Module 5 - Basic Macroeconomic Models + Long-Run Aggregate Supply + Aggregate Demand

key assumptions of classical economics

1. pure competition exists and markets function effectively and efficiently 2. wages and prices are flexible *** 3. people are motivated by their self-interests 4. people are not fooled by money illusion (make decisions based on the real value of money or its purchasing power, people are aware of and adjust for inflation)

long-run aggregate supply curve + aggregate demand curve

= economy's long-run macroeconomic equilibrium = real GDP at full employment (shows effects of the price level, potential real GDP, and employment when factors change)

change in long-run aggregate supply

a right-shift causes: decrease in price level (secular deflation), increase in real potential GDP, increase in employment level (natural rate unchanged)

what causes a right-shift in the aggregate demand curve

an increase in consumer spending, gross private investments, government purchases, and net exports

what causes long-run economic growth?

an increase in savings, productivity, human capital (education), number of resources, technology

relationship between possibilities production curve and long-run aggregate supply curve

LRAS is essentially all goods from PPC combined and placed on the horizontal axis to create the real GDP

the real balance effect (wealth effect)

changes in price level (inflation) inversely effects purchasing power because real income and wealth as decreased

four types of spending

consumer expenditure, gross private domestic investment, government purchases, net exports

an increase in price level . . .

decrease in aggregate quantity demanded and no impact on long-run aggregate supply

do firms have an incentive to produce more output as prices increase?

no; input prices also increase and profit remains the same

how is economic growth represented on the LRAS?

outward shift

classical economic theory

some of the earliest schools of economic thought focusing primarily on the benefits of market economies to explain changes in price level, real GDP, employment, and other macroeconomic variables

long-run macroeconomic goal relating to GDP?

sustained increase in long-run economic growth

potential real GDP

the level of real GDP when a country is at full employment and production is at full capacity; represented by LRAS; typically means increase in standard of living

three explanations for the inverse relationship between price level and aggregate quantity demanded

the real balance effect, the interest rate effect, the open economy effect

classical economists advocate for

unregulated competitive markets and free trade

***remember effect of changes in each individual curve in order to decide effect if both change at the same time

very important

the open economy effect

when US price level increases, US goods and services become relatively more expensive, and exports decrease while imports increase

the interest rate effect

when price level increases, borrowing increases, interest rates increase, costs of borrowing increases, and spending decreases

natural rate of unemployment

when wages are flexible and the labor market is at full employment (no cyclical unemployment)

Adam Smith

wrote wealth of nations --> free market competition is best way to promote economic growth

long-run aggregate supply curve

represents the relationship between the price level and output (real GDP) at the natural rate of unemployment

aggregate demand curve

represents the total planned spending (quantity demanded) in an economy

change in long-run aggregate demand

right-shift causes: increase in price level (inflation), same real potential GDP, same full employment

Jean-Baptiste Say

Say's law --> production or supply creates demand (aggregate supply curve > aggregate demand curve)

because prices and wages are flexible,

free markets can regulate themselves and competitive markets keep the economy at potential real GDP and full employment in the long-run

assumptions of the long-run aggregate supply curve

full employment (an amt. of real GDP), full information, no changes in technology, all resources (labor and capital) are used fully and efficiently, changes in price level do not affect LRAS curve

variables that effect C, I, G, NX and therefore cause a shit in the aggregate demand curve

household and business expectations, real interest rates, taxes/tariffs, the money supply, exchange rates, other countries' economic conditions

why is the long-run aggregate supply curve vertical

represents full employment, all prices are flexible in the long-run (because increase in price = increase in input prices)