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

Figure 12.1.1 - Our Macro Picture

Y

AD

Y* YF

P*

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

PMore inflation

More real GDP

More employmentLess unemployment

Y

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

Figure 12.1.2 - Fall in AD and the Great Depression

Y

AD

Y1Y2

P'

P

Fall in AD

YF

AD'

After Pearl Harbor

war means big increase in AD, for

reasons we’ll also see later

P

AS

Figure 12.1.3- World War II and Expanding AD

Y

AD

Y2Y1

P*

P*'

Rise in AD

YF

AD'

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

P

AS

Figure 12.1.4 - Oil Price Shocks and AS Shifting Up

Y

AD

Y1 YFY2

P*

P*' Shift upin AS

AS'

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

Figure 12.2.1 - Increase in AE Shifting AD to the Right

Y

ADY1

P1

AD'

P3

P2

Y1'Y2 Y2'Y3 Y3'

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

P

AD

Y

Ex. An increase in G

AD´

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:

Increase in C,G,I,X

Decrease in T,M

AD moves left when:

Decrease in C,G,I,X

Increase in T,M

Example - Great Depression

Year Investment(I)

Real GDP(Y)

Unemploymentrate

1929 34.2 175.9 3.21930 23.3 159.2 8.71931 14.7 147.7 15.91932 3.3 125.3 23.61933 3.7 123.4 24.9

Decrease in I moves AD

left, ceteris paribus

P

AS

Figure 12.2.3 - The Great Depression

Y

AD

Y YFY'

Collapse of Investment Contributesto Huge AD Fall

AD'

12.2.4

Outbreak of WWII after Pearl Harbor

Huge increase in G moves AD

right, ceteris paribus

P

AS

Figure 12.2.4 - From The Great Depression to World War II

Y

AD'

Y'YFY

War Production DemandPushes AD Way Out

AD

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

PLAS

Figure 12.3.1 - Long Run Aggregate Supply (LAS)

YYF

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

PLAS

Figure 12.3.2 - Short Run Aggregate Supply

YYF

AS

12.3.4

The AS line has three distinct segments

They are labeled k, l, and m

PLAS

Figure 12.3.3 - AS Line Divided Into Segments

YYF

AS

k l

m

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-segmenteconomy reaches limit of short-term capacityThese three distinct segments make up the AS curveYou can surge beyond what is sustainable for a while,

but people and machines can not work 24 hours a day

forever.Ex. WartimeFurther 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'

Figure 12.3.4 - A Shift Up in AS Due to Rising Factor Prices

Y

AS

A Shift Up in ASDue to RisingFactor Prices

12.4.1

Combining AD, LAS, and AS

Putting the tool kit together

P

AS

Figure 12.4.1 - Increasing Unemployment Due to Falling Aggregate Demand

Y

AD

Y YFY'

FallingAD

LAS

AD'

P

AS'

Figure 12.4.2 - Falling Unemployment and Falling Price LevelAs AS Shifts Down Due to Falling Factor Prices

Y

AD

Y'Y

P'

P

ASLAS

Effect ofFalling Factor

Prices

YF

PAS

Figure 12.4.3 - Increasing Unemployment and Rising Price LevelAs AS Shifts Up Due to Rising Factor Prices

Y

AD

YY'

P'

P

AS'

LAS

Effect of RisingFactor Prices

YF

P

AS

Figure 12.4.4 - Falling Unemployment and Rising Price LevelDue to Increasing Aggregate Demand

Y

AD'

Y'YF

Y

P

P'

LAS

AD

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:

P

AS

Figure 12.4.5 - A Wage-Price Spiral

Y

AD'

YF

LAS

AD

AD"

AS'

12

34OO

OO

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