1. The Aggregate Model of the Macro Economy Chapter 14

2. The Aggregate Demand Curve (AD) The AD curve shows the alternative combinations of the price level (P) and real income (Y ) that result in simultaneous equilibrium in both the real goods and the money markets. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 2

3. Deriving the Aggregate Demand Curve Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 3 r M/P RLMS 1 RLMS 2 r1r1 r2r2 M/P 1 M/P 2 RLMD A B r IRE r1r1 r2r2 IRE 1 IRE 2 IRE = f(r) A B E Y E(Y 1 ) E(Y 2 ) Y1Y1 Y2Y2 A B Change in the price level and the effect on the money market Interest-related expenditure and equilibrium income 45 o

4. Shape of the Aggregate Demand Curve Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 4 P Y AD A B P1P1 P2P2 Y1Y1 Y2Y2

5. Shifting the Aggregate Demand Curve Monetary policy Fiscal policy Other autonomous spending changes Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 5 P Y AD 1 AD 2 P1P1 Y1Y1 Y2Y2 Effect of expansionary monetary or fiscal policy or an autonomous increase in spending

6. Household Consumption Spending and Aggregate Demand AD CURVE SHIFTS OUT TO THE RIGHTAD CURVE SHIFTS BACK TO THE LEFT Decrease in personal taxes (TP)Increase in personal taxes (TP) Increase in consumer confidence (CC )Decrease in consumer confidence (CC) Increase in consumer wealth (W)Decrease in consumer wealth (W) Increase in consumer credit (CR)Decrease in consumer credit (CR) Decrease in consumer debt (D)Increase in consumer debt (D) Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6

7. Business Investment Spending and Aggregate Demand AD CURVE SHIFTS OUT TO THE RIGHTAD CURVE SHIFTS BACK TO THE LEFT Decrease in business taxes (TB)Increase in business taxes (TB) Increase in expected profits and business confidence (PR) Decrease in expected profits and business confidence (PR) Increase in capacity utilization (CU)Decrease in capacity utilization (CU) Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 7

8. Foreign Sector and Aggregate Demand AD CURVE SHIFTS OUT TO THE RIGHTAD CURVE SHIFTS BACK TO THE LEFT Increase in the level of foreign GDP or real income (Y*) Decrease in the level of foreign GDP or real income (Y* ) Decrease in the currency exchange rate (R) Increase in the currency exchange rate (R) Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 8

9. Implementation Issues and Fiscal Policy Any changes in government expenditure or taxes meant to stimulate or contract the economy may take weeks or months to be approved by both the Senate and the House of Representatives and then sent to the president for his signature. Fiscal policy takes even longer to have an impact on the economy after the changes are passed by Congress and signed by the president. Some aspects of federal expenditures and taxes act as automatic stabilizers for the economy. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 9

10. Implementation Issues and Monetary Policy The Federal Open Market Committee (FOMC) can enact policy changes very rapidly. Spending changes on real goods and services that result from changes in monetary policy may vary by sector and take time to move through the economy. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 10

11. Interaction of Fiscal and Monetary Policy The final level of interest rates and real income in the economy typically depends on the Federal Reserve’s reaction to fiscal policy or other autonomous changes in spending. There might also be a concern about crowding out, the decrease in interest-related spending of consumers and businesses that occurs when the interest rate rises from increased government spending. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 11

12. The Aggregate Supply Curve (AS) The AS curve shows the relationship between the price level at which firms in the economy are willing to produce different levels of real goods and services and the resulting level of real income. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 12

13. Potential output (GDP) The maximum amounts of real goods and services or real income (GDP) that can be produced in the economy at any point in time based on the economy’s aggregate production function. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 13

14. Short-Run Aggregate Supply Curve An aggregate supply curve that is either horizontal or upward sloping, depending on whether the absolute price level increases as firms produce more output. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 14 P Y SAS

15. Keynesian Model A model of the aggregate economy, based on ideas developed by John Maynard Keynes, with a horizontal short-run aggregate supply curve in which all changes in aggregate demand result in changes in real output and income. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 15 P Y SAS AD 0 AD 1 P0P0 Y0Y0 Y1Y1 AB

16. Upward Sloping Aggregate Supply The short-run aggregate supply curve slopes upward as real income and output approach the economy’s potential output. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 16 P Y SAS AD 1 AD 2 P1P1 P2P2

17. Long-Run Aggregate Supply Curve (Vertical) A vertical aggregate supply curve that defines the level of full employment or potential output based on a given amount of resources, efficiency, and technology in the economy. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 17 P Y LAS YfYf

18. Shifting Aggregate Supply The short-sun aggregate supply curve will shift as a result of productivity changes and changes in the costs of the inputs of production that are independent of overall demand changes. The long-run aggregate supply curve can also shift over time if there are increases in the amount of inputs (labor, land, capital, and raw materials) in the economy and increases in technology and efficiency. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 18

19. Measuring Changes in Aggregate Demand and Supply Leading indicators are economic variables, such as manufacturing, employment, monetary, and consumer expectation statistics, that generally turn down before a recession begins and turn back up before a recovery starts. Coincident indicators are economic variables, including employment, income, and business production statistics, that tend to move in tandem with the overall phases of the business cycle. Lagging indicators are economic variables, including measures of inflation and unemployment, labor costs, and consumer and business debt and credit levels, that turn down after the beginning of a recession and turn up after a recovery has begun. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 19

20. 1.The following events have occurred at times in the history of the United States: A deep recession hits the world economy. The world oil price rises sharply. U.S. businesses expect future profits to fall. a.Explain for each event whether it changes short-run aggregate supply, long-run aggregate supply, aggregate demand, or some combination of them. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 20

21. A deep recession in the world economy decreases aggregate demand. A sharp rise in oil prices decreases short-run aggregate supply. The expectation of lower future profits decreases investment and decreases aggregate demand. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 21

22. b.Explain the separate effects of each event on U.S. real GDP and the price level, starting from a position of long-run equilibrium. c.Explain the combined effects of these events on U.S. real GDP and the price level, starting from a position of long-run equilibrium. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 22

23. A deep recession in the world economy decreases aggregate demand, which decreases real GDP and lowers the price level. A sharp rise in oil prices decreases short-run aggregate supply, which decreases real GDP and raises the price level. The expectation of lower future profits decreases investment and decreases aggregate demand, which decreases real GDP and lowers the price level. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 23

24. The combined effect of a deep recession in the world economy, a sharp rise in oil prices, and the expectation of lower future profits decreases both aggregate demand and short- run aggregate supply, which decreases real GDP and the price level rises, falls, or remains the same. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 24