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Objectives of macroeconomic analysis and macroeconomic policy

Лекция

Макроэкономика

Тhe GDP deflator reflects what’s happening to the overall level of prices in the economy. In most systems of national accounts the GDP deflator measures the ratio of nominal (or current-price) GDP to the real (or chain volume) measure of GDP.

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2014-06-22

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Тема 8. Измерение результатов макроэкономической деятельности. Модель совокупного спроса и совокупного предложения

Objectives of macroeconomic analysis and macroeconomic policy.

  1.  High (sustainable) economic growth. Economic growth is achieved by increasing the economy's ability to produce goods and services. This goal is best indicated by measuring the growth rate of production.  Economic growth is also indicated by increases in the quantities of the resources--labor, capital, land, and entrepreneurship--used to produce goods. Russia: 2011 – 4.5%, 2012  +/- 5%; USA 2011-2%, 2012-2.2%
  2.  Low Unemployment or Full Employment. Full employment is achieved when all available resources (labor, capital, land, and entrepreneurship) are used to produce goods and services. A high unemployment rate means economy is not achieving its full economic potential. Russian unemployment: 2010 – 7.5%; 2011 - 6.6%; USA: 2010-9.6%; 2011-9.1%
  3.  Price Stability. Price level stability, meaning a low (generally between 2% and 4%) inflation rates. Russian inflation: 2010 – 8.8%; 2011 – 6.1%; USA 2010- 1.6%, 2011-3%.
  4.  Economic efficiency. Usage primarily of better resources; more developed technologies and qualified labor.  
  5.  Economic freedom. Freedom of choice for economic objects of their activity, occupation and way of making money.
  6.  Equitable distribution of income. Enhances the effectiveness of workforce performance.
  7.  Economic security. Social governmental policy.
  8.  Trade balance. (export =import). Stimulation of national production.

Conflicting goals: Economic efficiency Full Employment

Macroeconomic policy instruments: fiscal policy, monetary policy, supply-side policies

Basic macroeconomic indicators. 

  1.  Gross domestic product (GDP) - market value of all nal goods and services produced within an economy in a given period of time. Cost of intermediate goods and services not included in GDP.  Russia's GDP in PPP terms - 2011 - 6th place in the world 2.376 trillion USD. High place, but many people -> not an indicator. GDP per capita – 53rd in the world 16687 USD. Accession to WTO =>+3/4% GDP growth.

Computation of GDP:

Expenditure method: GDP = private consumption + gross investment + government spending + (exports − imports), or GDP= C+I+G+(X-M).

Production approach. "Market value of all final goods and services calculated during 1 year "

Income approach. "Sum total of incomes of individuals living in a country during 1 year"

GDP = compensation of employees + gross operating surplus + gross mixed income + taxes less subsidies on production and imports.

2.    Gross National Product (GNP) - market value of all products and services produced in one year by labour and property supplied by the residents of a country. Unlike GDP, which defines production based on the geographical location of production, GNP allocates production based on ownership. GNP was introduced by Simon Kuznets and Richard Stone, since 1992 in Russia. GNP is computed every 3 years.

3. Net domestic product (NDP) equals the gross domestic product (GDP) minus depreciation on a country's capital goods. NDP = GDP-Depreciation. NDP estimates how much the country has to spend to maintain the current GDP.

4. Net national income (NNI) (formerly ‘net national product’): gross national income minus depreciation.

5.    Personal income - an individual’s total earnings from wages, investment interest, etc.

6.    Disposable personal income - total personal income minus personal current taxes and non-tax payments.

7.   Foreign trade balance. Russia has positive trade balance (high price for energy resources on world market) 2011 Exports: $498.6 billion, Imports: $310.1 billion

8.   Gross capital formation.

GDP: calculation by costs and income.

Gross domestic product (GDP) - market value of all nal goods and services produced within an economy in a given period of time. Russia's GDP in PPP terms - 2011 - 6th place in the world 2.376 trillion USD. High place, but many people -> not an indicator. GDP per capita – 53rd in the world 16687 USD. Accession to WTO =>+3/4% GDP growth.

GNP calculation by costs: GNP = С + I + G + Еn , where private consumption (C); gross investment (I); Government purchases (G); Net exports (E).
GNP calculation by income: GNP = W + R + i + P + A + Т, where salaries of employees (W); rental income (R); interest income (income of real and money capital) (i); profits (profit of individual enterprises) (P); "income" includes depreciation (A) and indirect taxes (T) - taxes included in the price of the goods.

