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Lecture 9: Macro Mod 5
C.L. Mattoli
(C) Red Hill Capital Corp., Delaware, USA
2008
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This week

Chapter 14: A Simple Model of the Macro
Economy
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Notice
 Since
most people from
tutorial 1, Monday 2:00 had
already transferred
themselves to other
tutorials, that tutorial will no
longer exist, beginning
today.
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2008
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Prelude

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We looked at macroeconomic concepts
and variables, such as GDP and its
make-up, inflation, unemployment, and
short- and long-term growth of the
economy.
In this lecture we shall look more deeply
into some of the concepts that we have
talked about, and we shall discuss supply
and demand on the aggregate level.
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Prelude
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We have looked into some simple
concepts and models of economic growth,
which, after all, is one of the main
concerns of people and, therefore, their
governments.
Way back in the beginning of the course
when we talked about the PPF, we said
that there were two ways that an economy
could get to a new PPF.
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Prelude
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The first was changing its mix of output to
more capital goods. Even then, we pointed
out that the economy would have to produce
less consumer goods.
The implicit result was that the people would
have to give up consumption.
In the preceding lecture, we elaborated on
that idea by pointing out that consuming less
means saving more, and savings is required
to fund investment.
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Prelude
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Then, we went on to think about how since
capital goods wear out and need to be
replaced, there will need to be investment
(requiring savings) just to replace the worn
out capital.
To increase the capital stock, resulting in an
increase of production factors/person,
resulting in more potential output per person,
resulting in higher gross output for the
economy, will require more savings.
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Prelude
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In the end, we talked about a Golden Rule
level of savings.
The Golden rule is simply a conceptual
argument based on some of the concepts
that we covered in looking at production on
the micro level in module 3.
To get to a higher level of output, we need
more capital.
The more capital stock we accrue, the more
that will wear out.
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Prelude
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Also, since there is the law of
diminishing returns, there will be an
optimal level of capital goods/ person
beyond which we should not go because it
will just be a waste of money for the extra
capital beyond that.
That means that the extra savings is
wasted and that the only result will be that
consumption will be less than it could have
been.
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Prelude
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The simple result of the Golden Rule is
that it brings to economy to the perfect
level of capital stock and capital
stock/person, and after that level is
reached, the savings supports exactly
enough investment, each year, to replace
the part of the capital stock that is wearing
out.
The Economy will be at a maximal PPF
and at one exact point on that PPF.
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Prelude
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What makes it possible for economies
to grow (and expand their PPF’s
beyond the one that would come from
the Golden Rule) is changing
technology.
Then, as new technology is invented
and used to replace the old technology,
output/person can continue to
increase, so total output can increase.
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Prelude
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Although we have not filled in the extra result,
all through our discussion, the other end
result is that since output increases,
income/person increase, and that means
everyone’s standard of living has increased,
which is the major goal of it all.
As a result, the economy can again continue
to grow beyond the point where it got to from
the Golden Rule.
We shall examine some models of the macro
economy.
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Learning objectives
On successful completion of this module, you
should be able to:
 Articulate Keynes’ rejection of the classical
school’s explanation of the Great Depression
of the 1930s
 Explain the economic determinants of the
components of aggregate expenditure
(consumption, investment, government
expenditure, and net exports)
 Construct and use the ‘aggregate demandoutput’ model for macroeconomic analysis
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Learning objectives
Construct and use the ‘aggregate demandaggregate supply’ model for macroeconomic
analysis
In the next lecture:
 Use the concepts of money demand and
money supply to explain the determination of
interest rates in an economy
 Explain the effect of monetary policy on
interest rates, prices, output and employment
 Describe the Australian financial system as an
example of a typical financial system in the 21st
century

