Macroeconomics Ch. 11, 12 & 13

Chapter Overview

  • Aggregate Demand (AD) and Aggregate Supply (AS) Model: Essential for understanding the overall economy.

Learning Objectives

  • Understand the Aggregate Demand and its components.
  • Learn about shifts in AD and Aggregate Supply.
  • Explore different schools of economic thought.
  • Analyze shifts in AS and macroeconomic equilibrium.
  • Differentiate growth vs. recessions within the AD-AS model.
  • Study the impact of unemployment and inflation in the AD-AS model.
  • Understand the Keynesian spending multiplier.

Aggregate Demand Curve

  • Definition: A curve showing the quantity demanded of Real GDP (RGDP) at various price levels, ceteris paribus.
  • Characteristic: Downward sloping.

GDP by Expenditure Approach

  • Total Spending in the Economy = Consumption + Investment + Government + (Exports - Imports).
  • Aggregate Demand = Total spending in the economy defined through the expenditure approach.

Components of Aggregate Demand

Consumption
  • Disposable Income: Positively related; as income increases, consumption increases.
  • Net Wealth: Positively related; accumulated wealth enhances consumption.
  • Interest Rates: Negatively related; higher rates discourage borrowing and spending.
  • Consumer Confidence: Positively related; higher expectations boost consumption.
  • Tax Rates: Negatively related; higher taxes reduce disposable income.
Investment
  • Definition: Spending on capital goods for future production.
  • Characteristic: Independent of current income; investment occurs before income is realized.
  • Funding: Often through borrowings.
Determinants of Investment
  • Rate of Return: Positively related; higher expected profits encourage investment.
  • Interest Rates: Negatively related; higher borrowing costs deter investment.
  • Business Confidence: Positively related; higher confidence prompts investment.
Government Purchases
  • Definition: Government Spending = Government purchases + Transfer payments.
  • Note: Transfer payments are excluded from AD; fiscal policy influences government purchases significantly.
Net Exports
  • Definition: Net exports = Exports - Imports.
  • Imports: Rise with higher domestic income.
  • Exports: Independent of domestic income, driven by foreign income.
  • Economic fluctuations in one country can affect others through net exports.
Exchange Rates and Net Exports
  • Effects of Exchange Rates:
    • Appreciation of USD: Makes foreign goods cheaper and US goods more expensive; thus, imports rise and exports fall.
    • Depreciation of USD: Makes foreign goods more expensive and US goods cheaper; leading to increased exports and decreased imports.

Aggregate Supply Curve

  • Definition: A curve showing the quantity supplied of RGDP at various price levels, ceteris paribus.

Schools of Economic Thought

  • Different views on economic behavior arise from varying assumptions and historical observations.
  • Classical & Neoclassical: Assume flexible prices.
  • Keynesian & New Keynesian: Assume sticky prices.
Neoclassical Perspective
  • Assumption: The economy reaches full employment output quickly; potential RGDP is pivotal.
  • Flexible wage and price adjustments lead to short-term fluctuations around potential output.
Long Run Aggregate Supply (LRAS)
  • Economy reaches maximum sustainable output in the long run, represented as vertical LRAS at potential output (full employment).
  • Potential Output: Dependent on resources and technology, unaffected by price levels.
Keynesian Aggregate Supply Assumptions
  • Sticky Wages: Wages resistant to change in the short run due to contracts.
  • Menu Costs: Costs incurred by firms in altering prices can lead to price stickiness.
Keynesian Supply Curve
  • In the short run, AS is horizontal until full employment is reached, becoming vertical afterwards.
Synthesis in AD-AS Model
  • The AD-AS model incorporates both Keynesian stickiness and Classical flexibility.
  • Short Run Aggregate Supply (SRAS): Upward sloping due to fixed input prices initially.

Macroeconomic Equilibrium

Short-run Equilibrium
  • Condition met when quantity demanded equals quantity supplied (Qd = Qs), determining price level, RGDP, and unemployment rate.
Long-run Equilibrium
  • Achieved when Qd = Qs = short-run equilibrium, and Qs matches potential output with unemployment at its natural rate.
  • Desirable condition for economic stability.

Economic Fluctuations

  • Changes in AD or AS shift macroeconomic equilibrium, emphasizing that ideal long-run equilibrium is rarely attained.
Price Level Dynamics
  • Variations in AD lead to expansions or contractions in RGDP and fluctuations in price levels.

Supply Shocks and SRAS

Unexpected Changes in Production
  • Adverse Supply Shocks: Increase in input costs leads to a leftward shift of SRAS.
  • Beneficial Supply Shocks: Decrease in input costs or improved conditions that shift SRAS rightward.

Unemployment and Output

  • No cyclical unemployment occurs at potential output.
  • Output Gap: Difference between actual RGDP and potential output indicating economic health.
Recessionary Gap
  • Result of decreased AD leading to negative output gap and increased unemployment.
Expansionary Gap
  • Occurs with increased AD leading to overproduction, often unsustainable.
Cost-Push Inflation
  • Results from decreased SRAS, characterized by high inflation and high unemployment (stagflation).

Spending Multiplier

  • Reflects circular flow in the economy where one person's spending becomes another's income.
  • Changes in autonomous spending trigger larger impacts on AD and output.
Marginal Propensity to Consume (MPC)
  • Defined as change in consumption divided by change in income; indicates consumption habits.
Marginal Propensity to Save (MPS)
  • Complementary to MPC; MPC + MPS = 100%.

Multiplier Effect

Calculation
  • Simple spending multiplier = rac1MPSrac{1}{MPS}.
Practical Examples
  • If MPC = 60% and investment spending increases by $1000, the multiplier effect leads to a total output increase of $2500.

Summary

  • AD is downward sloping; SRAS is upward sloping while LRAS is vertical.
  • Highlights the Keynesian theory on price stickiness versus neoclassical flexibility.
  • Economics functions in equilibrium states, shifting due to variations in AD and SRAS, impacting inflation and unemployment rates.
  • Presence of cyclical unemployment indicates actual output is below potential output, and shifts in AD can lead to varying inflation types.