BASIC MACROECONOMIC MODELSWe can use the basic macroeconomic models to analyze scenarios and evaluate policy recommendations.This approach can be used in problems involving any macroeconomic model, including models of AD and AS, production possibilities, money markets, and the Phillips curve.
A STRUCTURE FOR MACROECONOMIC ANALYSIS No matter what the specific question is, most macroeconomic problems have the following components:1. A starting point2. A pivotal event (a change in the economy of a policy response to the initial situation)3. Secondary and long-run effects of the event (effects and move to long-run equilibrium)
THE STARTING POINT Most often you will use an AD-AS model to evaluate macroeconomic scenarios. There are three possible starting points:1. Long-run macroeconomic equilibrium: AD and SRAS both intersect on the LRAS, equilibrium at potential output.
THE STARTING POINT2. A recessionary gap: Short run macroeconomic equilibrium with aggregate output level below potential output (AD and SRAS intersect at a point below LRAS)
THE STARTING POINT3. Inflationary gap: Short run macroeconomic equilibrium with aggregate output level above potential output (AD and SRAS intersect at a point to the right of LRAS)
THE PIVOTAL EVENTThe group of determinants of change is put into small sets of major factors that influence macroeconomic models in Table 45.1 on page 446.The major factors are matched with the curves they affect.Many curves are shifted by changes in only two or three major factors.
THE PIVOTAL EVENTEven for the AD curve, which has the largest amount of associated factors, you can simplify the task by asking yourself if the event affects consumer spending, investment spending, government spending, or net exports.If the answer to any of these questions is yes, then aggregate demand shifts.
THE PIVOTAL EVENTA shift in the long-run aggregate supply curve is caused only by events that affect labor productivity or the number of workers.Remember that having correctly labeled axes on your graph is crucial to correct analysis.
FACTORS THAT SHIFT AGGREGATE DEMAND AND AGGREGATE SUPPLY AGGREGATE SHORT-RUN LONG-RUN DEMAND AGGREGATE SUPPLY AGGREGATE SUPPLYExpectations Commodity prices ProductivityWealth Nominal wages • Physical capitalSize of existing capital Productivity • Human capitalstockFiscal and monetary Business taxes • TechnologypolicyNet exports Quantity of resourcesInterest ratesInvestment spending
FACTORS THAT SHIFT DEMAND AND SUPPLY DEMAND SUPPLYIncome Input pricesPrices of substitutes and Prices of substitutes andcomplements complements in productionTastes TechnologyConsumer expectations Producer expectationsNumber of consumers Number of producers
FACTORS THAT SHIFT THE LOANABLE FUNDS MARKET DEMAND CURVE SUPPLY CURVE1. Investment opportunities 1. Private saving behavior2. Government borrowing 2. Capital inflows
FACTORS THAT SHIFT THE MONEY MARKET DEMAND CURVE SUPPLY CURVE1. Aggregate price level 1. Supply set by the Federal Reserve2. Real GDP3. Technology (related to themoney market)4. Institutions (related to themoney market)
FACTORS THAT SHIFT THE FOREIGN EXCHANGE MARKET DEMAND SUPPLYForeigners’ purchases of Domestic residents’ purchases of:domestic: • Goods• Goods • Services• Services • Assets• assets
THE PIVOTAL EVENTOften the event is a policy response to an undesirable starting point (such as a recessionary or inflationary gap).Expansionary policy is used to combat a recession and contractionary policy is used to combat inflationary pressures.
THE PIVOTAL EVENTThe Federal Reserve can implement each type of monetary policy (increase or decrease the money supply) or the government can implement expansionary or contractionary fiscal policy by raising or lowering taxes or government spending, or both.
THE INITIAL EFFECT OF THE EVENTThe event will create short-run effects in the models.In the short-run fiscal and monetary policy both affect the economy by shifting the AD curve.To illustrate the effect of a policy response, shift the AD curve on your starting point graph and indicate the effects of the shift on the aggregate price level and aggregate output.
SECONDARY AND LONG-RUN EFFECTS OF THE EVENTIn addition to the initial short-run effects of any event, there will be secondary effects and the economy will move to its long-run equilibrium after the short-run effects run their course.Negative or positive demand shocks move the economy away from long-run macroeconomic equilibrium.
SECONDARY AND LONG-RUN EFFECTS OF THE EVENTIn the absence of policy responses, such events will eventually be offset through changes in the short-run aggregate supply resulting from changes in nominal wage rates.This will move the economy back to long-run macroeconomic equilibrium.
SECONDARY AND LONG-RUN EFFECTS OF THE EVENTIf the short-run effects of an action result in changes in the aggregate price level or real interest rate, there will be secondary effects throughout the open economy.International capital flows and international trade will be affected as a result of the initial effects experienced in the economy.
SECONDARY AND LONG-RUN EFFECTS OF THE EVENTA price level decrease will encourage exports and discourage imports, causing an appreciation in the domestic currency on the foreign exchange market.A change in the interest rate affects AD through changes in investment and consumer spending.
SECONDARY AND LONG-RUN EFFECTS OF THE EVENTChanges in the interest rate affect AD through changes in imports or exports caused by the currency appreciation and depreciation.These secondary effects act to reinforce the effects of monetary policy.
LONG RUN EFFECTSWhile deviations from potential output are corrected in the long-run, other effects may remain.For example, in the long run, the use of fiscal policy affects the federal budget.Changes in taxes or government spending that lead to budget deficits can “crowd out” private investment spending in the long run.
LONG RUN EFFECTSThe government’s increased demand for loanable funds drives up the interest rate, decreases investment spending, and partially offsets the initial increase in AD.If the deficit were addressed by printing money, that would lead to problems with inflation in the long run.
LONG RUN EFFECTSIn the long run, monetary policy affects only the aggregate price level, not real GDP.Because money is neutral, changes in the money supply have on effect on the real economy.The aggregate price level and nominal values will be affected by the same proportion, leaving real values unchanged (including the real interest rate).