Macroeconomics is very much about tying together facts and theories. We start with a few grand facts and then turn to models that help us explain these and other facts about the economy.
• Over a time span of decades, Dubai economy grows rather reliably at 2 or 3 percent a year.
• In some decades, the overall price level has remained relatively steady. In the 1970s prices roughly doubled.
• In a bad year, the unemployment rate is twice what it is in a good year. The study of macroeconomics is organized around three models that describe the world, each model having its greatest applicability in a different time frame.
The very long run behavior of the economy is the domain of growth theory, which focuses on the growth of the economy’s capacity to produce goods and services. The study of the very long run centers on the historical accumulation of capital and improvements in technology. In the model we label the long run, we take a snapshot of the very long run model. At that moment, the capital stock and the level of technology can be taken to be relatively fixed, although we do allow for temporary shocks. Fixed capital and technology determine the productive capacity of the economy we call this capacity “potential output”. In the long run, the supply of goods and services equals potential output. Prices and inflation over this horizon are determined by fluctuations in demand. In the short run, fluctuations in demand determine how much of the available capacity is used and thus the level of output and unemployment. In contrast to the long run, in the short run prices are relatively fixed and output is variable. It is in the realm of the short run model that we find the greatest role for macroeconomic policy. Nearly all macro economists subscribe to these three models, but opinions differ as to the time frame in which each model is best applied. Everyone agrees that behavior over decades is best described by the growth theory model. There is less agreement over the applicable time scope for the long run versus the short run model.
Aggregate Supply and Aggregate Demand
For now we’ll present the aggregate supply and aggregate demand schedules as the relationships between the overall price level in the economy and total output. The aggregate supply curve depicts, for each given price level, the quantity of output firms are willing to supply. The position of the aggregate supply curve depends on the productive capacity of the economy. The aggregate demand curve presents, for each given price level, the level of output at which the goods markets and money markets are simultaneously in equilibrium. The position of the aggregate demand curve depends on monetary and fiscal policy and the level of consumer confidence. The intersection of aggregate supply and aggregate demand determines price and quantity. In the long run, the aggregate supply curve is vertical.
Economists argue over whether the long run is a period of a few quarters or of a decade.
Output is pegged to the position where this supply curve hits the horizontal axis. The price level, in contrast, can take on any value. Mentally shift the aggregate demand schedule to the left or right. You will see that the intersection of the two curves moves up and down (the price changes), rather than horizontally (output doesn’t change). It follows that in the long run output is determined by aggregate supply alone and prices are determined by both aggregate supply and aggregate demand. This is our first substantive finding. The growth theory and long run aggregate supply models are intimately linked. The position of the vertical aggregate supply curve in a given year equals the level of output for that year from the very long run model. Since economic growth over the very long run averages a few percent a year, we know that the aggregate supply curve typically moves to the right by a few percent a year. Aggregate Supply and Aggregate Demand. The level of aggregate supply is the amount of output the economy can produce given the resources and technology available. The level of aggregate demand is the total demand for goods to consume, for new investment, for goods purchased by the government, and for net goods to be exported abroad.
• You should be warned that the economics underlying the aggregate supply and aggregate demand schedules is very different from the economics of the ordinary, garden variety supply and demand that you may remember from studying microeconomics.
• Sometimes there are shocks that temporarily disrupt the orderly rightward progression of the aggregate supply schedule. These shocks are rarely larger than a few percent of output.
THE SHORT RUN
When we take a magnified look at the path of output, we see that it is not at all smooth. Short run output fluctuations are large enough to matter a great deal. Accounting for short run fluctuations in output is the domain of aggregate demand. The mechanical aggregate supply aggregate demand distinction between the long run and the short run is straightforward. In the short run, the aggregate supply curve is flat. The short run aggregate supply curve pegs the price level at the point where the supply curve hits the vertical axis. Output, in contrast, can take on any value. The underlying assumption is that the level of output does not affect prices in the short run.
• Temporary price increases of 10 or 20 percent can be due to supply shocks for example, the failure of the monsoon to arrive in an agricultural economy. However, ongoing double digit annual price increases are due to printing too much money.
THE MEDIUM RUN
We need one more piece to complete our outline of how the economy works:
Question: How do we describe the transition between the short run and the long run? In other words, what’s the process that tilts the aggregate supply curve from horizontal to vertical?
Answer: The simple answer is that when high aggregate demand pushes output above the level sustainable according to the very long run model, firms start to raise prices and the aggregate supply curve begins to move upward. The medium run looks something like the situation, the aggregate supply curve has a slope intermediate between horizontal and vertical.
Question: How steep is the aggregate supply curve?
Answer: is in effect the main controversy in macroeconomics. The speed with which prices adjust is a critical parameter for our understanding of the economy. At a horizon of 15 years, not much matters except the rate of very long run growth. At a horizon of 15 seconds, not much matters except aggregate demand.
Question: What about in between?
Answer: It turns out that prices usually adjust pretty slowly. thus, over a (1year) horizon, changes in aggregate demand give a good, though certainly not perfect, account of the behavior of the economy. The speed of price adjustment is summarized in the Phillips curve, which relates inflation and unemployment.
• mostly This is an example of what we mean when we say that applying a model requires judgment. There have certainly been historical periods when supply shocks outweighed demand shocks in the determination of output.
• Everything you will learn about macroeconomics can be fitted into the growth theory, aggregate supply, and aggregate demand framework. This intellectual outline is so vital that it is worth the time to repeat parts of the previous section in slightly different words.
GROWTH AND GDP
The growth rate of the economy is the rate at which the gross domestic product GDP is increasing. On average, most economies grow by a few percentage points per year over long periods. For instance, Nigeria real GDP grew at an average rate of 3.2 percent per year from 1993 to 2021. But this growth has certainly not been smooth.
Question: What causes GDP to grow over time?
Answer: The first reason GDP changes is that the available amount of resources in the economy changes. The principal resources are capital and labor. The labor force, consisting of people either working or looking for work, grows over time and thus provides one source of increased production. The capital stock, including buildings and machines, likewise rises over time, providing another source of increased output. Increases in the availability of factors of production, the labor and capital used in the production of goods and services. thus account for part of the increase in GDP.
The second reason GDP changes is that the efficiency of factors of production may change. Efficiency improvements are called productivity increases. Over time, the same factors of production can produce more output. Productivity increases result from changes in knowledge, as people learn through experience to perform familiar tasks better, and as new inventions are introduced into the economy. Studies of the sources of growth across countries and history seek to explain the reasons that a country like Dubai grew very rapidly while Kenya, for example, has had very little growth. Kenya’s per capita income was lower in 2016 than it was in 1999, while Dubai income doubled. Obviously, it would be well worth knowing what policies, if any, can raise a country’s average growth rate over long periods of time.
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