Chapter 12 The Basic Macro Model

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Chapter 12 -- The Basic
Macro Model

• This chapter presents the first examination of
  our primary theory and model to describe the
  economy and predict effects.
• The model itself is known as the Aggregate Demand
  - Aggregate Supply Model.

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The Aggregate Demand-Aggregate Supply Model

• Purpose -- seeks to examine the underlying
  behavior of what determines real GDP (Y) and the
  price level (P) (and therefore inflation) for the
  whole economy.
• We can then use the theory/model to make concise
  predictions of how events and policies will
  affect the economy.

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Aggregate Demand

• Aggregate Demand (AD) -- the sum of all the newly
  produced US final goods and services that
  consumers, businesses, government, and foreigners
  intend to purchase (i.e. real GDP demanded).

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Aggregate Demand Causes

• The Price Level (P)
• P? (ceteris paribus) ? AD?
• Aggregate Expenditure (AE) -- desire to purchase
  quantities of newly produced final goods and
  services, apart from price considerations.
• AE? (ceteris paribus) ? AD?

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Formalizing the Theory of Aggregate Demand

• Graph AD versus one of its causes -- the price
  level (P).
• Inverse relationship implies that the curve is
  downward sloping.
• Changes in P are described as a movement along
  the curve.
• Graph is drawn assuming that AE is constant
  (ceteris paribus).

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Describing Changes in One of the Other Causes

• AE changes (or changes in any cause other than
  the price level) are described by a shift of the
  Aggregate Demand curve.
• Contrast this with changes in P -- movement along
  the curve.
• Different descriptions occur only because P is
  the cause that appears on the graph.

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Shifting the AD Curve

• Changes -- other than P -- that make AD increase
  are described as a rightward shift of the curve,
  or an increase in AD.
• Changes -- other than P -- that make AD decrease
  are described as a leftward shift of the curve,
  or a decrease in AD.

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A Brief Look at Aggregate Expenditure (AE)

• AE C I (G - T) (X - M)
• AE is total net demand for US newly produced
  final goods and services by all buyers.

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Aggregate Expenditure (AE) Variable Definitions

• C Consumption, consumer purchases of goods and
  services.
• -- nondurable goods (e.g. food)
• -- durable goods (e.g. new cars,
• 
  personal computers)
• -- services (e.g. auto mechanic,
• medical
  doctor)
• I Investment, business purchases of new plants
  and equipment purchases of new residential
  housing changes in inventories.

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AE -- More Variable Definitions

• G Government purchases of goods and services.
• T Net Taxes, tax revenues minus transfer
  payments.
• (T G) is commonly known as the government
  budget.
• (G T), within AE is referred to as the
  government budget position.

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AE Even More Variable Definitions

• X Exports, foreign purchases of US produced
  goods and services.
• M Imports, US purchases of foreign produced
  goods and services.
• (X M) is commonly referred to as Net Exports,
  or the Balance of Trade.

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Aggregate Expenditure (AE) -- Continued

• AE C I (G - T) (X - M)
• The causes of AE are the causes of C, I, (G -
  T), and (X - M) -- next chapter.
• A change in any of them is described as a shift
  the AD curve.
• Increases in C, I, G, or X increase AE (and
  therefore increase AD).
• Increases in T or M decrease AE (and therefore
  decrease AD).

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Short-Run Aggregate Supply (AS)

• Short-Run Aggregate Supply (AS) -- the sum of all
  the newly produced US final goods and services
  that firms wish to produce (real GDP supplied),
  given inflexible input prices, in particular
  nominal wage rates (W).

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Short-Run Aggregate Supply --
Causes

• Price Level (P)
• P? ? AS?
• Price of Energy (PE)
• PE? ? AS?
• The Nominal Wage Rate (W)
• W? ? AS?
• Other Production Related Causes (e.g. labor
  productivity)

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Short-Run Aggregate Supply Formalizing

• Graph AS versus one of its causes -- the price
  level (P).
• Positive relationship implies that the curve is
  upward sloping.
• Changes in P are described as a movement along
  the curve.
• Graph is drawn assuming that PE, W, and any other
  causes are constant (ceteris paribus).

