1. Unit 3 Introduction to Macroeconomic Models: AD/AS

2. Models Required to understand the economy –PPF –Circular Flow Model –The business cycle –AD/AS Model

3. The relationship between injections and withdrawals –the links between them –planned injections may not equal planned withdrawals Equilibrium in the circular flow Circular Flow

4. Actual and potential growth Economic growth and the business cycle –fluctuations in actual growth –the phases of the business cycle The Economy

5. fig O National output Time Potential output The business cycle

6. fig O National output Time Potential output Actual output The business cycle

7. fig O National output Time Potential output Actual output 1 The upturn The business cycle

8. fig O National output Time Potential output Actual output 1 2 The boom The business cycle

9. fig O National output Time Potential output Actual output 1 2 3 The peaking out The business cycle

10. fig O National output Time Potential output Actual output 1 2 3 4 The recession The business cycle

11. fig O National output Time Potential output Actual output 1 2 3 4 1 2 3 4 The business cycle

12. Fear the Boom and Bust Keynes – Hayak Rap –http://www.youtube.com/watch?v=d0nE RTFo-Skhttp://www.youtube.com/watch?v=d0nE RTFo-Sk

13. Aggregate Demand Aggregate Supply Help us to understand economic fluctuations and the use of macro- economic policies to smooth those fluctuations

14. AS Curve Shows the relationship between the aggregate price level and aggregate output –the total quantity of final goods and services producers are willing to supply As the aggregate level of prices increases, the aggregate production increases There is a movement along the AS curve with a change in aggregate price level

15. AS shift Commodity/factor prices increases or decreases –These have the greatest effect on AS Nominal wage increases or decreases –Nominal wages are 'sticky' downward in short run In long run, they are flexible –Nominal wages increase slowly even in periods of low unemployment Productivity/efficiency improvements

16. PL SRAS Real GDP All goods/services supplied PL2 GDP2 PL1 GDP1 Short Run Aggregate Supply SR: PL rise, wages “sticky,” profit- maximizing firms increase aggregate quantity supplied.

17. Long run AS Vertical –The level of potential output for the country The level of real GDP the economy would produce if prices and wages were flexible Wages and prices in the long run are flexible –Therefore, in the long run aggregate price has no effect on the quantity of output supplied

19. PL SRAS Real GDP All goods/services supplied PL2 GDP2 PL1 GDP1 Long Run Aggregate Supply LRAS is the yellow line.

20. Horizontal section indicates price rigidity results in a reduction in real production. Vertical section indicates that full employment is more or less maintained at higher price levels. Price does not matter; GDP is a function of the quality and availability of factors of production Keynes: Prices and wages are ‘sticky’ Keynes LRAS

21. AD Aggregate Demand Relationship between GDP and price level AD must use real (not nominal) figures AD can change due to the income effect or the substitution effect (related to the price level) or the curve can shift

22. AD Curve AD is the sum of all planned expenditures in the economy. C + I + G + X − M AD curve shows the amount of goods/services in the whole economy that are demanded at any given price level. The price level is the average price level for all goods/services in the whole economy.

23. Movement Along the AD curve Interest rates: –If the price level rises, the rate of interest rises in an effort to stop the price rise Changes in real wealth: –If the price level rises, for a given level of nominal wealth, then peoples' real wealth will fall. The foreign sector: –For a given exchange rate, if the UK price level rises, then home produced goods will become relatively more expensive in other countries, and so the demand for exports will fall. Also, imports into the UK from other countries will appear relatively cheaper, because their price level has remained unchanged while the price of the home produced goods are rising. The demand for foreign imports will, therefore, rise.

24. Shifting the AD curve Unemployment Taxation Government spending The stock market / The Wealth Effect –For those who had much of their wealth tied up in stocks, both directly and indirectly the crash was bad news. \ They felt less wealthy and this would directly affect the amount they spent. Business confidence –Keynes emphasized this factor. Whereas monetarists feel that the rate of interest is the main determinant of firms' investment, Keynesians feel that confidence is far more important. –It doesn't matter how low the rate of interest is for a firm if they believe that a downturn is around the corner. –They simply will not invest.

25. AD Curve Why does it slope downward? –AD and price level are inversely related –Substitute effect –Income effect How do these effects explain the inverse relationship between aggregate price level and aggregate output?

26. PL Price Level AD Real GDP PL 1 ConsumptionInvest NX GDP 1 Gov’t Aggregate Demand

27. PL AD Real GDP PL 1 ConsumptionInvest NX GDP 1 Gov’t Price Level Change and AD PL 2 US PL falls, US goods relatively less expensive, net exports rise.

