Chapter 7 Aggregate demand and supply: an introduction

The aggregate demand curve A change in the price level:  Initially, P=P 0 ;  Equilibrium income: Y 0 ;  Price change: P 0  P;  The LM curve shifts to LM;  New equilibrium income: Y.

The aggregate demand curve Formal presentation of aggregate demand:

The aggregate demand curve The slope of the AD curve:  From IS-LM analysis: An increase in real balances generates a larger increase in equilibrium income for larger  G and b, or smaller h and k.  The AD curve is flatter for larger  G and b, or smaller h and k;  The classical case: h  0 AD curve is flat but not horizontal.  The liquidity trap: h  AD curve is vertical.

The aggregate demand curve The slope of the AD curve.

Aggregate demand policies Fiscal expansion:  IS  IS;  Same price: Y 0  Y;  The AD curve shifts out: AD  AD.

Aggregate demand policies Monetary expansion:  LM  LM;  Same price: Y 0  Y;  The AD curve shifts out: AD  AD;  K v.s. E: same income  same real balance;  The AD curve shifts upward in proportion to the increase in nominal money.

The aggregate supply curve The AS curve describes how much output firms are willing to supply for any price level; Quantity of supply is determined by the output price and real wage rate, as well as technology; The AS curve reflects resource and technological constraints.

The aggregate supply curve The Keynesian case:  Price rigidity;  Large amount of unemployment;  Firms can get as much labor as they want at the current wage rate;  The average cost of production remains constant;  The supply curve is perfectly flat.

The aggregate supply curve The Keynesian case.

The aggregate supply curve The classical case:  Price and nominal wage rate adjust quickly;  The labor market is always in equilibrium;  Output is solely determined by labor input at full employment;  The supply curve is vertical.

The aggregate supply curve The classical case:

Fiscal and monetary policy under alternative assumptions The Keynesian case: same as IS-LM.

Fiscal and monetary policy under alternative assumptions The classical case: fiscal policy.  Fiscal expansion: AD  AD;  At P 0 : equilibrium would be E;  Bidding up wage and price;  Equilibrium becomes E .

Fiscal and monetary policy under alternative assumptions Crowding out again:  Fiscal expansion: IS  IS;  At P 0 : equilibrium would be E;  Bidding up wage and price;  LM  LM;  Equilibrium becomes E  ;  Full crowding out of private investment.

Fiscal and monetary policy under alternative assumptions Monetary expansion under classical conditions:  Monetary expansion: AD  AD;  At P 0 : equilibrium would be E;  Bidding up wage and price;  Move along AD;  Equilibrium becomes E  ;

Fiscal and monetary policy under alternative assumptions Frictional unemployment and the natural rate of unemployment:  Full employment does not imply zero unemployment;  Fictional unemployment: unemployment as a result of individuals’ shifting between jobs and looking for new jobs;  Natural unemployment rate: the unemployment rate arising from normal labor market frictions in equilibrium.

The quantity theory and the neutrality of money The classical case:  The result of an increase in nominal money: Price rise proportionally, nominal wage rate and interest rate rise by the inflation rate; No real effect: real GDP, consumption, private investment, government purchase, unemployment, real interest rate, real wage rate, and real balance remain unchanged.  Money is neutral. Monetarism:  Money is neutral in the long run, but may not be so in the short run.