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WEEK V
Aggregate Demand and Supply
WEEK V
Keynesian Macroeconomic Model Transmission
Theory of Liquidity
Preference
Keynesian Cross
LM Curve
IS Curve
IS-LM Model
AD Curve
AS Curve
Economic
fluctuations
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Aggregate 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 
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2. 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:
1. Upward sloping; a positive relationship between Y and P
2. 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
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Based on above characteristics, 3 properties of AS curve (continued):
3. Changes Pe in will shift AS curve
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Aggregate 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 
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   
M

AD relation : Y  Y  , G, T 
 P



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AS & AD: Equilibrium condition
AS relation: P = Pe (1 + m) F[1 - (Y/L), z]
   
M

AD relation : Y  Y  , G, T 
 P



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
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The SR equilibrium: Y > Yn
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2. Medium and long run (LR): Pe changes
a) Y = Yn
due to an automatic adjustment process over time:
i. Y > Yn thus Pt > Pet-1
ii. Pet > Pet-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)
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The dynamics of automatic adjustment in LR
WEEK V
Dynamic 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
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Effect expansionary monetary
policy on interest rate and output
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1. 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.
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Effect of expansionary monetary policy on output and price level:
SR and LR
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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
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Effect contractionary fiscal policy
on interest rate and output
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2. Contractionary fiscal policy: G
1. In LR: adjustment of Pe (Pe > P) thus:
a) P   (M/P) 
b) LM curve shift downward
c) 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
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Effect of contractionary fiscal policy on output and price
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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
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Effect of increase in world oil price on unemployment
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Effect of increase in world oil price on output and price
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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
further
c) P  further and Y  until Y = Yn
d) Equilibrium condition in LR at A” with Y’n