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12.0 The Basic Macro Model
12.1.1
Each micro concept has an analogous macro
concept
price : Price Level (P)
quantity exchanged: real GDP (Y)
The Macro Picture
P
AS
P*
AD
Y*
YF
Figure 12.1.1 - Our Macro Picture
Y
In this picture,
Price level is on the vertical axis
Real GDP is on the horizontal axis
YF is full employment or full GDP
12.1.2
AD - aggregate demand
AS - aggregate supply
The intersection of these curves represents the
current conditions in the macroeconomy
More
inflation
P
Y
More real GDP
More employment
Less unemployment
12.1.3 - A preview
Great Depression caused by a great fall in AD
More on the specifics later, but
look what happens
P
AS
Fall in AD
P
P'
AD
AD'
Y2
Y1
YF
Figure 12.1.2 - Fall in AD and the Great Depression
Y
After Pearl Harbor
war means big increase in AD, for
reasons we’ll also see later
P
Rise in AD
AS
P*'
P*
AD'
AD
Y1
YF
Y2
Figure 12.1.3- World War II and Expanding AD
Y
Further,
it is not just AD which can move
AS moves due to changes in input prices,
as you will see in greater detail later
Ex. Oil shocks of the 1970’s
AS'
P
AS
Shift up
in AS
P*'
P*
AD
Y2
Y1
YF
Figure 12.1.4 - Oil Price Shocks and AS Shifting Up
Y
This should give you some idea
about how useful this macro picture can be
in explaining the world
We now need to look at each line in detail
12.2.1
Aggregate Demand (AD) is the sum of all the
stuff that individuals and firms and
governments are prepared to buy in a given
year
How much they actually demand depends on
how much things cost
The total amount planned to be spent is called
Aggregate Expenditure (AE)
AE is a nominal measure
measured in current dollars
The AD line
represents the relationship between real GDP
demanded
and the price level
for a given level of aggregate expenditure
In functional form
Y = AD (P | AE)
AD slopes downward
given constant AE because
as price level (P) falls,
constant AE buys more real GDP (Y)
AE is the shift variable
more AE shifts AD to the right
P
P3
P2
P1
AD'
AD
Y3
Y2
Y3'
Y1
Y2'
Y1'
Figure 12.2.1 - Increase in AE Shifting AD to the Right
Y
12.2.2
AE is a huge number
There are six components of AE
AE = C + I + G - T + X - M
Consumption (C)
nominal value of spending done by
households
(stuff you buy)
Investment (I)
nominal amount spent by firms on
plants, equipment
Government Spending (G)
nominal amount government spends
planes, tanks, schools, etc.
Taxes (T)
money taken out of hands of households by
government
this represents net taxation - doesn’t count
transfer payments like
Social Security where gov’t passes resources
from one group to another
(G-T) is the government budget position
Exports (X)
money spent by foreigners on U.S. products
Imports (M)
money spent by U.S. citizens on foreign
goods
(X-M) is the trade balance
12.2.3
Y = AD (P | AE)
while
AE = C + I + (G - T) + (X - M)
so
Y = AD (P | C, I, G, T, X, M)
a change in any of these six variables shifts
AD
An increase in C, G, I, or X
will move AD right
if P stays the same, Y will increase as each of
these three increases
Ex. An increase in G
P
AD
AD´
Y
The same is true for an increase
in C, I or X
The reverse is true for T or M
because they have a negative sign
in front of them
What moves AD?
