UNIT 1 THE CONCEPTS OF MACROECONOMICS

Transcription

1 Macroeconomic Principles and Issues UNIT 1 THE CONCEPTS OF MACROECONOMICS Contents Page 1.1 Introduction to the Course Introduction to this Unit Gross Domestic Product Demand, Supply and Equilibrium Schools of Thought Conclusion 16 Answers to Review Questions 17

2 2 MACROECONOMIC PRINCIPLES AND ISSUES What this unit is about This unit is an introduction to the course, Macroeconomic Principles and Issues. It indicates the topics you will be studying throughout the course, and how these are organised. As well as reviewing the ideas of the market, demand, supply and equilibrium, this unit provides an overview of the different schools of thought within macroeconomics the main theoretical approaches to macroeconomic models. It introduces the idea of a simple economy and, using a circular flow diagram, it derives the basic identities between income, expenditure and output for a simple economy. It explains the basic concepts of national income accounting and provides some examples of how GDP is calculated. What you will learn When you have completed this unit and its readings, you will be able to define the goods market derive the basic macroeconomic identities for the goods market of a simple economy discuss the basic concepts of national income accounting explain how GDP is measured outline the key national accounting terms define the aggregate demand and aggregate supply and market clearing equilibrium, and draw appropriate curves discuss the main schools of thought in macroeconomics and how they differ. Reading for Unit 1 Textbook Rudiger Dornbusch, Stanley Fischer and Richard Startz (2008) Macroeconomics: Chapters 1 and 2, and Chapter 5, Sections 5-1 to 5-3. Course Reader Two articles from The Economist Grossly Deceptive Product and Grossly Distorted Picture. CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

3 UNIT ONE Introduction to the Course This course, Macroeconomic Principles and Issues, is concerned with the economic principles used to model the economy as a whole. It is designed to teach you the tools and techniques used for analysing aggregate economic behaviour and policy formulation in a market economy. The course is comprised of the eight Course Units, which you will be studying in the coming weeks. This course focuses on the study of Macroeconomics, which is concerned with behaviour of the economy as a whole or in aggregate. The types of questions you will consider in studying this course are those relating to the headline economic issues of inflation, unemployment, economic growth, money supply, government deficits and interest rates. You will study economic models designed to answer such questions as: how do we explain inflation? what determines economic growth? why are there periods of sustained unemployment? what determines the rate of interest? There are two further key questions that arise in macroeconomics, and these relate to how the economy behaves in relation to other economies. These questions are: how are foreign exchange rates determined? why can there be persistent deficits or surpluses in the balance of payments? In this course we will concentrate on the first four questions; that is, we will be focusing on the economic behaviour and relationships of the domestic economy. Macroeconomics also encompasses the study of an economy s international relationships, as the last two questions illustrate. Although your studies in this course will introduce some international dimensions, we will defer most of our discussion of the economy s international relationships until the course on International Economics, which follows on from this one in your Diploma programme. Macroeconomics focuses on the overall level of prices and resource use for the economy as a whole, while microeconomics is concerned with the analysis of price determination and the allocation of scarce resources between alternative uses. For example, in your microeconomics course, you studied the determination of the relative prices of goods and services. In macroeconomics, we are concerned with the overall price level, and we assume that relative prices are unimportant. These two branches of economics focus on different aspects of the same subject and are based on different assumptions. In saying that, we may seem to be stating that the two are completely distinct, but that is not necessarily so. Although there have been times when macroeconomic theories have not been firmly linked to microeconomic principles, economics theoreticians usually try to connect the two. In this course, your study will focus on macroeconomic theories and policy but we will point out the links to microeconomics when this is relevant. Macroeconomic theory is closely linked to the policies adopted by governments to deal with the questions of inflation, unemployment, economic growth and so on. There is considerable debate amongst economists about the economic principles and models that can be used to analyse such phenomena. In Europe and North America, the most intense debates over policy issues in the 1970s and 1980s concerned the relative merits of Monetarist and Keynesian policies. Since then, the debates have moved to those between the New Classicals and the New Keynesians. In this course, we will refer to these debates and analyse the similarities and the differences between these different schools of thought. So what topics will you be studying in this course, and how will you go about it? In this unit, the aim is to introduce you to the subject of macroeconomics and the basic concepts required for your studies, including those of national income accounting. In UNIVERSITY OF LONDON

