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equations for a macroeconomic model including private, public, and international sectors. Derive the aggregate demand function. List the forces (i.e., factors) which are held constant for each behavioral equation. Select four of these and, for each, explain how a change in the exogenous factor will affect the aggregate demand function. Explain the effect of each change on real income and output, employment, the price level, the interest rate, the foreign exchange rate, and the government budget balance.
While this question asks us to derive the aggregate demand function, it should be noted that aggregate demand models do not exist sui generis but rather as a part of the paired set of aggregate supply and aggregate demand. These paired ideas together form a model of an aggregate economy, which is simply one in which the price level of any good is set by a balance that exists (or is sought) between the ability of an individual, nation or set of nations to produce goods and services and their ability to raise and spend money to acquire the same products.
Aggregate supply is simply the ability of individuals, nations, or supra-national groups to produce goods and services. This ability is derived from the degree and availability of technology, the type and availability of raw materials (or subcomponents) and the availability of the necessary labor. As one might surmise, the aggregate demand is the mirror image of this. Thus the aggregate demand is the "ability to spend," which is itself a combination of income and interest rates. Aggregate demand can be seen as an expression of the inverse relationship that always exists between the price level and purchasing power: As prices rise (because interest rates rise or real income rises and produces inflation or output falls and produced scarcity), purchasing power falls.
The equation is actually a little more complicated than this, because it must also take into effect (on the international level) the exchange rate between nations (which becomes a part of cost and so affects demand) as well as governmental budgetary levels because government intervention, which can serve to increase or decrease employment levels, increase or decrease interest levels, make raw products more or less available, and affect exchange rates.
Of course, economies are rarely even close to equilibrious states, and the aggregate supply-aggregate demand model can also be used to model shifts in demand and supply as can be seen in the following graphs. In fact, this model may be more useful for helping us to understand economic "shocks." supply-side shock, such as an increase in labor productivity, would shift AS outward -- there is a greater potential to produce at each and every price level. We can see this change in figure 1 to the left. This shock, in time, creates an excess supply of goods (Y* > YR) and puts downward pressure on the price level. As prices fall, purchasing power increase reflecting an increase in the ability to spend (i.e., a movement from A to B). The net result in an increase in output and spending and a lower price level.
In figure 2 to the left, we have a demand-side shock perhaps the result of an increase in government spending. This shock shifts the AD relation outward. Initially there is an excess demand for goods (A to B) evidenced by a depletion of inventories. Given that potential output has not changed, in time this excess demand will cause the price level to increase. As prices increase, purchasing power falls and the ability to spend decreases (B to C). The net result of this shock is an increase in the price level with no change in output or real spending.
While the aggregate demand-aggregate supply to some extent stands alone, it is also of course part of larger contemporary economic theory. In fact, much contemporary growth theory can be viewed as an attempt to develop a theoretical model that allows one to bring the rate of growth of demand and the rate of growth of supply into line.
2. Explain the three versions of the aggregate supply curve, i.e., the short-run, the long-run, and the intermediate range.
The aggregate supply curve in economics is a graphical representation of the relationship that exists at a given time (three separate versions of the curve designate different time frames for analysis; longer time periods must allow for a greater complexity of factors and a greater degree of uncertainty). On a standard aggregate supply curve, the price of a product is graphed on the vertical axis with the available quantity of that product graphed on the horizontal axis. Quantity is the independent variable as cost depends upon it.
In a simplified (one might even argue idealized) aggregate supply curve, the curve itself appears as a slope that rises upward as one progresses from left to right on the graph. This is true if one assumes that amount determines price. Of course, this is only true to some extent: Amount determines cost (and produces a standardized aggregate supply curve) only in a ceteris paribus argument: Only if other significant economic factors are held constant. Among these factors that must be held constant to produce a standard curve (and that may not be and so may produce variations in supply curves, especially in intermediate and long-range curves, are technological developments, the monopolistic or anti-monopolistic state of the market, prices of components or of related products, and expectations on the part of sellers about costs and profits.
Suppose that people around the world withdraw substantial amounts of money from their bank deposits in anticipation of supply disruptions at the beginning of the new millennium. Without central bank intervention, how would this affect the supply of money and the availability of credit? In the U.S., what should the Federal Reserve do to offset this shock to the economy? Use balance sheets to explain in detail how these forces work.
Although we tend to think about the ideas of supply and demand as pertaining to products like carrots or Diet Coke, in fact it also applies to money itself. If everyone were to withdraw substantial amounts of their money from banks at the same time (as happened, for example, during the Great Depression), money becomes in short supply and economies can suffer deflation. Deflation - an increase in the value of money - reduces the availability of credit in precisely the same way that a drought decreases the availability of wheat.
To understand this phenomenon better it may help to look more closely at the constituent parts of the U.S. monetary supply. That monetary supply consists primarily of currency (including of course both bills and coins) in addition to deposits held by commercial banks, savings and loans and credit unions. There are three different widely accepted measures (because of their acceptance by the Federal Reserve) of determining the money supply. The first of these is M1. This is the most restrictive measure and "counts" as money those funds that are usable as a medium of exchange. The M2 measure of money also takes into consideration the ways in which money is used to store wealth. Finally, M3 also takes into consideration other forms of wealth that are seen as analogous to money.
The hypothetical situation that we are dealing with here has to do primarily with M1.
While in some sense money is illusory - a metaphor for labor and stored wealth - it is also real and has a powerful effect on the overall economy because it is used in nearly every economic transaction that occurs in contemporary society. Because of this, an increase in the supply of money (or rather an increase in the supply of money that people have available to spend - which must have subtracted from it the amount of money that people are hoarding because they are afraid to spend it) makes more money available to consumers. This tends to increase spending since people believe themselves to be wealthier. Because people are spending more, production tends to increase, which increases the demand for labor, which tends in turn to increase the money supply. This leads to prosperity and, in time, to potential inflation unless interest rates are raised.
The reverse occurs when the money supply contracts: People feel poorer so that they spend less, which reduces the amount of production, which reduces the demand for labor, which does in fact make people poorer and lead to a further reduction in the money supply. A reduced money supply produces either actual deflation (when prices fall) or at least disinflation, which is a reduction in the level of inflation.
However, the money supply is not actually entirely like the supply of wheat because the government has far greater control over the supply of money than it does (for example) over rainfall. (Although of course the government could sign the Kyoto accord, thereby reducing global warming and decreasing the chance for drought, but that is the subject of another paper.) The…[continue]
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