Nominal and real GDP.

Nominal GDP - value of goods and services measured at current prices/ GDP not adjusted to inflation. Also known as current dollar GDP or chained dollar GDP.

Real GDP – value of goods and services measured using a constant set of prices/ An inflation-adjusted measure that reflects the value of all goods and services produced in a given year, expressed in base-year prices. Unlike nominal GDP, real GDP can account for changes in the price level, and provide a more accurate figure.

Russia's GDP in PPP terms - 2011 - 6th place in the world 2.376 trillion USD. High place, but many people -> not an indicator. GDP per capita – 53rd in the world 16687 USD. Accession to WTO =>+3/4% GDP growth.

GDP deflator.

The GDP deator reects what’s happening to the overall level of prices in the economy. In most systems of national accounts the GDP deflator measures the ratio of nominal (or current-price) GDP to the real (or chain volume) measure of GDP. The formula used to calculate the deflator is:

Nominal GDP measures the current dollar value of the output of the economy. Real GDP measures output valued at constant prices. The GDP deator measures the price of output relative to its price in the base year.

Gross National Income (GNI).

GNI – income from the production factors or/ GDP less primary incomes payable to non- resident units plus primary incomes receivable from non-resident units).  An alternative approach to measuring GNI at market prices is as the aggregate value of the balances of gross primary incomes for all sectors.

GDP represents the amount of final goods and services or newly created value and GNI - the flow of primary income received by residents of the country as a result of their participation in the creation of the country's GDP and the GDP of other countries.

In developed countries, GNI > GDP, while in developing countries  GNI<GDP. This is due to the fact that developed countries provide financial and material resources, and receive revenues from developing countries for their use. In Russia, GNI < GDP, part of which forms in the form of interest on a loan, repatriation of dividends, etc.

Basic macroeconomic equations.

1. The basic macroeconomic equation (equation of income) reflects the equality of income and expenses: Y = C + I + G + Nx, (Y-income; C- consumer spending,  I-investments; G-governmental spending  on goods and services, Nx-net export). GNP calculation in open economy.

2. The equation of savings and investments.

Consider a closed economy in which there is no public sector, hence, taxes. Then: Expenditure on GDP = Consumption + Investment.
Income, or GDP, measured by income = consumption + savings.
Since the GDP and expenditure on income derived from production of GNP, are equal, then equating the equation, we have: C + I = S + C and I = S.
The total savings are divided into private (Sp), state (Sg) and saving the rest of the world (Sr):
S = Sp + Sg + Sr.
= The sum of private savings income (Y), transfers (TR),% of public debt (N), net of taxes (T) and consumption (C): Sp = (Y + TR + N - T) - S.
Public savings are defined as: Sg = (T - TR - N) - G.
If you are saving the state a positive value, they represent a budget surplus. If they are negative, then this deficit (BD): BD = - Sg.
Saving = income of the external world, which receives the external world through our imports (IM), minus the cost of our exports (X): Sr = IM - X or Sr = - NX = - Xn.
Saving the external world can be used to buy financial assets in this country to reduce foreign debt, and then we have the inflow of capital into the country. Sp + Sg + Sr = (Y + TR + NT) - C + (T-TR-N) - G + (- NX) = Y - C - G - NX;
S = I.

3.The equation of the state budget. Savings can be used for investments in real assets or to increase the financial assets. For example, there are two types of financial assets, government bonds and cash. Public savings can be used either to cover the debt, or to reduce the money supply.  Sg = - (ΔM + ΔB), where ΔM - change in the money supply; ΔB - change in the amount of bonds issued.

Real and financial sectors.

The Real sector encompasses activities related to the aggregate supply and aggregate demand in an economy. Data on this sector cover gross domestic and national product, consumption, savings, and capital formation. Demographic features of the population and labour force characteristics are closely associated with both aggregate demand and supply. Further, developments in the above areas are reflected in the movements of wages and prices at different stages from production to consumption.

The principle of the classical dichotomy (money neutrality) - one of the fundamental principles of the neoclassical theory of money asserts that the economy is divided into two sectors - the real and financial, to obey their own laws and have no direct effect on each other. The real and financial sectors are interconnected only through the establishment of the absolute level of prices, which in this case does not affect the equilibrium in the real economy. The financial sector has no effect on the formation of relative prices and real interest rates, which are set in the real economy. The principle of neutrality of money implies that monetary aggregates have no effect on real macroeconomic indicators - GDP, employment and investment. Neutrality of money observed in the long run, but not in the short and medium term.