4 4 MACROECONOMIC PRINCIPLES AND ISSUES microeconomics, the basic tool of analysis is the supply and demand framework. In macroeconomics there is a similar framework known as the aggregate demand and aggregate supply model. This will be introduced in Unit 1. Units 2 and 3 cover the IS-LM model, which sets out the inter-relationship in an economy between the market for goods and the market for money, and the role of interest rates as the link between them. This model can then be used to show how the level of aggregate demand in the economy can be determined. At the end of Unit 3 the aggregate demand curve, which shows how changes in the price level affect aggregate demand, will be derived from the IS-LM model. Unit 4 will then explore further the behavioural functions that underpin the IS-LM model. This will mean an examination of factors affecting consumption, investment, and the demand for money. Unit 5 focuses on the ways in which government monetary and fiscal policies can influence aggregate demand. In Unit 6 we will begin to explore the supply side of the economy and investigate how output and the price level will react to a change in aggregate demand. The analysis of aggregate supply is one of the most contentious areas of macroeconomics. The approach that we will take in Unit 6 is based on the idea that output will be the first thing to alter following a change in demand, and that this then affects the price level. Alternative approaches to aggregate supply suggest that the price level is the first thing to respond to a demand change, and that this then leads to output changes. These alternative approaches are covered in Unit 7. Finally, in Unit 8, we refocus on the economy and consider how economic models can be used to analyse economic growth. The textbook you will be using for this Course is Macroeconomics (tenth edition) by Rudiger Dornbusch, Stanley Fischer and Richard Startz (hereafter referred to as DFS). This is a widely used standard intermediate level macroeconomics textbook, which has a traditional approach to the subject. In studying this course, you will be asked to read assigned sections and chapters of DFS that deal with the material you are studying. The course units are designed to help you understand these readings and to cover points we think you might find difficult. There are other textbooks which cover the same material and, while we will not be assigning you readings from those, you may refer to them for additional exposition if you want to and have access to a library or bookshop that stocks them. If you do decide to consult another textbook, we suggest you read the author s Introduction so you are aware of the approach being taken in presenting the theoretical material. It may differ from that of DFS. Also, some textbooks are better on specific topics than others in that the material is covered in more detail or set out more clearly. So you should be aware of such differences. Other textbooks you might want to consult include: Olivier Blanchard (2009) Macroeconomics (Fifth Edition) New Jersey: Pearson/Prentice Hall International N Gregory Mankiw (2007) Macroeconomics (European Edition) Basingstoke UK: Palgrave Macmillan Michael Parkin (2008) Macroeconomics (Eighth Edition) Boston MA: Pearson Addison Wesley. At the end of each chapter of your set text, Dornbusch, Fischer and Startz have included a Summary of the main topics and ideas covered and the Key Terms introduced. You will find it useful to consult these. The authors also include a set of Problems, which are designed to review the main concepts used in the chapter. Some of the problems are essaytype questions asking you to explain theoretical principles or economic concepts. Other questions are numerical ones in which you have to use your theoretical knowledge in order CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

