Chapter 1 1 Macroeconomics

Supply

Most important determinant of the size of the macroeconomy while demand just tags along

Demand

Most important factor in the size of the macroeconomy while supply just tags along

Say’s Law

“Supply creates its own demand”

Neoclassical Economists

Economists who generally emphasize the importance of aggregate supply in determining the size of the macroeconomy over the long run

Over periods of years or decades, as the productive power of an economy to supply goods and services increases, total demand in the economy grows at roughly the same pace

Keynes’ Law

“Demand creates its own supply”

Can apply well in the short run of months to years, when many firms experience either a drop in demand for their output during a recession, or so much demand that they have trouble producing enough during an economic boom

Aggregate Demand/Aggregate Supply Model

A model that shows what determines total supply or total demand for the economy, and how total demand and total supply interact at the macroeconomic level

Aggregate Supply (AS)

The total quantity of output (i.e., real GDP) firms will produce and sell

Aggregate Supply (AS) Curve

Shows the total quantity of output (i.e., real GDP) that firms will produce and sell at each price level

Potential GDP

The maximum quantity that an economy can produce given full employment of its existing levels of labor, physical capital, technology, and institutions

Full-Employment GDP

Another name for potential GDP, when the economy is producing at its potential and unemployment is at the natural rate of unemployment

Aggregate Demand (AD)

The amount of total spending on domestic goods and services in an economy

Aggregate Demand (AD) Curve

Shows the total spending on domestic goods and services at each price level

Short Run Aggregate Supply (SRAS) Curve

Positive short run relationship between the price level for output and real GDP, holding the prices of inputs fixed

Long Run Aggregate Supply (LRAS) Curve

Vertical line at potential GDP showing no relationship between the price level and real GDP in the long run

Two of the most important factors that can lead to shifts in the AS curve:

productivity growth
changes in input prices

The aggregate supply curve can also shift due to unexpected shocks to
input goods or labor.

Examples: large weather events affecting crops or an overseas war that requires a
large number people to fight instead of work.

Stagflation

an economy experiences stagnant growth and high inflation at
the same time

Remember that the components of aggregate demand are:

• consumption spending
• investment spending
• government spending
• spending on exports minus imports.

A shift of the AD curve to the right means

that at least one of these components
increased so that a greater amount of total spending would occur at every price
level

A shift of the AD curve to the left means

that at least one of these components
decreased so that a lesser amount of total spending would occur at every price
level

Higher government spending

cause AD to shift to the right, while lower
government spending will cause AD to shift to the left

Tax cuts for individuals

tend to increase consumption demand, while
tax increases will tend to diminish it

Tax policy

pump up investment demand by offering lower tax rates
for corporations or tax reductions that benefit specific kinds of investment

The vertical line representing potential GDP (or the “full employment level of
GDP”

gradually shift to the right over time as well.

Remember, there are two types of unemployment:

Short run variations in unemployment (cyclical unemployment) caused by the
business cycle as economy expands and contracts

Long run unemployment rate (typically hovers around 5% in U.S.) when the
economy is healthy

The AD/AS diagram shows cyclical unemployment by how close the
economy is to the potential or full GDP employment level

Low cyclical unemployment for an economy occurs when the level of output
is close to potential GDP
High cyclical unemployment arises when the output is substantially to the left
of potential GDP

The AD/AS framework implies two ways that inflationary pressures may
arise:

If the aggregate demand continues to shift to the right when the economy is already
at or near potential GDP and full employment, thus pushing the equilibrium into the
AS curve's steep portion
A rise in input prices that affects many or most firms across the economy (e.g., oil or
labor) and causes the aggregate supply curve to shift back to the left

Keynesian zone

portion of the SRAS curve where GDP is far below
potential and the SRAS curve is flat

If the AD curve crosses a portion of the SRAS curve in the Keynesian
zone, the equilibrium level of real GDP is far below potential GDP, so:

the economy is in recession,
cyclical unemployment is high,
inflationary price pressure is not much of a worry

Neoclassical zone

portion of the SRAS curve where GDP is at or near
potential output where the SRAS curve is steep

If the AD curve crosses a portion of the SRAS curve in the neoclassical
zone, the equilibrium is near potential GDP, so:

cyclical unemployment is low (structural unemployment may remain an
issue),
the only way to increase the size of the real GDP is for AS to shift to the right,
shifts in AD will create pressures to change the price level

Intermediate zone

portion of the SRAS curve where GDP is below
potential but not so far below as in the Keynesian zone; the SRAS
curve is upward-sloping, but not vertical in the intermediate zone

If the AD curve crosses a portion of the SRAS curve in the
intermediate zone, we expect unemployment and inflation to move in
opposing directions

A shift of AD to the right will move output closer to potential GDP:

-Reduce unemployment
-Higher price level and upward pressure on inflation.

A shift of AD to the left will move output further from potential GDP:

-Raise unemployment
-Lower price level and downward pressure on inflation.