12.0 the basic macro model. 12.1.1 each micro concept has an analogous macro concept price : price...
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12.0 The Basic Macro Model
12.1.1
Each micro concept has an analogous macro concept
price : Price Level (P)
quantity exchanged: real GDP (Y)
The Macro Picture
P
AS
Figure 12.1.1 - Our Macro Picture
Y
AD
Y* YF
P*
In this picture,
Price level is on the vertical axis
Real GDP is on the horizontal axis
YF is full employment or full GDP
12.1.2
AD - aggregate demand
AS - aggregate supply
The intersection of these curves represents the current conditions in the macroeconomy
PMore inflation
More real GDP
More employmentLess unemployment
Y
12.1.3 - A preview
Great Depression caused by a great fall in AD
More on the specifics later, but
look what happens
P
AS
Figure 12.1.2 - Fall in AD and the Great Depression
Y
AD
Y1Y2
P'
P
Fall in AD
YF
AD'
After Pearl Harbor
war means big increase in AD, for
reasons we’ll also see later
P
AS
Figure 12.1.3- World War II and Expanding AD
Y
AD
Y2Y1
P*
P*'
Rise in AD
YF
AD'
Further,
it is not just AD which can move
AS moves due to changes in input prices,
as you will see in greater detail later
Ex. Oil shocks of the 1970’s
P
AS
Figure 12.1.4 - Oil Price Shocks and AS Shifting Up
Y
AD
Y1 YFY2
P*
P*' Shift upin AS
AS'
This should give you some idea
about how useful this macro picture can be
in explaining the world
We now need to look at each line in detail
12.2.1
Aggregate Demand (AD) is the sum of all the stuff that individuals and firms and governments are prepared to buy in a given year
How much they actually demand depends on how much things cost
The total amount planned to be spent is called
Aggregate Expenditure (AE)
AE is a nominal measure
measured in current dollars
The AD line
represents the relationship between real GDP demanded
and the price level
for a given level of aggregate expenditure
In functional form
Y = AD (P | AE)
AD slopes downward
given constant AE because
as price level (P) falls,
constant AE buys more real GDP (Y)
AE is the shift variable
more AE shifts AD to the right
P
Figure 12.2.1 - Increase in AE Shifting AD to the Right
Y
ADY1
P1
AD'
P3
P2
Y1'Y2 Y2'Y3 Y3'
12.2.2
AE is a huge number
There are six components of AE
AE = C + I + G - T + X - M
Consumption (C)
nominal value of spending done by households
(stuff you buy)
Investment (I)
nominal amount spent by firms on
plants, equipment
Government Spending (G)
nominal amount government spends
planes, tanks, schools, etc.
Taxes (T)
money taken out of hands of households by government
this represents net taxation - doesn’t count transfer payments like
Social Security where gov’t passes resources from one group to another
(G-T) is the government budget position
Exports (X)
money spent by foreigners on U.S. products
Imports (M)
money spent by U.S. citizens on foreign goods
(X-M) is the trade balance
12.2.3
Y = AD (P | AE)
while
AE = C + I + (G - T) + (X - M)
so
Y = AD (P | C, I, G, T, X, M)
a change in any of these six variables shifts AD
An increase in C, G, I, or X
will move AD right
if P stays the same, Y will increase as each of these three increases
P
AD
Y
Ex. An increase in G
AD´
The same is true for an increase in C, I or X
The reverse is true for T or M because they have a negative sign in front of them
What moves AD?
