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Chapter 5 Macroeconomics Dornbusch, Fischer, Startz (9/e) 1 Aggregate Supply and Demand 1 Aggregate Model 2 - The aggregate demand - aggregate supply model is the basic macroeconomic tool for studying output fluctuations and determination of price level and the inflation rate. - The aggregate supply (AS) curve describes, for each given price level, the quantity of output firms are willing to supply - The aggregate demand (AD) curve shows the combinations of the price and level of output at which the goods and money markets are simultaneously in equilibrium. Equilibrium 3 Change in Nominal Money Supply and AD Shift 4 Change in AS 5 The Aggregate Supply Curve 6 - Classical AS Curve (long run): - The classical aggregate supply curve is vertical, indicating that

the same amount of goods will be supplied whatever the price level. - Labour market is in equilibrium with full employment of the labour force - Level of output is potential GDP, Y* - Potential GDP grows over time and nation accumulates resources The Aggregate Supply Curve 7 - Keynesian AS Curve (short run) - The Keynesian aggregate supply curve is horizontal, indicating that firms will supply whatever amount of goods demanded at the existing price level. - Due to unemployment, additional resources available - Price level does not depend on GDP 8 9 The Frictional Unemployment 10 - Frictional unemployment people temporary out of job or interested to change job - The natural rate of unemployment is the rate of unemployment arising from normal labor market frictions that exist when the labour market is in equilibrium. The Aggregate Demand Curve 11 - The aggregate curve shows the combinations of the price level and level of output at which the goods and money markets are simultaneously in equilibrium. - The key to the aggregate demand relation between output and prices is that aggregate demand depends on real money supply. - The real money supply is the value of the money provided by the central bank and the banking system Value of Money 12

- Expansionary policies move AD curve to the right - Expansionary Policies - Increase in government spending - Cuts in taxes - Increase in money supply - Confidence of consumers and investors Aggregate Demand 13 - The aggregate demand relation between output and price is IS-LM model, which is sophisticated. - The aggregate demand relation between output and prices is dependent on the real money supply. - Real money supply is the value of money provided by the banking system. Value of Money 14 Aggregate Demand 15 - When real money supply rises, interest rate falls and investment rises, overall aggregate demand rises. - When real money supply falls, interest rate increase and investment falls, overall aggregate demand falls. - AD curve represents equilibrium in both the goods and money markets. The Quantity Theory of Money 16 - Nominal GDP = P X Y - Quantity of money = M X V - V is velocity of money - MV = PY - When V is constant, MV = PY is AD curve. With money supply constant, any increase in Y must be offset by decrease in P and vice versa. - The inverse relation between price and output gives the downward slope of AD. - An increase in the money supply shifts AD upward for any given

value of Y. Aggregate Demand 17 - An increase in the nominal money stock shifts the AD schedule up by exactly in proportion to the increase in nominal money. Shift in Aggregate Demand 18 Keynesian Case of AD 19 - Equilibrium: AD = Keynesian AS - Expansionary policy, AD shifts to the right - No effect of price - Only effect is output and employment The Classical Case of AD 20 - AS vertical because full employment - Expansionary policies cause shift to AD to right - Only effect increase in price level, no change in output level. Supply Side Economics 21 - Move AS curve to the right by increasing potential GDP. - Supply side policies: - Removing unnecessary regulations - Efficient legal system - Technological progress - Some believe tax-cut will increase AS and will increase tax collection. Tax Cut and Supply Side Economics 22

- Tax cut initially increase both AD and AS; but AD increases more - Initially economy moves to E from E for purely demand effect (AD). - AS shift smaller than AD shift, equilibrium moves to E from E. Tax collection falls - Less tax collection, rise in deficit and permanent price rise. AD and AS in Long-Run 23 Exercise 24 - If the government were to reduce income taxes, how would the reduction affect output and the price level in the short run? Show how the aggregate supply and demand curves should be affected, in both cases.