Framework for Framework for Macroeconomic AnalysisMacroeconomic Analysis

Chapter 8Chapter 8

EconomyEconomy

1929 Great 1929 Great DepressionDepression

Resulted in large Resulted in large unemploymentunemployment

WWII lifted us out WWII lifted us out of the depression of the depression with increased with increased spendingspending

Micro vs. MacroMicro vs. Macro

The most fundamental difference The most fundamental difference between these two models is what between these two models is what they measure on the horizontal and they measure on the horizontal and vertical axis.vertical axis.

P

Q

One good

AD

ASPrice level

GDP

Equilibrium in MacroeconomyEquilibrium in Macroeconomy

If price level starts above equilibrium, If price level starts above equilibrium, there would be surplus capacity that would there would be surplus capacity that would pressure the price level lower. pressure the price level lower.

If price level starts below the equilibrium, If price level starts below the equilibrium, there would be shortages and the price there would be shortages and the price level would be pushed uplevel would be pushed up

Changes in the price level would lead to Changes in the price level would lead to changes in the behavior of consumers and changes in the behavior of consumers and firms until the economy stops at eq.firms until the economy stops at eq.

EquilibriumEquilibrium

AD

AS

Equilibrium

Short and LongShort and Long

Long run involves underlying Long run involves underlying economic forces that make economic forces that make themselves felt over timethemselves felt over time

Short run a period of time during Short run a period of time during which the economy transitions to the which the economy transitions to the long runlong run

KeynesianKeynesian

John Maynard KeynesJohn Maynard Keynes– General Theory of General Theory of

Employment, Interest, Employment, Interest, and Moneyand Money

– Government Government involvement in the involvement in the economyeconomy

– Keynesian theory Keynesian theory suggest that suggest that government action is an government action is an appropriate response to appropriate response to short run problemsshort run problems

Classical TheoryClassical Theory

Says law: supply Says law: supply creates its own creates its own demanddemand

Unemployment Unemployment corrected when the corrected when the marketplace marketplace figures out the figures out the profit maximizing profit maximizing mix of goods and mix of goods and services to produceservices to produce

Classical TheoryClassical Theory

Full employment: Full employment: – According to the classical view, According to the classical view,

unemployment is nothing more than a unemployment is nothing more than a transitory disequilibrium in the transitory disequilibrium in the marketplace.marketplace.

– Wages will fall when unemployment Wages will fall when unemployment existsexists

Classical TheoryClassical Theory

Downwardly flexible wagesDownwardly flexible wages– Even if the economy began to Even if the economy began to

experience a recession, both wages and experience a recession, both wages and prices would adjust downward to ensure prices would adjust downward to ensure that workers remained employed and that workers remained employed and the goods and services produced would the goods and services produced would be soldbe sold

Classical TheoryClassical Theory

Minimal government intervention in Minimal government intervention in the economythe economy– Invisible handInvisible hand

Keynesian TheoryKeynesian Theory

Savings and Savings and InvestmentInvestment– Saving motivated Saving motivated

by all too human by all too human desire to hoard or desire to hoard or to accumulate to accumulate wealthwealth

InvestmentInvestment– People had to be People had to be

optimistic about the optimistic about the future, since future, since investing involves investing involves riskrisk

– Existence of savings Existence of savings cannot create cannot create investmentinvestment

Keynesian TheoryKeynesian Theory

Sticky wages and Sticky wages and pricesprices– Wage and price Wage and price

cuts were rarecuts were rare

UnemploymentUnemployment– Classical view was Classical view was

falsefalse– If aggregate If aggregate

demand is not demand is not sufficient to keep sufficient to keep everyone everyone employed.employed.

Government Government intervention is intervention is neededneeded

Aggregate DemandAggregate Demand Relates how much real GDP Relates how much real GDP

consumers, businesses, consumers, businesses, government, and foreign government, and foreign buyers will purchase at each buyers will purchase at each price level; graphically, price level; graphically, aggregate demand slopes aggregate demand slopes downwarddownward

Real GDP varies inversely Real GDP varies inversely with changes in the price with changes in the price levellevel

Downward sloping demand Downward sloping demand curvecurve

AD

Downward slopeDownward slope

Purchasing power effectPurchasing power effect– The effect of the price level on The effect of the price level on

consumers’ ability to buy goods and consumers’ ability to buy goods and servicesservices

Wealth effectWealth effect– Higher price level would reduce the real Higher price level would reduce the real

value of savings and lead consumers to value of savings and lead consumers to spend more of their current incomesspend more of their current incomes

