macro

Building the Macro Model – Copy/Paste Notes

Macro Picture Basics

  • Vertical Axis = P = Price Level

  • Horizontal Axis = Y = Real GDP

At Y = YF, the economy is at:

  • Full sustainable capacity GDP

  • Natural rate of unemployment

  • Efficient use of resources

Long Run Aggregate Supply (LAS / LRAS)

Long Run Definition

The macro “Long Run” is when:

  • “All of the micro adjustments are completed under our nice assumptions”

  • The micro economy is at General Competitive Equilibrium (GCE)

  • The macro economy is at YF

LAS Characteristics

  • LAS is a vertical line at YF

  • Independent of price level

  • Represents full/potential sustainable GDP

LAS Shift Variables

LAS shifts when society’s resource endowment changes:

  • Population growth

  • Natural resource growth

  • Production capital growth

Economic Growth

  • Economic growth = LAS shifts right

  • Expands potential GDP

Short Run Aggregate Supply (AS / SRAS)

What AS Represents

AS shows:

  • Relationship between productive capacity and inflation pressure

  • Pressure created as GDP approaches/exceeds YF

Important Ideas

  • Lots of slack → little inflation

  • Less slack → more inflation pressure

  • Beyond YF → strong inflation pressure

AS Shift Variables

AS shifts due to changes in:

  • Factor prices (costs of production)

  • Productivity

Rising factor prices:

  • Shift AS up/left

  • Increase inflation

  • Reduce GDP

  • Increase unemployment

Falling factor prices:

  • Shift AS down/right

Aggregate Demand (AD)

What AD Represents

AD shows:

  • Relationship between price level and quantity of goods/services demanded

AD determines:

  • Current real GDP

  • Current price level

AD Functional Form

Y=AD(P∣AE)Y = AD(P\mid AE)Y=AD(P∣AE)

Meaning:

  • Real GDP demanded depends on:

    • Price Level (P)

    • Aggregate Expenditure (AE)

Why AD Slopes Down

For a given AE:

  • Higher P → less real stuff purchased

  • Lower P → more real stuff purchased

Aggregate Expenditure (AE)

AE=C+I+(G−T)+(X−M)AE = C + I + (G-T) + (X-M)AE=C+I+(G−T)+(X−M)

These are the shift variables of AD.

Components of AE

1. Consumption (C)

  • Consumer spending

  • 65–70% of AD

  • Usually stable

Effects

  • More C → AD shifts right (stimulative)

  • Less C → AD shifts left (contractionary)

2. Investment (I)

  • Spending on capital/inventories

  • Volatile

  • Driven by optimism/fears (“animal spirits”)

Effects

  • More I → AD shifts right

  • Less I → AD shifts left

3. Government Spending (G)

  • Government purchases/spending

Effects

  • More G → AD right

  • Less G → AD left

4. Taxes (T)

  • Government taxation

Effects

  • More T → AD left

  • Less T → AD right

Government Budget Position

(G−T)(G-T)(G−T)

  • (G − T) = 0 → Balanced Budget → Neutral

  • (G − T) < 0 → Budget Surplus → Contractionary → AD left

  • (G − T) > 0 → Budget Deficit → Stimulative → AD right

5. Exports (X)

  • Foreign spending on domestic goods

Effects

  • More X → AD right

  • Less X → AD left

6. Imports (M)

  • Domestic spending on foreign goods

Effects

  • More M → AD left

  • Less M → AD right

Trade Balance

(X−M)(X-M)(X−M)

  • (X − M) = 0 → Balanced Trade → Neutral

  • (X − M) < 0 → Trade Deficit → Contractionary → AD left

  • (X − M) > 0 → Trade Surplus → Stimulative → AD right

Key Macro Relationships

If AD Increases

  • GDP rises

  • Unemployment falls

  • Price level rises

  • Inflation may occur

If AD Decreases

  • GDP falls

  • Unemployment rises

  • Price level falls

  • Possible deflation

Great Depression Example

  • AD collapsed

  • GDP fell sharply

  • Unemployment > 25%

  • Deflation occurred

World War II Example

  • Government spending exploded

  • AD increased dramatically

  • GDP rose

  • Unemployment fell to ~1%

  • Inflation increased

Stagflation

Occurs when:

  • AS shifts up/left

  • Inflation rises

  • Unemployment rises

  • GDP falls

Example:

  • 1970s OPEC oil embargo

Important Exam Ideas

Know the Three Lines

  1. LAS

  2. AS

  3. AD

Know Their Shift Directions

  • LAS → left/right

  • AS → up-left or down-right

  • AD → left/right

Price Level is NOT a Shift Variable

  • Changes in P cause movement ALONG curves

Essential Questions Answers

1. Components of AE

AE = C + I + G − T + X − M

  • C = Consumption

  • I = Investment

  • G = Government Spending

  • T = Taxes

  • X = Exports

  • M = Imports

All are measured in nominal terms.

2. Economic Growth in the Macro Picture

  • Economic growth is shown by LAS shifting right

  • Represents growth in potential GDP

3. Falling Unemployment + Rising Price Level

  • Caused by increasing AD

  • GDP rises

  • Unemployment falls