5 UNIT ONE 5 to calculate the answers. We suggest that you look at these problems and try answering some of them. Note that the textbook does not provide any answers to its problems, so you will have to consult the chapter contents to check your replies. During the course, we will occasionally ask you to read articles or extracts from economics journals and from other books that we think are particularly good at explaining a specific theoretical topic or at presenting arguments within one of the main macroeconomics debates. Some of these articles will present a particular point of view. In reading such articles and extracts, you should adopt a critical attitude to the arguments presented. STUDY NOTE Economists are famous for disagreeing amongst themselves. The main reason for this is that economic analysis is invariably based on particular economic models, which in turn are based on certain assumptions as to how the economy behaves. Different assumptions will give rise to different results. It is very difficult in economics to judge which models are the most accurate, because testing in any scientific sense is not always possible. Therefore models are sometimes chosen on the grounds of simplicity or because they are consistent with other views of how the economy behaves. Some economic models are better than others in analysing and explaining some aspects of economic behaviour. However, the best way to study is to learn each model on its own terms and to evaluate its strengths and weaknesses. No model is perfect, and each one you study will have strengths and weaknesses. In studying this course, we hope that you will appraise critically all the materials that you read, including the course units like this one, the textbook and the other readings. When you write essays for your assignments, you will be expected not only to explain the relevant theories and models but also to set out both their good points and weaknesses that is, to analyse them critically. Remember that models are used to predict the impact of changes in certain variables on the economy. When using a particular model you must work within the confines of that model. Different models will give different predictions. Some models will be inconsistent with others. Predictive accuracy is usually taken as the main way in which models and theories can be judged. Sometimes different theories come up with the same prediction. This makes theory choice very difficult. All this means that you must remember that when you analyse a particular problem or issue you will be expected to use a particular economic model. Your success on the course will be based on your understanding and use of these models. Try not to rely on common sense or ideas that you have picked up in the media. Your task is to show that you can manipulate, understand and apply economic models How to approach the course These units are designed to act as an aid to your understanding of the main macroeconomic models as presented by DFS. We suggest that you work through the units with the textbook open by your side. Periodically you will be asked to read particular sections of the text, and to think about certain issues or questions. We know that there is a temptation to ignore these questions (which are written in italics), but they have been designed to help and further your understanding of the issues. A little time spent thinking about them will pay dividends. The full benefit will be gained if you jot down your answers. The mere act of writing out an answer forces you to focus on the issues. Just mentally coming to a conclusion does not focus your ideas as clearly. If you fail to answer the questions correctly, this is part of the learning process. Remember, people learn from their mistakes and as long as you can understand the logic of the solutions provided, you have furthered your understanding. You will find that at times we have not followed the order in which a topic is covered in DFS. This is because we feel that our structure gives a clearer explanation of the issues. This means that you will cover the material in the text, but in a different order. It would be a useful exercise if, after completing the unit you go back to the text and read the relevant UNIVERSITY OF LONDON

6 6 MACROECONOMIC PRINCIPLES AND ISSUES chapters as identified at the beginning of the unit. This will give you DFS s order of presentation and will reinforce your grasp of the topic. Over the scheduled weeks of this course, you must complete two assignments in which you will be asked to write essays. The assignments will be marked by your tutor in the United Kingdom and you will be sent comments and advice on your work. The grades you receive on your two assignments will count for 30% of your final course grade. To complete the course, you will take an examination according to the University of London examination schedule. Your examination result will account for the other proportion of your course grade. Your essays, examination and study of the course should reflect its main themes and reasoning. At this level of study it is not really enough to learn the various theories by rote; you should aim also in your study and writing to be able to consider significant policy problems use appropriate theoretical models to analyse policy issues. We will try to help you do this in the course texts by asking you to think about the theory and its policy implications. In general, we give great weight to the use you make of theoretical models in your essays, and models presented in diagrams or equations are usually the clearest. However, the best marks will be awarded to essays and examination answers that not only demonstrate your knowledge of the theoretical concepts but also use these concepts to analyse economic problems and their implications for policy. Your work for each unit will be organised around one or two thematic questions relating to the unit. The overall, broad questions which run through this course as a whole are the first four set out at the very beginning of this unit; namely How do we explain inflation? What determines economic growth? Why are there periods of sustained unemployment? What determines the rate of interest? STUDY NOTE At this point, you might like to refer back to the Induction Course unit that you studied at the very start of this programme, and review the concepts of economic theory, models and policy that were discussed there. 1.2 Introduction to this Unit In this first course unit on macroeconomic theory and policy, you will be introduced to the basic concepts required to study macroeconomic models. The first topic looks at how economists measure the level of economic activity in the economy at the macroeconomic level. This involves examining how the value of output, known as Gross Domestic Product, in the economy is estimated. This is important for two reasons. First of all, most of this course will be concerned with how the levels of output and employment are determined. It is obviously sensible that you have a clear idea of what the value of output means, and how the various components of output are defined. Secondly, in showing how the value of output is determined you will come across ideas that provide the basis for a large part of the analysis which is concerned with how output is determined. As DFS put it (page 23), national income accounts provide the formal structure for our macrotheory models. The second topic is a review of the ideas of the market, demand, supply and equilibrium, and you will see how to use these fundamental concepts in macroeconomics. At this point, CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

