12.0 The Basic Macro Model

Each micro concept has an analogous macro concept price : Price Level (P) quantity exchanged: real GDP (Y)

The Macro Picture

In this picture, Price level is on the vertical axis Real GDP is on the horizontal axis Y F is full employment or full GDP

AD - aggregate demand AS - aggregate supply The intersection of these curves represents the current conditions in the macroeconomy

P More inflation More real GDP More employment Less unemployment Y

A preview Great Depression caused by a great fall in AD More on the specifics later, but look what happens

After Pearl Harbor war means big increase in AD, for reasons we’ll also see later

Further, it is not just AD which can move AS moves due to changes in input prices, as you will see in greater detail later Ex. Oil shocks of the 1970’s

This should give you some idea about how useful this macro picture can be in explaining the world We now need to look at each line in detail

Aggregate Demand (AD) is the sum of all the stuff that individuals and firms and governments are prepared to buy in a given year How much they actually demand depends on how much things cost The total amount planned to be spent is called Aggregate Expenditure (AE)

AE is a nominal measure measured in current dollars

The AD line represents the relationship between real GDP demanded and the price level for a given level of aggregate expenditure In functional form Y = AD (P | AE)

AD slopes downward given constant AE because as price level (P) falls, constant AE buys more real GDP (Y) AE is the shift variable more AE shifts AD to the right

AE is a huge number There are six components of AE AE = C + I + G - T + X - M

Consumption (C) nominal value of spending done by households (stuff you buy)

Investment (I) nominal amount spent by firms on plants, equipment

Government Spending (G) nominal amount government spends planes, tanks, schools, etc.

Taxes (T) money taken out of hands of households by government this represents net taxation - doesn’t count transfer payments like Social Security where gov’t passes resources from one group to another (G-T) is the government budget position

Exports (X) money spent by foreigners on U.S. products

Imports (M) money spent by U.S. citizens on foreign goods (X-M) is the trade balance

Y = AD (P | AE) while AE = C + I + (G - T) + (X - M) so Y = AD (P | C, I, G, T, X, M) a change in any of these six variables shifts AD

An increase in C, G, I, or X will move AD right if P stays the same, Y will increase as each of these three increases

P AD Y Ex. An increase in G AD ´

The same is true for an increase in C, I or X

The reverse is true for T or M because they have a negative sign in front of them

What moves AD? AD moves right when: Increase in C,G,I,X Decrease in T,M AD moves left when: Decrease in C,G,I,X Increase in T,M

Example - Great Depression

Decrease in I moves AD left, ceteris paribus

Outbreak of WWII after Pearl Harbor

Huge increase in G moves AD right, ceteris paribus

This push moved the economy beyond sustainable capacity people and machines can’t keep up that pace forever notice what happens to price level as you move further and further right inflation starts to become an issue

Aggregate supply line represents the relationship between the Price level and real GDP produced by the economy Actually, there are two different lines

Long-run aggregate supply Represents situation when all micro adjustments have been completed under the nice assumptions Most efficient condition – biggest pie Full GDP – Full employment

The LAS line Vertical line at full employment Full, sustainable capacity is determined by Initial endowment – that society’s natural resources, labor, and capital It is vertical because in the long-run, real GDP is independent of the price level

In the very long run endowment changes can shift LAS Population growth, new innovations, new natural resources can move LAS steadily rightward Natural disasters, war can move LAS leftward

We will assume That the LAS remains stationary in order to focus on the long run macroeconomy We will use LAS as our orientation line for full employment

Short-run aggregate supply line (AS) In the short run, we assume that not all markets have had time to adjust Specifically, factor markets have not adjusted Along an AS line, factor prices (like wages) are constant

The AS line has three distinct segments They are labeled k, l, and m

k-segment is significantly below full-employment real GDP large quantities of idle factors exist Under these circumstances, you can hire more people and increase production without the price level increasing

l-segment real GDP approaches, and then meets sustainable full employment GDP Bottlenecks may begin to occur, because not all industries might reach capacity at the same time Cost pressures might lead to higher output prices Shape of l-segment is important to understanding inflation

m-segment economy reaches limit of short-term capacity These three distinct segments make up the AS curve You can surge beyond what is sustainable for a while, but people and machines can not work 24 hours a day forever. Ex. Wartime Further production pressure just increases the price level

because exhausted, unproductive workers are being paid double- or triple-time to work those extra hours Chart p.187 shows WWII effect Inflation only stopped by gov’t price controls

12.3.7

AS curves shift due to changes in factor prices These factor price changes are the exogenous variables in this relationship These exogenous shocks are called aggregate supply shocks Ex. Oil prices, wages

Combining AD, LAS, and AS Putting the tool kit together

More complex case – a wage/price spiral As inflation occurs, workers lose value if their nominal wage remains the same They take steps to account for inflation by demanding wage increases in order to maintain their standard of living

This is easier to do when unemployment is low (who else are you going to get, boss?) This is called a tight labor market

Inflation set off by expanding AD sets off a wage response When wages increase, AS shifts up If AD continues to shift outward the net result after several of these is as follows:

People would often index their wages to the CPI in labor contracts, Making this spiral even more likely Wage/price spirals can become very persistent

Now that we have a tool to represent various macro conditions We can look at the forces that cause the curves to move