E.  Aggregate Model of the Macro Economy

1.  Aggregate demand curve

• Shows combinations of the absolute price level (P) and real income or GDP (Y) that result in simultaneous equilibriums in both the real goods and money markets

a.  Derivation

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b.  Shifting the aggregate demand curve

(1) Monetary policy

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(2) Fiscal policy

• Use government spending and / or tax changes to affect economy

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(3)  Other factors

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c.  Policy implementation and issues

(1)  Fiscal policy

(a)  Lags - Takes time for policy to take effect

• Recognize problem

• Pass legislation

• Implement policy

• Have impact on problem

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(b)  Automatic stabilizers - expenditure and taxation programs that slow the economy during economic expansions and stimulate the economy during recessions

Ex. - Unemployment insurance, progressive income tax system

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(c)  Progressive income tax system - tax rate increases as income increases

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(d)  Budget deficit and the national debt

• Deficit if government expenditures > government revenue

• Debt = accumulated deficits

• Are deficits and debt a problem?

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i)  Crowding out

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ii)  Who owns the debt?

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iii)  Is the debt a burden on future generations?

• Depends on how it it used now

• Future generations can borrow to push debt into future

• Problem if more productive private sector investments are crowded out

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(2)  Monetary policy issues

(a)  Lags

• Recognition lag - same as fiscal policy

• Implementation lag - faster than fiscal policy

• Impact lag - slower than fiscal policy

- Less impact than fiscal policy - can't force people to borrow money

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(b)  Interest rates

• Target federal funds rate to influence other interest rates

• Term structure of interest rates - relationship between maturity and interest rates

• Yield curve - graphical representation of the term structure

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2.  Aggregate supply curve

• Shows the price level at which firms are willing to produce different amounts of real goods and services

• Depends on quantity and quality of resources used in production, efficiency with which resources are used, and production technology

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a.  Short-run aggregate supply

• Amount of resources, efficiency of their use, and level of technology constant in short-run

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b.  Long-run aggregate supply

• Potential output - full-employment level of output

• Maximum amount that can be produced, given resources and technology available

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3.  Equilibrium

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4.  Changes

a.  Aggregate demand

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b.  Short-run aggregate supply

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c.  Long-run aggregate supply

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5.  Business cycle

• Expansion - increase in economic activity

• Recession - decrease in economic activity

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a.  Economic indicators

(1)  Concurrent indicators

• Move along with the economy

- Employees on nonagricultural payrolls
- Personal income less transfers
- Industrial production
- Manufacturing and trade sales

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(2)  Leading indicators

• Move in advance of the economy

- Average weekly hours, manufacturing
- Average weekly initial claims for unemployment insurance
- Manufacturer's new orders, consumer goods and materials
- Institute for Supply Management new orders index
- Manufacturer's new orders, nondefense capital goods excluding aircraft
- Building permits, new private housing units
- Stock prices, 500 common stocks
- Leading Credit Index
- Interest rate spread, 10-year Treasury bond less federal funds
- Average consumer expectations for business and economic conditions

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(3)  Lagging indicators

• Move after the economy moves

- Average duration of unemployment
- Inventories to sales ratio, manufacturing and trade
- Labor cost per unit of output, manufacturing
- Average prime rate
- Commercial and industrial loans
- Consumer installment credit to personal income ratio
- Consumer price index for services

• Calculated by the Conference Board

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b.  Impact on managerial decisions

• Demand affected through impact on income

• More intense competition for market share and profits

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