7 UNIT ONE 7 we should also stress that you will be studying macroeconomic theories and models of market economies. There are theories and models for command and developing economies as well, but those topics will not be covered in this course. In this unit, your study is focused on the following question: How can the concepts of market equilibrium and national income accounting be used to explain the basic relationships of a simple economy? 1.3 Gross Domestic Product Gross Domestic Product (GDP) is defined as the value of all final goods and services produced in the economy within a given period of time. The total economy is very diverse and is comprised of a multitude of goods and services being bought and sold by innumerable consumers, firms, the government and other economic agents. This leads us to ask: How are we are going to focus on the output of the economy as a whole? How are we going to measure the total output of the economy? Three approaches to GDP To answer these questions, we need to have a way of combining apples, oranges, tractors, turbines and all the various outputs of the economy. The easiest way to do this is to use money as a numeraire. So we shall not be talking about the amount produced in terms of quantities of apples, oranges, tractors and so on, but instead the monetary value of this output. However, we will also need a method of adding up all this output that is useful for analytical purposes. To do that, we will adopt the concepts of national income accounting, which provides us both with a framework for describing the relationships and flows of the key variables of the goods market and with a way of measuring them. Let us start by assuming a simple economy consisting of two sectors households and firms. Households are where factors of production live and firms are where productive activity takes place. National income accounting tries to measure the value of output in the economy, the value of incomes earned in the economy and the value of goods produced in the economy. Can you think of any relationship between these three values? Take a minute to think about it before moving on. In a simple economy of only households and firms, the total expenditure of households and firms must equal the total income of the two, and it must equal the total value of output of goods and services. This is an important identity: aggregate income a aggregate expenditure a aggregate value of output. STUDY NOTE An identity exists when two terms are not just equal, but actually represent the same concept. Thus in the example above, aggregate income does not only equal the value of goods and services produced, it is the value of goods and services produced. An identity is shown by the use of the symbol (a). It indicates that the terms on either side of the symbol are the same concept and so must always be equal. When an expression is expressed as an equation an equals sign (=) is used. This indicates that the term on the left hand side is determined by the term on the right. If we have an equation C = cy UNIVERSITY OF LONDON

8 8 MACROECONOMIC PRINCIPLES AND ISSUES we know that given values of Y we can calculate the value of C. Thus C depends upon Y. There is a functional relationship between C and Y. Of course, we cannot solve this equation because there are two unknowns and only one equation. If we have an equation 100 = 2X we can find values of X which solve this equation. Thus, an equation specifies a relationship between two variables. The aggregate value of the output, expenditure or income of an economy is called its Gross Domestic Product (GDP) and is denoted as Y. Therefore, in our simple economy, this identity can be written as Y a Exp a GDP. It is important that you understand the logic behind this conclusion. Please read DFS pages (Section 2-1), where the link between the value of output and the value of incomes is explained and then answer the following question. Jot down your answers before you continue. If the value of output is always received by someone in the form of income, would an increase in the value of pensions paid by government to the elderly increase GDP? [Hint: GDP measures the value of goods and services produced and so income should only be included if it represents or reflects output produced.] Distinguish between GDP, GNP, NDP. Pensions are not part of GDP because they do not represent incomes earned from a productive activity. They are income transfers from one section of society (taxpayers) to pensioners. They are therefore known as transfer payments. Check your answer to the second question against DFS page 24. The relationship between output and expenditure relies on the fact that all goods and services produced must end up in someone s possession. Consumption goods which are produced for consumers will either be bought by consumers or remain unsold. Expenditure by consumers is known as consumption (C). Goods that are unsold will be acquired by firms as an increase in the level of stocks. This is known as inventory investment. It can be thought of as unintended expenditure by firms on their own production. Of course, some investment in inventories may be planned by firms. Changes in inventories will therefore contain two elements, one planned and one unplanned. In a two sector economy, some goods and services will be produced because they are required not by consumers, but by other firms. Both of these expenditures by firms are classed as investment (I). Please read DFS pages 31 33, just the section entitled A Simple Economy. This yields the relationship Y a C + I where I includes planned expenditure by firms on goods and services plus any unplanned changes in inventories. Manipulation of this equation shows that Y C a I If Y C a S CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