Macroeconomic aggregates and the system of national accounting.

The basic macroeconomic aggregates are: Gross Domestic Product (GDP),Consumption, Investment, Government purchases, Net exports, Imports, Inflation, Unemployment, Population etc.

National accounts are an essential tool for evaluating, analyzing and forecasting economic phenomena. The system of national accounts (SNA) - a system of accounting achievements of the national economy, which characterizes the performance, structure, and the most important relationship between economic entities, represented as a set of interrelated macroeconomic indicators, constructed in the form of accounts and balance sheet tables. The purpose of SNA is to provide quantitative information on the creation, distribution and use of the social product, calculated on a uniform for all countries using SNA methodology and suitable for international comparisons. In other words, the SNA - an international standard for the calculation of basic macroeconomic indicators. The account is a two-way table on the left side which reflects the resources and the right - their "use". The indicators are reflected in the basic prices (excluding indirect taxes, but including subsidies).

The particular importance of national accounts: information on the structure and evolution of a country’s economy; framework used for economic forecasting; central statistical framework; help to establish a country’s economic policy; international comparisons base.

The System of National Accounts 1993 (SNA) has been prepared under the joint responsibility of the United Nations, the International Monetary Fund, the Commission of the European Communities, the OECD and the World Bank. The SNA is a comprehensive, consistent and flexible set of macroeconomic accounts intended to meet the needs of government and private-sector analysts, policy makers and decision takers. The main characteristics of SNA: Universality; Transparency; Harmonization; Flexibility. 2008 SNA, contains changes in economic structures and improvements in methodologies for measuring economic activities.

Labor market.

The labor force is dened as the sum of the employed and unemployed, and the unemployment rate is dened as the percentage of the labor force that is unemployed. labour force - number of individuals age 16 and over, excluding those in the military, who are either employed or actively looking for work. A related statistic is the labor-force participation rate, the percentage of the adult population that is in the labor force:

 

Together with the goods and nancial markets, the labor market, as a third market, completes the (open or closed) economy. While inventories in the goods market are often kept deliberately and nancial markets move to their equilibria quickly, the labor market seems to be in a state of persistent disequilibrium, as there are unemployed persons who, though willing to supply labor, do not nd a corresponding demand.

Because employed workers help to produce goods and services and unemployed workers do not, increases in the unemployment rate should be associated with decreases in real GDP. This negative relationship between unemployment and GDP is called Okun’s law: Percentage change in Real GDP= 3%-2xChange in the unemployment rate.  If the unemployment rate remains the same, real GDP grows by about 3 percent; this normal growth in the production of goods and services is a result of growth in the labor force, capital accumulation, and technological progress. In addition, for every percentage point the unemployment rate rises, real GDP growth typically falls by 2 percent.

Supply and demand. The typical roles of supplier and demander are reversed. The suppliers are individuals, who try to sell their labor for the highest price. The demanders of labor are businesses, which try to buy the type of labor they need at the lowest price. The equilibrium price for a certain type of labor is the wage rate.

Supply and demand for labor.

The Classical approach assumes that markets behave as described by the idealized supply-and-demand model: the labor market is seen as though it were a single, static market, characterized by perfect competition, spot transactions...

The labour market is an example of a factor market. Supply of labour – those people seeking employment (employees). The amount of people offering their labour at different wage rates. Involves an opportunity cost – work v. Leisure. Wage rate must be sufficient  to overcome the opportunity cost  of leisure. The share of the labor force in the active population (denitions vary, e.g., resident population from 15/18 and 65) is called the (labor) participation rate. Income effect of a rise in wages: As wages rise, people feel better off and therefore may not feel a need to work as many hours. Substitution effect of a rise in wages: As wages rise, the opportunity cost of leisure rises (the cost of every extra hour taken in leisure rises). As wages rise, the substitution effect may lead to more hours being worked. The elasticity of supply of labour depends upon: geographical mobility of labour, occupational mobility of labour.

Demand for labour – from employers. A ‘Derived Demand’ – not wanted for its own sake but for what it can contribute to production. Demand for labour related to productivity of labour and the level of demand for the product. Elasticity of demand for labour related to the elasticity of demand for the product. The demand for labour is highly dependent on the productivity of the worker – the more the worker adds to revenue, the higher the demand. Marginal Revenue Productivity: MRP = the addition to total revenue (TR) received from the sale of an additional unit of output - Worker instrumental in producing that output.

