Download Introduction to Microeconomics

Adding Inflation To Our Model:
Aggregate Demand and
Aggregate Supply
Lecture 19
Jennifer P. Wissink
©2015 Jennifer P. Wissink, all rights reserved.
October 29, 2015
Practice Problem Solving given A MODEL. Suppose you are given the following:
C = consumption
Id = investment spending
Y = national income/output
G = govern. spending
T = taxes
r = interest rate
MD = money demand
MS = money supply
Yd=disposable income
C = 600 + 0.75Yd; Id = 2000 – 1500r ; G=100; T=100; EX=0; IM=0
Money demand: MD = 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: YFE=$9,600.
4. Should the FED buy or sell securities to achieve this goal? How much (give a dollar
figure) should the FED buy or sell?
Try MORE!
set up, but now assume YFE=$9,000
 Add an import function... and do the
problem over.
 Make the tax function more
interesting...and do the problem over.
 How about FISCAL policy instead of
monetary... and do the problem over.
 Same
END OF MATERIAL FOR PRELIM 2
Thank
goodness!
New Wrinkle – The Price Level



Up to now we’ve pretty much (not completely)
ignored the overall price level - now we want to reintroduce it.
How will it alter our understanding of the model and
fiscal and monetary policy?
Where does the price level appear in the model?
– In the Money Demand Function!
– Recall, MD depends on r, Y and PL where PL is the
aggregate price level
» HOW?

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

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.

The Aggregate Demand (AD) curve is negatively
sloped.

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 (Ms).
– And no changes in exports and imports, which we are
ignoring for now anyway.
The Aggregate Demand Curve: A Warning
 The
AD curve is not a market demand curve like
in Econ 1110. It’s a more complex concept.
– It’s an equilibrium locus, really.
 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

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).

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).

Note: These are not directly in the model we’ve
constructed... but you will see them later if you take more
macro.