Aggregate Market Model Aggregate Demand () is derived from Snarrian aggregate expenditure by imposing the AE equilibrium ( = AE ) and then solving for. AE = [W + e r mpc T + I + G + X ] + { mpc mpm } is the relationship between the quantity of real GDP demanded and the price level when all other influences on expenditure plans remain the same Short-run Aggregate Supply () is the relationship between the quantity of real GDP supplied and the price level in the short-run when all other influences on expenditure plans remain the same. Long-run Aggregate Supply () is the value of potential output ( p ) and determine equilibrium real GDP and the. The difference between real GDP and potential GDP determines the unemployment rate. Aggregate Demand Snarrian Aggregate Demand is found by substituting AE = [W + e r mpc T + I + G + X ] + { mpc mpm} = [W + e r mpc T + I + G + X ] + { mpc mpm} = [W + e r mpc T + I + G + X ] + {mpc mpm} 1 = [W + e r mpc T + I + G + X ] + {mpc mpm 1} = [W + e r mpc T + I + G + X ] { mpc + mpm + 1} = [W + e r mpc T + I + G + X ] {1 mpc + mpm} = [W + e r mpc T + I + G + X ] {mps + mpm} 1
Aggregate Demand Snarrian Aggregate Demand Example: In addition to W = 5, e = 7, =, r = 2, mpc =.75, and T = 3, assume, investment expenditures total $1 trillion (I = 1), government expenditures total $3.5 trillion (G = 3.5), exports total $.5 trillion (X =.5) with mpm =.25. Derive the AE equation. First, ignore the fact that = because is the relationship between real GDP and = [W + e r mpc T + I + G + X ] { mps + mpm } Aggregate Demand Snarrian Aggregate Demand Example: =.75.5.75 By assumption, aggregate planned expenditure equals real GDP ( = AE ). Recall that in the AE model, = 9.5 when = at the Keynesian equilibrium point. 9.5 2
Aggregate Demand Snarrian Aggregate Demand Example: What happens if government spending is increased by $.5 trillion? = [5 + 7 2.75 3 + 1 + 3.5 +.5] {.25 +.25}.75 9.5 Aggregate Demand Snarrian Aggregate Demand Example: What happens if taxes are lowered by $.5 trillion instead? = [5 + 7 2.75 3 + 1 + 3.5 +.5] {.25 +.25}.75 9.5 3
Aggregate Demand Snarrian Aggregate Demand = [W + e r mpc T + I + G + X ] { mps + mpm } The Congress and President are in charge of fiscal policy. Expansionary fiscal policy involves Restrictive fiscal policy involves The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy involves Restrictive monetary policy involves Long Run Aggregate Supply Example: Suppose the economy s production function shows the volume of output that can be produced by its labor force of size L given levels of K units of capital, R units of resources and Z percent of the knowledge/talent that is contained in the universe. Suppose resources, capital, & technology/talent are currently at R =.4 (trillion dollars of land, oil, coal, natural gas ), K = 2.5 (trillion dollars of machines, roads, networks ) and z = 1 (percent of all knowledge in the universe is known on Earth). 1. What is the economy s short-run production function? 4
Long Run Aggregate Supply 2. Graph the economy s short-run production function. L Short-run production function L. 5 7.7 1 1. 15.25 real GDP 1 6 4 2 25 5 75 1 5 15 175 Llabor Long Run Aggregate Supply 3. Suppose there are 9 million workers that are frictionally or structurally unemployed, and 135 million of the 4 million in the labor force are employed. Compute u, u n, u c, real GDP, and p. U n 9 un 6.25% L 4 L E 4 135 u 6.25% L 4 u u u 6.25 6.25 % c n real GDP 1 6 4 Short-run production function E U n 135 9 trillion $ 2 25 5 75 1 5 15 175 Llabor 5
Long Run Aggregate Supply 4. Graph with. p = =.75.5.75 Long Run Aggregate Supply 5. Suppose there are 9 million workers that are frictionally or structurally unemployed, and 1 million of the 4 million in the labor force are employed. Compute u, u n, u c, real GDP, and p. U n 9 un 6.25% L 4 L E 4 1 u 22.22% L 4 u u u 22.22 6.25 15.97% c n real GDP 1 6 4 Short-run production function E U n 1 9 11 trillion $ 2 25 5 75 1 5 415 175 Llabor 6