Labor market equilibrium.

Equilibrium in the labor market occurs where the supply and demand curves intersect. The equilibrium model of the aggregate labor market discussed assumes that all workers and all jobs are identical, and therefore that all workers are equally well suited for all jobs. If this was true and the labor market was in equilibrium, then a job loss would not cause unemployment: a laid-off worker would immediately nd a new job at the market wage.

The concept of full employment.

Full employment, in macroeconomics, is the level of employment rates when there is no cyclical unemployment. It is defined by the majority of mainstream economists as being an acceptable level of natural unemployment above 0%, the discrepancy from 0% being due to non-cyclical types of unemployment. Unemployment above 0% is advocated as necessary to control inflation, which has brought about the concept of the Non-Accelerating Inflation Rate of Unemployment (NAIRU was developed by Milton Fridman and Edmund Phelps, previously - Abba Lerner); the majority of mainstream economists mean NAIRU when speaking of "full" employment. Contrary to neoclassic, James Tobin considered full employment as 0% unemployment.

William Beveridge: unemployment rate of 3% was full employment.

OECD, USA gives an estimate of the "full-employment unemployment rate" of 4 to 6.4%.

Ideas associated with the Phillips curve questioned the possibility and value of full employment in a society: this theory suggests that full employment—especially as defined normatively—will be associated with positive inflation. The Phillips curve tells us also that there is no single unemployment number that one can single out as the "full employment" rate. Instead, there is a trade-off between unemployment and inflation: a government might choose to attain a lower unemployment rate but would pay for it with higher inflation rates. In 1968, Milton Friedman, leader of the monetarist school of economics, and Edmund Phelps posited a unique full employment rate of unemployment, what they called the "natural" rate of unemployment. Friedman argues that policy-makers should try to keep prices stable (a low or even a zero inflation rate). If this policy is sustained, he suggests that the economy will gravitate to the "natural" rate of unemployment automatically. Post-Keynesian economists have suggested ensuring full employment via a job guarantee program, where those who are unable to find work in the private sector are employed by the government.

Unemployment and its types.

Labor Force = Number of Employed + Number of Unemployed, the unemployment rate is dened as the percentage of the labor force that is unemployed:

Types of unemployment:

a. Frictional - consists of search and wait unemployment which is caused by people searching for employment or waiting to take a job in the near future. Could happen because of change in the composition of demand among industries or regions - a sectoral shift, when worker’s job performance is deemed unacceptable, or when their particular skills are no longer needed. Workers also may quit their jobs to change careers or to move to different parts of the country, etc… Public policy- unemployment insurance.

b. Structural - is caused by a change in composition of output, change in technology, or a change in the structure of demand. A reason for unemployment is wage rigidity—the failure of wages toadjust until labor supply equals labor demand. 3 causes of this wage rigidity: minimum-wage laws, the monopoly power of unions, and efficiency wages. Structural unemployment arises because rms fail to reduce wages despite an excess supply of labor.

 

c. Seasonal.Unemployment - that results from the normal seasonal change in aggregate economic activity.

d. Cyclical - due to recessions, (business cycle). When business cycles are at their peak, cyclical unemployment will be low because total economic output is being maximized. When economic output falls, as measured by the gross domestic product (GDP), the business cycle is low and cyclical unemployment will rise.

Natural rate of unemployment —the summation of frictional, seasonal and structural unemployment, that excludes cyclical contributions of unemployment e.g. recessions.

Negative relationship between unemployment and GDP is called Okun’s law: Percentage change in Real GDP= 3%-2xChange in the unemployment rate.  If the unemployment rate remains the same, real GDP grows by about 3 percent; this normal growth in the production of goods and services is a result of growth in the labor force, capital accumulation, and technological progress.

Any policy aimed at lowering the natural rate of unemployment must either reduce the rate of job separation or increase the rate of job nding. Similarly, any policy that affects the rate of job separation

job nding also changes the natural rate of unemployment.

Because employed workers help to produce goods and services and unemployed workers do not, increases in the unemployment rate should be associated with decreases in real GDP. This negative relationship between unemployment and GDP is called Okun’s law: Percentage change in Real GDP= 3%-2xChange in the unemployment rate.

