Topic 9 Basics of Macroeconomics and the Aggregate Supply and Aggregate Demand Model. © Pearson Education, 2005.

Topic 9 Basics of Macroeconomics and the Aggregate Supply and Aggregate Demand Model. © Pearson Education, 2005

After studying this topic, you will able to
Describe the origins of macroeconomics and the problems with which it deals Describe the trends and fluctuations in economic growth Describe the trends and fluctuations in unemployment Describe the trends and fluctuations in inflation Describe the trends and fluctuations in government and international deficits Identify the macroeconomic policy challenges and describe the tools available for meeting them Define GDP and use the circular flow model to explain why GDP equals aggregate expenditure and aggregate income Explain two ways of measuring GDP Explain how we measure economic growth, real GDP and the GDP deflator Explain how real GDP is used as an indicator of economic welfare and describe its limitations Explain what determines aggregate supply Explain what determines aggregate demand Explain macroeconomic equilibrium and the effects of changes in aggregate supply and aggregate demand on economic growth, inflation and the business cycle Explain UK economic growth, inflation and business cycles by using the AS-AD model. Explain the main schools of thought in macroeconomics today QUESTIONS FOR MACROECONOMICS Will tomorrow’s world be more prosperous than today? Will jobs be plentiful? Will the cost of living be stable? Will the government and the nation remain in deficit? 2. CONTEXT FOR THE DEVELOPMENT OF MACROECONOMICS Economists began to study economic growth, inflation, and international payments during the 1750s Modern macroeconomics dates from the Great Depression, a decade ( ) of high unemployment and stagnant production throughout the world economy. John Maynard Keynes book, The General Theory of Employment, Interest, and Money, began the subject. 3. Short-Term Versus Long-Term Goals Keynes focused on the short-term issues of unemployment and lost production. “In the long run,” said Keynes, “we’re all dead.” During the 1970s and 1980s, macroeconomists became increasingly concerned with the long-term issues of inflation and economic growth. © Pearson Education, 2005

Economic Growth Economic Growth in the United Kingdom
This figure shows real GDP in the United Kingdom from 1963 to 2003. The figure highlights: Fluctuations of real GDP Smoother growth of potential GDP During the 1970s and early 1980s, real GDP growth slowed—a productivity growth slowdown. Economic growth is the expansion of the economy’s production possibilities—an outward shifting PPF. We measure economic growth by the increase in real GDP. Real GDP—real gross domestic product—is the value of the total production of all the nation’s farms, factories, shops, and offices, measured in the prices of a single year. Potential GDP is the value of real GDP when all the economy’s labour, capital, land, and entrepreneurial ability are fully employed. Real GDP fluctuates around potential GDP in a business cycle—a periodic but irregular up-and-down movement in production. © Pearson Education, 2005

Economic Growth Every business cycle has two phases:
1. A recession is a period during which real GDP decreases for at least two successive quarters. 2. An expansion is a period during which real GDP increases. and two turning points: 1. A peak 2. A trough © Pearson Education, 2005

Economic Growth This figure shows the most recent UK cycle.

Economic Growth This figure shows the UK cycles over the past 150 years. © Pearson Education, 2005

Economic Growth The Lucas Wedge
The Lucas wedge is the accumulated loss of output from a slowdown in the growth rate of real GDP per person. Figure 19.5(a) shows that the UK Lucas wedge is some £4 trillion or four year’s GDP. © Pearson Education, 2005

Economic Growth The Okun Gap
The Okun gap is the gap between potential GDP and actual real GDP and is another name for the output gap. Figure 19.5(b) shows that the Okun gaps since 1973 are £98 billion or about 5 week’s real GDP. Benefits and Costs of Economic Growth The main benefit of long-term economic growth is expanded consumption possibilities, including more health care for the poor and elderly, more research on cancer and AIDS, better roads, more and better housing and a cleaner environment. The costs of economic growth are forgone consumption in the present, more rapid depletion of non-renewable natural resources, and more frequent job changes. © Pearson Education, 2005

Jobs and Unemployment Unemployment
Unemployment is a state in which a person does not have a job but is available for work, willing to work, and has made some effort to find work within the previous four weeks. The workforce is the total number of people who are employed and unemployed. The unemployment rate is the percentage of the people in the workforce who are unemployed. A discouraged worker is a person who available for work, willing to work, but who has given up the effort to find work. Jobs: Between 1979 and 2003 The EU economy created 10.4 million jobs The UK economy created 2.5 million jobs The US economy created 42.3 million jobs The record of job creation in the EU and UK could be better! © Pearson Education, 2005

Jobs and Unemployment Unemployment in the United Kingdom
This figure shows the UK unemployment rate since 1855. WHAT THE FIGURE TELLS US During the 1930s, the unemployment rate hit 16 percent The lowest rate occurred during World War II During the recessions, of the 1980s and 1990s, the unemployment rate climbed to 11 per cent The unemployment rate fell to about 5 percent during the 2000’s expansion Unemployment Around the World Figure 19.7 compares the EU unemployment rate with that in Japan and the United States. Japan and the United States have lower unemployment than the EU. Why Unemployment Is a Problem Unemployment is a serious economic, social, and personal problem for two main reasons: Lost production and incomes Lost human capital Lost production and income is serious but temporary. Lost human capital is devastating and permanent. © Pearson Education, 2005

Inflation Inflation is a process of rising prices.
We measure the inflation rate as the percentage change in the average level of prices or price level. The Retail Prices Index—the RPI—is a common measure of the price level. © Pearson Education, 2005

