Agenda The IS-LM/AD-AS Model: A General Framework for Macroeconomic Analysis, Part 3 + Price Adjustment and the Attainment of General Equilibrium General equilibrium in the AD-AS model Disequilibrium in the AD-AS model + Equilibrium in the 4D-4S model: the economy is NOT in general equilibrium, economic forces will work to restore general cenuilibrinas in both the IS-LM and AD-AS model,Price Adjustment and General Equilibrium * Price adjustment in the IS-LM and AD-4S models: > Am increase in govemment purchases, > Am increase in the real money supply. > A shorten adverse supply shock, and > A long-run adverse supply shoek, Price Adj tment and General Equilibrium + An increase in government purchases: > In Year 0, the economy isin general equilibrium. + Denote the ger equlieium level of ouput by ¥* An inerease in government purchases Price Adjustment and General Equilibrium + An increase in government purchases: > in Year 1, government purchases increase + Assume Rican es does NOT hal + An increase in goverment prchass shits bth the IS snd AD curves tothe htPrice Adjustment and General Equilibrium Price Adjustment and General Equilibrium + An increase in government purchases: > Ia Year 1, the increase in government purchases increases ourput bus leaves the price level snachange! + Shorr equiv is: ~Thesntrssron ofthe IS a LM ones, and ~ Thesntrsstion ofthe 4D an SRAS curves +The nkor make temporarily cut of equibium, Employment hacen = The unemployment ate has declined, + An increase in government purchases: > In Year 2, the price level begins to rise + In Year, the SRS curve shits up because of excess agaregnie demand in Year se, ¥,=Y" = How far the SRAS curve hie up depends onthe capi pie adjusient proces fo he econo ~ Genel sa mulyenr process dependent ca tae amount of ences aggresnte demand. Price Adjustment and General Equilibrium Price Adjustment and General Equilibrium + An increase in government purchases: > In Year, the price level begin to rise +A biger pice evel reduces the ral money supy MP ~ Alera, the arching pom ofthe nominal snes sop Mr hns heen red + A loec real money soppy shits the Meare tothe Jef sug he ea restate + An increase in government purchases: > in Year 2, the price level begins to rise ~ Rednoeinnressenaie sensing, — Reduce ouput and employment snd — Rate the unanploymnen ste,Price Adjustment and General Equilibrium Price Adjustment and General Equilibrium + An increase in government purchases > In Year 3, the price level canines to adjust up + In Year3, the SRAS core shite wp beens f ay cress aggregate demand in Year 2,1, Yy= Y" Because access aggrgute demand in Year? ee ‘han a Year I the upd sof the SRAS x Yew 5 ll be slr than Your 2. + An increase in government purchases: > In Year 4 and beyond, this process contnnes until general equilibrium is re-established in both the IS- IM and AD-AS models + Out wil a it fal employment level. = Exployament wil be a Sill ployment ve ~The unemployment rate wil ea tat +The price lve wil be permanely bier Price Adjustment and General Equilibrium Price Adjustment and General Equilibrium + An increase in government purchases: > Once general equilibrium has been re-established: + Out ack att fall ployment eve «The real mney sop ilo The ren imesest rate hoe +The composition of ouput as changed + An increase in the real money supply: > In Year 0, the economy isin general equilibrium,An increase in the money supply Price Adjustment and General Equilibrium + An increase in the real money supply: > In Year I, the nominal money supply increases. + Am intense in the nominal money sop shits both the EMfand AD cures ote she +The aceat in the rel money supply inceans output but eaves the price level uachanged Price Adjustment and General Equilibrium Price Adjustment and General Equilibrium ‘+ An increase in the real mons y supply > In Year 2, the price level will begin tose + In Yenr2 the SRAS curve hfe upbecaue of cess egrets demand in Vee ie. YoY" Hover the SR4S cue site up depends oa the cexpliee pie adjustment proces forthe economy = Generally itis a muivenr process dependest onthe tauovatof excess aggcaue demand + An increase in the real money supply: > in Year 2 2 price evel will begin tose +A higher price evel rece the rea money spp MP ~ Alematey, he purchasing power ofthe nomial money spol, Msredaced + Allover real mone soply shits the LMenrse othe [ef rasag the vel siresterePrice Adjustment and General Equilibrium Price Adjustment and General Equilibrium + An increase in the real money supply. > Ia Year, the price level will begin to rise. + Ache tel ners te wl = Reduce interes sensitive spending Reducing ouput as employment an Fase the unemployzsat sate + An increase in the real money supply: > In Year 3, the price level continues to sdjust + tn Year the SRAS curve shite up Decne of an exces agzregnte demand in Yesr 10, Y= Y" Because sucess aggegue damand in Year? i lse ‘nn eur 1 the upatd satof the SRA curve 'n Year} wll besmaleetan awnsin Yere2 Price Adjustment and General Equilibrium Price Adjustment and General Equilibrium + An increase in the real money supply > In Year and beyond, this provess continues until general equilibrium is re-established in both the 15- EMand AD-AS models + Outpt willbe back tie fullenployanent level Employment wl be bas et Fl-eplosmen evel ~The uncrploy ment sate willbe bak ats usa te + The pice Level wl be permanent Bigher + An increase in the real money supply: > Once general equilibrium has been re-established: + Output back att ful-enplonment eve + These money apply is bak tits ain! leve. Teal tees ate ask ats ginal eve, + The composition of ctpt has NOT changedPrice Adjustment and General Equilibrium