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)