Inflation Inflation in the United Kingdom
This figure shows the UK inflation rate since 1963. Inflation was low during the 1960s … … increased during the 1970s … … and decreased during the 1980s and 1990s The inflation rate fluctuates, but it is always positive—the price level has not fallen during the years shown in the figure. A falling price level—a negative inflation rate—is called deflation. Inflation Around the World Figure 19.9 compares inflation rates in a number of countries. Industrial countries have similar inflation rates. But industrial countries have lower inflation rates than developing countries. Is Inflation a Problem? Unpredictable changes in the inflation rate are a problem because they redistribute income in arbitrary ways between employers and workers and between borrowers and lenders. A high inflation rate is a problem because it diverts resources from productive activities to inflation forecasting. Eradicating inflation is costly because it brings a period of greater than average unemployment. © Pearson Education, 2005

Surpluses and Deficits
Government Budget Surplus and Deficit If a government collects more in taxes than it spends, it has a government budget surplus. If a government spends more than it collects in taxes, it has a government budget deficit. © Pearson Education, 2005

This figure shows the changing surplus and deficit of the UK government since 1973. The government budget has had persistent deficits and only rarely been in surplus during these years. © Pearson Education, 2005

This figure shows The UK current account balance since 1973. There has been a persistent current account deficit since 1983 International Surplus and Deficit If a nation imports more than it exports, it has an international deficit. If a nation exports more than it imports, it has an international surplus. The current account deficit or surplus is the balance of exports minus imports plus net interest paid to and received from the rest of the world. © Pearson Education, 2005

Macroeconomic Policy Challenges and Tools
Five widely agreed policy challenges for macroeconomics are to: 1. Boost economic growth 2. Stabilize the business cycle 3. Lower unemployment 4. Keep inflation low 5. Reduce government and international deficits Two broad groups of macroeconomic policy tools are : Fiscal policy—making changes in tax rates and government spending Monetary policy—changing interest rates and changing the amount of money in the economy © Pearson Education, 2005

Gross Domestic Product
GDP Defined GDP or gross domestic product, is the market value of all final goods and services produced in a country in a given time period. What exactly is GDP? How do economic statisticians arrive at the GDP number and what does the number tell us? How do we take the effects of inflation out of GDP to compare economic well-being over time? And how to we compare economic well-being across countries? © Pearson Education, 2005

This definition has four parts: Market Value GDP is a market value  goods and services are valued at their market prices. Final Goods and Services GDP is the value of the final goods and services produced. A final good (or service) is an item bought by its final user during a specified time period. Produced Within a Country GDP measures production within a country  domestic production. In a Given Time Period GDP measures production during a specific time period Excluding intermediate goods and services avoids double counting  normally a year or a quarter of a year. Market Value: To add apples and oranges, computers and ice cream, we add the market values so we have a total value of output in pounds. Final Goods and Services: A final good contrasts with an intermediate good, which is an item that is produced by one firm, bought by another firm and used as a component of a final good or service. Excluding intermediate goods and services avoids a problem called double counting. {Final goods versus intermediate goods. The distinction between final and intermediate goods is one of the key points in this first section. Use some standard examples to make the key point—tires and autos, chips and computers, and so on. Also, if you want to spend a bit of time on this topic, tell your students about the Bureau of Economic Analysis (BEA) revision in the treatment of business spending on software. The BEA began a major revision in 1998 and published the first revisions to reclassify software from intermediate to final good status in When the 1996 GDP was recalculated to include software, it increased by $115 billion, or 1.5 percent of GDP.} © Pearson Education, 2005

GDP and the Circular Flow of Expenditure and Income GDP measures the value of production, which also equals total expenditure on final goods and total income. The equality of income and output shows the link between productivity and living standards. Figure 20.1 illustrates the circular flow of expenditure and income. © Pearson Education, 2005

We will build the circular flow shows the transactions among households, firms, governments and the rest of the world. The blue and red flows are the circular flow of expenditure and income. The green flows are borrowing and lending. FIRMS AND INDIVIDUALS Firms hire factors of production from households. The blue flow, Y, shows total income paid by firms to households. Households buy consumer goods and services. The red flow, C, shows consumption expenditures. Households save, S, and pay taxes, T. Firms borrow some of what households save to finance their investment. Firms buy capital goods from other firms. The red flow I represents this investment expenditure by firms. Note on Presentation Emphasize that the blue flows are incomes and the red flows are expenditures on final goods and services. (The expenditures on intermediate goods and services are omitted from the circular flow model.) And emphasize that the green financial flows are not part of the circular flow of expenditure and income and are shown in Figure 20.1 only so that the student can see what happens to the money that isn’t spent and how spenders get the money that they’ve not earned as income. © Pearson Education, 2005

GOVERNMENT Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than taxes. Governments buy goods and services, G, and borrow or repay debt if spending exceeds or is less than taxes. © Pearson Education, 2005

REST OF THE WORLD The rest of the world buys goods and services from us, X, and sells us goods and services, M. Net exports are X – M. And the rest of the world borrows from us or lends to us depending on whether net exports are positive or negative. EQUILIBRIUM The sum of the red flows equals the blue flow. That is: Y = C + I + G + X  M © Pearson Education, 2005

GDP Equals Expenditure Equals Income The circular flow demonstrates how GDP can be measured in two ways: by total expenditure or by total income. Total expenditure on final goods and services equals the value of final goods and services, which is GDP. Aggregate income earned from production of final goods, Y, equals the total amount paid for the use of resources: wages, interest, rent and profit. Total expenditure = C + I + G + (X – M)=Y (Income). Firms pay out all their receipts from the sale of final goods and services, so aggregate income equals total expenditure © Pearson Education, 2005