Unemployment rate in Russia: 2011- 6.8%, 2010 -7.5% (143 millions)

Unemployment rate USA: 2011 -9.1%; 2010 - 9.6% (Population – 313 millions)

Aggregate demand (AD) and its components.

An aggregate demand curve (AD) shows the relationship between the total quantity of output demanded (measured as real GDP) and the price level (measured as the implicit price deflator). In other words, the aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices. There is a negative relationship between the price level and the total quantity of goods and services demanded, all other things unchanged. 

The Quantity Equation as Aggregate Demand: MV =PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is the amount of output. If the velocity of money is constant, then this equation states that the money supply determines the nominal value of output, which in turn is the product of the price level and the amount of output. You might recall that the quantity equation can be rewritten in terms of the supply and demand for real money balances: M/P =(M/P)d =kY, where k =1/V is a parameter determining how much money people want to hold for every dollar of income. In this form, the quantity equation states that the supply of real money balances M/P equals the demand (M/P)d and that the demand is proportional to output Y. The velocity of money V is the “flip side” of the money demand parameter k. For any fixed money supply and velocity, the quantity equation yields a negative relationship between the price level P and output Y. Figure 9-2 graphs the combinations of P and Y that satisfy the quantity equation holding M and V constant. This downward-sloping curve is called the aggregate demand curve.

The reasons for the downward sloping aggregate demand curve are:

a. Wealth or real balance effect - higher price level reduces the real purchasing power of consumers' accumulated financial assets; b. Interest-rate effect - assuming a fixed supply of money, an increase in the price level increases interest rates, which in turn, reduces interest sensitive expenditures on goods and services (e.g., consumer durables - cars etc; c. Foreign purchases effect - if prices of domestic goods rise relative to foreign goods, domestic consumers will purchase more foreign goods as substitutes.

The aggregate demand curve slopes downward: the higher the price level P, the lower the level of real quantity of goods and services demanded Y.

A decrease in the money supply shifts the aggregate demand curve inward, an increase in the money supply shifts the aggregate demand curve outward.

Determinants of aggregate demand - factors that shift the aggregate demand curve: Expectations  concerning real income or inflation (including profits from investments in business sector); Consumer indebtedness;  Personal taxes; Interest rates,  Changes in technology, Amount of current excess capacity in industry, Government spending, Net exports, National income abroad and Exchange rates.

Consumption and savings.

The main factor that determine the dynamics of consumption and savings (Keynesian economic theory) – is not the interest rate but the value of disposable income. The sum is saved after all the consumer spending is made. The interest rate influence is secondary.

Consumer function: C= a + b(Y-T), where C- consumer spending; a- autonomous consumption (it is not dependant on the disposable income); b - marginal propensity to consume; Y- income; T- tax deductions; (Y-T) или DI– disposable income.

Marginal propensity to consume (MPC) – share of increase in consumption for the consumer spending for goods and services in any change of the disposable income: MPC=∆C/∆DI.

Average propensity to consume (APC) - share of disposable income that households use for consumer goods and services: APC=C/DI.

The simple function for savings: S=-a+(I-b)(Y-T), where S- savings in private sector; a –autonomous consumption;  (I-b) – marginal propensity to save; Y- income; T- taxes.

Marginal propensity to save (MPS)share of increase in savings in any change of the disposable income: MPS=∆S/∆DI, where S- increase in savings.

Average propensity to save (APS) – share of disposable income that households save: APS=S/DI.

In short run, when current disposable income increases, APC decreases and APS increases, meaning that if family income growth, the share of consumption decreases and the share of savings increase.

In long run, APC stabilizes, because other factors influence on consumption, such as overall life standard, expected and fixed income.

Factors that define consumption and savings dynamics: household’s income; wealth accumulated in household; price level; economic expectations; value of consumer debt; level of tax burden.

Investments.

Main types: capital-productive investment; inventory investment; investments in construction of houses.

The simple function of autonomous investments: I=e-dR, where I – autonomous from the total income investment costs and expenses; e- autonomous investments? Defined by external economic factors (mineral resources, etc.), R- real interest rate, d – empirical coefficient sensitivity of investments to dynamics of interest rate.

Factors that define the dynamics of investments: expected norm of net income; real interest rate; level of taxation; changes in technology of production; cash basic capital; economic expectations; dynamics of total income.