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Classical Economics
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In classical economics, as led by the famous
Adam Smith who imagined markets having an
invisible hand that would make everything right,
it was believed that markets would always
clear.
Classically, it was believed that the forces of
supply and demand would lead to all goods
and services offered being sold and would
naturally lead to full employment.
That was taken as a corollary of the flexibility
of all prices, including wages and interest rates.
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Say’s Law…isn’t!
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Laws cannot be broken, or they aren’t
laws. Such is the case for one of the laws
of classical economics: Say’s Law.
Say’s Law states that production of G&S
(supply) generates an equal amount of
spending (demand).
First, since people have unlimited wants,
while there is limited supply of anything, it
might seem logical.
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Say’s Law…isn’t!
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Second, suppose that we look at the simple
circular flow model of GDP, consider a firm in
the economy that produces 100,000 packets
of noodles to sell at $1/pack.
The supply decision potentially creates
$100,000 of income through the factor
markets as wages, profits and payment for
the wheat. So it creates just enough income
to clear the market in demand, and everyone
remains employed.
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Say’s Law…isn’t!
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Indeed, if the market could not clear, the price
of noodles would be bid down.
In turn, wages and payments would also fall,
and, again, there would be just enough income
taken in to keep everyone employed and clear
the noodle market.
If that might not happen immediately, then, it
would happen over a short period of
adjustment as the price and resulting factor
payments came to new equilibrium levels that
again balance out.
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Say’s Law…isn’t!
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A prolonged depression (long recession), like
that in the early 1930’s after the great stock
market crash of 1929, would be impossible
according to this law.
However, people do not like change, especially
change for the worse, and even when change
would be to their benefit they are slow to do so,
if at all.
That is the case with accepting decreases in
wages or any other financial loss.
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Keynes Theory
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Keynesian economics
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Keynes, in his General Theory of
Employment, Interest and Money, turned
Say’s Law around, and said that demand
creates it’s own supply.
He argued that over long periods
aggregate demand (expenditures),
C+I+G+(X–M) from the modules about GDP
(expenditure approach), can be too small to
achieve full employment.
We shall examine each of these categories of
expenditures, in greater detail in what follows.
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C is for Consumption
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HH consumption
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The primary factor in determining what
you and your family spend on food,
clothing, shelter, education, and other
things is how much money you have,
which depends on how much you earn.
Disposable income, DI, which is
personal income after taxes, is how
much you earn.
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HH consumption
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Psychologically, it is expected that the
more a person earns, the more he or she
will consume, although that does not mean
she or he will spend all of it (they might
save some, S).
The relationship between C and DI is
called the consumption function, C =
f(DI), consumption is a function, f, of
disposable income.
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HH consumption
In modern developed countries, C
accounts for almost two-thirds of
aggregate expenditures (equals GDP
+M) and is the largest component.
 Of course, there are other factors that
affect consumption, and we shall also
discuss those, below.

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Marginal Propensities for C & S
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If HH do not use DI for spending, C, what
they do with it is to save, S: DI = C+S.
Since we are talking about how C will depend
on DI, we introduce the concept of marginal
propensity to consume, MPC, which is just
the change in consumption per change in
disposable income, or: MPC = ΔC/ΔDI.
For example, if a person’s MPC=0.75, then,
for every extra (marginal) dollar of DI she
gets, she will use 75% of it for consumption.
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Marginal Propensities for C & S
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Although there is reason to believe that MPC
will be higher for lower income than for
higher, in the models that we shall discuss,
we assume that MPC is constant for all DI.
Hand-in-hand with MPC, we will have MPS,
the marginal propensity to save.
Certainly, since DI = C + S, ΔDI/ΔDI = 1 =
ΔC/ΔDI + ΔS/ΔDI = MPC + MPS, so that
MPS = 1 – MPC. Thus, the person, above
will have MPS = 1 – 0.75 = 0.25 (25%).
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Expectations and consumption demand
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Consumer expectations (sentiment) about
the future can also affect spending habits
in the present.
They will tend to spend more when they are
optimistic about the future and less when
they are pessimistic.
Expectations will cover a number of things,
like future inflation, future employment,
future income, and future prices.
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Expectations and consumption demand
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For example, if people expect inflation to
move higher, they may buy, now, to avoid
higher prices, later.
Then, prices will also be bid up.
If they expect a recession and the
possibility of being unemployed, they
might tighten their belts (means spend
less money) and spend less, now.
Then, there might be a recession.
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Wealth
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The wealth of HH’s includes things, like cars,
TV sets, furniture, art, horses, and financial
assets, as well (home purchases are part of I,
not C).
The more wealth HH’s accumulate, the more
they are expected to spend, ceteris paribus,
and conversely.
The large losses of wealth in the stock market
crashes of 1929 and 2001 were blamed for
large dips in consumption spending, and the
latter also resulted in a negative savings rate
in the U.S. in the early 2000’s.
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Price levels
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Changes in the general level of prices can
affect consumption spending (demand) by
increasing or decreasing the purchasing
power of financial assets that have fixed
nominal values.
For example, if you have a $100,000 bond,
and prices increase by 10%. Then, the same
financial asset will buy approximately 10%
less in G&S when you sell it.
If the real value of wealth drops, HH’s will
tend to spend less at any level of current DI.
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Interest rates
Interest rates, as we learned in the
last module, also vary with the rate of
inflation (nominal interest rate = real
rate + inflation; NI = RI + INF).
 Some HH purchases (big-ticket
items), like cars, large appliances,
boats and houses, are usually at least
partly paid for with borrowed funds.

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Interest rates
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Lower interest rates encourage
borrowing, and higher rates discourage
taking on debt. (Interest rate is % per year
of borrowed money that you pay to use the
money)
As a result, HH’s will be more disposed
to using debt to finance consumption,
when rates fall, and may be less inclined
to make purchases on credit when rates
are higher.
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I is for Investment
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I and C
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It is widely believed that that changes in
private-sector spending (as opposed to
government, public sector), C+I, are the
major cause of business cycles.
The more volatile of these two
components is I.
The greater stability of C has to do with
factors, other than income, acting to offset
one another.
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I and C
Indeed, people might simply be
reluctant to change personal
spending habits and will dip into
savings or borrow money to maintain
their lifestyles.
 Remember: I consists of spending on
new residential and non-residential
structures, P&E, and inventories.