Financial Flows Financial markets finance deficits and investment. Household saving, S, is the income minus net taxes and consumption expenditure. Y = C + S + T (A) Saving flows from households to the financial markets [S]. (B) If government expenditures exceed net taxes, the deficit [G – T] is borrowed from the financial markets (if T exceeds G, the government surplus flows to the financial markets). (C) If imports exceed exports, the deficit with the rest of the world [M – X] is borrowing from the rest of the world. How investment is financed. Don’t skimp on this topic. It provides the foundation for what the student will meet in Chapter 30. Investment is financed from three sources: Private saving, S Government budget surplus, (T – G) Borrowing from the rest of the world (M – X). © Pearson Education, 2005

How Investment Is Financed We can see these three sources of investment finance by starting with the fact that aggregate expenditure equals aggregate income. Y = C + S + T = C + I + G + (X – M). Then rearrange to obtain I = S + (T – G) + (M – X) Private saving S plus government saving (T – G) is called national saving. © Pearson Education, 2005

Gross and Net Domestic Product “Gross” means before accounting for the depreciation of capital. The opposite of gross is net. To understand this distinction, we need to distinguish between flows and stocks. Flows and Stocks in Macroeconomics A flow is a quantity per unit of time; a stock is the quantity that exists at a point in time. e.g. Wealth, the value of all the things that people own, is a stock. Saving is the flow that changes the stock of wealth. © Pearson Education, 2005

Capital and Investment Capital, the plant, equipment, and inventories of raw and semi-finished materials that are used to produce other goods and services is a stock. Investment is the flow that changes the stock of capital. Depreciation is the decrease in the stock of capital that results from wear and tear and obsolescence. Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital. Net investment is the change in the stock of capital (= Gross investment  Depreciation). © Pearson Education, 2005

This figure illustrates the relationships among the stock of capital, gross investment, depreciation and net investment. Back to the Gross in GDP Gross profits, and GDP, include depreciation. Similarly, gross investment includes that amount of purchases of new capital goods that replace depreciation Net profits, net domestic product, and net investment subtract depreciation from the gross measures. The Short Run Meets the Long Run Investment plays a central role in the economy. One of the reasons why GDP grows is that the capital stock grows. One of the reasons why real GDP fluctuates is that investment fluctuates. © Pearson Education, 2005

Measuring UK GDP The Office for National Statistics uses the concepts that you met in the circular flow to measure GDP and its components, which are published in the United Kingdom National Accounts. Two approaches to measuring GDP are: The expenditure approach The income approach The low cost of economic data. You might like to tell your students that measuring real GDP is actually very cheap. We don’t have the UK or EU data. But for the United States, the Bureau of Economic Analysis that creates the national accounts employs fewer than 500 economists, accountants, statisticians, and IT specialists at an annual cost of less that $70 million. It costs each American less than 0.25¢ (a quarter of a cent) to measure the value of US production. For some further perspective, the National Oceanic and Atmospheric Administration, whose mission is to “describe and predict changes in the Earth’s environment, and conserve and manage wisely the nation’s coastal and marine resources so as to ensure sustainable economic opportunities,” employs more than 11,000 scientists and support personnel at an annual cost of $3.2 billion! Most of the income data used by the ONS comes from the Inland Revenue. Expenditure data comes from a variety of sources. Creative accounting and GDP measurement. In recent years, the first estimates of GDP, which are based on companies reported profits, have been revised downward when data on company profits as reported to the IRS became available. Enron-style accounting has contaminated the initial estimates of GDP but not the final estimates. You can make a nice point with one example of creative accounting. For some years, in its reports to stock holders AOL recorded its advertising expenditure as investment and amortized it over a number of years. First, you can explain that the correct treatment of this item is as an expenditure on intermediate goods and services by AOL and as a charge against AOL profit. The expenditure on AOL services is the value of AOL’s production. And AOL’s expenditure on advertising is part of the value of the production of the advertising agencies used by AOL. You can go on to explain that AOL accounting practice would misleadingly swell GDP by causing some double counting. On the expenditure approach, AOL’s advertising expenditure shows up as investment in the national accounts. On the income approach, because the expenditure is not a cost, it swells profit, so AOL’s corporate profit increases by the same amount as its “investment.” If AOL filed its income tax return in this same way, the national income accounts wouldn’t get corrected. But if when AOL files its tax returns it calls its advertising a cost and lowers its profits by that amount, the BEA picks up these numbers from the IRS and the national accounts get adjusted appropriately. © Pearson Education, 2005

Measuring UK GDP The Expenditure Approach
The expenditure approach measures GDP as the sum of consumption expenditure, investment, government expenditures on goods and services and net exports. The Income Approach The income approach measures GDP by summing the incomes that firms pay households for the factors of production they hire. Table 20.1 in the textbook shows the expenditure approach with data for 2003. © Pearson Education, 2005

Measuring UK GDP The Income Approach
In the United Kingdom National Accounts, incomes are divided into three categories Compensation of employees Gross operating surplus Mixed incomes The sum of these three income components is gross domestic income at factor cost. GDP is gross domestic product at market prices. Market prices and factor cost would be the same except for indirect taxes and subsidies. To get from factor cost to market prices, we add indirect taxes and subtract subsidies. Table 20.2 in the textbook shows the income approach with data for 2003. © Pearson Education, 2005

Measuring Economic Growth
Real GDP is the value of final goods and services produced in a given year when valued at constant prices. The first step in calculating real GDP is to calculate nominal GDP. Nominal GDP Nominal GDP is the value of goods and services produced during a given year valued at the prices that prevailed in that same year. When GDP increases, we know that either We produced more goods and services or We paid higher prices Producing more goods and services contributes to an improvement in our standard of living. Expansion of production is economic growth. Paying higher prices means our cost of living has increased. Ballooning of prices is called inflation. © Pearson Education, 2005

