Principles of Macroeconomics...Principles of Macroeconomics Module 3.1 Aggregate Demand 120. AD-AS Model Snapshot of the aggregate economy • Why and how an economy experiences growth

PrinciplesofMacroeconomicsModule3.1

AggregateDemand

120

AD-ASModelSnapshotoftheaggregateeconomy• Whyandhowaneconomyexperiencesgrowthinlongrun andfluctuationsintheshortrun

• Whyandhowthepricelevelchanges

• Howoutputchangesasaresultofshortrunshocks

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AD-ASModel

• Aggregatedemand(AD):allgoodsandservicesallhouseholds,firms,andgovernmentwantstobuyateachpricepoint

• LongRunAggregateSupply(SRAS):allgoodsandservicessuppliedbyfirmsateachpricepointinthelongrun

• ShortRunAggregateSupply(SRAS):allgoodsandservicessuppliedbyfirmsateachpricepointintheshortrun

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AggregateDemand

Y=C+I+G+NXTherelationshipbetweenPriceandADisdrivenbytheinfluenceofPrice

onC,I,G,andNX

LowerP=HigherC,I,NXHigherP=LowerC,I,NX

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DeterminingAggregateDemand

WealthEffect:(C)• Atlowerpricelevel– valueofmoneyishigher

• Consumerscanbuymorewitheach$andthereforearecompelledtospendmore

• Atlowerpricelevels– higherlevelofConsumptionspending

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DeterminingAggregateDemandInterestRateEffect:(I)

• Atlowerpricelevel– householdsreducemoneyholdingsbylendingsomeout,leadingtoafallininterestrates

• Interestratesfallandfirmsareencouragedtoborrowandinvest

• Atlowerpricelevels– higherlevelofInvestmentspending

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DeterminingAggregateDemandExchangeRateEffect:(NX)

• Basedontheinterestrateeffect:lowerpricelevelscorrespondtolowerinterestrates(domestically)

• Withlowerinterestrates,domesticandforeigninvestorswillseekhigherreturnsabroad

• Netcapitaloutflow:↑demandforFX↓demandforUSD

• USDdepreciates-- USexportsbecomecheaper,importsaremoreexpensive

• Atlowerpricelevels– higherlevelofNetExports126

ShiftsinAggregateDemandADCurvewillshiftifanyofthecomponentsofADchange• ChangeinC:Familiesacrosstheeconomyareincreasingspendingongoodsandservices

• ChangeinI:Firms,overall,arebuyingnewcapitalgoodsandmachines,expandingtheirbusinessfacilities,ect.

• ChangeinG:Governmentisspendingmore,buildingnewinfrastructure,improvingtheeducationsystem,buyingnewweapons

• ChangeinNX:ExportsfromtheUStoothercountriesincrease127

KeyTakeaways• AD-ASmodelexplainshortrunfluctuationsintheeconomyaswellaslongruntrends

• Therearemanyfactorsthatcaninfluencetheeconomyasawholeandthismodelwillhelpexplainhowandwhy

• AggregateDemand:summarizesallofthespendingbehaviorongoodsandservicebyallhouseholds(C),firms(I),government(G)andforeigntransactions(NX)intheeconomy

• ChangesinAD:drivenbyC,I,G,orNX128

PrinciplesofMacroeconomicsModule3.2AggregateSupply

129

AD-ASModelSnapshotoftheaggregateeconomy• Why/howexperienceeconomicgrowthinlongrun andfluctuationsintheshortrun

• Why/howpricelevelchanges

• Howmonetaryandfiscalpolicyimpacttheeconomyasawhole

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AD-ASModel

• Aggregatedemand(AD):allgoodsandservicesallhouseholds,firms,andgovernmentwantstobuyateachpricepoint

• LongRunAggregateSupply(SRAS):allgoodsandservicessuppliedbyfirmsateachpricepointinthelongrun

• ShortRunAggregateSupply(SRAS):allgoodsandservicessuppliedbyfirmsateachpricepointintheshortrun