Price Adjustment and General Equilibrium + An increase in the real money supply: > Once general equilibrivun has been re-established: +All eal vansble ae wnchansee + All nomial varablos have increased proposnstely ‘ith he increave in te money spl > The result is known asthe Classical Dichotomy. + Orshe Lone sun Neuality of Money + An increase in the real money supply: > Tread money growth sud inflation: + This analysis casio handle the ae in which the money supply is growing continvouhy ~ 1 both the money supply an pic evel eo at the saute ate then eet uo change in the ee taney Spi and the Lifcurve does noth ~2fthe money supply grow fans tan tha pice ices then the J care would sro thei Price Adjustment and General Equilibrium Price Adjustment and General Equilibrium + An increase in the real money supply. > Trend money growth and inflation: + Thus, “an ncrent inthe seal money cupply" cam be thought ofa: ~ An increase inte roma rte of money relate ‘stead, ot ~ An increase inte ron rte of money alte ‘be womb ate of sation + An increase in the real money supply: > Trend money growth end inflation: + Simul, “a deceae nthe pice evel” cn be thous oft ~ Ain decease in the price lve or inftaion roan to ‘trend or ~ An decease in nfiation elie othe row cate ofPrice Adjustment and General Equilibrium Price Adjustment and General Equilibrium + The self-correcting economy: > The economy is brought bac into general cquilibrium by adjustment of the price level. > How rapidly docs the economy reach general cquilibrivan? + Clusia! and Keynesian economists de sgeticany ‘anther eave the quenion, + The self-correcting economy: > Classicals believe that price adjustment is rapid. + Fim change pics iste of oop in reponse to changes n demand + The adjuster proce alow scat + There NO appropiate sole for monet an rfc policy in stabs the econo Price Adjustment and General Equilibrium Aggregate Demand and Aggregate Supply + The self-correcting economy: > Keynesian believe tha rie adjustments slow + Trakes years before prices and wages fll adjustto changes dean + When tia gen equbaum ouput detemszed by agtepatederand andthe nbor market snot cqutnsm + There an appropiate role fr monetary ce scl soley insblinns the economy + A short-run adverse supply shock: > In Year 0, the economy isin general equilibrium,A short-run adverse supply shock Aggregate Demand and Aggregate Supply + A short-run adverse supply shock: > In Year I, imported goods prices increase. + An crease in imported goods pices immediately ‘nerenses the pice level and shi he SRAS curse up + Alghes pic evel eduose the zeal money spp MP. + A lower seal money soply sis the ZW eure sii to ‘he eft rainy the real eres rat Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply + A short-run adverse supply shock: In Year |, the increase in imported goods prices tnises the price level and decreases output + igh teal interes ate wil — Reduce interest sensitive spending — Reduce ouput and employment and = Fase he nemplosment ae + A short-run adverse supply shock: > In Year 2, the price level will begin to fal. + In Year2 the SS come shits don becave ofthe ‘testiciesragarepte demand in er eis Vy 2% ~ As the SRAS cove sis dom, the pice evel fil. ~ Alower price lve increases there money sus ~ Aigher eel money soppy shift the LM curve therishe reducing the real ners teAggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply + A short-run adverse supply shock: > Ia Yesr2, the price level will begin to fall, +A loc rea ineres ate silts ~Tcneaes erst sensitive sponding Increase ouput and employment and ~Desenses the unemployent ate + A short-run adverse supply shock: > In Year 3 and beyond, the price level continues to {all until general equilbviumn i re-established in both the IS-LM and 4D-4S model. + up wil be bck at it ll employment level. +The price lve wil be back ait orginal ee Aggregate Demand and Aggregate Supply A long-run adverse supply shock + A long-run adverse supply shock: > In Year 0, the economy isin general equilibrium. 10Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply + A long-run adverse supply shock: > In Yeor I, there iss decrease in productivity + A destees in prods shits BOTH the SRAS coe vp and the LRAS curve (andthe FE ie 10 the lef Euler + A long-run adverse supply shock: > In Year 1, tae upward shift of the SRAS curve: 1 Inceass the price les + Reduces theres! money supply + Sis the Lieve tothe le + Roses the ea interest ae, Aggregate Demand and Aggregate Supply Aggregate Demand and Aggregate Supply + A long-run adverse supply shock: > In Year|, the leftward shift of the ZR4S enrve seduces the eeonomy’s fulleemployment level of comp + Which duces ge al equim op shock: + A long-run adverse supply > In Year 2, ifthe short-run effects are les than the Tong-tun effects, then: + Outpo in Year I greater hand new, ower Sl sceploynen level foun sey P + Sothere sexes agregate demand and the SRAS curve il sa op adhe price lve wil ie > This process continues uatil general equilibyium is re-established 11A long-run adverse supply shock Aggregate Demand and Aggregate Supply + A long-run adverse supply shock: > In Year 2, ifthe short-run effects are greater than the long-run effects, then: + Output in Year 1 les than he ne; Lower fil caeploynen level ofoutpat te.

This process continues until general equilibrium is recestablshed. A long-run adverse supply shock Aggregate Demand and Aggregate Supply shock: + A long-run adverse supply > Once general equilibrium has been re-established: + Onnpot a mie ne loner fillet eve + The price level willbe pean hisher. +The eel money soply wl be lower. + Tae sel neon sae wll be higher. + The composition of ouput has changed 12