ECN202: Macroeconomics

ECN202: Macroeconomics

Circular Flow & Aggregate Supply-Aggregate Demand

Circular Flow DiagramThe Circular flow diagram is comparable to a wiring or plumbing diagram for a house. Here is shows the flow of money in a modern economy, and in it you can see the four key players (Households, Firms, Government, and Foreigners) and the four macro markets in which these players conduct their business (labor, output, capital, and foreign exchange). For each market there is a S & D curve and price and quantity measures that we look into later. In the circular flow you just need to “follow the money” to understand how the macro economy functions and how shocks in any market spread to the other markets.

Macro Markets, Players, & Indicators

Markets Demanders Suppliers Key Concepts

Outputcars

FirmsGDP, NI / CPI /

Productivity

Laborjob

Firms / Government

Employment / Earnings /

Unemployment

Capitalloan

Money supply / Interest Rates

Foreign Capitaltravel Foreign

Trade balances / Exchange Rates3

Demand

Supply

Each Market has one of these

Q*

P*

Price

Quantity

Headlines Headlines are about are about

Price & Output Price & Output changeschanges

4

ForeignersForeigners

Four Players

Four Markets

An overview of macro environment


OutputFirms / Households /

Government / Foreign FirmsGDP, NI / CPI /

Productivity

Labor

CapitalFirms / Households /

Government / Foreign

Firms / Households / Fed / Foreign


Foreign Capital Buyers of US “stuff”

Sellers of US “stuff” Exchange rate8

Demand

Supply

Foreign ExchangeForeign Exchange Market (US $s)

Q*

P*

Price = Exchangerate

Quantity = units of currency 9

10

What is happening to the What is happening to the value of the US $ in value of the US $ in

these two graphsthese two graphs





Productivity

Labor Firms / Government Households


Unemployment





Foreign Capital Foreign US


Demand

Supply

LaborLabor Market

Q*

P*

Price = wage

Quantity = Employment





Productivity



Unemployment






Trade balances / Exchange Rates

Demand

Supply

CapitalCapital Market

Q*

P*

Price = Interestrate

Quantity = Funds $s

What is happening here What is happening here to interest rates?to interest rates?

Demand

Supply

OutputOutput Market

Q*

P*

18





Productivity



Unemployment







What is happening to What is happening to real GDP growth rate?real GDP growth rate?

How does WW II seem How does WW II seem to divide the two to divide the two

periods?periods?

Aggregate Supply & Aggregate DemandAggregate Supply & Aggregate Demand

You have now looked at the labor and output markets, and now we are going to look at the “picture” of the output market more carefully. This is the market for ALL goods and services – cars, lawyers, school, milk – and while it looks like the S&D graph, it is not. One thing is the same – if you follow the rules you will be OK. Now we will look at the AS-AD model economists use to understand the macro economy.

AS-AD Analysis Cookbook Approach

1. Identify the participants1. AS: Suppliers (firms…)2. AD: Demanders ( firms, households,

government, foreigners)

2. Identify the determinants of behavior 3. Identify the appropriate curves

KNOW the AXES (variables)

4. Identify any special situation

Determinants of aggregate supply (AS)

1. Number of inputs Capital, labor, resources

2. Costs of production Price of inputs / resources

Productivity / efficiency of resources

3. Price level

Aggregate Supply Curve

P0

Q1

P1

Q0

PriceLevel

GDP

AS (depends on # and price of inputs & their productivity

AS has positive slope since higher prices coax out more supply

What shifts the Aggregate Supply curve?

Change in any of the factors (other than price level) that affect Aggregate Supply will change the AS curve.

Aggregate Supply Curve

P0

Q1

P1

Q0

PriceLevel

Quantity = GDP

When productivity increases @ each price Aggregate Supply has

increased and curve shifts to the right

AS

Components of aggregate demand (AD)

Who buys American “stuff” in the output market?

1.(Households) Consumption Spending

2.(Firms) Investment spending

3.(Government) Government spending

4.(Foreigners) Export & Import spending

Determinants of aggregate demand (AD)What affects demand for American “stuff”?