AD moves right when:
AD moves left when:
Increase in C,G,I,X
Decrease in T,M
Decrease in C,G,I,X
Increase in T,M
Example - Great Depression
Year
1929
1930
1931
1932
1933
Investment
(I)
34.2
23.3
14.7
3.3
3.7
Real GDP
(Y)
175.9
159.2
147.7
125.3
123.4
Unemployment
rate
3.2
8.7
15.9
23.6
24.9
Decrease in I moves AD
left, ceteris paribus
P
Collapse of Investment Contributes
to Huge AD Fall
AS
AD
AD'
Y'
Y
Figure 12.2.3 - The Great Depression
YF
Y
12.2.4
Outbreak of WWII after Pearl Harbor
Huge increase in G moves AD
right, ceteris paribus
P
War Production Demand
Pushes AD Way Out
AS
AD'
AD
Y
YF Y'
Figure 12.2.4 - From The Great Depression to World War II
Y
This push moved the economy
beyond sustainable capacity
people and machines can’t keep up that pace
forever
notice what happens to price level
as you move further and further right
inflation starts to become an issue
12.3.1
Aggregate supply line represents the
relationship between the
Price level and real GDP produced by the
economy
Actually, there are two different lines
Long-run aggregate supply
Represents situation when all micro
adjustments have been completed under the
nice assumptions
Most efficient condition – biggest pie
Full GDP – Full employment
The LAS line
Vertical line at full employment
Full, sustainable capacity is determined by
Initial endowment – that society’s
natural resources, labor, and capital
It is vertical because in the long-run, real GDP
is independent of the price level
P
LAS
YF
Figure 12.3.1 - Long Run Aggregate Supply (LAS)
Y
12.3.2
In the very long run endowment changes can
shift LAS
Population growth, new innovations, new
natural resources can move LAS steadily
rightward
Natural disasters, war can move LAS leftward
We will assume
That the LAS remains stationary
in order to focus on the long run
macroeconomy
We will use LAS as our orientation line for
full employment
12.3.3
Short-run aggregate supply line (AS)
In the short run, we assume that not all
markets have had time to adjust
Specifically, factor markets have not adjusted
Along an AS line, factor prices (like wages)
are constant
P
LAS
YF
Figure 12.3.2 - Short Run Aggregate Supply
AS
Y
12.3.4
The AS line has three distinct segments
They are labeled k, l, and m
P
LAS
AS
m
k
l
YF
Figure 12.3.3 - AS Line Divided Into Segments
Y
k-segment
is significantly below full-employment real
GDP
large quantities of idle factors exist
Under these circumstances, you can hire more
people and increase production without the
price level increasing
12.3.5
l-segment
real GDP approaches, and then meets sustainable full
employment GDP
Bottlenecks may begin to occur, because not all
industries might reach capacity at the same time
Cost pressures might lead to higher output prices
Shape of l-segment is important to understanding
inflation
12.3.6
m-segment
economy reaches limit of short-term capacity
These three distinct segments make up the AS curve
You can surge beyond what is sustainable for a
while, but
people and machines can not work 24 hours a day
forever.
Ex. Wartime
Further production pressure just increases the price
level
because exhausted, unproductive workers
are being paid double- or triple-time to work
those extra hours
Chart p.187 shows WWII effect
Inflation only stopped by gov’t price controls
12.3.7
AS curves shift due to changes in
factor prices
These factor price changes are the exogenous
variables in this relationship
These exogenous shocks are called aggregate
supply shocks
Ex. Oil prices, wages
P
AS'
AS
A Shift Up in AS
Due to Rising
Factor Prices
Y
Figure 12.3.4 - A Shift Up in AS Due to Rising Factor Prices
12.4.1
Combining AD, LAS, and AS
Putting the tool kit together
LAS
P
Falling
AD
AS
AD
AD'
Y'
Y
YF
Figure 12.4.1 - Increasing Unemployment Due to Falling Aggregate Demand
Y
P
LAS
AS
AS'
P
P'
AD
Y
Y'
YF
Figure 12.4.2 - Falling Unemployment and Falling Price Level
As AS Shifts Down Due to Falling Factor Prices
Y
Effect of
Falling Factor
Prices
AS'
P
LAS
AS
Effect of Rising
Factor Prices
P'
P
AD
Y'
Y
YF
Y
Figure 12.4.3 - Increasing Unemployment and Rising Price Level
As AS Shifts Up Due to Rising Factor Prices
LAS
P
AS
P'
AD'
P
AD
Y
YF
Y'
Figure 12.4.4 - Falling Unemployment and Rising Price Level
Due to Increasing Aggregate Demand
Y
12.4.2
More complex case – a wage/price spiral
As inflation occurs,
workers lose value if their nominal wage
remains the same
They take steps to account for inflation by
demanding wage increases
in order to maintain their standard of living
This is easier to do when
unemployment is low
(who else are you going to get, boss?)
This is called a tight labor market
Inflation set off by expanding AD
sets off a wage response
When wages increase,
AS shifts up
If AD continues to shift outward
the net result after several of these is as
follows:
LAS
P
AS'
AS
O
3
O
1
O
4
O
2
AD"
AD'
AD
YF
Figure 12.4.5 - A Wage-Price Spiral
Y
People would often
index their wages to the CPI in labor
contracts,
Making this spiral even more likely
Wage/price spirals can become very persistent
12.4.3
Now that we have a tool to represent various
macro conditions
We can look at the forces that cause the
curves to move