9 UNIT ONE 9 where S = saving, Then S a I This suggests that savings are always equal to investment expenditure. This is only true if investment expenditure includes expenditure on changes in inventories. This is a significant result, since if firms experience unplanned changes in inventories because planned expenditure is not equal to output, the economy will not be in equilibrium since firms will alter their behaviour in order to prevent these unplanned changes The measurement of GDP As noted above, aggregate income equals aggregate expenditure equals the aggregate value of output in the economy. So we should be able to measure GDP in three ways, and we should get the same answer each time. In theory, this is correct. In practice, it is not because some types of data required to compile GDP figures for some of the measures are harder to come by than others. This means that GDP figures cannot be relied upon to give a definitive figure for Gross Domestic Product. Each method of measurement will give a slightly different result. If different countries experience different degrees of difficulty in obtaining accurate figures, international comparisons of GDP are likely to be inaccurate. This problem is made worse by two important factors. First, in order to compare GDP figures they need to be put into a common currency. This requires conversion at a particular exchange rate. This means that exchange rate changes can affect relative GDP figures. Second, some economies have a large informal sector where economic activity takes place but where such economic activity is impossible to measure. GDP figures can only include economic activity where goods and services are bought and sold. If a country has a large agricultural sector, but the farmers are self-sufficient and crops are consumed by the people who grow them, this output will not show up in GDP figures. Three approaches to measuring GDP The expenditure approach measures GDP by adding together the expenditure of all sectors in the final product market. That is, consumers expenditure, firms investment, government expenditure of goods and services and the net of exports minus imports. From a statistician s point of view, this is the easiest way to calculate GDP. The income approach measures GDP by aggregating all the incomes paid by firms and government to households for factors of production, and this includes wages and salaries, interest on capital, rent for land and profits. GDP is calculated using this approach, although some figures, such as income earned by the selfemployed, have to be imputed as they are difficult to measure directly. The output approach measures GDP by adding together the value added of each sector of the economy, such as agriculture, manufacturing, transport, banking and finance and so on. This measure of GDP is conceptually straightforward but is in fact difficult to calculate. The two extracts from The Economist, Grossly Deceptive Product and Grossly Distorted Picture, provided in your Course Reader, give you the flavour of the debate about the accuracy of GDP figures. You should read them now because they illustrate the important point that economists cannot always accurately measure important concepts that they are quite happy to define. UNIVERSITY OF LONDON

10 10 MACROECONOMIC PRINCIPLES AND ISSUES STUDY NOTE In studying national income accounting it is very easy to become bogged down in the maze of detail of the calculations for each of these approaches to measuring GDP. At this stage, it is important that you understand the concepts and step back from all the detail. If you want to learn more about national income accounts, then please do feel free to study the details. From the point of view of this course, it is important to understand and feel comfortable in using the main concepts and the components of the expenditure approach, Y = C + I + G + (X M) GDP, identities and equilibrium As was noted above, the expenditure approach to measuring GDP is the simplest way to calculate GDP from the point of view of a statistician. It is also the most significant approach because it provides a framework within which economists can analyse changes in GDP. We have seen that when changes in inventories are classed as investment expenditure output must be the same as total expenditure. This gives the identity Y = C + I Output must either be bought be consumers (C) or other firms (I) or remain unsold and so add to inventories that are included in I. However if unplanned changes in inventories have occurred, it is unlikely that firms will continue producing the same level of output. Firms will react to the unplanned changes in inventories. If firms are changing their behaviour, the economy cannot be in an equilibrium position, since this implies a state of rest where there are no forces of change at work. This means that when I represents the amount of expenditure on inventories and other goods and services that firms want or plan to make, the expression can be interpreted as an equilibrium condition for the economy. If I is defined as planned investment then (C + I) is classed as planned expenditure. In this case if Y = C + I firms can sell all they want to sell, and there will be no unplanned change in inventories. Therefore, firms will have no incentive to change their level of output. The economy is said to be in equilibrium. This relationship is expressed as an equation because we have said that Y is determined by planned expenditure, and that when planned expenditure just equals output, the economy will be in equilibrium. It is no longer an identity because planned expenditure does not have to equal output. In economics, the idea of the economy being in equilibrium when planned expenditure is just equal to output is the cornerstone of macroeconomic analysis GDP, government and the foreign sector We can now expand the two-sector economy seen in the previous section to a four sector economy by adding in expenditure from the government sector and the foreign sector. Please read DFS Section 2-2, pages Make sure that you can identify all the terms in equation (3) on page 26. This is a fundamental equation as far as macroeconomics is concerned. Y = C + I + G + NX If investment includes unplanned changes in inventories, this equation is an identity. CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