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Major factors for I
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The two most important variables in the
investment decision are: the expected return
from the investment and the interest rate for
funds to finance the investment.
For example, suppose that I want to buy a
truck for transporting beer between Qingyuan
and Guangzhou.
The cost of the truck is $30,000, it will be
scrap in a year, and I can earn $33,000
during the year.
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Major factors for I
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Then, my return on investment (ROI) is
($33,000 – $30,000)/$30,000 = 10%: my
earnings minus cost divided by
investment.
Next consider the cost of borrowing money
to finance the truck (interest payments).
If the interest rate is below 10%, I can
make a positive return by borrowing all of
the money to finance the truck.
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Major factors for I
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If the rate is above 10%, my net return
would be negative, and I could not do it.
Ceteris paribus, this simplistic example
suggests that as interest rates fall,
aggregate investment spending will
increase. As interest rates rise, people will
take on fewer investment projects as
required return is higher.
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The expectations factor in I
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If you look closely at our 2 major factors in
I, the word expected should pop out.
Expectations play a primary role in
business decisions since all investment
has a future-oriented nature.
We invest, now, to get money, then, and
many things can affect expected returns.
As irrational human beings, business
people are moody and can become
optimistic or pessimistic about economic
conditions.
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The expectations factor in I
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Then, those expectations involve
normative analysis in forecasting sales,
costs, and ultimately profitability of
investment projects.
Forecasting, in turn, involves consideration
of a mass of ever-changing factors, such
as consumer sentiment, population
growth, trends in tastes, government
spending, taxes, central bank monetary
policy, conditions in securities markets,
and national and world events.
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The expectations factor in I
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Forecasting and confidence in forecasts is
quite difficult, and there can be waves of
pessimism and optimism in business
because people talk to each other and
watch each other, and attitudes spread.
All of this is against a background of a
current rate of interest for investment
funds.
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The expectations factor in I
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The result can be broad-based reductions
or increases in investment spending in the
economy.
That was the case during the Great
Depression of the 1930’s. It also played a
part in the early part of this century.
Thus business confidence is a major
cause of fluctuations in investment
spending.
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Technological change
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Technological progress includes the
introduction of new products or new ways of
doing things.
New technology results in a flurry of
investment spending as firms buy the latest
technology to improve production and to keep
up with or ahead of the competition, so
investment demand rises.
Indeed sometimes purchases of technology are
necessary, like was the case in the 1990’s as
everyone rushed to buy technological fixes as
the world approached Y2K.
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Capacity utilization
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The amount of capacity being used by
businesses in the economy will also have a
major affect on new investment decisions.
During recessions, many businesses are
operating below their maximum potential
productive capacities. Thus, there is little
incentive for business to make new
investment to add to their capital stock to
increase productive capacity.
When cap utilization is high and the outlook
for increased sales is good, there is pressure
to invest to increase capacity.
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Business taxes
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Since, after all, businesses, as anyone,
focus on profits after tax, changes in
taxes can also affect business decisions
about investing.
If taxes increase, profitability of
potential projects will decrease at any
interest rate, and investment spending
will decrease.
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Business taxes
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On the other hand, government can
encourage investment with, for example,
investment tax credits of some sort for
new investments.
For example, the government could offer a
tax credit of 10% on new investment in
addition to the usual depreciation expense
available for investment.
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G is for Government Demand
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G equals government consumption &
investment
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Government spending is considered
autonomous expenditure: they are not
affected in any systematic way by changing
interest rates or income.
The rationale for that assumption is that
government spending results, primarily, from
political decisions, not from economic
impetus, like the level of output or interest
rates.
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G equals government consumption &
investment

This particular part of expenditures was
crucial for Keynes, in that, even if private
sector was fearful about the future and
was reluctant to spend for consumption
and investment, the government could be
the vanguard of spending and could kick
start the economy and stimulate private
sector spending by improving sentiment
about the future.
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X – M is for Net Exports
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Export demand = X
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In a first approximation, exports can be
treated as independent of a nation’s level
of domestic real GDP.
So, like G, they are autonomous (versus
domestic) expenditures.
Export spending depends on economic
conditions in the countries that buy export
goods from Australia
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Imports = M
On the other hand, the level of
imports will depend on conditions in
the domestic economy.
 As real GDP increases, ceteris
paribus, imports, along with other
spending, will increase, and net
exports, being X – M, may decline,
depending on world economic activity
and consequent demand for exports.

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Foreign exchange rates
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Currencies of other countries are
generally referred to as foreign exchange
(FX), and the rate of one currency in terms
of another is called the exchange rate.
For example, the rate between Australian
dollars (FX symbol AUD) and the Chinese
Yuan (CNY) is currently (May 2007) AUD
= 6.37 CNY.
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Foreign exchange rates

In general, FX rates change (most
countries allow their currency rates to float
in the market and allow them to be
determined by market forces; China is only
now working towards allowing its currency
to fully freely float), for example, just last
year the rate between AUD and CNY was
AUD = 5.9 CNY; now it is 6.6.
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Foreign exchange rates
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In that regard, when the exchange rate
decreases, i.e., if AUD declined to 5
CNY/AUD, exports from Australia to China
would be cheaper, and demand for
exports might increase.
Concurrently with a drop in currency price
and cheaper exports, imports become
more expensive for Australians.
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Foreign exchange rates
Thus, the net result of a decrease in a
country’s currency price will, ceteris
paribus, be that net exports, X – M,
will increase.
 Conversely for an increase in the
country’s currency vis-à-vis its trading
partners’ currencies.

