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*Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business...*

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- Slide 1
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard1 of 49 Review Review of IS-LM AS-AD Model Jenny Xu
- Slide 2
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 49 From Chapter 5 and 6 Chapter 5 talks about the determination of output and interest rate in the short-run. Chapter 6 tells us the determination of output in the medium run by the natural rate of unemployment. This chapter we look at the output determination in both the short-run and medium run the AS-AD model; AS- from the labor market; AD- from the IS-LM analysis;
- Slide 3
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 49 IS Curve IS Curve is derived from the Goods Market Clearing condition: Supply of goods: Y equals to Demands of Goods coming from: Consumption demand: C; Investment demand: I; Government Expenditure: G
- Slide 4
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 49 IS Curve IS Curve captures the effect of nominal interest rate i on output Y, for given values of T and G. (tax and government purchase). Investment demand depends negative on interest rate. Hence, when i increase, the investment and then the total demand will fall. So will the total output Y. Therefore, IS curve is downward sloping.
- Slide 5
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 49 LM Curve LM Curve is derived from the financial market clearing condition. Supply of nominal money: M equals to Demands of nominal money coming from the transaction demand, which in turn depends positively on the price level P, and the total output Y, and negatively on the nominal interest rate. (Why? Because higher i implies a higher OC of holding money). So nominal money demand is given by PYL(i)
- Slide 6
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 49 LM Curve LM Curve captures the effect of output Y on nominal interest rate i, for given values of M (nominal money supply) and P (in short run price is assumed to be fixed). Higher total output implies higher transaction demand. So for given level of nominal money supply, high demand implies the interest rate that clear the money market has to increase. So when Y increases, the nominal interest rate i increases. Therefore, LM curve is upward sloping.
- Slide 7
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 49 Aggregate Demand When we derive the AD and AS curve, we no longer assume that price level is fixed. The AD curve indicates that, for given levels of M, T, and G, when the price level change, how does the output level change. The aggregate demand relation captures the effect of the price level on output. It is derived from the equilibrium conditions in the goods and financial markets.
- Slide 8
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 49 Aggregate Demand Recall the equilibrium conditions for the goods and financial markets described in chapter 5: When P increases, then real money supply will decrease, so the nominal interest rate will increase, investment and output will fall. So the AD curve is downward sloping.
- Slide 9
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 49 Aggregate Demand An increase in the price level leads to a decrease in output. The Derivation of the Aggregate Demand Curve Figure 7 - 3
- Slide 10
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard10 of 49 Shift of Aggregate Demand AD curve describes the relationship between price level and the output. So changes in monetary or fiscal policyor more generally in any variable, other than the price level, that shift the IS or the LM curvesshift the aggregate demand curve.
- Slide 11
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard11 of 49 Aggregate Demand An increase in government spending increases output at a given price level, shifting the aggregate demand curve to the right. A decrease in nominal money decreases output at a given price level, shifting the aggregate demand curve to the left. Shifts of the Aggregate Demand Curve Figure 7 - 4
- Slide 12
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard12 of 49 Aggregate Demand Lets summarize: Starting from the equilibrium conditions for the goods and financial markets, we have derived the aggregate demand relation. This relation implies that the level of output is a decreasing function of the price level. It is represented by a downward-sloping curve, called the aggregate demand curve. Changes in monetary or fiscal policy or more generally in any variable, other than the price level, that shifts the IS or the LM curves shift the aggregate demand curve.
- Slide 13
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard13 of 49 Aggregate Supply The aggregate supply relation captures the effects of output on the price level. It is derived from the behavior of wages and prices. Recall the equations for wage and price determination from chapter 6:
- Slide 14
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard14 of 49 Aggregate Supply Step 1: Eliminate the nominal wage from:, then Step 2: Express the unemployment rate in terms of output: Step 3. Substitute u, In words, the price level depends on the expected price level, P e, and the level of output, Y (and also , z, and L, but we take those as constant).
- Slide 15
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard15 of 49 Aggregate Supply The AS relation has two important properties: First, How does the change in Y affect P? An increase in output leads to an increase in the price level. This is the result of four steps: 1. 2. 3. 4.
- Slide 16
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard16 of 49 An increase in the expected price level leads, one for one, to an increase in the actual price level. This effect works through wages: 1. 2. 2. Aggregate Supply The second important property ask the relationship between expected price level and P :
- Slide 17
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard17 of 49 Aggregate Supply Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level. The Aggregate Supply Curve Figure 7 - 1
- Slide 18
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard18 of 49 Aggregate Supply The AS curve has three properties that will prove to be useful in what follows: The AS curve is upward sloping. As explained earlier, an increase in output leads to an increase in the price level. The AS curve goes through point A, where Y = Y n and P = P e. This property has two implications: When Y > Y n, P > P e. When Y < Y n, P < P e. An increase in P e shifts the AS curve up, and a decrease in P e shifts the AS curve down.
- Slide 19
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard19 of 49 Aggregate Supply , z, An increase in the expected price level shifts the aggregate supply curve up. Meanwhile, changes of , z, also lead to shift of the AS curve. The Effect of an Increase in the Expected Price Level on the Aggregate Supply Curve Figure 7 - 2
- Slide 20
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard20 of 49 Aggregate Supply Lets summarize: Starting from wage determination and price determination in the labor market, we have derived the aggregate supply relation. This means that for a given expected price level, the price level is an increasing function of the level of output. It is represented by an upward-sloping curve, called the aggregate supply curve. Increases in the expected price level shift the aggregate supply curve up; decreases in the expected price level shift the aggregate supply curve down.
- Slide 21
- Chapter 7: Putting All Markets Together: The AS-AD Model 2006 Pren