Editing Macroeconomics (section)

==Macroeconomic models==
{{Further|Macroeconomic model}}

Macroeconomic teaching, research and informed debates normally evolve around formal ([[diagrammatic]] or [[equation]]al) [[macroeconomic model]]s to clarify assumptions and show their consequences in a precise way. Models include simple theoretical models, often containing only a few equations, used in teaching and research to highlight key basic principles, and larger applied quantitative models used by e.g. governments, central banks, think tanks and international organisations to predict effects of changes in economic policy or other [[exogenous factor]]s or as a basis for making [[economic forecasting]].<ref>{{cite book |last1=Watson |first1=Mark W. |chapter=Macroeconomic Forecasting |chapter-url=https://link.springer.com/referenceworkentry/10.1057/978-1-349-95121-5_2434-1 |title=The New Palgrave Dictionary of Economics |publisher=Palgrave Macmillan UK |access-date=9 September 2023 |pages=1–3 |language=en |doi=10.1057/978-1-349-95121-5_2434-1 |date=2016|isbn=978-1-349-95121-5 }}</ref>

Well-known specific theoretical models include short-term models like the [[Keynesian cross]], the [[IS–LM model]] and the [[Mundell–Fleming model]], medium-term models like the [[AD–AS model]], building upon a [[Phillips curve]], and long-term growth models like the [[Solow–Swan model|Solow–Swan]] model, the [[Ramsey–Cass–Koopmans model]] and [[Peter Diamond]]'s [[overlapping generations model]]. Quantitative models include early [[large-scale macroeconometric model]], the new classical [[Real business-cycle theory|real business cycle models]], microfounded [[computable general equilibrium]] (CGE) models used for medium-term (structural) questions like international trade or tax reforms, [[Dynamic stochastic general equilibrium]] (DSGE) models used to analyze business cycles, not least in many central banks, or [[Integrated assessment modelling|integrated assessment]] models like [[DICE model|DICE]].

===Specific models===
====IS–LM model====

[[File:Islm.svg|thumb|In this example of a traditional IS–LM chart, the IS curve moves to the right, causing higher interest rates (i) and expansion in the "real" economy (real GDP, or Y).]]

The [[IS–LM]] model, invented by [[John Hicks]] in 1936, gives the underpinnings of aggregate demand (itself discussed below). It answers the question "At any given price level, what is the quantity of goods demanded?" The graphic model shows combinations of interest rates and output that ensure equilibrium in both the goods and money markets under the model's assumptions.{{sfn|Durlauf|Hester|2008}} The goods market is modeled as giving equality between investment and public and private saving (IS), and the money market is modeled as giving equilibrium between the [[money supply]] and [[liquidity preference]] (equivalent to money demand).{{sfn|Peston|2002|pp=386–87}}

The IS curve consists of the points (combinations of income and interest rate) where investment, given the interest rate, is equal to public and private saving, given output.{{sfn|Peston|2002|p=387}} The IS curve is downward sloping because output and the interest rate have an inverse relationship in the goods market: as output increases, more income is saved, which means interest rates must be lower to spur enough investment to match saving.{{sfn|Peston|2002|p=387}}

The traditional LM curve is upward sloping because the interest rate and output have a positive relationship in the money market: as income (identically equal to output in a closed economy) increases, the demand for money increases, resulting in a rise in the interest rate in order to just offset the incipient rise in money demand.{{sfn|Peston|2002|pp=387–88}}

The IS-LM model is often used in elementary textbooks to demonstrate the effects of monetary and fiscal policy, though it ignores many complexities of most modern macroeconomic models.{{sfn|Durlauf|Hester|2008}} A problem related to the LM curve is that modern central banks largely ignore the money supply in determining policy, contrary to the model's basic assumptions.<ref name=Romer/>{{rp|262}} In some modern textbooks, consequently, the traditional IS-LM model has been modified by replacing the traditional LM curve with an assumption that the central bank simply determines the interest rate of the economy directly.<ref name=Romer/>{{rp|194}}<ref name=Blanchard/>{{rp|113}}

====AD-AS model====

[[File:AS + AD graph.svg|thumb|A traditional AD–AS diagram showing a shift in AD, and the AS curve becoming inelastic beyond potential output]]

The [[AD–AS model]] is a common textbook model for explaining the macroeconomy.{{sfn|Healey|2002|p=12}} The original version of the model shows the price level and level of real output given the equilibrium in [[aggregate demand]] and [[aggregate supply]]. The aggregate demand curve's downward slope means that more output is demanded at lower price levels.{{sfn|Healey|2002|p=13}} The downward slope can be explained as the result of three effects: the [[Pigou effect|Pigou or real balance effect]], which states that as real prices fall, real wealth increases, resulting in higher consumer demand of goods; the [[Keynes effect|Keynes or interest rate effect]], which states that as prices fall, the demand for money decreases, causing interest rates to decline and borrowing for investment and consumption to increase; and the net export effect, which states that as prices rise, domestic goods become comparatively more expensive to foreign consumers, leading to a decline in exports.{{sfn|Healey|2002|p=13}}

In many representations of the AD–AS model, the aggregate supply curve is horizontal at low levels of output and becomes inelastic near the point of [[potential output]], which corresponds with [[full employment]].{{sfn|Healey|2002|p=12}} Since the economy cannot produce beyond the potential output, any AD expansion will lead to higher price levels instead of higher output.

In modern textbooks, the AD–AS model is often presented slightly differently, however, in a diagram showing not the price level, but the inflation rate along the vertical axis,<ref name=Romer/>{{rp|263}}<ref name=Mankiw/>{{rp|399–428}}<ref name=Sørensen/>{{rp|595}} making it easier to relate the diagram to real-world policy discussions.<ref name=Sørensen/>{{rp|vii}} In this framework, the AD curve is downward sloping because higher inflation will cause the central bank, which is assumed to follow an [[inflation target]], to raise the interest rate which will dampen economic activity, hence reducing output. The AS curve is upward sloping following a standard modern [[Phillips curve]] thought, in which a higher level of economic activity lowers unemployment, leading to higher wage growth and in turn higher inflation.<ref name=Romer/>{{rp|263}}