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Terms of trade
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The terms of trade are defined as the ratio
of export prices to import prices.
Thus, increased terms of trade means that
the country’s exports are becoming relatively
more valuable in the international market.
In turn, increased terms of trade will
encourage exporters to expand output, and
exports can be expected to increase and,
ceteris paribus, net exports will increase.
The opposite will result from a decrease in a
country’s terms of trade.
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The Aggregate Demand-Output
Model: Keynesian Model
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Aggregate demand (AD)

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In module 4, we used this format,
C+I+G+(X – M), to describe the
accounting definitions that make up GDP.
There, any discrepancy between what was
bought and what was produced was
accounted for by change in inventory.
Now, we are talking about the demand
represented by these various components
of spending in the economy.
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Aggregate demand (AD)
Spending decisions are made by
one set of people based on certain
factors, while production decisions
are made by another group based
on other completely different factors.
 Keynes was the first to argue that AD
might not equal total production,
contrary to classical thinking.

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Aggregate Supply (Production)
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Based on expectations and predictions about
demand for their products, firms will, at any
given time, be offering certain quantities of
output for sale at prices that they expect will be
acceptable to buyers.
Those prices and quantities are linked to the
return on investment: the surplus of revenues
over and above all explicit costs, including
interest on debt.
This newly produced output for the economy is
referred to as aggregate supply (AS).
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In the marketplace: supply meets demand
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Buyers, including HH, business, government
and foreigners, will be in the market bidding
on the output.
This aggregate demand will depend on their
needs, wants, expectations of the future,
prices in relation to their income and to close
substitutes, and for large purchases, the price
of money, interest rates.
Aggregate demand is the willingness to
purchase the G&S offered.
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Where do they cross?

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AD and AS do not necessarily have to be
equal.
In national accounting, any difference
between the two is accounted for by
unintentional changes in inventory, in the
period.
In subsequent periods, the supply side will
respond with change in output, prices, or both.
In the Keynesian model, it is assumed that the
response to the mismatch in supply and
demand, on the supply side, is purely in terms
of output, not prices.
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Aggregate example
Assume the economy is operating at
a particular time at full employment
with an output of $500 billion.
 In the next period, suppose that the
demanders were unwilling to take up
that amount of output, and purchased
only $490 billion of the output.

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Aggregate example
Then, firms will end up with inventory
of $10 billion on their shelves, an
unplanned investment.
 In response to this disequilibrium
between supply and demand, the
supply side will lay off workers and
will produce less output (supply) in
the next period.
 Thus, the economy will operate
below its full employment level.

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Classical vs. Keynesian
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In the classical view, the response to this
mismatch between supply and demand would
be dealt with trough a price adjustment.
Prices, including the underlying wage
component would be reduced, and the market
would clear at a lower equilibrium price.
The Keynesian view was that prices,
especially wages, were resistant to
downward pressure, and that the real world
response to such a situation as supply
outstripping demand would be reduction in
output, not price.
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Classical vs. Keynesian
As a result, people would be laid off,
and expectations about the future
would decline.
 Moreover, such a situation might
continue for an extended period of
time, and the economy could continue
to operate below its full-employment
output capacity, resulting in continued
involuntary unemployment.

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Classical vs. Keynesian
The Keynesian policy solution to
such a state of affairs is for
government to take up the slack
and increase aggregate demand,
through G, until the full-employment
level is reached. Otherwise, the
economy may never readjust and
unemployment and poor expectations
will continue.
 That was the way out of the Great
Depression of the 1930’s

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The spending multiplier effect


In the Keynesian world, increased
aggregate demand can be met because
there is sufficient excess capacity to
increase output to a higher level.
The change in the economy is begun with
government spending or taxation, which is
multiplied in the economy by rounds of respending.
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The spending multiplier effect



It is important to note that the components
of AD, C, I, G, X – M, are not independent
of one another.
For example, a stimulus, for some reason,
to consumption could lead to firms
increasing their output and buying
machinery, I, to further expand.
That would result in higher employment in
the equipment manufacturing and related
industries, which would feed into more
increased consumption.
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The spending multiplier effect



The feedback through the system would
continue.
The induced expenditures comprise a
multiplier effect: the original expenditure
increase (or decrease) gets multiplied.
Thus, in the Keynesian policy prescription,
if a government acts to stimulate demand,
that will flow over into the private sector by
increasing employment, output and
consumption.
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The spending multiplier effect



That can be accomplished with a
relatively small stimulus due to the
multiplier effect.
The bad news is that a small decline in
aggregate demand due to, say,
consumer or business pessimism about
the future, can be multiplied on the
downside.
That could magnify the decrease in
output, employment and consumption.
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Formal Keynes: the Keynes Cross
Aggregate demand is aggregate
willingness to consume.
 Consumption is a major part of AD,
and income is a large factor in
determining consumption.
 Also important for consumption are
expectations, wealth, price level, and
interest rates.