The table provides data for 2002 and 2003. (A) 2002, nominal GDP is: Expenditure on balls £100 Expenditure on bats £100 Nominal GDP £200 (B) 2003, nominal GDP is: Expenditure on balls £80 Expenditure on bats £495 Nominal GDP £575 Item Quantity Price 2002 Balls 100 £1.00 Bats 20 £5.00 2003 160 £0.50 22 £22.50 © Pearson Education, 2005

Nominal GDP was £200 in 2002 and £575 in 2003, so nominal GDP increased by £375. The percentage increase in nominal GDP was (£375/£200)  100 = per cent. How much of this per cent increase is an increase in production and how much is just the effect of higher prices? The answer is found by valuing the 2003 quantities at 2002 prices. Chain-weighted output index method. Do take the time to explain the chain-weighted method. The textbook has stripped the explanation down to the bare bones and makes the approach intelligible to any student willing to make a small amount of effort. © Pearson Education, 2005

Current-year Production at Previous-year Prices Expenditure on balls in 2003 valued at 2002 prices is £160. Expenditure on bats in 2003 valued at 2002 prices is $110. Value of 2003 quantities at 2002 prices is £270. Item Quantity Price 2002 Balls 100 £1.00 Bats 20 £5.00 2003 160 £0.50 22 £22.50 © Pearson Education, 2005

With prices constant, GDP was £200 in 2002 and £270 in 2003. So production increased by £70  a 35 per cent increase. (£70/£200)  100 = 35 per cent. Production in 2003 valued at 2003 prices was £575 compared with £270 when valued at 2002 prices. So the increase from £270 to £575 was due to higher prices in 2003. © Pearson Education, 2005

We’ve separated the £375 change in GDP into an economic growth component of £70 and an inflation component of £305. Chain Linking We have compared production in two adjacent years, but to make comparisons across a number of years we link each year to a base year. The resulting measure of real GDP is called a chained volume measure. © Pearson Education, 2005

To see how chain linking works, let’s take the base year as 2001. Table 20.5 on the next slide shows the data: The blue numbers are nominal GDP in 2001, 2002 and 2003. The black numbers are real GDP valued at prices in the previous year. We’re going to fill in the (?) cells. © Pearson Education, 2005

GDP in Valued in prices of Real GDP in 2001 prices 2001 2002 2003 £50 ? £100 £200 £270 £575 © Pearson Education, 2005

Because 2001 is the base year, real GDP in 2001 equals nominal GDP in 2001, which is £50. Production in 2002 valued at 2001 is real GDP of £100. What is production in 2003 valued at 2001 prices? It is the value of 2003 production in 2002 prices chain linked back to 2001 prices. To link 2003 back to 2001, we apply the growth rate we calculated for 2003 (35 per cent) to real GDP in 2002. © Pearson Education, 2005

Real GDP in 2002 valued in 2001 is £100. Production in 2003 grew by 35 per cent. So real GDP in 2003 is 35 per cent higher than real GDP in 2002 and is £135. The red numbers in Table 20.5 on the next slide shows real GDP linked back to 2001. © Pearson Education, 2005

GDP in Valued in prices in Real GDP in 2001 prices 2001 2002 2003 £50 £100 £200 £270 £575 £135 © Pearson Education, 2005

Calculating the Price Level The average level of prices is called the price level. One measure of the price level is the GDP deflator, which is an average of current-year prices expressed as a percentage of the base-year prices. © Pearson Education, 2005

Nominal GDP and real GDP are calculated in the way that you’ve just seen. GDP Deflator = (Nominal GDP/Real GDP)  100. In 2001, the GDP deflator 100 by definition. Year Nominal GDP Real GDP GDP deflator 2001 £50 100 2002 £200 £100 2003 £575 £135 © Pearson Education, 2005

In 2002, the GDP deflator is (£200/£100)  100 = 200. In 2003, the GDP deflator is (£575/£135)  100 = Year Nominal GDP Real GDP GDP deflator 2001 £50 100 2002 £200 £100 200 2003 £575 £135 425.9 © Pearson Education, 2005

Deflating the GDP Balloon Nominal GDP increases because production  real GDP  increases. © Pearson Education, 2005

Nominal GDP also increases because prices rise. © Pearson Education, 2005

We use the GDP deflator to let the air out of the nominal GDP balloon and reveal real GDP. © Pearson Education, 2005

