Download AS Function

Monetary Macroeconomic Modeling
Setting the stage
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Key indicators of Macroeconomic Performance
- Definition
- Measurement
- Stylized Facts
Macroeconomic Policy Objectives
- Stabilization
- Long-run Growth
Monetary Macroeconomic Framework
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Gross Domestic product (GDP): a measure of
all currently produced final goods and services
in a given period.
Unemployment: the number of unemployed
persons expressed as a percentage of the labor
force.
Inflation: a rise in the general level of price.
These are three key economic variables that policy
makers try to influence….
Nominal VS Real
Measurements
GDP is NOT
• Nominal: valued
at current market
price.
• Real: valued at
constant price
(i.e. relative to the
base year)
• Expenditure
Approach:
summation of all
expenditures
made on goods
and services.
This is
represented by C
+ I + G + NX
• Production
approach
• Income approach
• Measuring nonmarket
productive
activities
• Measuring the
underground
economy
• Measuring a
welfare
(However, it is
used a measure
of development).
• RGDP =
NGDP/Price
Potential
Output
• The level of output that
would be reached if
productive resources are fully
utilized
Cyclical
Variation
in
Output
• This is referred as Business
Cycle
• It is the deviation of actual
output from the potential
output.
BUSINESS CYCLE
Business Cycle captures cyclical
variations of actual output around
potential output.
These cyclical variations are costly.
Expansion is normally related to
inflation while contraction is
related to unemployment.
The worst scenario is when
contraction is accompanied by
inflation, termed as
STAGFLATION.
Stabilization policies aim at
dampening the magnitudes of
cyclical variations
Growth policies aim at increasing
the trend in output over long
periods of time.
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Consumer price index: the retail prices of a
fixed market baskets of several thousand goods
and services purchased by households
Producer price index: the wholesale prices of
approximately 3000 items
GDP Deflator: the prices of all goods and
services currently produced.
The rates of changes in these prices are measures
of inflation
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Unemployment: Unemployed persons as a
percentage of the labor forces
Types of unemployment:
- Frictional: in-between jobs
- Structural: changes in economic structure
- Cyclical: due to cyclical downturns
What matters is cyclical unemployment
Full employment: when unemployment equals
frictional + structural unemployment
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Fluctuations are costly. But all economies have ridden
through the cycles.
It seems that cyclical fluctuations are inevitable but
they can be dampened.
Inflation-unemployment trade-offs
Highly fluctuating cycles may dampen long-term
growth
Issues:
- How to dampen the cycles?
- How to accelerate long-term growth?
Requirement:
- A need to understand theories of fluctuations and
long-term growth.
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Goods Market: Market for the production
(supply) and the aggregate demand for those
goods.
Money Market: Market for Money Demand
and Money Supply.
Factor Markets: markets for the factor inputs in
the production of goods and services.
OPEN-ECONOMY: markets that link the sales
and purchases of goods and services between
nations (Exports and Imports).
Goods Market
(IS Function)
Money Market
(LM Function)
Factor Inputs
Markets (AS
Function)
SR AS
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IS Function
Y = C(Y-T) + I(r) + G
CY-T > 0; Ir < 0; Both G and T assumed
exogenous and NX = 0
LM Function
M/P = L(Y, r); Ly > 0; Lr < 0
AS Function
Y = f(P); fp > 0
These are basic functions with no elements of
uncertainty and expectations
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IS: a graph of all combinations of Y and r that
result in goods market equilibrium.
Equilibrium in Goods Market
Output (Y) = Aggregate Expenditure (E)
Components of Aggregate Expenditure
- Household Expenditure (C)
- Firm Expenditure (I)
- Government Expenditure (G)
- International Sector (X – M)
Y = C + I + G + (X-M)
IS FUNCTION
The IS function is negatively
sloped…
Justification: A fall in interest
rate motivates investment
and, thus, planned
expenditure. To restore
equilibrium, output (Y) must
increase.
Slope: depends on marginal
propensity to consume and
Interest sensitivity of
Investment.
Intercept: containing the
factors that shift the curve.

Goods Market Equilibrium
𝑌 =𝐶 𝑌−𝑇 +𝐼 𝑟 +𝐺

Total Differentiation
𝑑𝑌 = 𝐶𝑌𝐷 𝑑𝑌 − 𝐶𝑌𝐷 𝑑𝑇 + 𝐼𝑟 𝑑𝑟 + 𝑑𝐺

Express dr as a function of the
remaining expressions
(1 − 𝐶𝑌𝐷 )
𝐶𝑌𝐷
1
𝑑𝑟 =
𝑑𝑌 +
𝑑𝑇 − 𝑑𝐺
𝐼𝑟
𝐼𝑟
𝐼𝑟
Slope
Intercept
Term
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A graph of all combinations of Y and r that
equate the supply and supply for real money
balances
Assuming that the stock of money supply is a
policy variable (i.e. influenced by monetary
instruments), we state this equilibrium as:
𝑀
= 𝐿(𝑌, 𝑟)
𝑃
LM FUNCTION

LM Curve is positively
sloped.
An increase in income raises
money demand. With money
supply fixed, interest rate
must increase to restore
equilibrium in the money
market.
𝑀
= 𝐿(𝑌, 𝑟)
𝑃

Intercept: Changes in money
appears in the intercept. It
leads to shift in LM function.
Total Differentiation
𝑃𝑑𝑀 − 𝑀𝑑𝑃
= 𝐿𝑌 𝑑𝑌 + 𝐿𝑟 𝑑𝑟
𝑃2

The SLOPE of the LM curve
depends on the income and
interest rate sensitivities of
money demand.
Market Equilibrium
Express dr as a function of the
remaining terms
𝑑𝑟 = −
𝐿𝑌
1 𝑃𝑑𝑀 − 𝑀𝑑𝑃
𝑑𝑌 +
𝐿𝑟
𝐿𝑌
𝑃2

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Function
Y = f(P)
Total Differentiation
dY = fPdP
fP = 0 (Classical)
fP > 0 (Keynesian)
The foundation of AS function is the assumption of wage stickiness or
imperfect information in the labor market.