A Model of the Macro-Economy: Aggregate Demand and SupplyOPTIONAL: http://www.colorado.edu/Economics/courses/econ2020/section7/section7-main.html Show
IntroductionMacroeconomics vs. Microeconomics We have defined economics as the study of how we choose to use limited resources to obtain the maximum satisfaction of unlimited human wants Macroeconomics Issues The issues discussed in macroeconomics are: 1. full employment We have already discussed the importance of these topics in reducing scarcity and receiving the maximum satisfaction possible from our limited resources. The Business Cycle Over time the levels of unemployment (UE), inflation (IN) and economic growth (EG) in an economy tend to fluctuate. These fluctuations can be illustrated on a graph of the business cycle. READ: http://www.acs.ucalgary.ca/~jwhunter/Social9/lesson_15.htm 1. Economists have given terms to the four phases of the business cycle:a. #1 = peak A Model of the Macro Economy: Aggregate Demand (AD) and Aggregate Supply (AS) We have already discussed the Supply and Demand model to determine individual prices and quantities. That was a microeconomic model. the key word is "individual" product or "Individual" industry.
Aggregate DemandDefinition Aggregate demand is the demand of all products in an economy - OR the relationship between the Price Level and the level of aggregate output (real GDP) demanded. Be able to define: Graphically: down-sloping -- why? Economists have three explanations of why the AD curve is downward sloping from left to right. They are:
We want to understand why if the Price Level increases why does the amount of aggregate output (real GDP) demanded decrease? Why is the AD curve downward sloping from left to right? Price Level Þ Amount of output demanded ¯We always want to understand why the graphs that we use in economics have the shapes that they do? Are their shapes realistic? The wealth effect: When the average level of prices in the economy increases, why do consumers, governments, business and foreigners purchase less? The interest-rate effect: When the average level of prices in the economy increases, why do consumers, governments, business and foreigners purchase less? The foreign purchases effect : When the average level of prices in the economy increases, why do consumers, governments, business and foreigners purchase less? Changes in AD Just like with supply and demand in the individual product market, there are determinants that will shift the AS and AD curves. These determinants are the REAL WORLD EVENTS that cause the graphs to shift. remember, that our goal is to better understand what causes the business cycles -- or what causes UN, IN, and EG to change.
Just like with demand in the individual product market, there are determinants of AD that, if they change, will shift the AD curve. They are:
Summary of the determinants of AD:
C Þ AD C ¯ Þ¯ AD I Þ AD I ¯ Þ¯ AD G Þ AD G ¯ Þ¯ AD Xn Þ AD Xn ¯ Þ¯ AD MS Þ ¯ Interest Rates Þ I Þ AD MS ¯ Þ Interest Rates Þ I ¯ Þ¯ AD T ¯ Þ C Þ AD T Þ ¯ C Þ ¯ AD S ¯ Þ C Þ AD S Þ ¯ C Þ ¯ AD But what causes these things to change? Well, economists have identified some determinants of the main components of spending: C, I, G, and Xn. Determinants of C, I, G, and Xn: C = consumer spending (and saving) Aggregate Supply (AS)Definition Aggregate Supply is the supply of all products in an economy - OR the relationship between the Price Level and the level of aggregate output (real GDP) supplied. Graphically Graphically, we would expect the AS curve to be upward sloping. If business expect that they can get a higher price for their products (higher price level) they will want to produce MORE. But, remember that the price level is the average level of ALL prices in the economy, therefore, if the price level increases, the price of resources will also increase. Higher resource prices will encourage businesses to produce LESS. So maybe the As curve should be downward sloping???? Shape We can identify three different parts, or ranges, to the AS curve:1. Keynesian (horizontal) range Aggregate Supply and Full Employment If we want to use the AS-AD model to better understand the macroeconomic issues of UE, IN. and EG, then we need to be able to locate the "full employment level of output" - the amount of GDP that can be produced if all resources are being used. Changes in AS Increase and decrease in AS Determinants of AS Just like with supply in the individual product market, there are determinants of AS that, if they change, will shift the AS curve. They are: Summary of the Determinants of AS
price of resources ¯ Þ AS price of resources Þ ¯AS productivity Þ AS productivity ¯ Þ ¯AS business taxes and gov't red tape¯ Þ AS business taxes and gov't red tape Þ ¯AS Macroeconomic EquilibriumEquilibrium You can use the AS-AD graph to find the equilibrium price level and the equilibrium level of output: Changes in AD and the Macroeconomic Issues The reason we have developed the AS-AD model is to better understand UE, IN, and EG. Employment Changes in AS and the Macroeconomic Issues A decrease in AS would decrease output and raise the price level. This would result in more unemployment and more inflation. We call this inflation "cost-push" inflation. It is inflation caused by a decrease in AS.
