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

2. 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

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

5. Exhibit 7 The Phases of the Business Cycle

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

8. Aggregate Demand Curve Exhibit 1P 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 )

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

10. 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.

11. 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 Pi 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

12. 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.

13. 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

14. 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.

15. 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 ev 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

16. 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

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

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

20. Exhibit 4 Changes in Aggregate Demand

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

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

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

24. Specifics of government spending will be covered in Chapter 8

25. Exhibit 5 Factors That Change Aggregate Demand

26. 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

27. Short Run Aggregate Supply Curvei 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 )

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

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

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

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

32. Short-Run Equilibrium

33. 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

35. 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

36. INCREASE IN AD

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

38. INCREASE IN AS

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

40. Decrease in AS

41. 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

42. 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

43. 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

44. 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

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

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

47. Exhibit 13 Long-Run Aggregate Supply (LRAS) Curve

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

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

50. 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

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

52. 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

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

54. 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