Long Run Aggregate Supply 6. Suppose there are 9 million workers that are frictionally or structurally unemployed, and 135 million of the 4 million in the labor force are employed, with 5 million of them working 6 hours per week. Compute u, u n, u c, real GDP, and p. U n 9 un 6.25% L 4 L E 4 135 u 6.25% L 4 u u u 6.25 6.25 % c n real GDP 1 6 4 2 Short-run production function 25 5 75 1 5 415 175 Llabor Long Run Aggregate Supply 7. Suppose technology rises to 1.1 percent. Re-graph the economy s production function, and re-compute full-employment output. 1.1 1.4 2.5 L Short-run production function 1 real GDP 6 4 2 25 5 75 1 5 415 175 Llabor 7
Long Run Aggregate Supply. Graph the initial with and final.75 6.75 Short Run Aggregate Supply is the relationship between the quantity of real GDP supplied and when all other influences on production plans remain the same As p gets increasingly positive, u u n gets increasingly negative prices generally rise Thus, the output gap is positively related to the price level p = B + b( p ) = [B b p ] + b For simulation purposes, let B be the sum of the following w be the money wage rate p be the money prices of other resources t be supply-side taxation (includes regulations)
Short Run Aggregate Supply Snarrian Example: In addition to R =.4 (trillion dollars of land ), K = 2.5 (trillion dollars of machines ), Z = 1 (percent of all knowledge is known to man), U n = 9 (million frictionally or structurally unemployed workers), E = 135 (million), and L = 4 (million), suppose nominal wages are 2.25 (thousand dollars per month), the nominal price of other production factors is.75 (thousand dollars per month), and the supply-side tax rate is 5 (percent). 1. Graph the potential GDP you computed in part (3) with p = = [ w + p + t b p ] + b Short Run Aggregate Supply Snarrian 2. Graph : = -4 + -4 9
Short Run Aggregate Supply Snarrian 3. What happens if government cuts supply-side taxes by 1 percentage point? = [ 2.25 +.75 + 5 ] + -4 Short Run Aggregate Supply Snarrian = [w + p + t b p ] + b AS The Congress and President are in charge of fiscal policy. Expansionary supply-side fiscal policy involves cutting t Restrictive supply-side fiscal policy involves raising t The Federal Reserve (our central bank) is in charge of monetary policy Expansionary monetary policy lowers the federal funds interest rate Restrictive monetary policy raises the federal funds interest rate 1
Aggregate Market Model 4. Graph with : p = = -4 + Aggregate Market Model 5. Suppose technology/talent increases by.1 percentage points. Show the effect of this on and. 1.4 2.5 L -4 11
Aggregate Market Model 6. Graph, & : p = =.75.5 = -4 +.75 6.75-4 Aggregate Market Model 6. Graph, & : p = =.75.5 = -4 +.75 Recessionary gap 7.167 11.167
Aggregate Market Model 6. Graph, & : p = =.75.5 = -4 + = [5 + 7 2.75 3 + 1 + 3.5 +.5] {.25 +.25}.75 Raising G by $1.25t, shifts, and closes the recessionary gap. Recessionary gap 7.167 11.167 Aggregate Market Model 6. Graph, & : p = =.75.5 = -4 + = [5 + 7 2.75 3 + 1 + 3.5 +.5] {.25 +.25}.75 Cutting T by $1.667t, shifts, and closes the recessionary gap. Recessionary gap 7.167 11.167 13
Aggregate Market Model 7. Graph, & : p = =.5 = -6 + 6-6 Aggregate Market Model 7. Graph, & : p = =.5 = -6 + Workers work overtime and/or more than one job, and firms compete for scarce labor. 7.167 Inflationary gap -6 13.333
Aggregate Market Model 7. Graph, & : p = =.5 = -6 + Over the long run, laissez faire permits innovation. 7.167 Inflationary gap 13.333 Aggregate Market Model. Graph, & : p = =.5 = -4 + = [W + e r mpc T + I + G + X] {.25 +.25} Induced Inflationary gap 15