Download Chapter 8

Framework for
Macroeconomic Analysis
Chapter 8
Economy
1929 Great
Depression
 Resulted in large
unemployment
 WWII lifted us out
of the depression
with increased
spending

Micro vs. Macro
 The
most fundamental difference
between these two models is what
they measure on the horizontal and
vertical axis.
Price level
P
AS
AD
Q
One good
GDP
Equilibrium in Macroeconomy
If price level starts above equilibrium,
there would be surplus capacity that
would pressure the price level lower.
 If price level starts below the equilibrium,
there would be shortages and the price
level would be pushed up
 Changes in the price level would lead to
changes in the behavior of consumers and
firms until the economy stops at eq.

Equilibrium
AS
Equilibrium
AD
Short and Long
 Long
run involves underlying
economic forces that make
themselves felt over time
 Short run a period of time during
which the economy transitions to the
long run
Keynesian

John Maynard Keynes
– General Theory of
Employment, Interest,
and Money
– Government
involvement in the
economy
– Keynesian theory
suggest that
government action is an
appropriate response to
short run problems
Classical Theory
Says law: supply
creates its own
demand
 Unemployment
corrected when the
marketplace
figures out the
profit maximizing
mix of goods and
services to produce

Classical Theory
 Full
employment:
– According to the classical view,
unemployment is nothing more than a
transitory disequilibrium in the
marketplace.
– Wages will fall when unemployment
exists
Classical Theory
 Downwardly
flexible wages
– Even if the economy began to
experience a recession, both wages and
prices would adjust downward to ensure
that workers remained employed and
the goods and services produced would
be sold
Classical Theory
 Minimal
government intervention in
the economy
– Invisible hand
Keynesian Theory

Savings and
Investment
– Saving motivated
by all too human
desire to hoard or
to accumulate
wealth

Investment
– People had to be
optimistic about the
future, since
investing involves
risk
– Existence of savings
cannot create
investment
Keynesian Theory

Sticky wages and
prices

Unemployment
– Classical view was
false
– If aggregate
demand is not
sufficient to keep
everyone
employed.
– Wage and price cuts
were rare

Government
intervention is
needed
Aggregate Demand



Relates how much real GDP
consumers, businesses,
government, and foreign
buyers will purchase at each
price level; graphically,
aggregate demand slopes
downward
Real GDP varies inversely
with changes in the price
level
Downward sloping demand
curve
AD
Downward slope
 Purchasing
power effect
– The effect of the price level on
consumers’ ability to buy goods and
services
 Wealth
effect
– Higher price level would reduce the real
value of savings and lead consumers to
spend more of their current incomes
Downward Slope
 Interest
rate effect
– A higher price level increases interest
rates, which represent the cost of
borrowing
 Higher
cost of borrowing will lower
household consumption
– International substitution effect
A
change in the price level changes the
quantity demanded of real GDP through its
effects on imports and exports
Shifts in Aggregate Demand
 Increase
– shifts to the right
– Consumer expectations are favorable
– Consumer income rises
– Business expectations are favorable
– Profit rise
– Government spending increases
– Taxes go down
– Foreign income rises
Shifts in Aggregate Demand
 Decrease
– shift to the right
– Consumer and business expectations
are unfavorable
– Consumer income falls
– Profits fall
– Taxes increase
– Government spending decreases
– Foreign income fall
Aggregate Supply
 The
relationship between aggregate
output as measured by real GRP and
the price level
 Long run – vertical curve
– Economy will produce at full
employment no matter the price level
– Full employment output – the real GDP
the economy produces when it fully
employs its resources.
Aggregate Supply
 In
the long run the desire of people
to receive incomes and the desire of
firms to earn profits holds
unemployment down and real GDP
near its full employment level
 L/R AS – shows the relationship
between full employment GDP and
the price level
Aggregate supply
 Short
run AS – tells how much
output the economy will offer in the
short run at each possible price level
 Upward sloping
– Higher prices lead to more output
Shifts in AS
 Increase
– shift right
 Decrease – shift left
Long run
AS
S/R AS
Achieving Full Employment
Equilibrium
 The
long run macroeconomic
equilibrium that occurs at a full
employment output
L/R AS
Equilibrium
AD
Achieving Full Employment
 At
any price level above the full
employment equilibrium price level,
AS will be insufficient to support full
employment output
– Wages drop and people complete for
jobs
– Prices drop
– Reach equilibrium
Achieving Full Employment
 If
the actual price level were below
the equilibrium, the economy would
overheat with aggregate purchasing
power exceeding the economy's
ability to produce.
– Firms compete for workers
– Wages rise
– Prices rise
Keynesian VS Classical
 The
debate is whether government
should wait for a movement along
aggregate demand or to take action
to manage aggregate demand
– Sticky wages and sticky prices
 Then
no change in the price level and
economy out of equilibrium
Roots causes of inflation

Demand side inflation
– Occurs when AD shifts to the right
– A movement up the long run AS curve to a
higher price level but no change in full
employment output

Supply side inflation
– Occurs when long run AS shifts to the left.
– A movement up the AD curve to a higher price
level and lower full employment output
– Supply shock – unexpected event that is major
enough to affect the overall economy and shift
AS