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The Shape of the AS Curve

• Describes different magnitudes of response to
  increases in the price level (P).
• k segment -- P increase generates large output
  response.
• l segment -- P increase generates moderate output
  response.
• m segment -- P increase generates small output
  response.

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Describing Changes in One of the Other Causes

• Changes in PE, W, or any cause other than the
  price level (P) are described by a shift of the
  AS curve.
• Different descriptions occur only because P is
  the cause that appears on the graph.

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Shifting the AS Curve

• Changes -- other than P -- that make AS increase
  are described as a rightward shift of the curve,
  or an increase in AS.
• Changes -- other than P -- that make AS decrease
  are described as a leftward shift of the curve,
  or a decrease in AS.

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Equilibrium The Market in
Action

• Equilibrium (Y and P) -- The values where real
  GDP and the price level will ultimately settle
  (what the model predicts).

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Shifts and Changing the Equilibrium --
Applications

• Example 1 -- The effect of a war on the economy.
• War? ? (G - T)?
• Increase in (G - T) increases AE.
• This behavior within the model is described by
  shifting the AD curve rightward.
• Draw the picture and evaluate the answer.

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Another Application

• Example 2 -- Firms become very pessimistic about
  the economy, decrease their purchases of new
  plants and equipment (1930s).
• Decreased purchases of new plants and equipment
  ? I?

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Business Pessimism and Investment, Continued

• Decrease in Investment (I), ceteris paribus,
  necessarily decreases AE.
• Within the model, this behavior is described by
  shifting the AD curve leftward.
• Draw the graphical situation and evaluate the
  answer.

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Still Another Application

• Example 3 -- The price of energy (PE) increases
  (energy crisis in US, 1970s).
• PE? hinders production, reduces Aggregate Supply.
• Therefore the AS curve shifts leftward.
• Draw the graphs and evaluate.

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Market Failure in the Economy (AS Curve)

• Market failure in the Economy -- W and PE stay
  constant, dont move easily.
• For institutional reasons (discussed later),
  factor markets dont move to their equilibriums.
• Describes the upward sloping Short-Run Aggregate
  Supply (AS) curve.

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Implications of Market Failure
in Economy

• Economy not at General Competitive Equilibrium
  (GCE).
• Equilibrium occurs where Y is not necessarily
  equal to YF.

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Characterizing the Economy (Short-Run)

• Y lt YF (sluggish economy,
• demand deficient
• unemployment)
• Y gt YF (accelerating inflation)
• Y YF (desired state of
• the economy)

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Long-Run Aggregate Supply (LAS)

• Long-Run Aggregate Supply (LAS) -- the sum of all
  the newly produced US final goods and services
  that firms wish to produce when all microeconomic
  adjustments have been completed under the nice
  assumptions (in particular, no market failure).

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Characteristics of Long-Run Aggregate Supply (LAS)

• Equilibrium under perfect competition with the
  nice assumptions satisfied (in particular, no
  market failure) ? the economy is in General
  Competitive Equilibrium (GCE).
• GCE ? economy necessarily operates at the
  full sustainable level of output (YF).

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Formalizing Long-Run Aggregate Supply (LAS)

• LAS curve is vertical when plotted against the
  price level (P).
• Vertical at the full sustainable level of real
  GDP (YF), all adjustments completed under the
  nice assumptions. Economy is in GCE.
• Curve shifts rightward (increase in LAS) or
  leftward (decrease in LAS).
• Will consider what shifts the curve in a later
  chapter.

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Putting The Model All Together -- Two Teasers

• Teaser 1 The Interventionist versus
  Non-interventionist positions on the economy
  returning in a big way within macro.
• Teaser 2 -- Spending gone too far, the
  wage-price spiral.