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Lecture 4

PM Lecture 4 (cont.) Aggregated Supply and Demand I.pdf

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CAS EC 102
Jay Zagorsky

PM Lecture #4 (cont.): Aggregated Supply and Demand I Tuesday, March 25, 2014 4:00 PM - Macroeconomicsis the study of forces that you cannot control ○ However,if you can predict macroeconomicchanges and correctlyadjust you will do very well  Andrew Carnegie's demand for rails Why Do Managers Care? - Macroeconomicindicators are past and current pieces of information ○ Unemploymentrate ○ Inflation rate ○ Productivity ○ GDP ○ Exchange rate ○ PPI - Managers who are able to predict and anticipate these data in the future, can do much better than those who simply react to changing macroeconomiccircumstances - The model of Aggregate Demand and Aggregate Supply both explains and predicts what will happen to GDP and inflation when major shocks and changes happen to an economy Why Do We Care? - Business success or failure is dependent on 2 factors ○ How good you are at running the business ○ The general economicclimate - Sometimes,even the best managers cannot save a business that is being effected by an economic recession - Sometimes,the worst managers make a lot of money during an economicexpansion - Tracking general economicconditions can have a large effect on businesses Introduction to the Aggregate Supply and Demand Curves - How can we explain and predict these business cycle changes? - How can we explain and predict what happens in the economywhen large shocks occur? Aggregate Supply-Demand Model - Aggregate Demand Curve (AD): Shows quantity of goods and servicesthat households, firms and gov't want to buy at each price level - Aggregate Supply Curve (AS): Shows quantity of goods and services that firms chooseto produce/sell at each price level - Natural Rate of Output: Is the long run AS, It is vertical because in the long run, the economy's production depends on the amount of land, labor and capital, which are not affected by short run changes in output Price Level - Vertical left hand axis is labeled price level - Understanding CPI and GDP Deflator is very important - Changes in price level is inflation of deflation ○ (New price level - Old price level)/Old x100 ○ Movement from low to higher price level: Inflation ○ Movement from higher to lower price level: Deflation InvestmentMangers Care! - During 1990s,investorswanted real return <5% - Bond prices inversely related to interest rates - Normal interest = Real interest + Inflation Quantity Output - Horizontal bottom axis is labeled quantity of output - Understanding GDP is very important - Changes in quantity is either economic expansion or contraction ○ Movement from low to higher quantity: Expansion ○ Movement from higher to lower quantity: Contraction InvestmentManagers Care! - GDP change is related to sales, note that change in GDP is not the same as change in sales - For most companies, when sales go up, profits go up, hence, GDP and profits are positivelylinked UnemployedResources - There are other forms of unemployed resources such as idle factories,farms and transportation - What happens if the LAS is to the left of where the short run AS and AD curve cross? AS-AD and Financial Markets - AS-AD Model is useful for trading socks and bonds - When shock hits, or change occurs in the economygood traders can use the AS-AD Model to quickly make a rough guess what will happen to prices and GDP which would indicate if you should be buying or selling in the financial markets 2 Key Ideas about Bonds - Bond prices are inverselyrelated to the nominal interest rate - Nominal Int. Rate = Real Rate + Inflation Rate ○ Assuming that real rates are roughly constant in the short run then when the CPI goes up unexpectedly  Inflation goes up  Nominal interest rates go up  Bond prices go down  Investmentstrategy is to sell bonds Key idea about stocks: prices are directly related to the amount of profits - The more profits companies have, the higher the value of stocks - One model of pricing stock is that the stock price should be equal to the present discounted value - One model of pricing stock is that the stock price should be equal to the present discounted value of all future profits - Key assumption for using AS-AD model for understanding short run changes in the stock market is that GDP and corporate profits are closely linked Are GDP-ProfitsLinked? - US gov't collects GDP data but also collects corporate profits
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