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Formal Keynes: the Keynes Cross
Given the large part of AD
represented by C and that income Y
is a large factor in C, we assume that
income is a large factor in demand.
 Also, given the theoretical
equivalence of income and output, we
represent income by real GDP.
 Then, we can plot AD versus Income
(real GDP) as in the graph in the next
slide.

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The Keynes Cross: Graphically
The AD line crosses the 45o-angle line, Y =
RGDP = Output: AD=output.
Aggregate Demand

AD = C+I+G+(X-M)
45o
Real GDP
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The Keynes Cross: Analytically





In the graph, we show the AD line versus real
GDP = income by relationships from chapter
11.
It rises at less than a 1-to-1 rate (slope < 1)
because consumption does not rise as fast
as income, although it rises as income rises.
The plot shows a 45 degree-angle line which
is just a plot of when AD = Y = RGDP.
Thus, the point at which the actual AD line
crosses the 1-1 line is an equilibrium between
AD and output.
That is a Keynes Cross.
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The Keynes Cross continued




Next, suppose that the AD curve shifts
because of some increased spending by
government.
Then, a new equilibrium will obtain but at a
higher level of real GDP but more than was
added to shift the AD curve up.
That is because of the multiplier effect in
the economy (trickle down).
The situation is depicted in the next slide.
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The Keynes Cross continued
The multiplier effect makes output increase by
more than the initial addition to spending.
AD
Aggregate Demand

AD
ΔAD
45o
∆Output
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Real GDP
79
The double cross




What happens is that the initial addition to
spending creates more production.
The extra production generates more income
which generates more production.
That continues until a new equilibrium is
reached.
Moreover by the time that the process has
paid itself out, it will have resulted in a greater
increase in output than the original increase
in spending.
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Moving the cross



Factors that can move the AD curve include
non-income determinants.
These could include an increase in
government spending, increased demand for
exports, changing sentiment of consumers
and/or businesses, or a change in interest
rates.
Indeed, interest rates are a policy tool of the
government. The RBA sets target rates for
the shortest-term borrowing in the wholesale
market for funds: the overnight, inter-bank
borrowing.
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Break time

10 minute break
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The Aggregate DemandAggregate Supply Model
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Intro



Keynes theory had a simple fix for the
Great Depression: government begins the
spending, jobs are created, and aggregate
demand follows suit.
Although inflation was not a big problem,
back then, his theory also has implications
for demand-pull inflation.
For that case, the Keynesian solution
would be for the government to cut
spending and raise taxes to take the heat
off aggregate demand.
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Intro



However, in order to properly understand
business cycles, we must also consider
aggregate supply added to the simple
Keynes theory of aggregate demand.
When we add the two curves, AD and AS,
together, we will be able to understand how
shifts in these aggregate curves can affect
the price level, the equilibrium level of real
GDP, and employment in the economy.
That will be the AD-AS model of
macroeconomics.
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The AD Curve
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The AD curve construction
The AD curve for the economy-wide
demand curve for all goods and
services.
 It is the level of real GDP that HH,
businesses, government and
foreigners would be willing to
purchase at different average price
levels during a specific period of time,
ceteris paribus.

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The AD curve construction


Like in the case of demand for a single
product, other factors remaining constant,
the lower the average economy price
level, the higher the aggregate quantity
demanded for the aggregate of G&S. It is
downward sloping.
While for individual products, the
horizontal axis measures physical units,
like tons, for AD the units are in terms of
real GDP, or the quantity of aggregate
production demanded, as measured in the
dollars of some base year.
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The AD curve construction


The vertical axis for AD is some sort of
average measure of prices, an index of
prices, like GDP deflator or the CPI. An
example is shown in a slide, below.
We must point out that while there is a
similarity between the aggregate demand
curve and an individual product demand
curve, there is a subtle but large
difference.
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The AD curve construction


When we move along an individual
demand curve, we assume that prices of
related goods are constant. When we
move along the AD curve, that assumption
is meaningless because we are using a
market basket measure for all G&S.
In the next slide we show an example AD
curve.
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Example AD curve

Price level
CPI, 1982-84 =100

The AD curve shows the relation between the price index level and the
level of real GDP. The lower the price level, the higher the GDP
demanded.
If the price level is at 100, the demand by HH, business, G and foreigners
is $400 bil. At point A; if it is 150, the real GDP demanded is $600 bil. At
B.
Causal Chain
200
A
Decrease in
Price level
B
100
Increase in
Real GDP
demanded
0
200
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400 600 800 1000 1200
Real GDP
($ billion/year)
91
Determining the shape of the AD curve
For an individual demand curve, it is
downward sloping, partly because we
assume that prices of close substitutes
remain constant.
 Thus as the price of an individual product
decreases, its price relative to substitutes
becomes more attractive, and we expect,
ceteris paribus, that a higher quantity will
be demanded.