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LongRunvs.ShortRun

• Inthelongrunà nominalvariablesandrealvariablesareseparate• Changesinnominalvariableswillhavenoimpactonrealvariables• ClassicalDichotomy• ChangesinPriceLevel,Inflation,MoneySupplywillnotimpactRealGDP

• Intheshortrunà nominalandrealandmorecloselylinked• Classicaldichotomybreaksdown• Nominalfactorssuchaschangingpricelevels,inflation,andmoneysupplywillhavesomeimpactonrealvariablesintheshortrun

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LongRunvs.ShortRun

• Inthelongrunà nominalvariablesandrealvariablesareseparate• Changesinnominalvariableswillhavenoimpactonrealvariables• ClassicalDichotomy• ChangesinPriceLevel,Inflation,MoneySupplywillnotimpactRealGDP

• Intheshortrunà nominalandrealandmorecloselylinked• Classicaldichotomybreaksdown• Nominalfactorssuchaschangingpricelevels,inflation,andmoneysupplywillhavesomeimpactonrealvariablesintheshortrun

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AggregateSupplyinLongRun

InLongRun:nominalvariableshavenoimpactonrealvariable

Supplyisdeterminedbyavailableresourcesandtechnology

NaturalRateofOutput:Rateofoutputachievedwhenproducingwhereunemploymentisatthenaturalrate

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AggregateSupplyinLongRunInLongRun:nominalvariableshavenoimpactonrealvariable

Supplyisdeterminedbyavailableresourcesandtechnology

NaturalRateofOutput:Rateofoutputachievedwhenproducingwhereunemploymentisatthenaturalrate

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ShiftsinLRAS

ShiftsinLRASwillcomeONLYfrompermanent changes in• availableresources• availableproductiontechnology

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LRAS.2

INCREASEINLRAS

AggregateSupplyintheShortRun

SRASupwardslopingbecauseof:• Stickywages• Stickyprices

Itisthereasonwhywehaveshortruneconomicfluctuations

Y2Y2 Y1

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UpwardSlopingSRASStickyWages:

• Firmshavewageagreementswithemployees• Ifpricesareunexpectedlylower– cannotdecreasewagetomatch• Instead:producelessintheshortrun(hirelessworkers)andmakelaboradjustmentsinthelongrun

StickyPrices:• Notallfirmscanimmediatelychangetheirpricesinresponsetoeconomicconditions

• Ifpricesareunexpectedlylower– relativepricesarehigher(ifcannotchangeprices)

• Higherrelativeprices– losesalesandcutproductionuntiltheycanchangeprices

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UpwardSlopingSRASStickyWages:

• Firmshavewageagreementswithemployees• Ifpricesareunexpectedlylower– cannotdecreasewagetomatch• Instead:producelessintheshortrun(hirelessworkers)andmakelaboradjustmentsinthelongrun

StickyPrices:• Notallfirmscanimmediatelychangetheirpricesinresponsetoeconomicconditions

• Ifthepricelevelisunexpectedlylower– theirrelativepricesarehigher(ifcannotchangeprices)

• Higherrelativeprices– losesalesandcutproductionuntiltheycanchangeprices

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AggregateSupplyintheShortRun

ShiftsinSRAS:• PermanentChangesinResourcesorTechnology

• TemporaryChangesinResourcesorTechnology

• Adjustmentinexpectationsofinflation

SRAS.1

INCREASEINSRAS

Y1

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KeyTakeaways• Aggregatesupplydiffersinthelongrunandshortrun

• Inthelongrun– realandnominalvariablesareseparate

• Intheshortrun– realandnominalvariablesareintertwined

• ShiftsinLRASaredeterminedonlybypermanentchangesinavailableresourcesandproductiontechnology

• ShiftsinSRASaredeterminedbytemporaryorpermanentchangesinavailableresourcesandproductiontechnologyANDinadjustmentsbetweenexpectedandactualpricelevels

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PrinciplesofMacroeconomicsModule3.3

MacroeconomicEquilibrium

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143


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LongRunEquilibrium

InLongRunEquilibrium:EconomyisoperatingattheNaturalRateofUnemployment

ProducingattheNaturalRateofOutput

EquilibriumPriceLevel

EquilibriumPriceLevel

NaturalRateofOutput


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Deviationsfromthelong runequilibrium representshort run

economicfluctuations

ShortRunEconomicFluctuations:OccurwhenthereareshiftsinADorSRAS• Determinepricelevelchangesà Inflationin

shortrun

• Determineshortrunfluctuationsinproduction

• Explainbusinesscycles– recessionsandboomperiodsinoureconomy

FactsaboutEconomicFluctuationsEconomicfluctuationsareirregularandunpredictable

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FactsaboutEconomicFluctuationsMosteconomicvariablesfluctuatetogether

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LongRunEconomicGrowthTwofactshavebeenobservedabouttheeconomyinthelongrun:(1) Technologicaladvancementisconsistent

andcontinuousthroughouttimeà LRASContinuallyINCREASES

(2) MoneySupplyincreasesovertimeàADContinuallyINCREASES

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P

Y

NRO

.1

NRO

.2

NRO

.3

LRAS.1

LRAS.2

LRAS.3




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P

Y

AD.1AD.2

AD.3




RESULT:- GROWTHINREALGDP- INFLATION

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P

Y

NRO

.1

NRO

.2

NRO

.3

LRAS.1

LRAS.2

LRAS.3

AD.1AD.2

AD.3

P.1

P.2

P.3

TestYourUnderstanding- 1Peoplebecomemoreconcernedaboutsavingforretirementascompanieseliminatepensionplansandotherfirm-sponsoredretirementsupport• DrawoutanAD-ASgraph• ExplainhowthiswillaffectADorAS• IllustratethechangeontheAD-ASgraph• Whathappensintheshort-run?Whathappensinthelong-run?

152

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TestYourUnderstanding- 1

1. Whichcurveshiftsandwhy?• ShiftAD– consumptionspending

dropstodayaspeoplesavemoreforretirement

2. Whichdirectiondoesitshift?

3. Illustrateandanalyze

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2. Whichdirectiondoesitshift?• Shiftsinortotheleft• DeclineinCà DeclineinAD

3. IllustrateandanalyzeAD.2

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2. Whichdirectiondoesitshift?• Shiftsinortotheleft• DeclineinCà DeclineinAD

3. Illustrateandanalyze• NewEquilibriuminShortRun:B• PriceLevelislower• Outputislower• NEWSHORTRUNEQUILIBRIUM

AD.2

BPb

Yb

TestYourUnderstanding- 2Considertherecentdropinoilpricesfromover$100/barrelin2014toaround$40bytheendof2015.Whatimpactdoesthishaveontheaggregateeconomy?• DrawoutanAD-ASgraph• ExplainhowthiswillaffectADorAS• IllustratethechangeontheAD-ASgraph• Whathappensintheshort-run?Canthisbeapermanentoutcome?

156

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1. Whichcurveshiftsandwhy?• ShiftSRAS– priceofaninput(oil)

islower• Costofproductionisloweroverall

2. Whichdirectiondoesitshift?


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1. Whichcurveshiftsandwhy?• ShiftSRAS– priceofaninput(oil)

islower• Costofproductionisloweroverall

2. Whichdirectiondoesitshift?• Shiftsoutortotheright• IncreaseinSRAS


SRAS.2

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2. Whichdirectiondoesitshift?• Shiftsoutortotheright• IncreaseinSRAS

3. Illustrateandanalyze• NewEquilibriuminShortRun:C• PriceLevelislower• Outputishigher• NEWSHORTRUNEQUILIBRIUM

SRAS.2

CPc

Yc

KeyTakeaways• AD-ASmodelhelpsexplainwhatishappeningintheaggregateeconomy

• Itexplainshowaneconomyexperienceslongruneconomicgrowthandinflation

• Itexplainshowweexperiencebusinesscyclesandeconomicfluctuationsintheshortrun

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Principles of Macroeconomics...Principles of Macroeconomics Module 3.1 Aggregate Demand 120. AD-AS Model Snapshot of the aggregate economy • Why and how an economy experiences growth

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