1. Building Macro Model
Chapter 12

2. Building the Macro Model
The axes for the “Macro Picture” look like this:
P represents the “price level” P
Y represents real GDP Y

3. Building the Macro Model
We’ll have an orientation point along the Y axis that represents the point at which Y = YF: P YF Y

4. Building the Macro Model
When the economy is at the Natural Rate (YF – it’s using its resources most efficiently and effectively) … there’s no “slack”
And … we noted the Micro condition that must be true for this to be the Macro case:
General Competitive Equilibrium (GCE)

5. Building the Macro Model
General Competitive Equilibrium (GCE) is realized when:
“all of the micro adjustments are completed under our nice assumptions”
We’re going to use this expression to define the Macro “Long Run”

6. Building the Macro Model
The “Long Run” is not measured in time, but rather by process …
In the Long Run “all of the micro adjustments are completed under our nice assumptions” …
So, in the Long Run
the Micro economy will be at GCE and
the Macro Economy will be at YF

7. Building the Macro Model
The long run represents sustainable production with the biggest possible pie… P
LAS
Long Run
Aggregate Supply
(LAS) YF Y

8. Building the Macro Model
The LAS, a vertical line at YF, represents a reference point reminding us that the Macro Economy will always be at YF in the “Long Run” … P
LAS YF Y

9. Building the Macro Model
In the Long Run “all of the micro adjustments are completed under our nice assumptions”
In the Short Run some of the micro adjustments have not happened
In particular … in the Short Run factor prices are constant

10. Building the Macro Model
The Short Run Aggregate Supply (AS) line reflects how, given constant factor prices, increasing Y ultimately puts pressure on the economy as it gets closer to or even exceeds YF

11. Building the Macro Model
In the economy “pressure” creates heat, and heat is inflation
If GDP supplied grows from Y1
to Y2
… there’s no pressure,
the economy is
just pulling
in slack P
LAS AS
No pressure …
No inflation Y2 Y1 YF Y

12. Building the Macro Model
But as Y begins to approach YF there’s less slack …
and there may be pressure P
LAS AS
Possible
pressure …
Possible
inflation Y2 YF Y

13. Building the Macro Model
When Y surpasses YF resources are being stretched
that creates pressure …
and
pressure
produces
heat … P
LAS AS P0 P1 Y3
Inflation YF Y

14. Building the Macro Model
And when Y moves well above YF
the pressure gets intense…
the economy
heats up … P
LAS AS P1 P2 Y4
Inflation
increases YF Y3 Y

15. Building the Macro Model
The AS line traces the pressure created by increasing the production of real GDP, Y
When there’s plenty of slack … no pressure … no problem…
But as we “take in” the slack that can begin to create pressure … that creates a problem: inflation
If we push the economy beyond full sustainable capacity, YF … inflation can become a serious problem

16. Building the Macro Model
So if plenty of slack means no problem from pressure (i.e., no inflation) … plenty of slack is a good thing … right?
NO!
More slack implies more demand deficient unemployment

17. Building the Macro Model
Less slack implies less demand deficient unemployment … so less slack is a good thing … right?
Not necessarily … less slack raises the danger of inflation
So the challenge of achieving a healthy economy is to eliminate the slack … to get to YF, without setting off inflation

18. The AS Line

19. What “moves” the economy along the AS line?
Aggregate Demand
What “moves” the economy along the AS line?

20. Building the Macro Model
Given the current short term and long term
Aggregate Supply conditions,
the level of Aggregate Demand determines the
current Real GDP, Y, and the Price Level, P AS P
LAS AD P0 Y0 YF Y

21. Building the Macro Model
The variables that move AD …
move the Macro economy AS P
LAS AD P0 Y0 YF Y

22. Building the Macro Model
To identify those variables we need to examine
the functional form of the AD line AS P
LAS AD P0 Y0 YF Y

23. Building the Macro Model
AD functional form: Y = AD (P | AE)
Which means: Real GDP Demanded, Y, is a function, AD,
of the Price Level, P, given the level of Aggregate Expenditure AS P
LAS AD P0 Y0 YF Y

24. Building the Macro Model
Aggregate Expenditure is the nominal amount of money that is spent in the economy. AS P
LAS AD P0 Y0 YF Y

25. Building the Macro Model
Y = AD (P | AE)
AD slopes down because, we can see from the equation,
for a given level of AE
as P rises Y will fall (i.e., as P rises
the given nominal spending (AE) buys less real stuff (Y)) AS P
LAS AD P0 Y0 YF Y

26. Building the Macro Model
Y = AD (P | AE)
AD moves when AE rises or falls AS P
LAS AD P0 Y0 YF Y

27. AD and the Great Depression
When AE rises or falls it moves AD,
and changes in AD move the economy …
e.g., in the Great Depression …
AD collapsed
Real GDP fell
dramatically … AS P
LAS
Unemployment
skyrocketed to
over 25% …
AD0 P0 Y0
and there was
Deflation.
AD1 P1 Y1 YF Y

28. WW II P YF Y World War II … another dramatic shift in AD
The government started spending like crazy to win the war …
AD expanded dramatically
Real GDP grew
dramatically … AS P
LAS
Unemployment
fell to
around 1% … P2
AD2
and there was
Inflation until
the government
stepped in.
AD1 P1 Y1 YF Y2 Y