1.Consumption Spending (Households)Income, expectations, interest rate…

2.Investment spending (Firms)Profit, expectations, interest rate…

3.Government spending (Government)Policies, state-of-economy, interest rate…

4.Export spending (Foreigners)Income, expectations, exchange rate in ROW

5.Import spending (US firms & Householde)Income, expectations, exchange rate in US

Aggregate Demand Curve

AD = C+I+G+X-M

P2

Q2

P1

Q1

AD has negative slope since higher prices mean there is less money to purchase “stuff”

Aggregate Demand Curve

AD = C+I+G+X-M

P2

Q2

P1

Q1

When interest rates fall and demand for cars increases @ each price = increases Aggregate

Demand and the curve shifts to the right

AD (C+I+G+X-M)

AS(# and price of inputs,productivity)

AS-AD Model of Output Market

Q*

P*

We now have a model that helps us understand changes in the price level (CPI) and national output (GDP). We can use it to explain past changes or forecast future changes in these variables and it looks very much like the analysis of S&D. We need to look at how the economy adjusts to “shocks” to the system using the same technique.

Use AS-AD model to explain the following headlines

a. a decrease in US consumer confidence that pushes consumption spending lower

b. a significant expansion in Asia that raises Asian demand for US exports

c. an increase in the productivity of American workers

d. China growth pushes oil prices higher

Get out that pad and draw the diagrams for each question before reading on

a. Impact of decrease in US confidence that pushes consumption spending lower.

AD

AS

Cookbook approach1.Identify the participants - US consumers = AD2.Identify the determinants of behavior – Consumer confidence decrease reduced consumption spending3.Identify the appropriate curves - AD curve shifts in4.Result: lower GDP (recession) and lower inflation (price level)

b. a significant expansion in Asia that raises Asian demand for US exports.

AD

AS

Cookbook approach1.Identify the participants - Asian demand for US exports = AD2.Identify the determinants of behavior – Expansion in Asia means more income = more demand for US exports3.Identify the appropriate curves - AD curve shifts out4.Result: higher GDP and higher inflation (price level)

c. an increase in the productivity of American workers.

AD

AS

Cookbook approach1.Identify the participants - productivity of workers = AS2.Identify the determinants of behavior – Increase productivity = lower costs of production – increase AS3.Identify the appropriate curves - AS curve shifts out4.Result: higher GDP and lower inflation (price level)

d. China growth pushes oil prices higher.

AD

AS

Cookbook approach1.Identify the participants - oil prices = AS2.Identify the determinants of behavior – higher oil prices raise costs of production – reduces AS3.Identify the appropriate curves - AS curve shifts in4.Result: lower GDP (recession) and higher inflation (price level)

Note on oil price shock

In a more complete analysis you need to account for the fact the US imports a good deal of its oil and that demand for oil is inelatic so when the price goes up we do not cut demand much. In this case if the price of oil rises then US imports rise so we get the inward shift of the AS curve from higher production costs AND an inward shift in the AD curve because imports rise. In exams you should not worry about the more detailed analysis.

Here are a few more examples

a. A rise in the value of the US $ pushes US imports higher

b. A rise in interest rates slows housing sales

c. Rise in housing prices raises household wealth

d. Business confidence falls lower spending on new equipment

Get out that pad and draw the diagrams for each question before reading on

a. A rise in the value of the US $ pushes US imports higher

b. A rise in interest rates slows housing sales

c. Rise in housing prices raises household wealth

d. Business confidence falls lower spending on new equipment

See how you did

a. A rise in the value of the US $ pushes US imports higher – higher US imports affects AD – but be careful since Imports have a negative sign so higher imports reduces demand for US “stuff” – so AD decreases and shifts left.

b. A rise in interest rates slows housing sales- higher interest rates reduce demand for housing = reduce home building = reduce investment spending = shift AD in

c. Rise in housing prices raises household wealth-households feeling wealthier increase consumption spending = shift AD out

d. Business confidence falls lower spending on new equipment-lower equipment spending = lower I spending = shift AD in

Generalization: Single Shift

Price Level GDP

AD -

AD -

AS -

AS -

Based on what you have done, fill in the following table

Questions

a. What happens when oil prices rise and war spending rises?

Get out that pad and draw the diagram before reading on

Questions

b. What happens when productivity rises and exports rise due to growth in China?

Get out that pad and draw the diagram before reading on

See how you did

a. What happens when oil prices rise and war spending rises?

1. Oil prices rise = decrease in AS = shift AS inward2. War spending increases = increase in AD (G) = shift AD

outward

See how you did

b. What happens when productivity rises and exports rise due to growth in China?

1. Productivity rises = increase in AS = shift AS outward2. Exports grow = increase in AD (X) = shift AD outward

Generalizations: Double Shift

Price LevelQuantity (GDP)

ADAS

AD AS

AD AS

AD AS

Fill in this table and see what you getRemember: Double shifts mean only predict price of output

ECN202: Macroeconomics

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