Adding Inflation To Our Model: Aggregate Demand and Aggregate Supply Lecture 19 Jennifer P. Wissink ©2016 Jennifer P. Wissink, all rights reserved. April 11, 2016

CES Event Today! u Courses After the Core: –WHEN: Monday, April 11th. 4:30-6:30 PM –WHERE: Rockefeller Hall 122 –Courses After the Core is an event that explores the various options for Economics majors upon completion of the core courses. The panelists we have are all people who have varying interests upon graduation and will be able to provide varying perspectives on what courses are good to take for different interests. –Wegmans catering will be served!

Announcements(mAcro)-Spring 2016 u Prelim 2 is Thursday April 14, 7:30pm-9:00pm. –Please go to Blackboard and register for Option 1 or Option 2 if you have a Cornell created evening prelim conflict. –NOTE: DO NOT EXPECT ANY REPLY. PRINT YOUR THANKYOU SCREEN AT THE END IF YOU WANT A “RECEIPT”. –See our syllabus for your options. –For all other prelim conflicts/issues you must come and see Prof. Wissink in person ASAP. –Information on coverage and all testing locations was posted on Bb Announcements already – please check there. u MEL Quiz#10 is due on April 11 – a review for everyone

Practice Problem Solving given A MODEL. Suppose you are given the following: C = consumptionG = govern. spendingM D = money demand I d = investment spendingT = taxesM S = money supply Y = national income/outputr = interest rateY d =disposable income C = Y d ; I d = 2000 – 1500r ; G=100; T=100; EX=0; IM=0 Money demand: M D = 900 – 1000r; The required reserve ratio for all banks in this economy is rrr=10%. No bank holds excess reserves, and everybody keeps all their money in the banking system (so no currency). The total reserves in the banking system are TR=$70. With all that, answer the following: 1. What is the total money supply? 2. What is the equilibrium interest rate? 3. What is the equilibrium level of national income? NOW Suppose: Y FE =$9, Should the FED buy or sell securities to achieve this goal? How much (give a dollar figure) should the FED buy or sell?

C = Y d ; I d = 2000 – 1500r ; G=100; T=100; EX=0; IM=0 Money demand: M D = 900 – 1000r; rrr=10%; TR=$70 and Y FE =$9,600

M r I Y AE d 45° help r

C = Y d ; I d = 2000 – 1500r ; G=100; T=100; EX=0; IM=0 Money demand: M D = 900 – 1000r; rrr=10%; TR=$70 and Y FE =$9,600.

Try MORE! u Same set up, but now assume Y FE =$9,000 u Add an import function... and do the problem over. u Make the tax function more interesting...and do the problem over. u How about FISCAL policy instead of monetary... and do the problem over.

END OF MATERIAL FOR PRELIM 2 Thank goodness!

New Wrinkle – The Price Level u Up to now we’ve pretty much (not completely) ignored the overall price level - now we want to re- introduce it. u How will it alter our understanding of the model and fiscal and monetary policy? u Where does the price level appear in the model? –In the Money Demand Function! –Recall, M D depends on r, Y and PL where PL is the aggregate price level »HOW? u It’s time to introduce two new notions: –Aggregate Demand = AD –Aggregate Supply = AS, both SR-AS and LR-AS

The Aggregate Demand Curve - AD u The Aggregate Demand (AD) curve is a curve that shows the relationship between aggregate output/income (Y) and the price level (PL) when the money market and goods market are both in equilibrium. u The Aggregate Demand (AD) curve is negatively sloped. u To derive the Aggregate Demand Curve, we examine what happens to aggregate output/income (Y) when the price level (PL) changes, assuming no changes in government spending (G), net taxes (T), or the monetary policy variable (M s ). –And no changes in exports and imports, which we are ignoring for now anyway.

Deriving the Aggregate Demand Curve The Impact of an Increase in the Price Level on the Economy – Assuming No Changes in G, T, and M s

The Aggregate Demand Curve: A Warning u The AD curve is not a market demand curve like in microeconomics. It’s a more complex concept. –It’s an equilibrium locus, really. u Remember: A higher price level causes the demand for money to rise, which causes the interest rate to rise. –Then, the higher interest rate causes aggregate output to fall. –At all points along the AD curve, both the goods market and the money market are in equilibrium.

Additional Reasons for a “Negative” AD Curve u The consumption link: There might be a decrease in consumption brought about by the increase in the interest rate brought about by a higher price level – this would contribute to the overall decrease in aggregate output (Y). u The real wealth effect, or real balance effect: There might be a decrease in consumption brought about by the decrease in real wealth that results from an increase in the price level – this would contribute to the overall decrease in aggregate output (Y). u Note: These are not directly in the model we’ve constructed... but you will see them later if you take more macro.

Shifts in Aggregate Demand via Monetary Policy u An increase in M s at a given price level shifts the aggregate demand curve to the right. u A decrease in M s at a given price level shifts the aggregate demand curve to the left.

Shifts in Aggregate Demand via Fiscal Policy u An increase in G or a decrease in net T at a given price level shifts the aggregate demand curve to the right. u A decrease in G or an increase in net T at a given price level shifts the aggregate demand curve to the left.

Tracking an increase in the money supply