1. The Basic Macro Model zThe first examination of our primary theory and model to describe the economy and predict effects. zThe model itself is known as the Aggregate Demand- Aggregate Supply Model.

2. Theories and Models zTheory -- An assertion about the major causes of observed behavior, done in order to predict outcomes. zModel -- A formalization of a theory, done to make concise predictions.

3. The Aggregate Demand- Aggregate Supply Model zPurpose -- seeks to predict the behavior of real GDP (Y) and the price level (P) (and therefore inflation).

4. Aggregate Demand zAggregate 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).

5. Aggregate Demand: Causes zThe Price Level (P) P  (ceteris paribus)  AD  zAggregate Expenditure (AE) -- desire to purchase quantities of newly produced final goods and services, apart from price considerations. AE  (ceteris paribus)  AD 

6. Formalizing the Theory of Aggregate Demand zGraph AD versus one of its causes -- the price level (P). zInverse relationship implies that the curve is downward sloping. zChanges in P are described as a movement along the curve. zGraph is drawn assuming that AE (and any other causes) are constant (ceteris paribus).

7. Describing Changes in One of the “Other Causes” zAE changes (or changes in any cause other than the price level) are described by a shift of the Aggregate Demand curve. zContrast this with changes in P -- movement along the curve. zDifferent descriptions occur only because P is the cause that appears on the graph.

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

9. A Brief Look at Aggregate Expenditure (AE) AE = C + I + (G - T) + (X - M) zAE: close to definition of real GDP. except that it subtracts out taxes. zIncreases in C, I, G, or X increase AE (and therefore increase AD). zIncreases in T or M decrease AE (and therefore decrease AD).

10. Aggregate Expenditure (AE) -- Continued AE = C + I + (G - T) + (X - M) zThe causes of AE are the causes of C, I, (G - T), and (X - M) -- next chapter. zA change in any of them will shift the AD curve.

11. Short-Run Aggregate Supply (AS) zShort-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.

12. Short-Run Aggregate Supply -- Causes zPrice Level (P) P   AS  zPrice of Energy (P E ) P E   AS  zThe Nominal Wage Rate (W) W   AS  zOther Production Related Causes (e.g. labor productivity)

13. Short-Run Aggregate Supply: Formalizing zGraph AS versus one of its causes -- the price level (P). zPositive relationship implies that the curve is upward sloping. zChanges in P are described as a movement along the curve. zGraph is drawn assuming that P E, W, and any other causes are constant (ceteris paribus).

14. The Shape of the AS Curve zDescribes different magnitudes of response to increases in the price level (P). zk segment -- P increase generates large output response. zl segment -- P increase generates moderate output response. zm segment -- P increase generates small output response.

15. Describing Changes in One of the “Other Causes” zChanges in P E, W, or changes in any cause other than the price level are described by a shift of the AS curve. zLike Aggregate Demand, different descriptions occur only because P is the cause that appears on the graph.

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

17. Equilibrium: The Market in Action zEquilibrium (Y* and P*) -- The values where real GDP and the price level will settle, given that the strategies of demands and suppliers play out.

18. Properties of Equilibrium zIf the price level is anywhere else, natural market forces bring it to equilibrium. zP* and Y* represent the actual price level and real GDP predicted by the theory. zShifts in either the AD or AS curves change the equilibrium.

19. Shifts and Changing the Equilibrium -- Applications zExample 1 -- The effect of a war on the economy. zWar   (G - T)  zIncrease in (G - T) increases AE, described by shifting the AD curve rightward. zDraw the picture and evaluate the answer.

20. Another Application zExample 2 -- Firms become very pessimistic about the economy, decrease their purchases of new plants and equipment (1930s). zDecreased purchases of new plants and equipment  I 

21. zDecrease in I also decreases AE, described by shifting the AD curve leftward. zDraw the graphical situation and evaluate the answer.

22. Still Another Application zExample 3 -- The price of energy (P E ) increases (energy crisis in US, 1970s). zP E  hinders production, reduces Aggregate Supply. zTherefore the AS curve shifts leftward. zDraw the graphs and evaluate.

23. The “Nice Assumptions” -- Market Efficiency zNo market power -- advantages in the market are transitory and can be eliminated by competition. -- equal access to information -- equal access to markets

24. zNo market failure -- markets function smoothly and quickly to coordinate choices. zMarket failure in the economy -- nominal wage rates and energy prices do not adjust flexibly to macroeconomic conditions.

25. Market Failure in Macro zMarket failure in Macro -- P changes, but W and P E stay constant. zDescribes the upward sloping Aggregate Supply (AS) curve. zMain implication -- In the AD-AS model, Y* does not have to be equal to Y F.

26. Characterizing the Economy (Short-Run) Y* < Y F (sluggish economy, demand deficient unemployment) Y* > Y F (accelerating inflation) Y* = Y F (desired state of the economy)

27. Long-Run Aggregate Supply (LAS) zLong-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 our nice assumptions (in particular, no market failure).

28. Characteristics of Long-Run Aggregate Supply (LAS) zUnaffected by the price level. zP   W  and P E  as well  no incentive for firms to change production plans. zAffected by production-oriented variables as well as peoples’ attitudes toward work (will study more later).

29. Formalizing Long-Run Aggregate Supply (LAS) zLAS curve is vertical when plotted against the price level (P). zVertical at the full sustainable level of real GDP (Y F ), all adjustments completed under the “nice assumptions”. zWill consider shifts of the curve in a later chapter.

30. Putting The Model All Together -- Two “Teasers” zTeaser #1 -- The role of Economic Policy, getting Y* closer to Y F. zTeaser #2 -- Spending gone too far, the wage-price spiral (nominal wage rates reacting to spending- induced inflation).