Uses and Limitations of Real GDP
We use real GDP for three main purposes: Economic welfare comparisons: Economic welfare is a comprehensive measure of the general state of well-being. International welfare comparisons: Real GDP is used to compare economic welfare in one country with that in another. Forecasts for stabilization policy: Real GDP is used to measure fluctuations in economic activity. Omissions from GDP. A discussion of omissions from GDP can arouse students’ interest. For example, you might point out that if one of your students mows her/his own lawn, the value of the student’s production doesn’t show up in GDP. But if you hire the student to mow your lawn (and if your student reports the income earned correctly to the tax authorities), the value of the student’s production does show up in GDP. Why don’t we measure all lawn mowing as part of GDP? Some reasons are cost of collecting data and the degree of intrusiveness we’d be willing to tolerate. But note how little we spend on collecting the GDP data and how relatively inexpensive it would be to add some questions about domestic production to either the Labor Force Survey or the Family Expenditure Surveys. The inclusion of the imputed rental of owner-occupied houses, but not owner-used cars and other durables, is a good example. You might like to explain how the omission of illegal goods and services also leads to some misleading comparisons. For instance, the day before prohibition ended, the production of (illegal) beer was not counted as part of GDP. But the day after prohibition ended, the production of (now legal) beer counted. Ask your students to suggest two good reasons why illegal goods and services are omitted. First, the data are hard (but not impossible) to obtain. Second, there may be the moral position that illegal activities should not be included in GDP. This latter observation can lead to an interesting discussion. Ask the students if they think that the production of, say, marijuana should be included in GDP. Some, maybe even many, of them will see no problem with this. Real GDP is not a perfect measure of economic welfare for seven reasons: 1. Quality improvements tend to be neglected in calculating real GDP, so the inflation rate is overstated and real GDP understated. 2. Real GDP does not include household production, that is, productive activities done in and around the home by members of the household. 3. Real GDP, as measured, omits the underground economic activity, which is illegal economic activity or legal economic activity that goes unreported for tax avoidance reasons. 4. Health and life expectancy are not directly included in real GDP. 5. Leisure time, a valuable component of an individual’s welfare, is not included in real GDP. 6. Environmental damage is not deducted from real GDP. 7. Political freedom and social justice are not included in real GDP. International Welfare Comparisons: Two special problems arise in making these comparisons. 1. Real GDP of one country must be converted into the same currency units as the real GDP of the other country, so an exchange rate must be used. Using the exchange rate to compare real GDP in one country with real GDP in another country is problematic because prices of particular products in one country may be much less or much more than in the other country. 2. The same prices should be used to value the goods and services in the countries being compared, but often are not. International comparisons and PPP prices. Students sometimes see estimates of GDP per person in developing nations. Most such estimates are extremely low, and students often ask how people can live on such low incomes. Point out that the estimate is biased downward in two ways. First, in poor nations, more transactions do not go through a market than in rich nations. For example, transportation services in developing nations include a lot of walking, which is not counted as part of GDP. In richer nations, people ride a bus or subway and pay a fare, which is counted as part of GDP. Second, many locally produced and consumed goods and services have extremely low prices in poor nations. For example, a haircut that costs £20 in London might cost £0.50 in Calcutta. (You might get a better haircut in London, but probably not one that is 20 times better!) Converting Indian GDP into UK pounds at the market exchange rate leaves this bias in the data. Using purchasing power parity prices to convert India’s GDP into UK pounds avoids this bias. Forecasts for Stabilization Policy: The timing of these fluctuations are probably accurate but the changes in real GDP probably overstate the changes in total production and people’s welfare caused by business cycles. © Pearson Education, 2005

Catching the Wave If you want a good economic ride, you must catch a wave. But economic waves are hard to read. What makes the economy ebb and flow in waves around its long-term growth trend? Why do some wave rise high and then crash, and sometimes rise and roll on a long high? How do waves in the global economy spread around the world? © Pearson Education, 2005

Aggregate Supply The quantity of labour (L )
Aggregate Supply Fundamentals The aggregate quantity of goods and services supplied depends on three factors: The quantity of labour (L ) The quantity of capital (K ) The state of technology (T ) The aggregate production function shows how quantity of real GDP supplied, Y, depends on labour, capital and technology. The aggregate production function is written as the equation: Y = F(L, K, T ). The aggregate supply  aggregate demand model enables us to understand three features of macroeconomic performance: Growth of potential GDP Inflation Business cycle fluctuations We use the model of aggregate supply and aggregate demand to determine real GDP and the price level. THE AGGREGATE PRODUCTION FUNCTION: In words, the quantity of real GDP supplied depends on (is a function of) the quantity of labour employed, the quantity of capital, and the state of technology. The larger is L, K, or T, the greater is Y. At any given time, the quantity of capital and the state of technology are fixed but the quantity of labour can vary. The higher the real wage rate, the smaller is the quantity of labour demanded and the greater is the quantity of labour supplied. © Pearson Education, 2005

Aggregate Supply Full employment Above full employment
The labour market can be in any of three states: Full employment Above full employment Below full employment The wage rate that makes the quantity of labour demanded equal to the quantity supplied is the equilibrium wage rate and the labour market is at full employment. At full employment, real GDP is potential GDP and the unemployment rate is called the natural rate of unemployment. Over the business cycle, employment fluctuates around full employment and real GDP fluctuates around potential GDP. We distinguish two time frames associated with different states of the labour market: Long-run aggregate supply Short-run aggregate supply © Pearson Education, 2005

Aggregate Supply Long-run Aggregate Supply
The macroeconomic long run is a time frame that is sufficiently long for all adjustments to be made so that real GDP equals potential GDP and full employment prevails. The long-run aggregate supply curve (LAS) is the relationship between the quantity of real GDP supplied and the price level when real GDP equals potential GDP. Along the LAS curve—two things happening. Students seem comfortable with the idea that the SAS curve has a positive slope; but they seem less at ease with the vertical LAS curve. Emphasize (as the textbook does) the crucial idea that along the LAS curve two sets of prices are changing — the prices of output and the prices of resources, especially the money wage rate. Once they get this point, students quickly catch on to the result that firms won’t be motivated to change their production levels along the LAS curve. The vertical LAS curve is both vital and difficult and class time spent on this concept is well justified. © Pearson Education, 2005

Aggregate Supply This figure shows an LAS curve with potential GDP of £1,000 billion. The LAS curve is vertical because potential GDP is independent of the price level. Along the LAS curve all prices and wage rates vary by the same percentage so that relative prices and the real wage rate remain constant. © Pearson Education, 2005

Aggregate Supply Short-run Aggregate Supply
The macroeconomic short run is a period during which real GDP has fallen below or risen above potential GDP. At the same time, the unemployment rate has risen above or fallen below the natural rate of unemployment. The short-run aggregate supply curve (SAS) is the relationship between the quantity of real GDP supplied and the price level in the short run when the money wage rate, the prices of other factors of production and potential GDP remain constant. © Pearson Education, 2005