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Determining the shape of the AD curve


For the AD curve, the reasons for its shape
are very different and include the real
balances effect (wealth effect), the interest
rate effect, and the net exports effect.
Moreover, the wealth and interest rate effects
are tempered by the further assumption that
the total nominal quantity of liquid financial
assets in the economy is fixed during the time
period under consideration.
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Liquid Assets
A liquid financial asset is one that can
be easily converted into a form of
exchange that can be used to
purchase G&S.
 Easily converted means with little
time-delay or effort and negligible loss
of nominal value.

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Liquid Assets



Cash is the most liquid. Then, there are
demand accounts at banks and
government bonds.
There are also things like corporate bonds
and stocks, which have a liquid trading
market but which might involve some loss
of value.
Other fixed-term deposits or bonds are
much less liquid.
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The Real Balances (Wealth) Effect


Liquid financial assets are but one
financial asset whose real value changes
with changing price level, i.e., in terms of
purchasing power (PP).
Thus, if you have $1,000 in bank and it will
buy 10 weeks worth of groceries, then, if
the price level drops by 20%, your money
will buy 12 weeks (10 weeks x 1.20) worth
of groceries.
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The Real Balances (Wealth) Effect



In that regard, if prices drop, people will feel
wealthier and they will show more willingness
to spend their money.
To them, real value of their financial assets is
measured in terms of the quantity of G&S
that their “money” will buy. The lower the
price level, the higher the real value, and vice
versa.
When inflation, on the other hand, reduces
the real purchasing power value of the
nominal stock of financial assets held by HH,
they will buy less and real GDP will fall.
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The Real Balances (Wealth) Effect


Prices up, real value of wealth down,
people feel poorer and are less willing to
part with their reduced stock of financial
assets.
The wealth effect is, then, defined as the
impact on total aggregate spending (real
GDP) of the inverse relationship between
the price level and PP of financial assets
of fixed nominal value.
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The Real Balances (Wealth) Effect


Thus, price level ↑, aggregate demand
↓, ceteris paribus, due to the wealth
effect.
When people feel richer, they are more
optimistic and they tend to spend more.
When they are feeling poorer, they feel
less confident about the future, they
tighten their belts and spend less.
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The Interest Rate Effect



As discussed in the lecture about inflation,
inflation is built into interest rates.
Indeed, if someone decides to save and to
limit current consumption, they will want to
be compensated by being paid at least the
rate of inflation for renting out their money.
If they forego consumption, now, they will
want to be able to buy at least as much in
real value, later, as now.
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The Interest Rate Effect

How inflation enters interest rates will
involve present inflation as well as
expected future inflation.

Thus, increasing price levels, in general, will
cause increasing interest rates.
As prices are bid up, more people will have
less money and will want to borrow to support
present consumption, and they will bid up the
nominal price of a fixed supply of funds
available for borrowing: the interest rate.

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The Interest Rate Effect



As interest rates rise, people are discouraged
to borrow. They will put off buying houses,
cars, boats, and plant and equipment, on the
business side.
Thus, a higher price level, further, induces
higher demand for limited available credit
funds, which pushes up interest rates, which
will cause aggregate demand for real GDP to
fall, ceteris paribus.
Price level ↑, demand for borrowed funds ↑,
interest rates ↑, aggregate demand for real
GDP ↓.
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The Net Export Effect


Because of the way that everything is mixed
into aggregate demand, products that can, for
example, compete with one another, we must
especially take note of the relationship
between domestic price levels and the prices
of foreign goods vis-à-vis competing locallyproduced goods.
If prices of imports, M, are relatively more
favorable than those of local goods, then, M
will increase, which will be at the expense of
aggregate demand for real GDP.
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The Net Export Effect
In addition, a higher relative price
level for domestically-produced G&S
for export will affect the demand for
exports, and aggregate demand for
real GDP will, again, be adversely
affected.
 Thus, domestic prices ↑ can also lead
to net export ↓ will result in aggregate
demand for real GDP ↓.

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The Causal Nature of downward-sloping AD
Effect
Causal connections
Real balances, or wealth,
effect
Price level ↓ → PP ↑ → Wealth
↑ → C ↑ → AD for real GDP ↑
Interest rate effect
Price level ↑ → Demand for
borrowed funds ↑ → Real value
of limited credit ↑ → Interest
rate ↑ → HH and business
consumption ↓
Net export effect
Price level ↓ → prices of
imports become less attractive
and prices of exports become
more attractive to foreigners →
AD for real GDP ↑.
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Non-Price-Level Determinants of AD




In analogy with demand curves for individual
products, we must look at non-price factors in
aggregate demand.
Recall that price changes correspond to
movement along a demand curve, while non-price
changes cause the D curve to actually shift and
become a new demand curve. Thus, it is with AD.
A change in any component, C, I, G, X-M, can
shift the entire AD curve: outward for an increase,
and to the left for a decrease.
We show an example of AD outward shift in the
next slide.
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Increase in non-price-level determinants

Increase in NPL
determinant, C,
I, G, X – M,
leads to an
outward shift of
aggregate
demand to
higher level of
real GDP at all
prices.
Conversely, for
decreases.
Increase in NPL
determinant,
C, G, I, X-M
Price level
CPI, 1982-84 =100

