1. ECO 120 Macroeconomics Week 6 Review of Weeks 1-5 Lecturer Dr. Rod Duncan

2. Topics General topics covered in first 5 weeks: –Consumption function –AE function –Calculation of equilibrium in the AE model –Multiplier in the AE model –AD/AS model –Investment and the NPV concept

3. But first, the big picture We have one central model in this subject, which is the AD-AS model. We draw the AD-AS model, then our prediction about the economy is where the AD and SR AS curves intersect. Y Y0Y0 P0P0 AD AS SR P AS LR YnYn

4. The big picture We want to use the AD-AS model to discuss the real world- to talk about the consequences to the Australian economy of: –New government policies –Changes in existing government policies –Events happening outside Australia –Changes within Australia, such as introduction of new technologies or the aging of the Australian population

5. The big picture But in order to do this, we have to know what factors can affect our AD-AS model: –Why the Ad and AS curves slope the way they do? –What changes will shift the AD and AS curves and the direction of the shift? In order to know these things, we have to know how the AD and AS curves are constructed. Once you understand where the AD and AS curves come from, you understand how they behave.

6. The big picture An alternative way to teach this class would be to simply start with the AD-AS model (at Chapter 8) and then simply list the factors that shift the AD and AS curves and the direction of change. You could do everything that we can do with the AD-AS model, but you wouldn’t understand why, for example, the AD curve shifts right if consumers’ wealth rises. This understanding is why we started this subject at the consumption function.

7. A linear consumption function C(Y) = a + b Y, a > 0 and b > 0 Y C(Y) a Slope is b > 0, so C is increasing in Y. C(0) = a, so even if Y=0, C > 0.

8. Linear savings function Y C(Y) Y* C(Y*) Y* S(Y*) Y’ Negative SPositive S Y S(Y) Y’ Negative SPositive S

9. Investment demand Then we add investment demand which depends on the interest rate, i. But total spending on goods and services is a sum of: AE = C + I + G + NX I I0I0 i0i0 I i

10. Aggregate expenditure function This equation is a relationship between income (Y) and aggregate expenditure (AE). Y AE = 200 + 0.5Y $200bn Slope is 0.5 $100bn $250bn

11. Equilibrium The equilibrium value of Y is where the 45 degree line and the AE line cross. Y* is at $400bn. Y Y AE = 200 + 0.5Y 400

12. Equilibrium Equilibrium occurs at a price level where goods demand (AD) is equal to goods supply (SR AS). Y Y0Y0 P0P0 AD AS P

13. The big picture P, Wealth, H/h Expectations, H/h Taxes P, i, Business Expectations, Business Taxes C Government policy, and? G P, and? NX AEAD I

14. The big picture This is essentially the path the subject has taken so far. In the next part of the subject, we will be looking at what determines G and NX, plus a lot of other topics.