Topic 9: Macroeconomic Theory and Policy

 9.1 Aggregate Demand (AD)

• AD = total demand for goods/services in the economy.
• Formula: AD = C + I + G + (X – M).
• C = consumption.
• I = investment.
• G = government spending.
• X – M = net exports.
• Downward sloping because:
• Wealth effect (higher prices reduce real wealth).
• Interest rate effect (higher prices → higher interest rates → lower investment).
• Net export effect (higher domestic prices → exports less competitive).

 

9.2 Aggregate Supply (AS)

• Short run AS: upward sloping (higher prices → more output).
• Long run AS: vertical (output limited by resources, technology).
• Shifts caused by changes in productivity, technology, costs, and government policies.

 

9.3 Keynesian vs Classical Views

• Classical: economy self‑corrects; markets are flexible; long run AS vertical.
• Keynesian: the economy may get stuck in a recession; government intervention is needed; the AS curve is flat at low output.

Memory cue: Classical = leave it alone, Keynesian = government helps.

 

9.4 Macroeconomic Equilibrium

• Occurs where AD = AS.
• Changes in AD/AS shift the equilibrium output and price level.
• Inflationary gap: AD too high → prices rise.
• Deflationary gap: AD too low → unemployment rises.

 

9.5 Policy Tools

• Fiscal policy: taxes + government spending.
• Expansionary → boost demand.
• Contractionary → reduce inflation.
• Monetary policy: interest rates, money supply.
• Lower rates → encourage borrowing/spending.
• Higher rates → reduce demand.
• Supply‑side policies: improve efficiency (education, deregulation, innovation).

 

9.6 Phillips Curve

• Shows trade‑off between inflation and unemployment (short run).
• Long-run Phillips curve = vertical → no trade‑off, only natural rate of unemployment.