Downward SlopeDownward Slope

Interest rate effectInterest rate effect– A higher price level increases interest A higher price level increases interest

rates, which represent the cost of rates, which represent the cost of borrowing borrowing Higher cost of borrowing will lower Higher cost of borrowing will lower

household consumptionhousehold consumption

– International substitution effectInternational substitution effectA change in the price level changes the A change in the price level changes the

quantity demanded of real GDP through its quantity demanded of real GDP through its effects on imports and exportseffects on imports and exports

Shifts in Aggregate Demand Shifts in Aggregate Demand

Increase – shifts to the rightIncrease – shifts to the right– Consumer expectations are favorableConsumer expectations are favorable– Consumer income risesConsumer income rises– Business expectations are favorableBusiness expectations are favorable– Profit riseProfit rise– Government spending increasesGovernment spending increases– Taxes go downTaxes go down– Foreign income risesForeign income rises

Shifts in Aggregate DemandShifts in Aggregate Demand

Decrease – shift to the rightDecrease – shift to the right– Consumer and business expectations Consumer and business expectations

are unfavorableare unfavorable– Consumer income fallsConsumer income falls– Profits fallProfits fall– Taxes increaseTaxes increase– Government spending decreasesGovernment spending decreases– Foreign income fallForeign income fall

Aggregate SupplyAggregate Supply

The relationship between aggregate The relationship between aggregate output as measured by real GRP and output as measured by real GRP and the price levelthe price level

Long run – vertical curveLong run – vertical curve– Economy will produce at full Economy will produce at full

employment no matter the price levelemployment no matter the price level– Full employment output – the real GDP Full employment output – the real GDP

the economy produces when it fully the economy produces when it fully employs its resources.employs its resources.

Aggregate SupplyAggregate Supply

In the long run the desire of people In the long run the desire of people to receive incomes and the desire of to receive incomes and the desire of firms to earn profits holds firms to earn profits holds unemployment down and real GDP unemployment down and real GDP near its full employment levelnear its full employment level

L/R AS – shows the relationship L/R AS – shows the relationship between full employment GDP and between full employment GDP and the price levelthe price level

Aggregate supplyAggregate supply

Short run AS – tells how much output Short run AS – tells how much output the economy will offer in the short the economy will offer in the short run at each possible price levelrun at each possible price level

Upward slopingUpward sloping– Higher prices lead to more outputHigher prices lead to more output

Shifts in ASShifts in AS

Increase – shift rightIncrease – shift right Decrease – shift leftDecrease – shift left

Long runAS

S/R AS

Achieving Full Employment Achieving Full Employment EquilibriumEquilibrium

The long run macroeconomic The long run macroeconomic equilibrium that occurs at a full equilibrium that occurs at a full employment outputemployment output

AD

L/R AS

Equilibrium

Achieving Full Employment Achieving Full Employment

At any price level above the full At any price level above the full employment equilibrium price level, employment equilibrium price level, AS will be insufficient to support full AS will be insufficient to support full employment outputemployment output– Wages drop and people complete for Wages drop and people complete for

jobsjobs– Prices dropPrices drop– Reach equilibriumReach equilibrium

Achieving Full EmploymentAchieving Full Employment

If the actual price level were below If the actual price level were below the equilibrium, the economy would the equilibrium, the economy would overheat with aggregate purchasing overheat with aggregate purchasing power exceeding the economy's power exceeding the economy's ability to produce.ability to produce.– Firms compete for workersFirms compete for workers– Wages riseWages rise– Prices risePrices rise

Keynesian VS ClassicalKeynesian VS Classical

The debate is whether government The debate is whether government should wait for a movement along should wait for a movement along aggregate demand or to take action aggregate demand or to take action to manage aggregate demandto manage aggregate demand– Sticky wages and sticky pricesSticky wages and sticky prices

Then no change in the price level and Then no change in the price level and economy out of equilibriumeconomy out of equilibrium

Roots causes of inflationRoots causes of inflation Demand side inflationDemand side inflation

– Occurs when AD shifts to the rightOccurs when AD shifts to the right– A movement up the long run AS curve to a A movement up the long run AS curve to a

higher price level but no change in full higher price level but no change in full employment outputemployment output

Supply side inflationSupply side inflation– Occurs when long run AS shifts to the left. Occurs when long run AS shifts to the left. – A movement up the AD curve to a higher price A movement up the AD curve to a higher price

level and lower full employment outputlevel and lower full employment output– Supply shock – unexpected event that is major Supply shock – unexpected event that is major

enough to affect the overall economy and shift enough to affect the overall economy and shift ASAS