Outline of Lecture 1 –Macroeconomics: National income determination and price level (Simplified version)
28 April 2009
Topics covered:
I.
Aggregate demand and its characteristics
II.
Aggregate supply and its characteristics
III.
Factors and policies affecting AD and AS
IV.
Determination of income and price level by AD-AS
I.
Aggregate demand and its characteristics
 Reasons for a downward sloping AD curve
Teaching advice

Begin by reviewing demand, supply, and equilibrium.

Make it clear that the microeconomic variables of price and quantity can be aggregated into a price level (either the GDP deflator or the Consumer Price
Index) and total output (real GDP).
Y = C + I + G + NX
 Reason 1 - The Price Level and Consumption: The Wealth Effect
A decrease in the price level

consumers feel wealthier

encourages them to spend more (increase in consumer spending)

a larger quantity of goods and services demanded.
1

 Reason 2 - The Price Level and Investment: The Interest-Rate Effect
A decrease in the price level

less money households need to buy goods and services

households try to convert some of their money into interest-bearing assets

the interest rate will drop

encourage borrowing by firms on investment goods

increases the quantity of goods and services demanded.
 Reason 3 - The Price Level and Net Exports: The Exchange-Rate Effect
A lower price level in Country A lowers its interest rate

investors will seek higher returns by investing abroad, increasing Country A’s net capital outflow

it raises the supply of Country A’s currency, lowering the real exchange rate  Country A’s goods become relatively cheaper to foreign goods

Country A’s exports rise

increasing the quantity of goods and services demanded.
Teaching advice

Highlight the fact that all three of these effects begin with a decrease (or increase) in the price level and end with an increase (decrease) in aggregate quantity demanded.
 Remind students that the aggregate demand curve (like all demand curves) is drawn assuming that all else is held constant.
2

II.
Aggregate supply and its characteristics

Reasons for an upward sloping short run AS curve
 Reason 1 -
“The sticky wage theory”
Nominal wages do not immediately adjust to the price level

a lower price level makes employment and production less profitable

firms lower the quantity of goods and services supplied.
 Reason 2 “The sticky price theory”
If a firm does not adjust the price of its product quickly in response to an unexpected fall in the price level

its relative price will rise

lead to a loss in sales  firms will produce a lower quantity of goods and services.
 Reason 3 “The misperceptions theory”
A drop in the price level can mislead suppliers to believe that the price of their product falls  they respond to the lower price level by decreasing the quantity of goods and services supplied.

Reasons for a vertical long run AS curve
 The meaning of potential output or full employment output or natural rate of output
 In the long run, an economy’s production of goods and services depends on its availability of resources and production technology which are not affected by the price level.
3

III.
Factors and policies affecting AD and AS

Determinants of aggregate demand
 Private consumption expenditure, which depends on disposable income, the desire to save, wealth (value of assets), interest rate, etc.
 Investment expenditure, which depends on business prospect, interest rate, etc.
 Government expenditure
 Net export, which depends on the economic conditions of trading partners, exchange rate, etc.
 Determinants of long run AS
 Changes in labor
 Changes in capital
 Changes in natural resources
 Changes in technological knowledge
 Determinants of short run AS
 Changes in labor
 Changes in capital
 Changes in natural resources
 Changes in technological knowledge
 Expected price level
4

Teaching advice

Get the students involved in suggesting factors that might shift the aggregate demand curve.

Relate changes in aggregate demand to changes in consumption, investment, government purchases, and net exports.

Show students that, if any of these four components of GDP change (for reasons other than a change in the price level), the aggregate demand curve will shift.
IV.
Determination of income and price level by AS-AD

Determination of the equilibrium level of output and price level in the
AS-AD model

Changes in the equilibrium level of output and price level caused by change(s) in the AD and/or AS
 A contraction in Aggregate Demand
Case study: Hong Kong economy is currently in a recession.
 A contraction in Aggregate Supply – occurrence of stagflation

Case study 1: The Great Depression and World War II

Case study 2: The Recession of 2001

Case study 3: Oil and the economy

Relationship between employment and output level

Recessionary gap and inflationary gap
Teaching advice

Students will be confused by the graphs showing the adjustment process that occurs when aggregate demand shifts.

Take the time to walk them through step-by-step several times, summarizing what moves the economy from one point to the next.
5


Two Causes of Economic Fluctuations
Long-Run Equilibrium
(I) The Effects of a Shift in Aggregate Demand
- Suppose a fall in aggregate demand
Short Run Effects
(a) If policymakers do nothing (refer to Fig. A)

A decrease in aggregate demand (AD
1

AD
2
)
 causes output to fall in the short run (recession) (Y
1

Y
2
),
 but overtime, people will correct the misconceptions, sticky wages &
Long Run Effects stick prices, the short-run aggregate-supply curve shifts (AS
1
 AS
2
),
 output returns to its natural rate (Y
2

Y
1
),
 equilibrium price level fall
* A nominal change (in the price level) but not a real change (output is the same).
6

(b) If policymakers want to eliminate the recession (refer to Fig. B)

A decrease in aggregate demand (AD
1

AD
2
)
 causes output to fall in the short run (Y
1

Y
2
),
 increase government spending or increase money supply causes aggregate demand to increase (AD
2

AD
1,
Y
2

Y
1
)
A Contraction in Aggregate Demand
Fig. A
SRAS, AS
Fig. B
SRAS, AS
7

(II) The Effects of a Shift in Aggregate Supply
- Suppose there’s a sudden increase in the costs of production.
Short Run Effects
(a) If policymakers do nothing

Short-run aggregate-supply curve will shift to the left (AS
1

AS
2
),
(Depending on the event, long-run aggregate supply may also shift.
We assume that it does not.)
 output falls (Y
1

Y
2
),
 price level rises (P
1

P
2
),
 the economy is experiencing stagflation
Definition of stagflation: a period of falling output (Recession) and
Long Run Effects rising prices (Inflation).

Over time, price expectations will adjust, causing the short-run aggregate-supply curve to shift back to the right (AS
2
 AS
1
),
 price falls back to P
1
(P
2

P
1
),
 output goes back to Y
1
(Y
2

Y
1
)
An adverse shift in aggregate-supply
SRAS, AS
8

(b) If policymakers can accommodate an adverse shift in Aggregate supply

When short-run aggregate supply falls (AS
1

AS
2
),
 price level rises (P
1

P
2
),
 policymakers can accommodate the shift by expanding aggregate demand (AD
1

AD
2
),

the price level rises further (P
2

P
3
),
 output is kept at its natural rate
Accommodating an Adverse Shift in Aggregate Supply
SRAS, AS
9