11 UNIT ONE 11 It becomes an equilibrium condition if it is interpreted as saying that the economy will be in equilibrium when (C + I + G + NX) constitutes planned expenditure and when this is just equal to the level of output in the economy (Y). The idea that the economy is in equilibrium when planned expenditure equals output is the macroeconomic analogy to the idea that you learned in microeconomics that a market is in equilibrium when demand (planned expenditure) equals supply (output). It is no surprise, therefore, that macroeconomics makes use of a demand and supply framework of analysis, and it is this that you will study next. 1.4 Demand, Supply and Equilibrium The market can be defined as the means by which buyers and sellers of goods and services interact, which presents the opportunity of exchange or trade taking place. In your study of microeconomics, you considered the market for one good or one type of output. In macroeconomics, we will be talking about the market for all goods and services; that is, the total output of the economy. We can also define the market more formally as a model in which there are a demand function, a supply function (that is, there are both buyers and sellers) and an equilibrium point. The demand function for a good is expressed as the total amount that buyers want to purchase as a function of its price, the price of other goods, the income level and other variables. For the economy as a whole, we refer to aggregate demand, which is a function for the whole of the economy s output. The supply function for a good is expressed as the amount a seller wants to sell as a function of its price, the price of other goods, the income level and other variables. In a similar way, we can talk about the aggregate supply of the total output of the economy. The third defining characteristic of a market is the equilibrium point, which is a point where there is no tendency to change. It is a point of rest and in terms of a market it is achieved when demand equals supply. This is a market clearing equilibrium as it occurs when both buyers demand is fully satisfied and sellers have sold all they want to supply to the market. Figure 1.1 is the familiar demand and supply model that you studied in Microeconomic Theory and Applications. A market clearing equilibrium is as illustrated by point E in Figure 1.1. That is, the market mechanism works to ensure that there are no surpluses or shortages of goods to be bought or sold. It is in equilibrium because there is no reason why the market should move to any other point, and it is market clearing because demand and supply are equal. In Figure 1.1, the market would not clear at any other point. If the price is P 1, then it is said to be in disequilibrium as supply, point B, is greater than demand, point A, and there is pressure for the price to fall until demand equals supply. Therefore, disequilibrium is defined as not being a point of rest, or a point at which equilibrium has not been achieved. UNIVERSITY OF LONDON

12 12 MACROECONOMIC PRINCIPLES AND ISSUES Figure 1.1 Equilibrium of Demand and Supply Price D S P 1 A B P E E Quantity Aggregate demand and supply In macroeconomics, we will be concerned with the determination of the aggregate demand and aggregate supply of output in the economy and the general price level. When using graphical analysis, the horizontal axis of a graph of aggregate demand and supply functions is the aggregate quantity of the economy s output, while the vertical axis is the general price level which is a measure of the prices of all goods and services in the economy. Such a model is shown in Figure 1.2 below. Figure 1.2 Aggregate demand and supply Price Level AD AS P 1 A B P 0 E Y 0 Output The aggregate demand (AD) curve shows the total planned expenditure on goods and services in the economy as a function of the price level. A higher price level will reduce total planned expenditure. (You will examine the reasons for this in Unit 3.) The aggregate supply (AS) curve shows the quantity of output which firms are prepared to supply at various price levels. The AS curve in Figure 1.2 suggests that firms are only prepared to supply more if the price level rises. (You will see the reason for this in Unit 6.) This model will be in equilibrium where AD equals AS, at point E. In terms of the equations you saw in the earlier section, planned expenditure (C + I + G + NX) just equals output Y or: Y = C + I + G + NX CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