29. Variables that move AD P YF Y
The variables that move AD …move the Macro economy
What are those variables? … i.e., What are the components of AE? AS P
LAS AD P0 Y0 YF Y

30. Aggregate Expenditure Variables
AE = C + I + G – T + X – M
So C, I, G, T, X, and M are the shift variables of AD and the forces that move AD and thus… move the Macro Economy
C= Consumption
I= Investment
G= Government spending
T= Taxes
X= Exports
M= Imports

31. Consumption Y = AD (P | C, I, G, T, X, and M ) C is Consumption
The aggregate nominal amount of spending we do as consumers … at the grocery or the mall and so on…
Makes up 65-70% of AD.
It’s big … but it doesn’t usually change dramatically quickly. People tend to try and maintain their standard of living

32. Consumption Ceteris paribus … More Consumption is stimulative
It shifts AD right.
Less Consumption is contractionary
It shifts AD left.

33. Investment Y = AD (P | C, I, G, T, X, and M ) I is Investment
The aggregate nominal amount of spending we do as individuals or firms to increase our production capital or inventories
It is not nearly as big as C, but it is significant and more importantly … it is volatile
It can change dramatically and quickly … driven by the optimism of our “animal spirits” (Keynes) or the fears of our human vulnerability

34. Investment Ceteris paribus … More Investment is stimulative …
It shifts AD right.
Less Investment is contractionary …
It shifts AD left.

35. Government Spending and Taxes
Y = AD (P | C, I, G, T, X, and M )
G is Government Spending and T is Taxes
The aggregate nominal spending and taxing the government does.
G and AD move together – the more Government Spending, the more AD, and vice versa
T and AD move in opposite directions – the more Government Taxing, the less AD, and vice versa

36. Spending, Taxes, and Budget
(G – T) is the Government’s Budget Position
(G – T) = 0 is a Balanced Budget
(G – T) < 0 is a Budget Surplus
(G – T) > 0 is a Budget Deficit

37. Spending, Taxes, and Budget
Ceteris paribus …
(G – T) = 0 , a Balanced Budget, is neutral. It doesn’t shift AD
(G – T) < 0 , a Budget Surplus, is contractionary. It shifts AD left.
(G – T) > 0 , a Budget Deficit, is stimulative. It shifts AD right.

38. Exports and Imports Y = AD (P | C, I, G, T, X, and M )
X is Exports and M is Imports
X is the aggregate nominal spending on domestic items by foreigners, M is the aggregate nominal spending on foreign items by domestic buyers
X and AD move together – the more foreigners spend domestically, the more AD, and vice versa
M and AD move in opposite directions – the more spent on foreign items the less AD, and vice versa

39. Exports and Imports (X – M) is the Trade Balance
(X – M) = 0 is a Balanced Trade
(X – M) < 0 is a Trade Deficit
(X – M) > 0 is a Trade Surplus

40. Exports and Imports Ceteris paribus …
(X – M) = 0 , a Balanced Trade, is neutral. It doesn’t shift AD
(X – M) < 0 , a Trade Deficit, is contractionary. It shifts AD left.
(X – M) > 0 , a Trade Surplus is stimulative. It shifts AD right.

41. AD Movements 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

42. LAS and AS
The Shift Variables

43. LAS and AS LAS shift variables
LAS is vertical at YF because it represents the condition of the economy in the Long Run, independent of the Price Level, P

44. The Long Run
The economy has reached the Long Run when all the micro adjustments are completed under our nice assumptions.
How long is this?
Describe the Macro condition in terms of GDP and Unemployment in the Long Run?
What is the Micro condition in the Long Run?

45. The Long Run The Micro condition in the Long Run is GCE.
What did we learn determines the size of the “pie” when the economy is at GCE?
Its determined by the size of society’s endowment …
So growth in society’s endowment grows the size of the “pie” society can produce

46. The Long Run
As growth in society’s endowment increases the size of the “pie” society can produce at GCE … by definition it is growing the Long Term Macro capacity of the economy…
So YF grows, shifting LAS to the right, as society’s resource endowment grows:
Population resource growth
Natural resource growth
Capital resource growth

47. AS Shift Variables
AS traces the pressure (inflation) created by increasing the production of real GDP (Y), holding factor prices constant
AS reflects the “cost structure” of the macro economy for a given level of factor prices

48. AS Shift Variables
Anything that raises “cost structure” of the macro economy shifts AS up …because for any level of real GDP (Y), it costs more to make that aggregate output …
so the Price Level, P, at every level of Y rises to cover this higher cost structure

49. Shift of AS
If factor prices rise AS shifts up:
AS1
AS0 P
LAS AD Y

50. Stagflation
Shifting AS up can result in “stagflation” …inflation and higher unemployment at the same time
This happened during the OPEC oil embargo of the 1970s

51. Oil Embargo and Stagflation
Oil prices went up shifting up AS
Real GDP fell, Y1 P1
and there was inflation
Unemployment rose,
AS1
AS0 P
LAS AD P0 Y0 YF Y

52. Wage-Price Spiral
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:

53. Wage-Price Spiral

54. Macro Model…Summary
LAS shifts right with increases in society’s endowment … this is growth in the economy (It can also shift left…why?)
AS shifts up and down with changes in factor prices
AD shifts right or left with changes in C, I, G, T, X, & M
Next we explore the sources of the forces that determine the level of C, I, G, T, X, & M