MACROECONOMIC MODELS Business Cycles Business cycles are 2-year to 5-year fluctuations around trends in real GDP and other related variables

MACROECONOMIC MODELS Business Cycles A recession is a large fall in the growth of real GDP and related variables A depression is an especially large recession

What Is a Business Cycle? Peak Contraction (Recession) Trough Recovery Expansion

Exhibit 7 The Phases of the Business Cycle

AGGREGATE DEMAND CURVE shows the amount of real output (RGDP) people are willing and able to buy at different price levels ceteris paribus

Aggregate Demand Curve Exhibit 1 P r i c e L e v e l ( P ) A g g r e g a t e D e m a n d C u r v e T h e p r i c e l e v e l a n d q u a n t i t y d e m a n d e d o f A P 1 R e a l G D P a r e i n v e r s e l y r e l a t e d . B P 2 A D Q Q 1 2 R e a l G D P ( Q )

Why Does the Aggregate Demand Curve Slope Downward? Real balance effect Interest rate effect International trade effect

Why Does the Aggregate Demand Curve Slope Downward? Real balance effect - the purchasing power of a given amount of money buys less at higher price levels than at lower price levels.

REAL BALANCE EFFECT P 2 P 1 R e a l B a l a n c e E f f e c t P 1 2 P i c e l e v e l r i s e s ® p u r c h a s i n g p o w e r f a l l s ® A D m o n e t a r y w e a l t h f a l l s ® b u y f e w e r g o o d s . Q P P r i c e l e v e l f a l l s ® 1 P 1 p u r c h a s i n g p o w e r r i s e s ® m o n e t a r y w e a l t h r i s e s ® b u y m o r e g o o d s . P 2 2 A D Q

Why Does the Aggregate Demand Curve Slope Downward? Real balance effect Interest rate effect - as price level rises, interest rates tend to rise and the cost of borrowing increases. Int. rate sensitive C and I decrease.

Interest Rate Effect Interest Rate Effect Price level falls®purchasing power rises®less money needed to buy fixed bundle of goods®save more®supply of credit rises®interest rate falls®businesses and households borrow more at lower interest rate®buy more goods. Price level rises®purchasing power falls®borrow money in order to continue to buy fixed bundle of goods®demand for credit rises®interest rate rises®businesses and households borrow less at higher interest rate®buy fewer goods. Interest Rate Effect

Why Does the Aggregate Demand Curve Slope Downward? Real balance effect Interest rate effect International trade effect- as domestic prices rise, imports become cheaper and rise. Exports fall as prices rise.

INT. TRADE EFFECT P 2 P 2 I n t e r n a t i o n a l T r a d e E f f e v e l i n U . S . r i s e s r e l a t i v e t o 1 P 1 f o r e i g n p r i c e l e v e l s ® U . S . g o o d s r e l a t i v e l y m o r e e x p e n s i v e t h a n f o r e i g n g o o d s ® b o t h A D A m e r i c a n s a n d f o r e i g n e r s b u y Q f e w e r U . S . g o o d s . P 1 P P r i c e l e v e l i n U . S . f a l l s r e l a t i v e t o 1 f o r e i g n p r i c e l e v e l s ® U . S . g o o d s r e l a t i v e l y l e s s e x p e n s i v e t h a n f o r e i g n g o o d s ® b o t h P 2 2 A m e r i c a n s a n d f o r e i g n e r s b u y m o r e U . S . g o o d s . A D Q

Changes in the Price level lead to movements along the aggregate demand curve people buy a higher level of real output at lower price levels

AGGREGATE DEMAND Aggregate demand changes if there is a change in Total Expenditures

TOTAL EXPENDITURES change when there are changes in: Consumption Investment Government Expenditures NX=EX - IM

Exhibit 4 Changes in Aggregate Demand

FACTORS THAT CHANGE CONSUMPTION Wealth Expectations about future prices and income Interest rate Taxes

FACTORS THAT CHANGE INVESTMENT Interest rate Expectations about future sales Business Taxes

FACTORS THAT CHANGE EX - IM Foreign real national income Exchange rate

Specifics of government spending will be covered in Chapter 8

Exhibit 5 Factors That Change Aggregate Demand

AGGREGATE SUPPLY The Short Run Aggregate Supply Curve (SRAS) shows the amount of real output (RGDP) producers will offer for sale at different price levels

Short Run Aggregate Supply Curve i c e L e v e l ( P ) S R A S P B S h o r t - R u n A g g r e g a t e S u p p l y C u r v e P A T h e p r i c e l e v e l a n d q u a n t i t y s u p p l i e d o f R e a l G D P a r e d i r e c t l y r e l a t e d . Q Q 1 2 R e a l G D P ( Q )

FACTOR THAT SHIFT AGGREGATE SUPPLY The wage rate prices of nonlabor inputs productivity supply shocks