With the increase in aggregate income, autonomous investments supplemented by stimulated investments, which rate increases with the increase in GDP. As the investments are financed from the entrepreneurial activity, and it increases with the growth of total income Y, so the investments increase with the increase of Y. With the growth of total income not only the production investment increase, but also inventory investment; investments in construction of houses because when economy grow=> stimulus for completion of the remaining capital stock increase and demand for houses grow.

Positive relationship of investments from income (function): I=e-dR+Y, where - marginal propensity to invest, Y- total income.

Marginal propensity to invest – share of increase in expenses for investments in any change of capital:

=∆I/∆Y.

The main factors of instability of investments: long terms of equipment service life; investments are not regular; change in economic expectations; cyclical fluctuations of GDP.

Actual and planned expenditures.

Actual investments include planned and not planned investments. Non-planned investments – unexpected changes of investments in inventories. These investments perform as leveling mechanism which harmonize actual values of savings and investments and establish macroeconomic equilibrium.

Actual Expenditure = Planned Expenditure: Y = E

Planned expenditures – the sum that households, governments, firms and external world plan to spend on goods and services.

Real expenditures differ from planned when firms are forced to make non-planned investments in inventory under the conditions of changed sales level.

Planned expenditure function:  E=C+I+G+Xn, graphically made as the consumption function: C=a+b(Y-T), which shifted upward for the value of I+G+Xn. In this case we assume that the value of net export is autonomous form the dynamics of total income Y. That’s why net export fully added to the value of autonomous expenditure. (a+I+G+Xn). The value of autonomous expenditure equals (a+I+G+g), taking into account net export function: Xn=g-m’Y, where Xn=net export; g- autonomous net export; m’-marginal propensity to import, Y-income. Marginal propensity to import – share of increase of expenditure for import goods in any change of income.

Equilibrium in the Keynesian cross.

The equilibrium in the Keynesian cross is at point A, where income (actual expenditure) equals planned expenditure. Actual Expenditure = Planned Expenditure: Y = E. Planned expenditure function:  E=C+I+G+(Xn). Whenever the economy is not in equilibrium, rms experience unplanned changes in inventories, and this induces them to change production levels. Changes in production in turn inuence total income and expenditure, moving the economy toward equilibrium.

The Adjustment to Equilibrium in the Keynesian Cross

The multiplier of autonomous expenditures. 

∆A = (a+I+g+Nx) => increase in total income ∆Y due to effect f multiplier.

The multiplier of autonomous expenditures is the ratio of the change of GDP equilibrium to changes of autonomous expenditures. M=∆Y/∆A, where ∆Y – change of GDP equilibrium, ∆A-change of autonomous expenditure that are not dependant on Y dynamics.

Multiplier shows for how many times GDP increased due to increase in autonomous expenditures (for examples, expenditures for Olympic games- not connected with revenue/income).

Multiplier causes fluctuations of business activity and creates economic instability. Fiscal policy – way to influence multiplier effect.

Paradox of thrift (Парадокс бережливости).

Paradox of thrift (or paradox of saving) is a paradox of economics, popularized by John Maynard Keynes, though it had been stated as early as 1714 in The Fable of the Bees.  The paradox states that if everyone tries to save more money during times of recession, then aggregate demand will fall and will in turn lower total savings in the population because of the decrease in consumption and economic growth. The paradox is, narrowly speaking, that total savings may fall even when individual savings attempt to rise, and, broadly speaking, that increase in savings may be harmful to an economy. If increase in savings not accompanied by increase in investments, then any attempt of households to save more will be in vain due to significant decrease of equilibrium GDP, conditioned by multiplier effect.

 

This paradox is based on the proposition, put forth in Keynesian economics, that many economic downturns are demand based. Within mainstream economics, non-Keynesian economists, particularly neoclassical economists, criticize this theory.

Interconnection of model AD-AS and “Keynesian cross”.

Increase in savings can cause anti0inflation impact on the economy in conditions, close to full employment of resources: decrease of consumption and further decrease in aggregate expenditures, employment and output (with multiplier effect) limit the inflation influence on demand => aggregate demand decrees from AD to AD1 => decrease in production from Y1 до Y2 and decrease price level from Р1 до Р2.

Model of Keynesian cross not allow illustrate the process of change of price level P, as assume that prices are fixed. Keynesian cross make more concrete Ad-As model for short-term macroeconomic analysis with rigit prices and could not be used for the long-term consequences of macroeconomic policy, that is connected with increase or decrease of inflation rate.