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
Example - Great Depression
Year Investment(I)
Real GDP(Y)
Unemploymentrate
1929 34.2 175.9 3.21930 23.3 159.2 8.71931 14.7 147.7 15.91932 3.3 125.3 23.61933 3.7 123.4 24.9
Decrease in I moves AD
left, ceteris paribus
P
AS
Figure 12.2.3 - The Great Depression
Y
AD
Y YFY'
Collapse of Investment Contributesto Huge AD Fall
AD'
12.2.4
Outbreak of WWII after Pearl Harbor
Huge increase in G moves AD
right, ceteris paribus
P
AS
Figure 12.2.4 - From The Great Depression to World War II
Y
AD'
Y'YFY
War Production DemandPushes AD Way Out
AD
This push moved the economy
beyond sustainable capacity
people and machines can’t keep up that pace forever
notice what happens to price level
as you move further and further right
inflation starts to become an issue
12.3.1
Aggregate supply line represents the relationship between the
Price level and real GDP produced by the economy
Actually, there are two different lines
Long-run aggregate supply
Represents situation when all micro adjustments have been completed under the nice assumptions
Most efficient condition – biggest pie
Full GDP – Full employment
The LAS line
Vertical line at full employment
Full, sustainable capacity is determined by
Initial endowment – that society’s
natural resources, labor, and capital
It is vertical because in the long-run, real GDP is independent of the price level
PLAS
Figure 12.3.1 - Long Run Aggregate Supply (LAS)
YYF
12.3.2
In the very long run endowment changes can shift LAS
Population growth, new innovations, new natural resources can move LAS steadily rightward
Natural disasters, war can move LAS leftward
We will assume
That the LAS remains stationary
in order to focus on the long run macroeconomy
We will use LAS as our orientation line for full employment
12.3.3
Short-run aggregate supply line (AS)
In the short run, we assume that not all markets have had time to adjust
Specifically, factor markets have not adjusted
Along an AS line, factor prices (like wages) are constant
PLAS
Figure 12.3.2 - Short Run Aggregate Supply
YYF
AS
12.3.4
The AS line has three distinct segments
They are labeled k, l, and m
PLAS
Figure 12.3.3 - AS Line Divided Into Segments
YYF
AS
k l
m
k-segment
is significantly below full-employment real GDP
large quantities of idle factors exist
Under these circumstances, you can hire more people and increase production without the price level increasing
12.3.5
l-segment
real GDP approaches, and then meets sustainable full employment GDP
Bottlenecks may begin to occur, because not all industries might reach capacity at the same time
Cost pressures might lead to higher output prices
Shape of l-segment is important to understanding inflation
12.3.6
m-segmenteconomy reaches limit of short-term capacityThese three distinct segments make up the AS curveYou can surge beyond what is sustainable for a while,
but people and machines can not work 24 hours a day
forever.Ex. WartimeFurther production pressure just increases the price
level
because exhausted, unproductive workers
are being paid double- or triple-time to work those extra hours
Chart p.187 shows WWII effect
Inflation only stopped by gov’t price controls
12.3.7
AS curves shift due to changes in factor prices
These factor price changes are the exogenous variables in this relationship
These exogenous shocks are called aggregate supply shocks
Ex. Oil prices, wages
P AS'
Figure 12.3.4 - A Shift Up in AS Due to Rising Factor Prices
Y
AS
A Shift Up in ASDue to RisingFactor Prices
12.4.1
Combining AD, LAS, and AS
Putting the tool kit together
P
AS
Figure 12.4.1 - Increasing Unemployment Due to Falling Aggregate Demand
Y
AD
Y YFY'
FallingAD
LAS
AD'
P
AS'
Figure 12.4.2 - Falling Unemployment and Falling Price LevelAs AS Shifts Down Due to Falling Factor Prices
Y
AD
Y'Y
P'
P
ASLAS
Effect ofFalling Factor
Prices
YF
PAS
Figure 12.4.3 - Increasing Unemployment and Rising Price LevelAs AS Shifts Up Due to Rising Factor Prices
Y
AD
YY'
P'
P
AS'
LAS
Effect of RisingFactor Prices
YF
P
AS
Figure 12.4.4 - Falling Unemployment and Rising Price LevelDue to Increasing Aggregate Demand
Y
AD'
Y'YF
Y
P
P'
LAS
AD
12.4.2
More complex case – a wage/price spiral
As inflation occurs,
workers lose value if their nominal wage remains the same
They take steps to account for inflation by demanding wage increases
in order to maintain their standard of living
This is easier to do when unemployment is low
(who else are you going to get, boss?)
This is called a tight labor market
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:
P
AS
Figure 12.4.5 - A Wage-Price Spiral
Y
AD'
YF
LAS
AD
AD"
AS'
12
34OO
OO
People would often
index their wages to the CPI in labor contracts,
Making this spiral even more likely
Wage/price spirals can become very persistent
12.4.3
Now that we have a tool to represent various macro conditions
We can look at the forces that cause the curves to move