13 UNIT ONE 13 Suppose that the economy is not in equilibrium because the price level is at P 1. At this price level planned expenditure (AD) is less than output (Y). However, the identity Y = C + I + G + NX will still hold because inventories equal to the distance AB will be added to firms inventory holdings. There will be unintended investment of AB. Thus actual expenditure (including unintended inventory accumulation) will equal output. This cannot be an equilibrium position because firms will react to their lack of sales. As you will see in later units there are convincing reasons why these reactions will force the economy towards E. An increase in planned expenditure would shift the AD curve to the right. E would no longer be an equilibrium position. Stop now and jot down your answers to the following questions. What would be the nature of the disequilibrium if AD increased? What would you expect to happen to inventories? How would you expect firms to respond? The increase in AD would cause an excess demand. Inventories will fall as firms satisfy the excess demand from their stocks. It is likely that firms will increase output (or prices). The extent to which firms will react, by increasing prices or output, depends upon the slope of the AS curve. The slope will depend crucially on the time period under consideration. DFS identify three models of aggregate supply a short run model, a medium term model and a long run model Short-run aggregate supply Let us start by examining the short-run model, where the AS curve is assumed to be flat. Equilibrium will be at the point where AD equals AS. Given a flat AS curve, the level of output in the economy is determined solely by the level of aggregate demand. Changes in aggregate demand will only affect output, with no impact on prices. Please read pages 8 9 of DFS, the section headed The short run, and then answer the following question. Under what circumstances will firms be able to satisfy an increase in demand without this having any impact on the price level? Write down your ideas. If firms can increase output without increasing their prices, this means that they can increase output without increases in their average costs of production. This must imply that they can obtain additional resources, especially labour, without experiencing higher costs. This is most likely to be true in periods of high unemployment, or when there are barriers to costs increasing. This view of aggregate supply is sometimes referred to as the Keynesian view of aggregate supply because it is a view associated with John Maynard Keynes who argued that the deep economic recession which was experienced in the 1930s was the result of a lack of demand and that the way to boost output was to expand aggregate demand. This was based on the idea that spare resources were plentiful and that firms could easily increase output without this putting pressure on the price level. Keynesian economics came to be associated with policies aimed at boosting aggregate demand, and at heart they are based on the view that the AS curve is flat. UNIVERSITY OF LONDON

14 14 MACROECONOMIC PRINCIPLES AND ISSUES This view of aggregate supply emphasises the importance of aggregate demand in the determination of output in the economy. Aggregate demand is explored in Units 2, 3, 4 and Long-run aggregate supply In the long run, the aggregate supply curve is vertical. This means that, in the long run, any change in aggregate demand will only affect the price level and will have no impact on output. Please read DFS pages 4 8 and then, using Figure 1-2 on page 6, answer the following question, If there was an increase in aggregate demand, what would Figure 1-2 predict would happen to the economy? The model predicts that output would not change, but that the price level would rise. Can you think of any reasons why the AS curve might be vertical? A vertical AS curve means that output does not expand when there is an increase in aggregate demand. This is usually explained by saying that the economy is operating under some sort of capacity constraint and that firms are unable to increase output. The constraint that is usually assumed is the constraint of full employment. Y 0 in Figure 1-3 is potential GDP, or the level of output associated with full employment. This view of aggregate supply is known as the Classical aggregate supply curve. Classical economics therefore is associated with the idea that changes in aggregate demand only affect the price level and have no impact on the level of output in the economy. Please read DFS, pages , the section headed The classical supply curve, and then answer the following question. What does Figure 1-2 on page 6 of DFS suggest would result from an increase in the level of output associated with full employment. i.e., an increase in productive potential? An increase in productive potential would shift the AS curve to the right. This would increase output and reduce the price level. The long run behaviour of productive potential is explored in Unit 8 when we investigate growth theory Aggregate supply in the medium run Most economists accept that the short run AS curve is flat and the long run AS curve is vertical. However, this leaves open the question of how long is the short run, and what is the process by which the AS curve becomes vertical? Please read the section headed The medium run from page 9 of DFS, and then answer the following question. If firms adjusted prices more rapidly what would happen to the slope of the AS curve? The faster prices adjust the steeper the AS curve will be. Since one of the major factors influencing prices will be the cost of labour, wages, the slope of the AS curve also depends upon how quickly wages adjust to an increase in output. CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

