Framework for Macroeconomic Analysis Chapter 8

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

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

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.

Equilibrium AS Equilibrium AD

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

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

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

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

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

Classical Theory Minimal government intervention in the economy Invisible hand

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

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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