Aggregate Supply This figure shows a short-run aggregate supply curve.
Along the SAS curve, a rise in the price level with no change in the money wage rate and other factor prices increases the quantity of real GDP supplied  the SAS curve is upward sloping. The SAS curve is upward sloping because: A rise in the price level with no change in costs induces firms to bear a higher marginal cost and increase production. A fall in the price level with no change in costs induces firms to decrease production to lower marginal cost. One LAS curve-many SAS curves. Another way of reinforcing the distinction between the two AS curves is to point out to students that at any given time, there is just one LAS curve, corresponding to potential GDP. But there is an infinite number of possible SAS curves, each corresponding to a different money wage rate. Along the SAS curve, real GDP might be above potential GDP… … or below potential GDP. © Pearson Education, 2005

Aggregate Supply Movements along the LAS and SAS Curves
This figure summarizes what you’ve just learned about the LAS and SAS curves. A change in the price level with an equal percentage change in the money wage rate creates a movement along the LAS curve. A change in the price level with no change in the money wage rate creates a movement along the SAS curve. © Pearson Education, 2005

Aggregate Supply Changes in Aggregate Supply
Aggregate supply changes if any influence on production plans other than the price level change. Changes in Potential GDP (LAS) for three reasons: 1. Change in the full-employment quantity of labour; 2. Change in the quantity of capital; 3. Advance in technology. Changes in SAS: Changes in the Money Wage rate and Other Resource Prices. A change in the money wage rate changes short-run aggregate supply and shifts the SAS curve. But a change in the money wage rate has no effect on long-run aggregate supply. The LAS curve does not shift. © Pearson Education, 2005

Aggregate Supply This figure shows how these factors shift the LAS curve and have the same effect on the SAS curve. When potential GDP increases, both the LAS and SAS curves shift rightward. © Pearson Education, 2005

Aggregate Supply This figure shows the effect of a rise in the money wage rate on aggregate supply. Short-run aggregate supply decreases and the SAS curve shifts leftward. Long-run aggregate supply does not change and the LAS curve does not shift. © Pearson Education, 2005

Aggregate Demand The quantity of real GDP demanded, Y, is the total amount of final goods and services produced in the domestic economy that people, businesses, governments and foreigners plan to buy. This quantity is the sum of consumption expenditures, C, investment, I, government expenditures, G, and net exports, X – M. That is: Y = C + I + G + X – M. Buying plans depend on many factors and some of the main ones are: 1. The price level; 2. Expectations; 3. Fiscal policy and monetary policy; 4. The world economy Keep it simple. You know that the AD curve is a subtle object—an equilibrium relationship derived from simultaneous equilibrium in the goods market and the money market. This description of the AD curve is not helpful to students in the principles course and is a topic for the intermediate macro course. At the same time that we want to simplify the AD story, we also want to avoid being misleading. The textbook walks that fine line, and we suggest that you stick closely to the textbook treatment and don’t try to convey the more subtle aspects of AD. Not a strict ceteris paribus event. A major problem with the AD curve is that a change in the price level that brings a movement along the curve is not a strict ceteris paribus event. A change in the price level changes the quantity of real money, which changes the interest rate. Indeed, this chain of events is one of the reasons for the negative slope of the AD curve. In telling this story, we must be sensitive to the fact that the student doesn’t yet know about the demand for money. We must provide intuition with stories (like the Maria stories in the textbook) without referring to the demand for money. Income equals expenditure on the AD curve. Some instructors want to emphasize a second and more subtle violation of ceteris paribus, that along the AD curve, aggregate planned expenditure equals real GDP. That is, the AD curve is not drawn for a given level of income but for the varying level of income that equals the level of planned expenditure. If you want to make this point when you first introduce the AD curve, you must cover the AE model of Chapter 24 before you cover this chapter. (The material is written in a way that permits this change of order.) If you do not want to derive the AD curve from the equilibrium of the AE model, don’t even mention what’s going on with income along the AD curve. Silence is vastly better than confusion. You can pull this rabbit out of the hat when you get to Chapter 24 if you’re covering the material in the order presented in the textbook. © Pearson Education, 2005

Aggregate Demand The Aggregate Demand Curve
Aggregate demand is the relationship between the quantity of real GDP demanded and the price level. The aggregate demand curve (AD) plots the quantity of real GDP demanded against the price level. © Pearson Education, 2005

Aggregate Demand This figure shows an AD curve.
The lower the price level, the greater the quantity of real GDP demanded. The higher the price level, the smaller the quantity of real GDP demanded. © Pearson Education, 2005

Aggregate Demand The AD curve slopes downward for two reasons:
Wealth effect Substitution effects Wealth effect: A rise in the price level, other things remaining the same, decreases the quantity of real wealth (money, bonds, stocks, etc.). To restore their real wealth, people increase saving and spend less, so the quantity of real GDP demanded decreases. Similarly, a fall in the price level, other things remaining the same, increases the quantity of real wealth. With more real wealth, people decrease saving and spend more, so the quantity of real GDP demanded increases. Substitution effects: Intertemporal substitute effect is a substitution across time. A rise in the price level, other things the same, decreases the real value of money and raises the interest rate. With a higher interest rate, people borrow less and spend less, so the quantity of real GDP demanded decreases. Similarly, a fall in the price level increases the real value of money and lowers the interest rate. With a lower interest rate, people borrow more and spend more, so the quantity of real GDP demanded increases. Intertemporal substitution effect A rise in the price level, other things remaining the same, decreases the real value of money and raises the interest rate. Faced with a higher interest rate, people try to borrow and spend less so the quantity of real GDP demanded decreases. Similarly, a fall in the price level increases the real value of money and lowers the interest rate. Faced with a lower interest rate, people borrow and spend more so the quantity of real GDP demanded increases. International substitution effect is a substitution across goods made in different countries. A rise in the UK price level, other things the same, increases the price of UK-made goods relative to foreign-made goods, so UK imports increase and UK exports decrease, which decreases the quantity of UK real GDP demanded. Similarly, a fall in the UK price level, other things the same, decreases the price of UK-made goods relative to foreign-made goods, so UK imports decrease and UK exports increase, which increases the quantity of UK real GDP demanded. © Pearson Education, 2005