28. AD SHIFT Fiscal policy Monetary policy Exchange rate changes –Devalue vs depreciate Foreign income changes Expectations External shocks –Recession –Hurricanes –wars

29. Substitution effect and income effect When the price of petrol falls people buy more of it. There are two reasons. –petrol has become cheaper relative to everything else, so people switch some of their consumption out of goods that are now relatively more expensive and buy more petrol instead. (substitute effect) –cheaper petrol means that real purchasing power rises, so consumers have more to spend on everything, including petrol. (income effect)

30. Net Export Effect Net Export effect aka import effect –Decrease in X and increase in M reduces AD Currently, we have relatively little inflation, yet still have huge negative balance in x-m –If there is inflation ( price level increasing) Imports increase as we spend more on the relatively cheaper foreign goods Exports decrease as foreigners spend less on our more expensive domestic goods

31. Real Balance Effect Real Balance Effect aka Savings Effect Purchasing power of consumer –Income less savings and taxes = Disposable income –MPS Marginal propensity to save How much we save –When price levels rise, bank balances fall –To counteract this, people will reduce spending in order to preserve the buying power of their bank balances –Consumption drops, AD drops

32. Interest Rate Effect Alternatively, people borrow money –Maintain bank balance –Maintain consumption As a result, the increase in borrowing increases the demand for money and interest rates rise –If interest rates rise, borrowing drops –Borrowing drops, spending drops, AD falls

33. Income effect Income effect describes the effects of changes in prices on consumption. According to the income effect, an increase in price causes a buyer to feel poorer, lowering the quantity demanded, and vice versa. Although the buyer's actual income hasn't changed, the change in price makes the buyer feel as if it has. –If price levels rise against a given money income level, AD drops –If price levels fall against a static money income, AD increases

34. Wealth Effect When the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more. economists in 1968 were baffled when a 10% tax hike failed to slow down consumer spending. Later this continued spending was attributed to the wealth effect. While disposable income fell as a result of increased taxes, wealth was rising sharply as the stock market moved up. Undaunted, consumers continued their spending spree.

35. AD change examples September 12 th, 2001 –Business and Consumers lose confidence –Investment and Consumption fall –AD Congress cuts taxes? –Households Spend, spend, spend - Consumption rises –AD

36. AD Change examples Federal Reserve Bank target lower interest rates –increases money supply –Interest rates fall further –Investment (and consumption of autos, etc.) rises –AD Fight four wars... –Iraq, Afghanistan, Terrorism, Drugs G overnment spending rises AD –(note: G up, Taxes down = budget deficit (G-T) way up!)

37. AD Change examples Business optimism leads to over- capacity –Cut inventory by cutting production –Investment falls –AD House market collapse in sub-prime crisis – investors lose billions Lose confidence, stocks fall –Wealth declines –AD

38. AD/AS Analysis Aggregate Supply –Sum total of all final goods and services which firms produce –Represented by a schedule/graph Shows level of real domestic output which will be produced at each price level Higher price levels encourage production Lower price levels discourage production

39. Moderate Consensus Aggregate Supply Curve Vertical Portion: Classical economists/monetarists Keynesian Intermediate: consensus Horizontal portion: Keynesian Equilibrium Price level depends on AD = Short run = Long run

40. PL SRAS Real GDP All goods/services supplied PL2 GDP2 PL1 GDP1 Short Run Aggregate Supply SR: PL rise, wages “sticky,” profit- maximizing firms increase aggregate quantity supplied.

41. Technological change – computer technology Increase in productivity SRAS increases – rightward shift Wages rise SRAS decreases – leftward shift Oil shock SRAS decreases – leftward shift Changes in SRAS = Shift Curve

42. SR Equilibrium PL GDP SRAS AD PL e GDP e

43. Adjustment to LR Equilibrium PL GDP SRAS1 AD PL e GDP e GDP full Recessionary gap Unemployment high: in LR, wages fall, SRAS shifts right. SRAS2 LRAS

44. Adjustment to LR Equilibrium PL GDP SRAS1 AD PL e GDP e GDP full Inflationary gap Unemployment low: in LR, wages rise, SRAS shifts left. SRAS2 LRAS

45. In Long Run, Economy Returns to Full Employment But, since wages are “sticky,” the adjustment process may take a long time, and –“in the long run, we are all dead.” –John Maynard Keynes »The General Theory Policy to speed the return to full employment –Fiscal policy: Government spending or tax policy –Monetary policy: Federal Reserve Bank money supply change

46. Keynesian Policy PL GDP SRAS AD 1 PL e GDP e GDP full Recessionary gap LRAS AD 2

47. The Recession of 2008 PL GDP SRAS AD 01 GDP e GDP full Recessionary gap LRAS AD 00 Events: Housing bubble Financial system crash war on terrorism

48. Expansionary Fiscal Policy Effects Cut in personal income taxes (direct taxes) –Leads to increased spending –MPC goes up because we have more money –Leads to shift in aggregate demand to right Cut indirect taxes –Lower prices –Higher real income –Shift in AD to right Cut corporate taxes –Higher post tax profit –Increase “I” –Shift AD to right as business capital spending goes up Cut in taxes on savings and investments –Boost disposable income –Increase in C –Shift AD to right

49. Contractionary Fiscal Policy Increase personal income taxes –Leads to decreased spending –MPC goes down because we have less money –Leads to shift in AD to the left