The ShortRun Macro Model

1
The Short-Run Macro Model
2
Overview

• National Savings and National Asset Formation
• Multiplier with Government and Net Exports
• Introducing Aggregate Demand and Aggregate Supply
• Short Run Macroeconomic Equilibrium with Price
  Adjustment

3
The Saving-Investment Approach
This approach is more complicated with government
and international trade. We must think about
desired national saving and desired national
asset formation.
National Saving
National saving is the sum of private saving and
public saving (governments budget
surplus) National Saving S (T - G)

• As national income rises
• public saving rises (budget surplus), and
• private saving rises (saving function).

4
National Asset Formation
In a closed economy, the only way to accumulate
assets is to devote some of national product
toward investment.
In an open economy, however, there is an
additional way to accumulate assets we can
purchase income-earning assets from foreigners
(stocks or bonds).
A country that exports more goods and services
than it imports must use the extra earnings to
buy income-earning assets such as stocks or
bonds. So National asset formation I (X - IM)
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Desired Saving, Desired Asset Formation
S (T - G)
147
Equilibrium national income occurs where desired
national saving is equal to desired national
asset formation.

I (X - IM)
0
300
600
Y
-81
6
The difference difference between desired
aggregate expenditure and actual national income
is always equal to the difference between desired
national saving and desired national asset
formation.
Suppose the difference between desired national
saving and desired national asset formation is
equal to W.
Desired National Asset Formation
(S T - G) - (I X - IM) W
Desired National Saving
Recall that disposable income, Y - T, is equal to
consumption plus saving
YD Y - T C S
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S Y - T - C
So national saving
S T G Y T C T G S T G Y C
G
Therefore,
(S T G) (I X IM) (Y C G) ( I
X IM) Y (C I G X IM)
Y AE W
8
Changes in Equilibrium National Income
The Multiplier with Taxes and Imports
With no government and no international trade, z
is simply the marginal propensity to consume out
of disposable income.
But imports and income taxes make z smaller, and
thus the simple multiplier is also smaller.
The new value of z is given by z MPC(1-t) -
m where t is the net tax rate and m is the
marginal propensity to import.
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A Realistic Value for the Multiplier
The lower value of the multiplier with taxes and
imports reflects that changes in autonomous
expenditure bring about smaller changes in
national income than before.
Using realistic values of taxation and imports
for Canada, the evidence shows that the value of
the multiplier is closer to 1 than 2.
10
Net Exports
As with other elements of AE, if the net export
function shifts upward, equilibrium national
income will rise if the net export function
shifts downward, equilibrium national income with
fall.
Generally, exports are autonomous with respect to
domestic national income.
Foreigners demand for Canadian exports depends
on foreign income, on foreign and domestic
prices, on the exchange rate, and on consumer
tastes.
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Fiscal Policy
Fiscal policy involves the use of government
spending and tax policies to influence desired
aggregate expenditure so as to change the
equilibrium level of national income.
Any policy that attempts to stabilize national
income at or near potential national income is
called stabilization policy.
Suppose the government reduces its purchases of
all consulting services, saving 100 million
annually. How much would equilibrium income
change?
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AE
A change in government purchases, ?G, will lead
to a change in equilibrium national income, ?Y.
AE Y
E0
e0

AE0
?G
AE1

e1
The change will equal the multiplier times the
change in government purchases.
e1

E1
Y1
Y0
Y
?Y
For example, suppose z 0.62. The multiplier is
then 1/.38 2.63. A 100 million decrease of
government purchases will therefore reduce
equilibrium national income by 263 million.
13
Or, the government may decide to reduce taxes in
an attempt to raise national income.
AE
AEY
AE1
AE0
E1

e2
A lower net tax rate raises the marginal
propensity to consume out of national income and
thus increases z the AE function gets steeper.

e0
E0
Y
Y0
Y1
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Demand-Determined Output
The simple income-expenditure model is based on
three central concepts

• equilibrium national income,
• the multiplier, and
• demand-determined output.

The third concept demand-determined output is
crucial. We (implicitly) assume that firms are
able and willing to supply any amount of output
at the given price level without requiring any
changes in price. We therefore assume national
income to be demand determined.
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There are two situations under which the
assumption that output is demand determined is
most reasonable.
The first is when there are unemployed resources
in the economy, so that output is below potential
and firms have excess capacity.
The second is when firms are price setters, which
means that firms have some influence over price,
either because of there are relatively few firms
in the market, or because products are
differentiated.
If the economys resources are fully employed and
firms are price takers, then the assumption of
demand-determined output may not be reasonable.
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The Demand Side of the Economy
Shifts in the AE Curve
Consider an exogenous change in the price level,
P. What happens to equilibrium GDP?
An increase in P reduces the real value of money
held by the private sector. A fall in P raises
the real value of money holdings.
Changes in P also affect the wealth of
bondholders and bond issuers, but because the
changes offset each other, there is no change in
the aggregate wealth.
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In summary, an increase in P reduces
private-sector wealth and leads to a fall in
desired consumption this implies a downward
shift in the AE curve.
Conversely, a fall in P increases private-sector
wealth and leads to an increase in desired
consumption this implies an upward shift in the
AE curve.