Aggregate Demand Changes in Aggregate Demand
A change in any influence on buying plans other than the price level changes aggregate demand. The main influences on aggregate demand are: Expectations Fiscal policy and monetary policy The world economy Expectations: Expectations about future income, future inflation and future profits change aggregate demand today. Increases in expected future income increase people’s consumption today and increases aggregate demand. A rise in the expected inflation rate makes buying goods cheaper today than in the future and increases aggregate demand today. An increase in expected future profits boosts firms’ investment, which increases aggregate demand today. Fiscal Policy and Monetary Policy: Fiscal policy is the government’s attempt to influence the economy by setting and changing taxes, making transfer payments and buying goods. A tax cut or an increase in transfer payments increases households’ disposable income  aggregate income minus taxes plus transfer payments. Consumption expenditure increases, which increases aggregate demand. Government purchases of goods and services is a component of aggregate demand, so more government expenditure on goods and services increases aggregate demand. Monetary policy consists of changes in interest rates and the quantity of money in the economy. An increase in the quantity of money increases buying power and increases aggregate demand. A cut in interest rates increases expenditure and increases aggregate demand. The World Economy: The world economy influences aggregate demand in two ways: A fall in the foreign exchange rate lowers the price of UK-made goods relative to foreign-made goods, increases UK exports, decreases UK imports, and increases UK aggregate demand. An increase in foreign income increases the demand for UK exports and increases UK aggregate demand. © Pearson Education, 2005

Aggregate Demand This figure illustrates changes in aggregate demand.
When aggregate demand increases, the AD curve shifts rightward… … and when aggregate demand decreases, the AD curve shifts leftward. © Pearson Education, 2005

Macroeconomic Equilibrium
Short-run Macroeconomic Equilibrium Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve. Short-run macroeconomic equilibrium. Emphasize that in short-run macroeconomic equilibrium, firms are producing the quantities that maximize profit and everyone is spending the amount that they want to spend. Describe the convergence process using the mechanism laid out on page 138 of the textbook. In that process, firms always produce the profit-maximizing quantities—the economy is on the SAS curve. If they can’t sell everything they produce, firms lower prices and cut production. Similarly, they can’t keep up with sales and inventories are falling, firms raise prices and increase production. These adjustment processes continues until firms are selling their profit-maximizing output. Emphasize also that with a fixed (sticky) money wage rate, this short-run equilibrium can be at, below, or above potential GDP. © Pearson Education, 2005

This figure illustrates a short-run macroeconomic equilibrium. If real GDP is above equilibrium GDP, firms decrease production and lower prices… … and if real GDP is below increase production and raise prices. These changes bring a movement along the SAS curve towards equilibrium. In short-run equilibrium, real GDP can be greater than or less than potential GDP. © Pearson Education, 2005

Long-run Macroeconomic Equilibrium Long-run macroeconomic equilibrium occurs when real GDP equals potential GDP  when the economy is on its LAS curve. Long-run macroeconomic equilibrium. You can use the idea that there is only one LAS curve-but many SAS curves to explain long-run equilibrium. In long-run equilibrium, real GDP equals potential GDP on the one LAS curve. The money wage rate is at the level that makes the SAS curve the one of the infinite number of possible SAS curves that passes through the intersection of AD and LAS. From the short run to the long run. Explain that market forces move the money wage rate to the long-run equilibrium level. At money wage rates below the long-run equilibrium level, there is a shortage of labour, so the money wage rate rises. At money wage rates above the long-run equilibrium level, there is a surplus of labour, so the money wage rate falls. At the long-run equilibrium money wage rate, there is neither a shortage nor a surplus of labour and the money wage rate remains constant. Shifting the SAS curve. Reinforce the movement toward long-run equilibrium with a curve-shifting exercise. Take the case where the AD curve shifts rightward. The fact that the initial equilibrium occurs where the new AD curve intersects the SAS curve is not difficult. But the notion that the SAS curve shifts leftward as time passes is difficult for many students. The trick to making this idea clear is to spend enough time when initially discussing the SAS so that the students realize that wages and other input prices remain constant along an SAS curve. Once the students see this point, they can understand that, as input prices increase in response to the higher level of (output) prices, the SAS curve shifts leftward. Avoid confusing students by using ‘up’ to correspond to a decrease in SAS. But do point out that that when the SAS curve shifts leftward it is moving vertically upward, as input prices rise to become consistent with potential GDP and the new long-run equilibrium price level. Most students find it easier to see why the SAS curve shifts leftward once they see that rising input prices shift the curve vertically upward © Pearson Education, 2005

This figure illustrates long-run macroeconomic equilibrium. Long-run equilibrium occurs where the AD and LAS curves intersect and results when the money wage rate has adjusted to put the SAS curve through the long-run equilibrium point. © Pearson Education, 2005

Economic Growth and Inflation Economic growth occurs because Quantity of labour grows, Capital is accumulated Technology advances Inflation occurs because the quantity of money grows faster than potential GDP, which increases aggregate demand by more than long-run aggregate supply. All these factors increase potential GDP and shift the LAS curve rightward and this results in Economic Growth. The AD curve shifts rightward faster than the rightward shift of the LAS curve and this results in inflation. © Pearson Education, 2005

The Business Cycle The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate but the money wage rate does not change rapidly enough to keep real GDP at potential GDP. © Pearson Education, 2005

A below full-employment equilibrium is an equilibrium in which potential GDP exceeds real GDP. These figures illustrate below full-employment equilibrium. The amount by which potential GDP exceeds real GDP is called a recessionary gap. © Pearson Education, 2005