Causal Chain
Increase in
AD curve
200
A
B
100
AD2
AD1
0
400 600 800 1000 1200
Real GDP
($ billion/year)
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200
107
Graphical analysis: shifts out



A cause may have been an increase in
consumer sentiment (more optimistic), and
they decided to loosen their belts and spend
some more money.
It might have been that prices of LT assets,
like houses or stock market prices made
people feel richer and spend more money.
Maybe business has become more optimistic,
expects good returns from new investment,
and they will buy more P&E.
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Graphical analysis: shifts out



Or maybe even the government will boost
its level of autonomous spending.
It can also come from a rise in net exports.
THIS IS PARTICULRLY TRUE FOR A
COUNTRY LIKE AUSTRALIA WHICH
RELIES HEAVILY ON INTERNATIONAL
TRADE.
Increased exports can come from better
economic outlooks in the economies of
trading partners.
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Graphical analysis: shifts out
It might also come from the relative
value of the country’s foreign
exchange rate.
 As the exchange rate becomes more
domestic currency per unit of foreign
currency, that means foreign money
can buy more domestic goods, and
export demand will increase.

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Graphical analysis: shifts out
With the price level at a standstill at
100, C pushes total AD outward.
 At the fixed price level, the new
demand will increase from $500 to
$600 billion real GDP.
 Aggregate demand will be higher at
any price level and the curve is
shifted from AD1 to AD2.

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Graphical analysis: shifts in
Similar factors can lead to inward
shifts of the AD curve and reduce AD
at any price level.
 It could be that a wave of pessimism
might be sweeping the consumer or
the business sector or both.
 Government might, for some reason,
reduce its spending.

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Graphical analysis: shifts in


Changes in government spending, for
example, might come especially as one
government regime exits and a new one
enters office after elections.
Exports might fall and imports might rise,
either from changes in the economies of
trading partners or competitors, or from
changing terms of the exchange rate
between currencies.
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The AS curve
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Intro
In the short run, the aggregate supply
curve, AS, is just like a supply curve
for an individual market.
 Again, the reasons for upward-sloping
AS are quite different from the
motivations for upward-sloping
individual market supply curves.

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Intro


For market supply, producers are
motivated by profits-maximization under a
constraint of fixed costs and variable costs
and will supply more quantity at a higher
unit price.
In the AS situation, rising price level
means rising prices of all things, not only
prices of final output but also some or all
of the inputs, including labor.
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The AS curve defined



Thus, the AS curve is defined as the level of
real GDP that firms would be willing to
produce at different general price levels
during a given period of time, ceteris paribus.
It is the value of G&S that firms are willing to
produce at various sales plus costs price
levels.
There are two polar opposite regions that we
shall discuss for AS curves: the Keynesian
horizontal supply curve and the classical
vertical supply curve.
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AS in Keynes




In Keynes view, an economy in depression
has many idle resources.
That results in producers willing to supply
more at current prices.
In turn, the supply of unemployed workers
willing to work at current prices diminishes
workers’ ability to seek increased wages.
Also, all of the excess capacity in the
economy will not allow firms to try to raise
prices as there are plenty of other firms
willing to supply without a price increase.
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AS in Keynes



Then, assuming Keynes’ stickiness of
prices, especially to the downside,
changes in aggregate demand shift the AD
curve outward at the same prices for more
G&S.
Thus, the Keynesian AS curve is strictly
horizontal.
We show the basic Keynesian view of
aggregate supply and increased demand
in the next slide.
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Keynesian horizontal AS


Sticky prices on the
downside and the
inability of either labor
or businesses to raise
prices because of excess
competition means that
increased AD will be
met with increased AS at
an unchanged price
level.
Demand creates its own
supply.
G increases
A Causal Chain
AD increases
and shifts
P constant
real GDP &
Employment
rises
200
A
100
B
AS
AD2
AD1
0
200 400 600 800 1000 1200
Real GDP
Full Employment
($
billion/year)
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AS, Classically




The AS curve is vertical in classical theory for
two reasons.
First, the normal tendency for an economy is
to operate at full employment output.
Second, prices of output and production
costs are flexible and will change rapidly in
order to maintain full employment in the
economy.
This is completely at odds with the Keynesian
view.
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AS, Classically




Suppose that aggregate spending from HH
and businesses because they have
developed negative sentiment.
That causes AD curve to shift downward.
A temporary surplus will exist on the market
at the current price, which manifests itself as
involuntary inventory accumulation.
In order to deal with the new reality, firms
begin to cut prices, to move inventory, and
they will plan on producing less output in the
next period.
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AS, Classically




In turn, there will be less demand for factors
of production, including raw materials and
labor.
That labor allows its price to be down is that
prices, in general are going down, so real
PP is not affected. Owners of other factors
of production will also accept lower prices
We look at this graphically in the next slide.
Supply creates its own demand.
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Classical vertical AS illustrated
A Causal Chain

