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Aggregate Demand and Supply Dynamics

This document discusses aggregate supply and aggregate demand relationships. It explains that the aggregate supply curve is upward sloping, and that an increase in output leads to an increase in price level. An increase in the expected price level also shifts the aggregate supply curve upwards. The aggregate demand curve captures the effect of price levels on output. In the short run, equilibrium occurs at the intersection of the aggregate supply and demand curves. In the medium run, expectations adjust until output equals natural output and the actual price level equals the expected price level. Monetary expansions cause a rightward shift of the aggregate demand curve.

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15 views4 pages

Aggregate Demand and Supply Dynamics

This document discusses aggregate supply and aggregate demand relationships. It explains that the aggregate supply curve is upward sloping, and that an increase in output leads to an increase in price level. An increase in the expected price level also shifts the aggregate supply curve upwards. The aggregate demand curve captures the effect of price levels on output. In the short run, equilibrium occurs at the intersection of the aggregate supply and demand curves. In the medium run, expectations adjust until output equals natural output and the actual price level equals the expected price level. Monetary expansions cause a rightward shift of the aggregate demand curve.

Uploaded by

jasleen.k9105
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOCX, PDF, TXT or read online on Scribd

Chapter 7

Aggregate supply relation (capture effects of output on the price level, labor market)

Derivation through wage setting and price setting


 W= Pe F (u, z) P= (1+U) W
 Putting w in p to get an equation P = (1+U) Pe F (u, z)
 Replace the unemployment rate u by its expression in terms of output u= 1-Y/L

It gives the aggregate supply relation


P = Pe (1+U) F (1-Y/L, z)

The as relation has two important properties


1. increase in output leads to increase in the price level
 Y (output) increases N (employment)
 Due an increase in N u (unemployment rate) decreases
 Lower u leads to an increase in W (nominal wage)
 Due to an increase in W P(prices) increase, thus it leads to an increase in the
price level
2. Increase in expected price level leads to an increase in actual price level (this works
through wages)
 If wage setter expects a higher Pe so they will set a higher W
 Increase in W leads to increase in cost which leads to increase in P

The as curve has three properties


 Upward sloping (Y increases P increases)
 If Y=Yn then P=Pe
 Increase in Pe will shift the curve up vice-versa so at any level of output the price
level is higher

If Y shifts to the right of Yn then P is higher than Pe


If Y shifts to the left of Yn then p is lower than Pe
Aggregate demand relation (capture effect of price level on output, goods and financial
market, derived from is-lm equation)

panel (a) draws out a relation between IS-LM curve. IS curve is a downward sloping
curve because increase in interest rates leads to a decrease in output where else LM
curve is a upward sloping curve because it has a positive relation between interest
rate and output

effect of increase in price level –

equilibrium clearly depends upon the vale of Pe and Pe determines the position of as curve
equilibrium in short run
 The equilibrium is given by the intersection of as – ad curve
 The equilibrium level of output is Y and P
 There is no reason why Y=Yn it all depend upon the specific value Pe and the value of
variables affecting ad
 In short run Y can be more or less than Yn

Equilibrium in medium run


 P is higher than Pe, wage setter revises their expectations so Pe increases to P’e
 Due to Increase in Pe AS curve shifts upwards
 The economy moves along the ad curve the equilibrium shifts from A to A’ and
output decrease from Y to Y’
 Further there will be adjustments until Y=Yn, and at that time P=Pe so there will no
reason for wage setters to revise their expectations
 In medium run Y=Yn

Effect of monetary expansions on the equilibrium


 Increase in M leads to an increase in M/P leading to an increase in Y
 Ad shifts to right
 In short run economy goes from A to A’ output goes to Y’ and the P increase to P’
 Now the adjustments of Pe comes into the picture, P is higher than Pe Y is higher
than Yn therefore wage setters will revise their expectations
 AS shifts upwards and the adjustments take place until Y=Yn and P=Pe

Change in is-lm curve

 Before change the equilibrium is at A , short run monetary expansion shifts the

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