A long-run equilibrium is an equilibrium in which potential GDP equals real GDP. These figures illustrate long-run equilibrium. © Pearson Education, 2005

An above full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP. These figures illustrate above full-employment equilibrium. The amount by which real GDP exceeds potential GDP is called an inflationary gap. Figure 22.11(d) shows how, as the economy moves from one type of short-run equilibrium to another, real GDP fluctuates around potential GDP in a business cycle. © Pearson Education, 2005

Fluctuations in Aggregate Demand Figure shows the effects of an increase in aggregate demand. Part (a) shows the short-run effects. Starting at long-run equilibrium, an increase in aggregate demand shifts the AD curve rightward. © Pearson Education, 2005

Fluctuations in Aggregate Demand Starting at long-run equilibrium, an increase in aggregate demand shifts the AD curve rightward. Firms increase production and raise prices  a movement along the SAS curve. In the short run, the economy is at above full-employment equilibrium. Fluctuations in Aggregate Demand: Figure shows the effects of an increase in aggregate demand. Part (a) shows the short-run effects. Starting at long-run equilibrium, an increase in aggregate demand shifts the AD curve rightward. © Pearson Education, 2005

The money wage rate begins to rise and short-run aggregate supply begins to decrease. The SAS curve shifts leftward. The price level rises and real GDP decreases until it has returned to potential GDP. Figure 22.12(b) shows the long-run effects of an increase in aggregate demand. Real GDP increases, the price level rises, and in the new short-run equilibrium, there is an inflationary gap. © Pearson Education, 2005

Fluctuations in Aggregate Supply This figure shows the effects of a decrease in aggregate supply. Starting at long-run equilibrium, a rise in the price of oil decreases short-run aggregate supply and the SAS curve shifts leftward. Real GDP decreases and the price level rises. The combination of recession and inflation is called stagflation. © Pearson Education, 2005

Economic Growth, Inflation and Cycles in the UK Economy
From1963 to 2003: Real GDP grew from £395 billion to £1,035 billion. The price level rose from 8 to 106. Business cycle expansions alternated with recessions. Figure interprets the changes in real GDP and the price level each year from 1963 to 2003 in terms of shifting AD and SAS curves. The figure shows the business cycle, … long-term economic growth,… …. and inflation Putting the AS-AD model to work. Don’t neglect the predictions of the model. This is the payoff for the student. With this simple model, we can now say quite a lot about growth, inflation, and the cycle. The price level doesn’t fall, and real GDP rarely falls. The AS-AD model predicts a fall in the price level when either aggregate demand decreases or aggregate supply increases. And the model predicts that real GDP decreases when either aggregate supply or aggregate demand decreases. Students are sometimes bothered by this apparent mismatch between the predictions of the model and the observed economy. The best way to handle this issue is to emphasize that in our actual economy, AS and AD almost always are increasing. When we use the model to simulate the effects of a decrease in either AS or AD, we’re studying what happens relative to the trends in real GDP and the price level. A fall in the price level in the model translates into a lower price level than would otherwise have occurred and a slowing of inflation. The story is similar for real GDP. © Pearson Education, 2005

Economic Growth, Inflation and Cycles in the UK Economy
Real GDP growth was rapid during the 1960s and 1990s and slower during the 1970s and 1980s. Inflation Inflation was the most rapid during the 1970s. Business Cycles Recessions occurred during the mid-1970s, 1980–1982 and 1990–1992 (& 2008?) © Pearson Education, 2005

Macroeconomic Schools of Thought
Macroeconomists divide into three broad schools of thought. We examine their views: The Keynesian view The Classical view The Monetarist view The flavor of the Keynesian-Classical-Monetarist views. The textbook explains the controversies in macroeconomics more fully when it reviews the business cycle and policy debate in Chapters 31 and 32. But if you want to convey the flavor of the controversies in macroeconomics earlier in the course, you can do so right now, using only the aggregate supply and aggregate demand curves. The difference between the upward-sloping SAS and the vertical LAS lies at the core of the disagreement between Classical economists who believe that wages and prices are highly flexible and adjust rapidly and Keynesian economists who believe that the money wage rate in particular adjusts very slowly. View about the most important shifters of aggregate demand enable you to distinguish between Keynesians and monetarists. The Keynesian View: A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full employment and that to achieve and maintain full employment, active help from fiscal policy and monetary policy is required. The Keynesian view is based on beliefs that: Expectation are the most significant influence on aggregate demand and The money wage rate behind short-run aggregate supply doesn’t fall. Keynesian Policy: The Keynesian view calls for fiscal policy and monetary policy to actively offset the changes in aggregate demand that bring recession. By stimulating aggregate demand, full employment can be restored. The Classical View: A classical macroeconomist believes that the economy is self-regulating and that it is always at full employment. The fluctuations that do occur are efficient responses of a well-functioning market economy that is bombarded by shocks, mainly coming from the uneven pace of technological change. Classical Policy: The classical view emphasizes the potential for taxes to create inefficiency. By minimizing the disincentive effects of taxes, employment, investment and technological advances are at their efficient levels and the economy expands at an appropriate rate. Monetarist Policy: The monetarist view of policy is the same as the classical view. Taxes should kept low to avoid disincentive effects that decrease potential GDP. Provided monetary growth is kept steady, no stabilization is needed to offset the changes in aggregate demand. © Pearson Education, 2005

Topic 9 Basics of Macroeconomics and the Aggregate Supply and Aggregate Demand Model. © Pearson Education, 2005.

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Topic 9 Basics of Macroeconomics and the Aggregate Supply and Aggregate Demand Model. © Pearson Education, 2005.

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