Economic Growth What about economic growth? In an earlier lesson we discussed three definitions of economic growth Using the AS / AD ModelNow that we have introduced the AS / AD model, let's learn how to use it. EXAMPLE 1 Read this short article from cnnfn.com. Analyze the article by identifying the determinants of AD and/or AS that have changed. Then graph the changes on the AS-AD model. Finally use your graph to discuss has happened to UE, IN, and EG.
EXAMPLE 2 Read this short article from http://news.bbc.co.uk. Analyze the article by identifying the determinants of AD and/or AS that have changed. Then graph the changes on the AS-AD model. Finally use your graph to discuss has happened to UE, IN, and EG. [http://news.bbc.co.uk/hi/english/business/the_economy/newsid_300000/300492.stm]
Original AS/AD graph: Currently the economy of the United States is operating at the full employment level of output as shown in the graph below: Draw the changes on the graph: ¯ AS What happened to UE, IN, and EG as a result of these changes? Since equilibrium RDO decreased from RDO1 to RDO' we can conclude that UE increased and EG decreased. The price level will rise from PL1 to PL' indicating inflation. With output down and prices up, this increase in oil prices may result in stagflation. EXAMPLE 3 Is an increase in exports good for an economy? Most students will quickly answer "yes" to this question, as would most newspaper writers. But WE know better. It depends. Currently the economy of the United States is operating at the full employment level of output as shown in the graph below: An increase in exports will do what to the graph above? An increase in exports will increase AD. GRAPH IT! The result: INFLATION! So is an increase in exports good for THIS economy? NO. But, if initially the economy is experiencing high unemployment like in the graph below: Then, an increase in exports would increase AD and move the economy closer to the full employment level of output with only a little inflation. See graph: This would of course be good for the economy. So is an increase in exports good for an economy? - - It depends. EXAMPLE 4 Now you try it. Read this short article from cnn.com. Analyze the article by identifying the determinants of AD and/or AS that have changed. Then graph the changes on the AS-AD model. Finally use your graph to discuss has happened to UE, IN, and EG. Send your answers to me using the form below. http://cgi.cnnfn.com/output/pfv/2000/05/30/economy/confidence/ MORE EXAMPLES / REVIEW: For more exercises see: http://www.harper.cc.il.us/mhealy/eco212i/lectures/asad/adasprac.htm Macroeconomic PoliciesNow that we have this handy tool, let's use it to discuss government policies (NOTE: when I use the term "policies", I always mean "government policies"). What is the role of the government in a market economy? In a market economy (capitalist economy) the government has a limited role, but some people believe that the government should try to help the economy maintain full employment and low inflation. We have discussed in the 5 Es lesson that unemployment results in greater scarcity since some resources are not being used so less will be produced. Government policies may be able to help the economy achieve full employment and therefore reduce scarcity. Stabilization Policies Definition: government policies design to reduce UE and/or inflation All the policies discussed here can be classified as stabilization policies. Demand-Management Policies Definition: Policies design to shift the AD curve in order to reduce unemployment or to reduce inflation. "Supply-Side Economics" Supply-Side economic policy occurs when the government tries to increase the AS curve. this will reduce both unemployment and inflation.
REVIEW
What happens when aggregate price level increases?As the price level rises, the wealth of the economy, as measured by the supply of money, declines in value because the purchasing power of money falls. As buyers become poorer, they reduce their purchases of all goods and services.
When the US price level rises relative to foreign price levels?When the U.S. price level rises relative to foreign price levels (and exchange rates do not respond quickly or completely), foreigners buy fewer U.S. goods and Americans buy more foreign goods. the relationship between a nation's price level and the amount of real domestic output that firms in the economy produce.
How does an increase in prices affect aggregate demand?Aggregate demand goes down as the price level rises not because people are thinking “the price of GDP has gone up, so I want to purchase less of it.” Instead, a higher price level means that a given quantity of money can facilitate fewer transactions and business and consumer loans.
How does foreign trade affect the aggregate demand of a country?A major determinant of net exports is foreign demand for a country's goods and services; that demand will vary with foreign incomes. An increase in foreign incomes increases a country's net exports and aggregate demand; a slump in foreign incomes reduces net exports and aggregate demand.
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