Macro Week 5 PDF

*Limitations of the circular flow of income model* - Demand driven model\ Everything in the model is related to the demand side of the model but the supply side is equally important in regards to firms' output.\ Does account for firms' supply decisions. - Aggregate demand chang...

*Limitations of the circular flow of income model* - Demand driven model\ Everything in the model is related to the demand side of the model but the supply side is equally important in regards to firms' output.\ Does account for firms' supply decisions. - Aggregate demand changes would affect both output and prices *Aggregate Demand Curve* Looking at the relationship between total demand for economy's goods and services and economy's average price level.\ Using a GDP deflator to look at price levels as a whole, not just looking at individual products.\ Would expect that aggregate demand to decrease as prices increase. Income Effect\ - Real incomes depressed, when prices go up, wages generally don't adjust at the same rate. Reduces consumer spending, purchasing power falls. Therefore, aggregate demand falls.\ - Could be partially offset by rise in profits which could potentially lead to an increase in investment, but this is unlikely because of demand reducing. Payment of dividends to shareholders could compensate for the real income effect. Substitution Effect\ - Real balance effect (wealth effect), erosion of financial wealth could depress consumption. As prices go up, the value of people's savings is eroded so people withdraw more in order to bring their saving back up to the level.\ - Inter-temporal substitution effect (interest effect), higher prices increase demand for money which means interest rates will likely go up. Interest rates increasing encourages people to postpone spending and continue to save. Investment also goes down because it is more expensive to borrow, so aggregate demand goes down.\ - International substitution effect (net exports effect). As prices go up people will look elsewhere for goods thus seeing an increase in imports. Domestic goods are more expensive so outside countries look to buy exports less. Any changes in the AD components will shift the curve.\ Increase in AD at any given price level shifts the curve rightwards (e.g. if consumers decide to spend more)\ Decrease in AD at any given price level shifts the curve leftwards (e.g. if government decides to spend less) *Aggregate Supply Curve* Modelling relationship between firms' output and the economy's average price level. The amount of goods and services firms are willing to supply at each price level. In short run, we would expect total supply to increase as prices increase. An increase in output prices makes increasing output profitable.\ Assuming certain things are held constant like wages paid by firms because they do not change significantly in the short run. Capital equipment doesn't change rapidly.\ This means firms have increased profit because price increase faster than costs in the short run. Output response to higher prices can depend on existing levels of output. - Marginal cost of additional output may be higher at higher output levels - Spare capacity, availability of resources, availability of employment - Diminishing returns to factors of production When the curve is at its steepest, this is visually capturing when availability of resources and employment are scares and there is diminishing returns on production. The effect of changes in price level on aggregate supply are very different between the short and long run. As prices of finals goods and services rise, prices of inputs such as wages or price of resources rise more slowly.\ Firms and workers fail to accurately predict the changes in price levels. - Contracts make some wages and prices 'sticky' - Firms are often slow to adjust wages - Menu costs make some prices 'sticky' Scenario 2 for an increasing AS curve:\ When potential output rises too\ - Increase in the quantity of factors of production\ - Technology changes\ - Increased stock of human capital *\ Equilibrium* When the AD curve shifts to the right cause of increased demand. The output required is higher than the equilibrium output point (positive output gap), this will lead to the AS curve shifting left to bring the output back to equilibrium which ends up with increased prices. When the AS curve shifts to the left because of lack of supply. The output decreases because of the shortage of supply so prices also increase (negative output gap). This leads to the income and substitution effects to occur and eventually bring the output back to normal levels. Alternatively, the government could inject capital to prop up the economy which also brings output level back to potential output. *Combining the AS/AD model and Keynesian Model* This is assuming that the supply has a lot of slack meaning the prices do not change with supply. This could occur after a recession when there is a lot of available capacity for output. Now accounting for a price change in the AS curve. We can see that the equilibrium point for AD2 and E2 are different until expenditure accounts for inflation and changes in withdrawals due to price changes such as increased imports, thus creating E3. P↑ → X↓ S↑ → D~m~ ↑ → r↑ → I↓ *Unemployment and Inflation* The deflationary gap (excess capacity in the economy) W and J model - The amount by which the withdrawals exceed the injections at full employment level of national income. Y and E model -- The amount by which national income exceeds aggregate expenditure at the full employment level of national income. This gap is shrunk by adjusting taxes, increasing government spending, adjusting interest rates, increasing available capital, all to encourage spending. The inflationary gap (excess demand in the economy) W and J model -- The amount by which injections exceed withdrawals at the full employment level of national income. Y and E model -- The amount by which aggregate expenditure exceeds national income at full employment level of national income. The gap is shrunk by contraction of fiscal policy, reduce government spending, adjust taxes, reduce interest rate etc.