Aggregate means to add up, aggregation usually implies that the things being added up are similar, but not exactly identical

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1 Macro Short Run AS & Model Essentials Up to this point, our discussions of unemployment, inflation, output, and income have revolved around how we measure theses indicators of economic performance. Now we want to focus on understanding how real world events and government policy change these measures of economic performance. Our tool for understanding how these events and policy changes affect inflation, unemployment, and output will be the aggregate supply and demand model. Aggregate means to add up, aggregation usually implies that the things being added up are similar, but not exactly identical The Short Run Aggregate Supply/Aggregate Demand Model Similar to our basic supply and demand model Output of all goods, measured by Real GDP, is on the horizontal axis Confusingly, we use on the horizontal axis as the symbol for Real GDP The price level, often measured by the GDP Deflator, is on the vertical axis In the short run model, we assume that input prices are fixed Sort Run Equilibrium = Short Run Equilibrium Occurs where the curve intersects the curve Why is this model useful? It allows us to see how real world events and policy changes affect output, unemployment, and the price level. Inflation can be tracked on the vertical axis. Real output/income and unemployment can be tracked on the horizontal axis.

2 Example Demand pull inflation resulting from a tax cut Demand pull inflation occurs when from increased overall demand for final goods and services bids up prices silver lining: real output increases from E to and unemployment likely falls Example Cost push inflation resulting from a higher oil prices Cost push inflation occurs when rising input prices force up the cost of production and therefore the prices of final goods and services also known as stagflation worst of all possible worlds: prices rise, real output falls, unemployment rises relatively uncommon occurrence, thankfully significant stagflation during the 970s Misery index = the unemployment rate + the rate of inflation

3 Aggregate Demand defined as the quantity of real domestic product that households, firms, government agencies, and foreign buyers wish to purchase at each price level, ceteris paribus = C + I + G + (X M) Components of Consumption (C) essentially all spending by households on final goods and services except new homes Investment (I) has 3 components: spending by households on new homes, spending by firms on new capital equipment, additions to inventories by firms Government Purchases (G) purchases of goods and services by the government, (this does not include transfer payments) Net Exports (X M) spending by foreign citizens on our final goods and services minus spending by our citizens on foreign final goods and services Short Run Aggregate Supply the quantity of real domestic product firms are willing to produce at each price level, ceteris paribus Slope of the curve Generally speaking, has a positive slope Higher prices of final goods and services lead to higher profits for firms if input costs are sticky Input costs are often assumed to be sticky due to the fact that wages and prices of other inputs are often fixed by long term contracts Slope of is a bone of contention responsible for a number of disagreements in modern macroeconomics Important because the steepness affects the outcome of policy changes Classical thought argues that it is very steep, even vertical Keynesian argues that it is much flatter, even horizontal at times Keynesian section represents a revision of thought resulting from the Great Depression Shape of the curve Remember, = C + I+ G + (X M) Generally speaking, we believe that has a negative slope for 3 reasons. ) Wealth, or real balances, effect ) Interest rate effect 3) Foreign purchases effect/net export effect

4 Wealth effect acts through consumer expenditures (C) as the price level of final goods and services falls, the quantity of goods and services that your nominal wealth will purchase increases (purchasing power, or real wealth, increases) this is true for wealth held in the form of bank deposits, etc. real wealth increase so, as P decreases, real wealth rises, we feel richer and spend more so consumption rises and increases Interest rate effect curve is drawn assuming that the supply of money is fixed as the price level falls, fewer dollars are needed to purchase goods and services demand for dollars falls price of dollars falls price of the dollar is known as the interest rate projects and home ownership become more affordable as interest rates drop investment rises as the interest rate falls so, as falls, the demand for money falls, interest rates fall, and therefore investments rise, and increases i S i E i E D Money Market D Q Net export, or foreign purchases, effect we buy foreign goods because they are cheaper than domestic goods same holds true for foreigners if our falls compared to the in other countries, our goods become more attractive residents of other countries, so our exports rise simultaneously, their goods become less attractive to us, so our imports fall as a result, (X M) rises so, as our decreases compared to the in other countries, net exports (X M) rise and therefore rises

5 Why are AS/ models useful? AS/ models can be used to predict how real world events and economic policies might change output, unemployment, and inflation. We need to understand what makes the curves shift in order to understand these changes. What factors would shift the curve? remember = C+I+G+(X M) anything that affects the desire of HH, firms, the government, or foreign citizens to purchase final goods and services will shift the curve Consumption determinants ) Changes in real wealth stock market gains ) Expectations regarding wealth, income, etc. 3) Indebtedness flip side of wealth 4) Taxes on wealth, income Investment determinants ) Interest rates ) Expectations regarding the profitability of projects 3) Business taxes esp. capital gains and ITC's 4) Technological change 5) Degree of excess capacity Government spending determinants ) Whatever the government decides to spend Net exports determinants ) Foreign national income ) Exchange rates 3) Tariffs and quotas What factors shift the curve? ) Wages and other input prices not the general price level ) Changes in productivity new technology allows greater output at constant price 3) Changes in the legal/institutional environment changing tax and regulatory structures affect the firms incentives, and ability, to produce

6 Example China grows rapidly Output and income are flip sides of the same coin If Chinese output rises, Chinese incomes rise Some of their additional income will be spent on goods and services from the U.S., so our exports rise shifts out Result: Real GDP rises, unemployment falls, the price level rises Example Consumer confidence takes a dive as Congress becomes more dysfunctional Nervous consumers put off large projects and new purchases of durable goods Consumption, and therefore, falls shifts back Result: Real GDP falls, unemployment rises, the price level falls

7 Example 3 New fracking technology makes it easier to extract oil and natural gas This reduces the cost of two major inputs shifts out Result: Real GDP rises, unemployment falls, the price level falls Example 4 Congress mandates months paid maternity leave for mothers and fathers from all jobs This essentially makes employees much more expensive shifts back Result: Real GDP falls, unemployment rises, the price level rises