In the classical view, if the
aggregate demand curve
drops, at the same price, a
surplus will exist, and
prices, including wages
will adjust downward to a
new equilibrium at the
same output level as in the
beginning, but at a lower
price of wages to maintain
full employment.
AD decreases
and shifts
G decreases
P falls
real GDP &
Employment
constant
AS
200
ESR
100
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E1
Surplus
E2
AD1
AD2
0
200 400 600 800 1000 1200
Real GDP
Full Employment
($ billion/year)
124
The mid-range of AS: upward sloping



Having examined the asymptotes of the AS
curve, we shall look at the middle range of
the curve.
In this neo-classical interpolation of
classical with Keynes AS, an intermediate
splice is put into the middle of the curve
where both price and output will rise as a
country approaches full employment.
We show the neo-classical AS supply curve
in the next slide.
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Neo-classical AS curve illustrated


The neo-classical
theory is an
interpolation of the
Keynesian and
classical extremes
as a j-shaped curve.
In the mid-range,
AS is curved and
upward trending.
Classical limit
Intermediate
Range
Keynes range
Full
Employment
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AS meets AD
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AS meets AD, neo-classically



Equilibrium is
achieved between AS
and AD at a certain
price and level of
output.
If output was below
demand, it would be
expanded.
If it was above,
output would be cut
back
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AS
E
GDP Gap
AD
Full
Employment
128
Changes in AD-AS Equilibrium



First we can look at changes in AD while the
AS curve remains fixed.
What will happen in the aggregate market
when aggregate demand changes will
depend on which range of the AS supply
curve we are in.
There are three areas and three different
types of adjustment processes to consider.
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Changes in AD-AS Equilibrium


In the Keynesian region, production will
increase through hiring and use of idle
capacity. The result will be higher output
equilibrium quantity at the same price level
as before.
In the intermediate range, first, will be
some bottlenecks to production when
some firms reach full capacity, while
others are still below capacity.
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Changes in AD-AS Equilibrium




For example, the steel industry might
already be at full capacity when car
production is not yet at its peak.
As a result the price of steel will be bid up
along with the price of cars.
Also, a shortage of certain labor skills may
obtain, and labor will demand a higher
price for skills in short supply.
That will also increase end prices.
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Changes in AD-AS Equilibrium



Finally, as the economy approaches full
employment, less productive employees and
less productive capacity will be put into use.
That creates higher production costs which
will be passed on to consumers in the form of
higher prices.
In the final classical range, as the aggregate
demand curve shifts out, only price changes,
and inflation is the result as there is already
full employment.
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Changes in AD-AS Equilibrium

Changes in AD over 3 ranges of neo-classical AS
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Changes in the AS curve




Changes can also occur in AS as changes in
factors of production change, like cost of
resources, both foreign and domestic, taxes,
technological change, regulation and
subsidies.
Each of those factors affects production
costs.
At a given price level production costs will
determine profits.
The response will be to cut output, increase
prices or both.
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Shift in the AS curve illustrated

Causal chain: change in non-price-level
determinant of supply → change in AS curve
Full
employment
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Changes in AS



Other things can change to cause a change
in AS.
For example, lower oil prices, better
management practices, improvements to
the infrastructure inputs into the production
process (microeconomic reform), lower
taxes and government regulation.
Opposite shifts in AS can occur for opposite
changes in those types of variables.
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Cost-push & demand-pull Inflation




We can now examine the two types of
inflation from the point of view of the ASAD Model.
Cost-push inflation comes about from an
inward shift in the AS curve.
Demand-pull inflation is caused by an
outward shift in the aggregate demand
curve.
We shall illustrate these basic types of
inflation with historical examples.
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The Stagflation of the 1970’s
Stagflation, stagnation plus inflation,
occurs when there is high
unemployment and rapidly increasing
prices.
 That occurred in the 1970’s after the
huge increase in oil prices caused
cost-push inflation.

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The Stagflation of the 1970’s
In our model, that is represented by a
shift to the left of the AS curve.
 The result will be a new equilibrium
with fixed demand at a lower level of
output, higher prices, and less
employment.
 On top of that, labor pushed for
higher wages without concomitant
increases in labor productivity.

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Demand-pull



In 1982-84 Australia experienced a
recession, and the government tried to
kick start the economy through Keynesian
expansionary macroeconomic policy.
As a result, the AD curve was pushed
outwards.
The new equilibrium point for AS and AD
moved output up but also led to demand
pull inflation, as prices also rose.
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The business cycle




Thus, changes in AS or in AD can result in
new equilibriums.
It depends on where we are on the aggregate
supply curve, considering the 3 regions.
Then, changes in AS or AD can lead to
swings in output and prices.
In the next several modules we look at how
other policy can affect the economy, including
changes in taxation, spending, and the
supply of financial liquidity.
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Ask yourself
1.
2.





Why is the AD curve downward sloping? What is
different about that versus demand for a good or
service?
If your disposable personal income increases from
$30,000 to $40,000 and your savings increase
from $2,000 to $4,000, your marginal propensity to
save (MPS) at this income level is:
a) 0.2
b) 0.4
c) 0.5
d) 0.8
e) 1.0
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Homework


Chapter 14
All problems and multiple choice.
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Next week
Break,
but
assignment due the
day that you return.
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END
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