ECON102: Principles of Macroeconomics (2021.A.01)

The Mechanics of The Course (1)

The Demand Side

• The aggregate demand (AD) curve represents the expenditure (demand) side of the economy. 
• Aggregate demand curve will relate price changes with changes in 'real' expenditures.
• Demand side of the economy will be the expenditure side of the economy!

$\text{Y = C + I + G + NX }$ (what we learned above)

• We will prove later in the course that the AD curve slopes down (take my word for it now). As prices increase, aggregate demand in the economy will fall. 

The AD Curve: Graphical Representation

Let Y = Real GDP

Let P = the aggregate price level (measured by some price index)

 

The AD curve does not need to slope down linearly - it could have some curvature. We draw it linearly for simplicity.

The AD curve only shifts when C, I, G, or NX changes.

The Mechanics of The Course (2) 

The Supply Side

• The aggregate supply (AS) curve represents the production (supply) side of the economy. The supply side of the economy is determined by firm production.
• Aggregate supply curve relates price changes with changes in production.
• The focus of next week's lecture will be on the aggregate production function for the economy. 

Y = f(inputs in the economy; land, labor, machines, oil, etc)

• We will prove later in the course that the short run AS curve slopes upward (take my word again!). As prices increase, aggregate production in the economy will rise. 

The AS Curve: Graphical Representations 

Let Y = Real GDP

Let P = the aggregate price level (measured by some price index)

The short run AS curve is not linearly sloped. We usually draw it linearly for simplicity. In the real world, the SRAS curve is flatter at lower levels of GDP.

The AS curve only shifts when the price of factors of production change (things like oil prices, wages, and such) or the means of production change (technology) – wait for next week!

LONG RUN: Potential Output (Y*)

• Potential Output (Y*) is going to be the level of output in the economy where the economy is in long run equilibrium. In other words, if no shocks hit the economy, the economy will stay at Y* (or it will gravitate towards Y*).

(ok, that definition is kind of technical, what does Y* really mean?)

• Think of it this way, Y* is the level of economic activity that the economy was designed to sustain:

• We will formalize this (and all concepts) as the course progresses.

Macroeconomic Equilibriums

• Short run equilibrium: AD = AS
• Long run equilibrium: AD = AS = Y* (economy at its potential level)

• Formal definition of "recession": Y < Y*.
• Formal definition of "expansion": Y > Y*

• Note: Y* is not static – it evolves over time (as does AD and AS).

We are going to eventually model a "three equation dynamic system".

Short run equilibrium: AD equals short run AS (SRAS)

What does that mean? What is produced is equal to what is purchased (total expenditures).

Long run equilibrium: AD equals short run AS at the potential level of output 

What does that mean? What is produced is equal to what is purchased and what is produced is equal to the sustainable level of production. 

How are these equilibriums ensured? prices in the economy adjust (price level, interest rates, wages).

Business Cycles vs. Economic Growth

• Business cycle analysis focuses on high frequency movements of Y

• Economic growth analysis focuses on the evolution of Y* over time.

Demand Shocks

The relationship between inflation and output when aggregate demand shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS) 

If the economy receives a negative aggregate demand shock, short run equilibrium will move from point (a) to point (b). Output will fall (from Y* to Y'). Prices will fall (from P to P').

If the economy receives a negative aggregate demand shock short run equilibrium If the economy receives a negative aggregate demand shock, short run equilibrium will move from point (a) to point (b). Output will fall (from Y* to Y’). Prices will fall (from P to P’).

Demand shocks cause prices and output to move in the same direction. (You should be able to illustrate a positive demand shock)

Supply Shocks

The relationship between inflation and output when aggregate supply shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS) 

If the economy receives a negative short run aggregate supply shock, short run equilibrium will move from point (a) to point (c). Output will fall (from Y* to Y''). Prices will rise (from P to P'').

Supply shocks cause prices and output to move in opposite directions. (You should be able to illustrate a positive supply shock)

Reinterpreting the Business Cycle Data 1970-2001