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I. AD/AS Model To Analyze changes in real GDP & price level simultaneously Provides insights on inflation, unemployment, & economic growth Aggregate.

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Presentation on theme: "I. AD/AS Model To Analyze changes in real GDP & price level simultaneously Provides insights on inflation, unemployment, & economic growth Aggregate."— Presentation transcript:

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3 I. AD/AS Model To Analyze changes in real GDP & price level simultaneously Provides insights on inflation, unemployment, & economic growth Aggregate Demand –Amounts of real output –Buyers collectively desire –At each possible price level Aggregate Supply –Levels of real domestic output firms will produce –At each possible price level

4 II. Aggregate Demand Curve Income & substitution effects do not apply AD Curve – negative slope –Real-Balances effect Higher price level means real value of savings decreases Thus lowering consumption –Interest-rate effect High demand for $ leads to high interest rates High interest rates limit investment spending Thus leads to less real output –Foreign purchases effect US price level up then foreigners buy less US goods

5 AGGREGATE DEMAND CURVE Price level Real domestic output, GDP AD

6 Price level Real domestic output, GDP CHANGES IN AGGREGATE DEMAND AD 1 AD 2 Aggregate Demand Can Increase

7 Price level Real domestic output, GDP CHANGES IN AGGREGATE DEMAND AD 1 AD 3 …or Decrease Aggregate Demand Can Increase

8 Determinants of AD Change in consumer spending (C) –Wealth effect –Consumer expectations –Household indebtedness –Personal income taxes Change in investment spending (Ig) –Real interest rates –Expected returns Future business conditions Technology Degree of excess capacity Business taxes Change in government spending (G) Net export spending (Xn) –National income abroad –Exchange rates

9 III. Aggregate Supply Long-run AS curve –Vertical at full-employment level of real GDP –Resource prices adjust to changes in PL – no incentive for firms to change output Short-run AS curve –Upward sloping –Rise in price level increases real output –Lag between product prices & resource prices make it profitable for firms to increase output when PL rises

10 AGGREGATE SUPPLY Price level Real domestic output, GDP Short Run AS Aggregate Supply Short-run QfQf Full- Employment

11 AGGREGATE SUPPLY Price level Real GDP AS 3 AS 1 AS 2 Increase In Aggregate Supply Decrease In Aggregate Supply Changes in Aggregate Supply

12 AGGREGATE SUPPLY Price level Real GDP Long Run AS LR Long-run Aggregate Supply QfQf Full-Employment

13 AS AS - amount of real output firms will produce at each PL. Higher price levelsincentive Higher price levels provide an incentive to produce more. AS has three ranges: Horizontal 1. Horizontal Keynesian (Keynesian) Intermediate 2. Intermediate Vertical 3. Vertical Classical (Classical) Price level Real domestic output, GDP Q Horizontal[Keynesian]Range Upsloping or IntermediateRange Vertical[Classical]Range AS

14 IV. Determinants of AS Input prices –Domestic Land Labor Capital –Prices of imported resources –Market power (OPEC)

15 Productivity = Total output/total inputs Legal-institutional environment –Business taxes and subsidies –Government regulation

16 Price Level Real Domestic Output, GDP Q P AS AD EQUILIBRIUM AND CHANGES IN EQUILIBRIUM ab Equilibrium Real Output

17 Price Level Real Domestic Output, GDP Q P AS AD 1 INCREASES IN AD: DEMAND-PULL INFLATION P2P2 P1P1 AD 2 QfQf Q1Q1 Q2Q2 [Good News – more jobs; Bad News – higher prices]

18 Price Level Real Domestic Output, GDP Q P AS AD 1 DECREASES IN AD: RECESSION & CYCLICAL UNEMPLOYMENT P1P1 AD 2 QfQf Q1Q1 a c b [Good News–lower prices; Bad News–job losses]

19 Price Level Real Domestic Output, GDP Q P AS 1 AD 1 DECREASES IN AS: COST-PUSH INFLATION P2P2 QfQf Q1Q1 a b AS 2 P1P1 [bad news – job losses; bad news – inflation]

20 V. Sticky Prices – prices inflexible (rigid) in a downward direction Wage Prices Morale, effort, productivity Minimum wage Menu costs Fear of price wars

21 ConsumptionInvestment Gov. Spending Exports SavingTaxesImports IncomeEmploymentOutput Full Employment [Frictional & structural] An economy in equilibrium at FE Injections Leakages *Classicals – A leakage down the drain of saving is returned thru the spigot of investment.

22 Review of the Marginal Propensities 1.If consumption increases from 465 to 480 and disposable income increases from 490 to 510. What is the marginal propensity to consume? 2.If the marginal propensity to consume is 0.8 then what is the marginal propensity to save? 3.Why will the MPC + MPS always equal 1? 15/20 =.75 MPS = 0.2 Consuming or saving is an either-or proposition

23 Aggregate Expenditures Model

24 M ult = AE(C+Ig 1 ) AE(C+Ig+G) Y R Y * Y R Y * 10 G Real GDP 0 AE 3 (C+Ig+G+Xn) ( Complex Economy) [ Mixed-open ] AE 2 (C+Ig+Xn) (Private-open) [X(40)-M(20)] AE 1( C+Ig )[Basic Economy][Private(no G)-Closed(no X or M)] Consumption C =390 ( AE 1 )470 ( AE 2 )550 ( AE 3 ) Xn +20 G +20 Ig Real GDP Building Private-open Mixed - open Private-closed Private-open Mixed-open [ Simple [ Basic ] economy to Complex economy] [C+Ig+G+Xn] [C + Ig] [C + Ig + Xn] Private - closed

25 I. AE Model / Keynesian Cross Model Aggregate Expenditures means total spending When AE fall – Total output & employment decrease When AE rise – Total output & employment increase

26 II. Mixed Economy AE = C + Ig + G + Xn Increase in public spending shifts AE upward & produces higher equilibrium GDP In a mixed economy the Savings (Leakages) = planned investment (Injections) –Sa + M + T = Ig + X + G Lump-sum tax (constant at each level of GDP) – Reduces C & S Proposed balanced budget requirement (G spending = G revenue) would eliminate discretionary fiscal policy Balance budget multiplier = 1 (equal increases in G & T) AE shift is equal to change in G or T

27 FULL-EMPLOYMENT GDP Aggregate Expenditures (billions of dollars) o 45 o Real domestic product, GDP (billions of dollars) AE 0 Recessionary Gap AE Recessionary Gap = $5 Billion Full Employment

28 FULL-EMPLOYMENT GDP Aggregate Expenditures (billions of dollars) o 45 o Real domestic product, GDP (billions of dollars) AE 0 Inflationary Gap AE Inflationary Gap = $5 Billion Full Employment

29 III. Limitations No price-level changes Ignores premature demand-pull inflation Limits real GDP to the full-employment level of output Ignores cost-push inflation Does not allow for self-correction


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