WEEK VAggregate Demand and Supply

WEEK VKeynesian Macroeconomic Model Transmission

Theory of Liquidity

PreferenceKeynesian Cross

LM Curve IS Curve

IS-LM Model

AD Curve AS Curve

Economic fluctuations

WEEK VAggregate Supply (AS)AS captures the effect of output (Y) on the price level (P). AS is derived from the behavior of wage setting (WS) and price setting (PS).

P = (1 + m)W

P = (1 + m) Pe F(u, z)

By replacing u in the equation by 1 – (Y/L):

AS relation: P = Pe (1 + m) F[1 - (Y/L), z]

Interpretation AS relation: 1. An increase in output (Y), while Pe constant, leads to an increase in the

price level (P):a) Y N b) N U & u c) u W d) W P

WEEK V2. An increase in expected price (Pe ), while u constant, leads to an increase in the price level (P):a) Pe W b) W Cost c) Cost P

3. If actual output (Y) = natural level of output (Yn), thus P = Pe

Based on above characteristics, 3 properties of AS curve:

4. Upward sloping; a positive relationship between Y and P

5. Goes through a point (e.g. A) in which Y = Yn and P = Pe thus this implies:a) Y > Yn P > Pe

b) Y < Yn P < Pe

WEEK V

WEEK VBased on above characteristics, 3 properties of AS curve (continued):

3. Changes Pe in will shift AS curve

WEEK VAggregate Demand (AD)AD captures the effect of the price level (P) on output (Y). AD is derived from the equilibrium in the goods market (IS) and financial market (LM)

IS : Y = C(Y – T) + I(Y, i) + G

LM: (M/P) = Y, L(i)

(M/P): real money stock which its changes depend on changes in nominal money (M) of the bank central and price level (P). Therefore: 1. P (= M ) (M/P) 2. (M/P) i 3. i I Z Y

WEEK V

WEEK V

TGP

MYYrelationAD ,,:

WEEK VAS & AD: Equilibrium condition

AS relation: P = Pe (1 + m) F[1 - (Y/L), z]

1. Short run (SR): Pe constant

a) At point A (AS intersect AD): all of markets [goods, financial (represented by AD curve) and labor (represented by AS curve)] is in equilibrium in which output level = Y and price level = P.

b) Y ≠ Yn and P ≠ Pe

TGP

MYYrelationAD ,,:

WEEK VThe SR equilibrium: Y > Yn

WEEK V2. Medium and long run (LR): Pe changes

a) Y = Yn

due to an automatic adjustment process over time:i. Y > Yn thus Pt > Pe

t-1

ii. Pet > Pe

t-1

iii. Pe Wt+1 Costt+1 iv. Costt+1 Pt+1

b) AS curve shifts upward to achieve Y = Yn in LR

c) Y decreases by moving along the AD curve (i.e. via M/P I Z/AD Y)

WEEK VThe dynamics of automatic adjustment in LR

WEEK VDynamic effects of policies & external shocks

1. Expansionary monetary policy: M

1. SR: a) M (M/P) Y b) LM curve shifts downward i I Z/AD c) AD : AD curve shifts to the right P

d) Equilibrium condition in SR at A with P’ and Y’e) Y > Yn

WEEK V Effect expansionary monetary

policy on interest rate and output

WEEK V1. Expansionary monetary policy: M

2. Over time (LR): adjustment of Pe (Pe < P) and shifting AS curve upward until :a) Equilibrium condition in LR at A” with P” and Y”b) Y” = Yn

c) AS curve upward : P d) since higher P offsets the increase in M thus (M/P) is back to

its initial value

e) M P but NO effect on Y and I called as the neutrality of money in the medium and long run.

f) Expansionary monetary policy can help the economy to move out of recession (Y < Yn ) and return to natural level of output.

WEEK V Effect of expansionary monetary policy on output and price

level: SR and LR

WEEK V

2. Contractionary fiscal policy: G

1. SR: a) G Z/AD Y b) AD curve shifts to the left P c) IS curve shifts to the left i

d) P (M/P) LM curve shift downward i further

e) Equilibrium condition in SR at A with P’ and Y’f) Y’ < Yn

WEEK V Effect contractionary fiscal

policy on interest rate and output

WEEK V2. Contractionary fiscal policy: G

1. In LR: adjustment of Pe (Pe > P) thus:a) P (M/P) b) LM curve shift downwardc) i d) Y = C(Yn – T) + I(Yn , i) + G in which Yn and T are

unchanged, G and I (due to i )

e) Equilibrium condition in LR at A” with P” and Y”f) Y” = Yn

WEEK VEffect of contractionary fiscal policy on output and price

WEEK V

3. External shocks: Increase in world oil price

1. SR: a) Oil Price m (oil as cost of energy)b) m : PS curve shifts downward W/P & u c) AS curve shifts upward P & Y

d) Equilibrium condition in SR at A’ with P’ and Y’e) Y’ < Yn

WEEK VEffect of increase in world oil price on unemployment

WEEK VEffect of increase in world oil price on output and price

WEEK V

3. Increase in oil price

2. Over time: adjustment of Yn (recall: un ) thus:a) AS curve shifts to upward Yn b) Therefore Y’n < Y makes Pe and AS curve shifts upward

furtherc) P further and Y until Y = Yn

d) Equilibrium condition in LR at A” with Y’n