Chapter The Basic Macro Model zThis chapter presents the 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.

The Aggregate Demand- Aggregate Supply Model zPurpose -- seeks to examine the underlying behavior of what determines real GDP (Y) and the price level (P) (and therefore inflation) for the whole economy. zWe can then use the theory/model to make concise predictions of how events and policies will affect the economy.

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).

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 

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 is constant (ceteris paribus).

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.

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.

A Brief Look at Aggregate Expenditure (AE) AE = C + I + (G - T) + (X - M) zAE is total net demand for US newly produced final goods and services by all “buyers”.

Aggregate Expenditure (AE): Variable Definitions zC = Consumption, consumer purchases of goods and services. -- nondurable goods (e.g. food) -- durable goods (e.g. new cars, personal computers) -- services (e.g. auto mechanic, medical doctor) zI = Investment, business purchases of new plants and equipment + purchases of new residential housing + changes in inventories.

AE -- More Variable Definitions zG = Government purchases of goods and services. zT = Net Taxes, tax revenues minus transfer payments. z(T – G) is commonly known as the government budget. z(G – T), within AE is referred to as the government budget position.

AE – Even More Variable Definitions zX = Exports, foreign purchases of US produced goods and services. zM = Imports, US purchases of foreign produced goods and services. z(X – M) is commonly referred to as Net Exports, or the Balance of Trade.

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 is described as a shift the AD curve. zIncreases in C, I, G, or X increase AE (and therefore increase AD). zIncreases in T or M decrease AE (and therefore decrease AD).

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, in particular nominal wage rates (W).

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)

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).

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.

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

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.

Equilibrium: The Market in Action zEquilibrium (Y* and P*) -- The values where real GDP and the price level will ultimately settle (what the model predicts).

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. zThis behavior within the model is described by shifting the AD curve rightward. zDraw the picture and evaluate the answer.

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 

Business Pessimism and Investment, Continued zDecrease in Investment (I), ceteris paribus, necessarily decreases AE. zWithin the model, this behavior is described by shifting the AD curve leftward. zDraw the graphical situation and evaluate the answer.

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.

Market Failure in the Economy (AS Curve) zMarket failure in the Economy -- W and P E stay constant, don’t move easily. zFor institutional reasons (discussed later), factor markets don’t move to their equilibriums. zDescribes the upward sloping Short- Run Aggregate Supply (AS) curve.

Implications of Market Failure in Economy zEconomy not at General Competitive Equilibrium (GCE). zEquilibrium occurs where Y* is not necessarily equal to Y F.

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)

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 the nice assumptions (in particular, no market failure).

Characteristics of Long-Run Aggregate Supply (LAS) zEquilibrium under perfect competition with the nice assumptions satisfied (in particular, no market failure)  the economy is in General Competitive Equilibrium (GCE). zGCE  economy necessarily operates at the full sustainable level of output (Y F ).

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”. Economy is in GCE. zCurve shifts rightward (increase in LAS) or leftward (decrease in LAS). zWill consider what shifts the curve in a later chapter.

Putting The Model All Together -- Two “Teasers” zTeaser #1 – The Interventionist versus Non-interventionist positions on the economy – returning in a big way within macro. zTeaser #2 -- Spending gone too far, the wage-price spiral.