO THE EQUILIBRIUM LEVEL AND AGGREGATE SUPPLY RETURNS TO THE POTENTIAL GDP. I a Spending I1+a1 I1 Y1 i i I1 Y2 Y i I a1 i a Y MD MDT P P M/P T Y M/P P P* W /P Y Y M*/P * M/P PRICE INCREASES (INFLATION) SHRINKS THE REAL MONEY SUPPLY. THIS CAUSES FURTHER INTEREST RATE INCREASES AND CHOKES OFF INVESTMENT SPENDING. AGGREGATE DEMAND IS BROUGHT BACK INTO LINE WITH POTENTIAL GDP. I a Spending I1+a1 I1 Y1 i i I1 Y2 Y i I a1 i a Y MD MDT P P M/P T Y M/P P P* W /P Y Y M*/P * M/P