1. Framework for Macroeconomic Analysis
Chapter 8

2. Economy 1929 Great Depression Resulted in large unemployment
WWII lifted us out of the depression with increased spending

3. Micro vs. Macro
The most fundamental difference between these two models is what they measure on the horizontal and vertical axis. AS
Price level P AD Q
GDP
One good

4. Equilibrium in Macroeconomy
If price level starts above equilibrium, there would be surplus capacity that would pressure the price level lower.
If price level starts below the equilibrium, there would be shortages and the price level would be pushed up
Changes in the price level would lead to changes in the behavior of consumers and firms until the economy stops at eq.

5. Equilibrium AS
Equilibrium AD

6. Short and Long
Long run involves underlying economic forces that make themselves felt over time
Short run a period of time during which the economy transitions to the long run

7. Keynesian John Maynard Keynes
General Theory of Employment, Interest, and Money
Government involvement in the economy
Keynesian theory suggest that government action is an appropriate response to short run problems

8. Classical Theory Says law: supply creates its own demand
Unemployment corrected when the marketplace figures out the profit maximizing mix of goods and services to produce

9. Classical Theory Full employment:
According to the classical view, unemployment is nothing more than a transitory disequilibrium in the marketplace.
Wages will fall when unemployment exists

10. Classical Theory Downwardly flexible wages
Even if the economy began to experience a recession, both wages and prices would adjust downward to ensure that workers remained employed and the goods and services produced would be sold

11. Classical Theory Minimal government intervention in the economy
Invisible hand

12. Keynesian Theory Savings and Investment Investment
Saving motivated by all too human desire to hoard or to accumulate wealth
Investment
People had to be optimistic about the future, since investing involves risk
Existence of savings cannot create investment

13. Keynesian Theory Sticky wages and prices Unemployment
Wage and price cuts were rare
Unemployment
Classical view was false
If aggregate demand is not sufficient to keep everyone employed.
Government intervention is needed

14. Aggregate Demand
Relates how much real GDP consumers, businesses, government, and foreign buyers will purchase at each price level; graphically, aggregate demand slopes downward
Real GDP varies inversely with changes in the price level
Downward sloping demand curve AD

15. Downward slope Purchasing power effect Wealth effect
The effect of the price level on consumers’ ability to buy goods and services
Wealth effect
Higher price level would reduce the real value of savings and lead consumers to spend more of their current incomes

16. Downward Slope Interest rate effect
A higher price level increases interest rates, which represent the cost of borrowing
Higher cost of borrowing will lower household consumption
International substitution effect
A change in the price level changes the quantity demanded of real GDP through its effects on imports and exports

17. Shifts in Aggregate Demand
Increase – shifts to the right
Consumer expectations are favorable
Consumer income rises
Business expectations are favorable
Profit rise
Government spending increases
Taxes go down
Foreign income rises

18. Shifts in Aggregate Demand
Decrease – shift to the right
Consumer and business expectations are unfavorable
Consumer income falls
Profits fall
Taxes increase
Government spending decreases
Foreign income fall

19. Aggregate Supply
The relationship between aggregate output as measured by real GRP and the price level
Long run – vertical curve
Economy will produce at full employment no matter the price level
Full employment output – the real GDP the economy produces when it fully employs its resources.

20. Aggregate Supply
In the long run the desire of people to receive incomes and the desire of firms to earn profits holds unemployment down and real GDP near its full employment level
L/R AS – shows the relationship between full employment GDP and the price level

21. Aggregate supply
Short run AS – tells how much output the economy will offer in the short run at each possible price level
Upward sloping
Higher prices lead to more output

22. Shifts in AS Increase – shift right Decrease – shift left S/R AS
Long run AS

23. Achieving Full Employment Equilibrium
The long run macroeconomic equilibrium that occurs at a full employment output
L/R AS
Equilibrium AD

24. Achieving Full Employment
At any price level above the full employment equilibrium price level, AS will be insufficient to support full employment output
Wages drop and people complete for jobs
Prices drop
Reach equilibrium

25. Achieving Full Employment
If the actual price level were below the equilibrium, the economy would overheat with aggregate purchasing power exceeding the economy's ability to produce.
Firms compete for workers
Wages rise
Prices rise

26. Keynesian VS Classical
The debate is whether government should wait for a movement along aggregate demand or to take action to manage aggregate demand
Sticky wages and sticky prices
Then no change in the price level and economy out of equilibrium

27. Roots causes of inflation
Demand side inflation
Occurs when AD shifts to the right
A movement up the long run AS curve to a higher price level but no change in full employment output
Supply side inflation
Occurs when long run AS shifts to the left.
A movement up the AD curve to a higher price level and lower full employment output
Supply shock – unexpected event that is major enough to affect the overall economy and shift AS