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Chapter 12
Macroeconomic Models
and Analysis
© 2001 South-Western College Publishing
Aggregate Demand (AD)
and Aggregate Supply (AS)
 Aggregate Demand
– AD curve
– real output
 Aggregate Supply
– AS curve
2
AS and AD Curves
P
AS
P1
AD
0
Y1
Y
3
Classical Analysis
Say’s law
Production, which creates supply, also
creates and equivalent amount of
monetary purchasing power, or demand
4
Keynesian Analysis
 Also known as income-expenditure
analysis
 Aggregate Expenditure (AE)
– the total planned spending for goods
and services by consumers, businesses
government, and foreign buyers
5
Two-Sector Economy
 Consumption
– consumption function: any table,
equation, or graph showing the relationship
between DI and the amount consumers plan
or desire to spend on currently produced final
output
– marginal propensity to consume
(MPC): ratio of the change in consumption
spending to the change in DI; the slope of the
consumption function
6
Two-Sector Economy (cont.)
– saving function: the relationship between
the amount of DI consumers receive and the
amount they save
– marginal propensity to save (MPS):
ratio of the change in planned saving to the
change in DI; the slope of the saving function
Investment
– planned investment demand
7
Expenditure
Consumption and Savings Functions
C
Saving
C2
C1
45 o
0
Saving
Y1
Y2
Real Income
S
S2
0
Saving
Y1
Y2
Real Income
8
Equilibrium Output when
Planned I = Planned S
Expenditure
C+1
C
0
45 o
Saving and
Investment
Y1 Y2 Y3 Y4
Real Income
S
I
0
I
Y1 Y2 Y3 Y4
Real Income
9
A Four-Sector Economy
 Government spending and taxes
 Net exports
AE = C + I + G + (X – IM)
 Equilibrium
10
Equilibrium with Unemployment
 Increased consumption and net exports
 Increased investment
 Increased government spending
11
Discretionary Government Spending
Used to Increase Income and Output
Expenditure
C + I + G2 + (X - IM)
C + I + G1 + (X - IM)
C
45 o
Y1
Y*
Real Income
12
Equilibrium with Inflation
To combat inflation
– decrease government spending
– raise interest rates
• discourage investment
– increase taxes
• lessen consumption
13
AE and the Multiplier
 The multiplier: relationship between a change
in aggregate expenditure and the resulting larger
change in the national output or income
 Relationship to consumption and saving
 Calculating the value of the multiplier:
– MPC is used to calculate the multiplier k
1  1
k = 1MPC MPS
14
Deriving an Aggregate Demand Curve
from Aggregate Expenditure Curves
Expenditure
AE3
AE2
AE1
(a)
45 o
0
P
Y1
Y2
Y3
Real Income
P1
(b)
P2
P3
0
AD
Y1
Y2
Y3
Real Income
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Classical and Keynesian Views of
Aggregate Supply
P
AS
P
P0
AS
AD2
AD2
AD1
AD1
0
Y*
(a)
Y
0
Y
(b)
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Aggregate Demand and Composite
Aggregate Supply
P
AS
AD5
AD4
AD3
AD2
AD1
0
Y1
Y2
Y*
Y
17
Monetarist School
 Economy automatically tends toward full
employment equilibrium; it is essentially
stable
 Money is the most important variable in
determining aggregate demand
 Government intervention worsens the
effects of the business cycle
18
New Classical School
 Economy is essentially stable and self-
correcting
 Active monetary policy has no place in
the economy
 Government intervention is ineffective
due to rational expectations
– people learn from past experiences and
with economic information available
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can correctly foresee the future