• There is also an effect on net exports
• A rise in P (with unchanged foreign prices)
  shifts the NX function downward this causes a
  further downward shift in the AE curve. The
  reverse will occur after a fall in P.

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Changes in Equilibrium GDP
An increase in P reduces private-sector wealth
and exports, therefore reducing desired aggregate
expenditure.
AE
AE Y
AE0
E0

AE1

This causes the AE curve to shift down, reducing
the equilibrium level of real GDP.
E1
Y1
Y0
Y
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The Aggregate Demand Curve
The aggregate demand (AD) curve relates
equilibrium real GDP to the price level.
For any given price level, the AD curve shows the
level of real GDP for which desired aggregate
expenditure equals actual GDP.
Changes in the price level that cause shifts in
the AE curve cause movements along the AD curve.
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AE
AE Y
E0
AE0

Consider a rise in the price level, from P0 to P2
AE1
E1
AE2

A rise in P causes the AE curve to shift down.
This is a movement upward along the AD curve.
E2

Y2
Y1
Y0
Y
P

P2
(Conversely, a fall in P causes the AE curve to
shift up. This is a movement downward along the
AD curve.)
P1

P0

AD
Y2
Y1
Y0
Y
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AE
AE Y
Shifts in the AD Curve
AE1
E1

AE0
Any shock that increases equilibrium GDP at a
given price level shifts the AD curve to the
right.
E0

Any shock that reduces equilibrium Y at a given
price level shifts the AD curve to the left.
Y1
Y0
Y
P
E1
E0
P0


The simple multiplier measures the horizontal
shift of the AD curve.
AD1
AD0
Y1
Y0
Y
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Exercise 23.5
AE 350 0.8Y 0.1 (M/P)
Autonomous Expenditure
Marginal Propensity to Spend out of National
Income
Real value of assets held. M nominal value P
Price level
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A rise in the price level reduces the real value
of those assets (M/P) and, through this reduction
in wealth, leads to less desired aggregate
expenditure.
Let M 6000
AE 350 0.8Y 0.1 (M/P)
AE 350 0.8Y 0.1(6000)
AE 350 0.8Y 0.1(1500)
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Equilibrium national income is that level of
income where Y AE. In general form we have Y
AE ? Y A 0.8Y ? Y(1 0.8) A ? Y
A/(0.2) In the six specific cases we
get P1 Y 950/0.2 4750 P2 Y 650/0.2
3250 P3 Y 550/0.2 2750 P4 Y
500/0.2 2500 P5 Y 470/0.2 2350 P6 Y
450/0.2 2250
Note that each successive increase in the price
level has a smaller effect on wealth and
equilibrium national income than the previous
increase.
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(No Transcript)
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P 6, Y 2250
P 5, Y 2350
P 4, Y 2500
P 3, Y 2750
P 2, Y 3250
P 1, Y 4750
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Deriving AD from AE
F(P) decreases with P
General Form AE A zY F(P)

• Step 1

Replace AE and Y with YAD
YAD A z YAD F(P)

• Step 2

Solve for YAD
YAD A F(P) 1 - z
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Example Deriving AD from AE
AE 350 0.8Y 0.1 (M/P)
To find aggregate demand, set AE Y YAD,
solve for YAD
YAD 350 0.8 YAD 0.1 (M/P)
YAD
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The Supply Side of the Economy
The Aggregate Supply Curve
The aggregate supply (AS) curve relates the price
level to the quantity of output that firms would
like to produce and sell.
The AS curve is drawn on the assumption that
technology and factor prices remain constant.
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Shifts in the Aggregate Supply Curve
Because unit costs rise with output, both
price-taking and price-setting firms will produce
more output only if prices increase. The AS curve
is therefore upward sloping.
Price Level
A change in either factor prices or productivity
will change costs and shift the AS curve.
AS1

P1
AS0
An increase in factor prices or a decrease in
productivity shifts the AS curve up and to the
left.
P0


Y0
Y1
Real GDP
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The Increasing Slope of the AS Curve
The slope of the AS curve is increasing because
when output is low, firms typically have excess
capacity. This means that output can be expanded
without causing a large increase in unit costs.
Therefore, only a small increase in price may be
needed to induce them to expand production.
Once output gets closer to capacity, however,
increases in output cause larger increases in
unit costs. Therefore, larger price increases are
needed to induce firms to expand output.
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Macroeconomic Equilibrium
AD
AS
Demand behaviour is only consistent with supply
behaviour at the intersection of the AS and AD
curves.
Price Level
E0
P0

P1


At P1 there is more output demanded (Y2) than
what firms want to produce (Y1).
Y0
Y1
Y2
Real GDP