CHAPTER II Macroeconomic Models 1

more important than the development of new technology.

employment and income generation
So, it studies the behaviour of the

economy as a whole

Macroeconomics studies:
Significance of total output
Rates of inflation and unemployment
Booms and recessions
Essence of Balance of payments and
Exchange rates

and
Long-run economic growth

Macroeconomics analyses short, medium and long run impact

of policies like:
Consumption and investment policies
Changes in wages and prices
Monetary and fiscal policies
Money stock, budget, interest rates, and the national debt
Foreign exchange rate and the trade balance

to make the economy perform better

Great macroeconomists suggest to intervene

in economy

Such economists are as for example:
John Maynard Keynes
Milton Friedman of the University of Chicago and the Hoover Institution
Franco Modigliani and Robert Solow of M.I.T
James Tobin of Yale University

intervention in economy

Such economists are:
Robert Barro, Martin Feldstein, and N.

Gregory Mankiw of Harvard University
Nobel laureate Robert Lucas and Thomas Sargent of the University of Chicago
Olivier Blanchard of MIT., Robert Hall, and John Taylor of Stanford University

have different time frame
The Models are:
Long run model
Medium run model
Short

run model

the economy
Long run model discusses growth theory
It focuses on growth

of productive capacity
In the Long run model the level of productivity determines:
Output, fluctuation in demand that determines price and inflation

in constant, and
Full employment is achieved
So, if the long-run demand

increases:
Firms have no possibility to increase supply (because of full employment)
Hence, if in the long run demand increases:
Output remains unchanged
Only price increases
Hence, in the long run aggregate supply curve is Vertical (Slide-9)

P Price Level




P1
 
P0

 






0 Yo Y Output/Income

the economy
It analyses level of output and unemployment
It analyses quantity

of output that firms are willing to supply at a given price level
If in short-run demand increases, firms increase supply
Firms use this opportunity to achieve gain
They keep price unchanged and increase supply
So, in short-run aggregate supply curve remains horizontal (Slide-11)

P Price

Level





P1 AS




0 Y Output, Income

the economy
It studies how economy grows from short run to

long run
In the medium run model productive capacity could be increased
In medium run growth theory the adjustment process of the economy from the short run to the long run has been discussed.
Medium run growth theory begins with the supply side of the economy.
It discusses the adjustment mechanism of the aggregate supply and price

the long run and short run aggregate supply curve.
It

has been assumed that in medium run aggregate supply curve rotates counter clockwise.
In medium run model the aggregate supply curve transforms with the time from horizontal to vertical curve.
During the shift the output as well as the price increase

t
t3

t2
t1
AS at t = 0







O Y1 Y Output

models
However, there is less agreement about time frame for short

and medium run model
There is different opinion in respect of time frame of models

investment in technology leads to increase living standard
Long run growth

model ignores recessions, booms and short run fluctuation
It is assumed that labour, capitals, raw materials and so on are fully employed in the long run

determined by the supply of the production factors
Aggregate supply and

aggregate demand determine relation between price and output
Supply curve (AS) gives quantity of output the firms are willing to supply at a price
Position of the aggregate supply curve depends on productive capacity of economy

level of output at which goods markets and money markets

are in equilibrium at a price level
Position of aggregate demand curve depends on monetary and fiscal policy and the level of consumer confidence
Intersection of aggregate supply and demand determines price and quantity
In the long run growth model, the supply curve is vertical
Supply cannot be increased in the long run

curve is flat
Price is not affected by the level of

output
Output is determined by aggregate demand

5. THE MEDIUM RUN
Medium run model describes:
How economy shifts from short run to long run
How aggregate demand pushes output above
How prices rise
How aggregate supply curve to move upward

graphics how different stages of economic development are explained by

the macroeconomic models

Hearing