SUPPLY SHOCKS ADVERSE BENEFICIAL bad weather cutback in oil regulatory change BENEFICIAL unusually good weather discovery of a major new resource

Wage Rates and a Shift in the Short-Run Aggregate Supply Curve Exhibit 6

SHORT RUN EQUILIBRIUM When the quantity demanded of Real GDP equals the (short run) quantity supplied of Real GDP

Short-Run Equilibrium

INFLATION AND UNEMPLOYMENT increases in the price level represent inflation decreases in the price level represent deflation EMPLOYMENT increases in Real GDP reduce unemployment decreases in Real GDP increase unemployment

SHIFT IN AGGREGATE DEMAND INCREASE AD shifts right price level rises Real GDP rises unemployment falls DECREASE AD shifts left price level falls Real GDP falls unemployment rises

INCREASE IN AD

INCREASE IN AGGREGATE SUPPLY AS curve shifts to the right price level falls Real GDP rises Unemployment falls

INCREASE IN AS

DECREASE IN AGGREGATE SUPPLY AS shifts to the left price level rises Real GDP falls unemployment rises

Decrease in AS

Examples Increase in wage rate + Increase in income taxes Decrease in business taxes + Good weather Increase in interest rates + Decrease in Foreign national income Depreciation of US dollar + Increase in oil price Decrease in expected future income + increase in productivity

SHORT RUN the short run is defined as a period of time in which at least one input is fixed for example, firms can change the number of workers relatively easily but it takes longer to build a new plant plant size is fixed in the short run

LONG RUN the long run is defined as a period of time long enough to adjust all inputs firms can make major adjustments in their plant size given enough time all inputs are variable in the long run

LONG RUN AGGREGATE SUPPLY the amount of real output the economy is able to supply at different price levels if the economy is at Natural Real GDP

NATURAL REAL GDP the amount of output the economy could produce if it operated at full employment called Qn or Qf

LONG RUN AGGREGATE SUPPLY (LRAS) vertical line at full employment Real GDP Qn = Qf

Exhibit 13 Long-Run Aggregate Supply (LRAS) Curve

THREE POSSIBLE STATES OF THE ECONOMY Recessionary gap Inflationary gap Full Employment Equilibrium

RECESSIONARY GAP The intersection of SRAS and AD is below (to the left of) the Natural Real GDP (full employment)

Three Possible States of the Economy RECESSIONARY GAP ( a ) P r i c e L e v e l S R A S 1 I n t h i s d i a g r a m , t h e e c o n o m y i s c u r r e n t l y i n s h o r t - r u n e q u i l i b r i u m a t a R e a l G D P l e v e l o f Q . Q i s 1 N N a t u r a l R e a l G D P o r t h e p o t e n t i a l o u t p u t o f t h e e c o n o m y . N o t i c e 1 T h e t h a t Q < Q . W h e n t h i s c o n d i t i o n e c o n o m y 1 N ( Q < Q ) e x i s t s , t h e e c o n o m y i s i s h e r e . 1 N s a i d t o b e i n a r e c e s s i o n a r y g a p . A D 1 Q Q R e a l 1 N G D P

INFLATIONARY GAP The intersection of SRAS and AD is above (to the right of) the Natural Real GDP (full employment)

Three Possible States of the Economy INFLATIONARY GAP ( b ) P r i c e L e v e l S R A S I n t h i s d i a g r a m , t h e e c o n o m y i s 1 T h e c u r r e n t l y i n s h o r t - r u n e q u i l i b r i u m e c o n o m y a t a R e a l G D P l e v e l o f Q . Q i s 1 N i s h e r e . N a t u r a l R e a l G D P o r t h e p o t e n t i a l o u t p u t o f t h e e c o n o m y . N o t i c e t h a t Q > Q . W h e n t h i s c o n d i t i o n ( Q > 1 N 1 Q ) e x i s t s , t h e e c o n o m y i s s a i d N t o b e i n a n i n f l a t i o n a r y g a p . A D 1 Q Q R e a l 1 G D P

FULL EMPLOYMENT EQUILIBRIUM The intersection of SRAS and AD is equal to the Natural Real GDP

Three Possible States of the Economy LONG-RUN EQUILIBRIUM ( c ) P r i c e L e v e l S R A S I n t h i s d i a g r a m , t h e e c o n o m y i s c u r r e n t l y o p e r a t i n g a t a R e a l G D P l e v e l o f Q , w h i c h h a p p e n s t o b e 1 e q u a l t o Q . I n o t h e r w o r d s , t h e N T h e e c o n o m y i s p r o d u c i n g i t s N a t u r a l 1 e c o n o m y R e a l G D P o r p o t e n t i a l o u t p u t . i s h e r e . W h e n t h i s c o n d i t i o n ( Q = Q ) 1 N e x i s t s , t h e e c o n o m y i s s a i d t o b e i n l o n g - r u n e q u i l i b r i u m . A D 1 Q R e a l N Q G D P 1