Overview

Overview

A key part of macroeconomics is the use of models to analyze macro issues and problems. How is the rate of economic growth connected to changes in the unemployment rate? Is there a reason why unemployment and inflation seem to move in opposite directions: lower unemployment and higher inflation from 1997 to 2000, higher unemployment and lower inflation in the early 2000s, lower unemployment and higher inflation in the mid-2000s, and then higher unemployment and lower inflation in 2009? Why did the current account deficit rise so high, but then decline in 2009?

To analyze questions like these, we must move beyond discussing macroeconomic issues one at a time, and begin building economic models that will capture the relationships and interconnections between them. This module introduces the macroeconomic model of aggregate supply and aggregate demand, how the two interact to reach a macroeconomic equilibrium, and how shifts in aggregate demand or aggregate supply will affect that equilibrium. The purpose of the AD/AS model is to explain how the price level and real GDP are determined. Real GDP depends on labor, capital, technology, land, and entrepreneurial talent. In the short run, only the quantity of labor can vary, so fluctuations in employment lead to changes in real GDP. When the quantity of labor demanded equals the quantity of labor supplied, there is full employment in the labor market and real GDP equals potential GDP. (20)

This module also relates the model of aggregate supply and aggregate demand to the three goals of economic policy (growth, unemployment, and inflation), and provides a framework for thinking about many of the connections and tradeoffs between these goals. Next, this module briefly describes the federal budget process and the recent history of revenues, outlays, deficits and debts. Then, using the AD/AS model, this module explains the effects of fiscal policy on the price level, employment and real GDP. The limitations of fiscal policy are also discussed. (1)