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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.