Principles of Macroeconomics / Unit 18 MAC 1737 review, 2 to 3 minutes
The Whole Economy in One Diagram
The idea
Almost everything this course taught can be assembled onto the aggregate demand and supply diagram, and doing that assembly once is the most useful revision available. The horizontal axis is real output and the vertical is the price level. Long-run aggregate supply stands vertical at potential output, which unit four said is set by physical capital, human capital and technology, and which grows over time as those grow. Short-run aggregate supply slopes up, because wages and some prices are sticky, and it shifts when input prices, productivity or expected prices change. Aggregate demand slopes down and is the sum of consumption, investment, government purchases and net exports — so every one of the course's other models feeds one of its components. The expenditure model of unit nine determines the position of aggregate demand at a given price level. The money market of unit twelve sets the interest rate that moves investment. Loanable funds sets the real rate that government borrowing competes in. The foreign exchange market of unit thirteen sets the rate that moves net exports. They are not separate subjects; they are the machinery behind one curve.
In practice
Worked example, one event traced through every model at once. A central bank raises the rate it pays on reserves. In the money market, banks hold reserves rather than lend, the federal funds rate rises, and other rates follow. In loanable funds, the real rate rises and some investment projects stop clearing their hurdle, so investment falls. In foreign exchange, higher domestic returns attract foreign funds, so demand for the currency rises and its supply falls, and it appreciates. In the goods market, the appreciation makes exports dearer abroad and imports cheaper at home, so net exports fall. Two components of aggregate demand have now fallen, so aggregate demand shifts left by the multiplier times their combined fall. On the diagram, output falls and the price level falls, and how much of each depends on which zone of short-run supply the economy was sitting in.
Where people slip
Three cautions. First, the diagram gives directions and not magnitudes: it can say the price level falls without saying by how much, and every quantitative answer in the course came from a model underneath it rather than from the diagram itself. Second, when both curves move the outcome for one variable is determinate and the other is not, and the honest answer to the indeterminate one is that it cannot be determined from the information given. Third, the long-run curve is doing quiet work throughout: everything that looks like a permanent gain in output is either a movement of that vertical line or a temporary deviation from it, and unit ten's whole argument is about which one you are looking at.
Your place on the trail
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