15 UNIT ONE 15 Please read Box 5-3 on page 107 of DFS where the authors suggest that factors other than time will be important in determining the slope of the AS curve. When you have finished, answer the following question. If output in an economy expands because of increased expenditure, and prices fail to rise, what does this imply about the level of unemployment in the economy? If increased output can be produced without prices rising, firms must be able to secure extra workers without putting pressure on wages. Hence there must be unemployed resources available. Unemployment must exist in the economy. In terms of the figure in Box 5-3 of DFS, output must be low and the economy is operating on the left hand portion of the AS curve. The mechanism through which output changes affect wages and prices forms the basis of Units 6 and 7. It is in those two units that you will study various views of how the price level and the output level respond to increases in aggregate demand in the medium term. In order to test your grasp of these ideas please draw AD/AS models to answer the following questions. 1 In the short run, how will the economy react to a fall in aggregate demand? 2 In the Classical case, how will the economy react to an increase in aggregate demand? 3 In the Keynesian case, how will the economy react to an increase in aggregate supply? 4 In the medium term, how will the economy react to an adverse supply shock? 5 On one diagram show the medium term impact of an increase in aggregate demand as well as the long run impact. Answers are provided at the end of the unit. 1.5 Schools of Thought In studying macroeconomics you will come across various schools of thought. We have already mentioned Keynesian and Classical models. You may also come across such terms as Monetarist, New Classical and New Keynesian. The key distinction between these schools of thought concerns whether or not market forces can be relied upon to achieve full employment or whether government intervention via fiscal and monetary policy is necessary to generate sufficient aggregate demand to secure full employment. This debate hinges on whether or not markets, left to their own devices, will achieve an equilibrium position. This can be summarised as one school argues that markets work best where left to themselves, with as little intervention from government as possible the other argues that government intervention can improve the operation of the economy and thus it should take an active role in policy terms. These two views are fundamentally based on assumptions about the aggregate supply curve. If the AS curve is vertical, or if the long run is a short period of time, the economy will always revert back to the original level of output because price changes will quickly restore equilibrium. This is known as the market clearing school of thought, which sees price changes as restoring equilibrium in all markets. Suppose that there is a drop in the demand for oranges. If the orange market is competitive, the excess supply of oranges will reduce the price of oranges, until supply and demand are again equalised. The market will always clear so that the excess supply of oranges will be eliminated. Now consider what will happen in the labour market when there is a fall in aggregate demand. There will be an excess supply of goods in the economy. Firms will reduce their demand for labour. There will be an excess supply of labour in the labour market. The excess supply of labour will reduce wages and prices. The UNIVERSITY OF LONDON

16 16 MACROECONOMIC PRINCIPLES AND ISSUES price level will fall, stimulating aggregate demand until equilibrium is again restored. In terms of the AS curve, this suggests that the AS curve is very steep and becomes vertical very quickly. The non-market clearing view suggests that this process will not work and that markets may operate out of equilibrium for a long time. In particular, the labour market may be characterised by excess supply for a long period of time. Firms will respond to a fall in demand by reducing output, not prices. Excess supplies can persist. In terms of the AS curve, this view suggests that the AS curve is flat and it may take a long time for wages and prices to adjust. Output may be depressed and unemployment may persist for a long period of time. 1.6 Conclusion We have seen that GDP can be measured in three ways, by the expenditure, income and output methods. The expenditure method tells us that aggregate expenditure is always equal to aggregate output (GDP) if unsold goods are included in expenditure as inventory accumulation. Older economics texts referred to this as ex post expenditure, always equalling output by definition. The expenditure approach also gives rise to an equilibrium condition for the economy, when unintended investment is zero, which will be when planned, or ex ante, expenditure, equals output. This then permits equilibrium to be examined in terms of aggregate demand and aggregate supply curves. The message you have learned from these is that the impact of changes in demand on the economy depends crucially on the slope of the AS curve. This will depend on the time period under consideration, but also on the way in which firms react to a change in demand. In this unit we have seen the main building blocks of macroeconomic analysis. To fill in the background, and to see the whole picture as presented by DFS, please read all the remaining sections of Chapters 1 and 2. CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES

17 UNIT ONE 17 Answers to Review Questions Question 1 In the short run, a fall in aggregate demand will cause a fall in output, but will leave the price level unaffected. Figure 1.3 Price Level AD 1 AD P 1 AS Y 2 Y 1 Output Question 2 In the Classical case, an increase in aggregate demand will increase the price level but leave the output level unaffected. See DFS page 111, Figure 5-10, where the increase in aggregate demand is caused by a fiscal expansion. Question 3 In the Keynesian case, an increase in aggregate supply would have no impact on the economy. Figure 1.4 Price Level AD AS AS 1 P 1 Y 1 Output UNIVERSITY OF LONDON

18 18 MACROECONOMIC PRINCIPLES AND ISSUES Question 4 In the medium term, an adverse supply shock will cause the output level to fall and the price level to increase. See DFS page 100, Figure 5-3. Question 5 In the medium term, the level of output and the price level would both rise. In the long run the output level would revert to the original level and the price level would rise further. Figure 1.5 Price Level AD AD 1 AS (Long Term) AS (Medium Term) P 3 P 2 P 1 Y 1 Y 2 Output CENTRE FOR FINANCIAL AND MANAGEMENT STUDIES