Relation between price and value of aggregate demand.

Aggregate demand (AD) is the relationship between the quantity of output demanded and the aggregate price level. In other words, the aggregate demand curve tells us the quantity of goods and services people want to buy at any given level of prices. MV = PY. where M is the money supply, V is the velocity of money, P is the price level, and Y is the amount of output. If the velocity of money is constant, then this equation states that the money supply determines the nominal value of output, which in turn is the product of the price level and the amount of output. For any xed money supply and velocity, the quantity equation yields a negative relationship between the price level P and output Y. Figure 9-2 graphs the combinations of P and Y that satisfy the quantity equation holding M and V constant. This downward-sloping curve is called the aggregate demand curve.

The aggregate demand curve slopes downward: the higher the price level P, the lower the level of real

balances M/P, and therefore the lower the quantity of goods and services demanded Y.

Non-price determinants in aggregate demand.

Non-price level determinants of aggregate demand and their determining characteristics

  1.  Consumption (C:  Wealth, if expected to increase, increases consumption; Expectations, like more overtime, increase consumption; taxes, if lowered, increase consumption.
  2.   Investment (I); Profit expectations, if high, increase investment; Business taxes, if decreased, increase investment; Excess capacity, if low, increases investment; Technology outlook, if positive, increase investment .
  3.  Government Spending (G)
  4.   Net Exports (XN) (exports minus imports): Economic activity abroad; Exchange rates.

All non-price factors affecting aggregate expenditures cause shifts in the aggregate demand curve.

Aggregate supply (AS) in the short and long time intervals. 

Aggregate supply (AS) is the relationship between the quantity of goods and services supplied and the price level. Because the rms that supply goods and services have exible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the time horizon.

The Long Run: 

According to the classical model, output does not depend on the price level. If the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not output. The vertical aggregate supply curve satises the classical dichotomy, because it implies that the level of output is independent of the money supply.

  

Shifts in Aggregate Demand in the Long Run. A reduction in the money supply shifts the aggregate demand curve downward from AD1 to AD. The equilibrium for the economy moves from point A to point B. Since the aggregate supply curve is vertical in the long run, the reduction in aggregate demand affects the price level but not the level of output.

The Short Run: In the short run, some prices are sticky and, therefore, do not adjust to

changes in demand. Because of this price stickiness, the short-run aggregate supply

curve is not vertical.  In this extreme example, all prices are xed in the short run. Therefore, the short-run aggregate supply curve, SRAS, is horizontal:

The short-run equilibrium of the economy is the intersection of the aggregate demand curve and this horizontal short-run aggregate supply curve. In this case, changes in aggregate demand do affect the level of output. Fall in aggregate demand reduces output in the short run because prices do not adjust instantly. Fall in aggregate demand, rms are stuck with prices that are too high. With demand low and prices high, rms sell less of their product, so they reduce production and lay off workers. The economy experiences a recession.

Supply and price.

Aggregate supply (AS) is the relationship between the quantity of goods and services supplied and the price level. Because the rms that supply goods and services have exible prices in the long run but sticky prices in the short run, the aggregate supply relationship depends on the time horizon.

In the long run, the level of output is determined by the amounts of capital and labor and by the available technology; it does not depend on the price level. The long-run aggregate supply curve, LRAS, is vertical.

In the short run, some prices are sticky and, therefore, do not adjust to changes in demand. Because of this price stickiness, the short-run aggregate supply curve is not vertical. In the extreme example, all prices are xed in the short run. Therefore, the short-run aggregate supply curve, SRAS, is horizontal

Non-price factors of aggregate supply.

Non-price factors affecting aggregate supply:
1. Factor prices: decrease in factor prices will increase AS;
2. Productivity: increases in productivity will increase AS;
3. Domestic and foreign tranquility will increase AS.

Establishment of equilibrium due to changes in supply and demand. 

Long-Run Equilibrium In the long run, the economy nds itself at the intersection of the long run aggregate supply curve and the aggregate demand curve. Because prices have adjusted to this level, the short-run aggregate supply curve crosses this point as well.

A Reduction in Aggregate Demand. The economy begins in long-run equilibrium at point A. A reduction in aggregate demand, perhaps caused by a decrease in the money supply, moves the economy from point A to point B, where output is below its natural level. As prices fall, the economy gradually recovers from the recession, moving from point B to point C.


 

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