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Lecture #1
chapter 24
Aggregate Demand and Supply Analysis
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Monetarist View of AD
P Y 2000V = ——— = —–— = 2
M 1000
Modern Quantity Theory of Money
M V = P Y
Implication: M determines P Y
Deriving AD Curve
M = 1000, V = 2 P Y = 2000
Point A: P = 2 Y = 1000 PY = 21000Point B: P = 1 Y = 2000 PY = 12000Point C: P = .5 Y = 4000 PY =.54000
Conclusion: P Y , downward sloping AD
Shift in AD Curve
M : PY , so at given P, Y AD shifts right
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The AD Curve
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Keynesian View of AD
Yad = C + I + G + NX
Downward Sloping AD
P , M/P , i , I , NX , Yad
Shift in AD
M , M/P , i , I , NX , Yad AD shifts right
C or G or T or NX : Yad AD shifts right
Complete Crowding Out
G , i C , I , NX C + I + G + NX = Yad unchanged
Partial crowding out: private spending down, but not fully offsetting G
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Aggregate Supply in Short-run
Upward slope of ASIn short-run production costs fixed P , profits , Y produced Shift in ASProduction costs : At given P, profits , Y Y shifts right
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Equilibrium in Short-Run
Equilibrium: AD = ASIf P > P*, AS > AD P to P*If P < P*, AS < AD P to P*
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Equilibrium in the Long-Run
Panel (a): Y > Yn
Wages : at given P, profits , Y produced AS shifts in until Y = Yn at long-run ASPanel (b): Y < Yn
Wages : at given P, profits , Y produced AS shifts out until Y = Yn at long-run ASActivist sees movement to long-run AS (self-correcting mechanism) as slow; nonactivist sees as fast
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Summary: Factors that Shift AD
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Effect of Shift in AD on Y
1. AD shifts right: Y P to point 1'2. Y > Yn: wages , AS shifts in until reach point 2, where Y = Yn
Conclusion: AD shifts right, Y in short-run only; in long-run only P
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Summary: Factors that Shift AS
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Effect of Shift in AS on Y
1. Negative supply shock: AS shifts in, Y P to point 22. Y < Yn: wages , AS shifts out until return to point 1Conclusion: AS shifts in, Y P in short-run, but in long-run Y and P are
unchanged
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Shifts in Long-Run Supply
Yn grows over time, but is shown as fixed in AD/AS diagram
Real Business Cycle Theory
1. Yn fluctuates a lot due to aggregate supply (real) shocks
2. Shifts in AD small
3. Conclusion: Business cycles due to real shocks
4. Supports nonactivism
Hysteresis
1. AD shifts in, natural rate of unemployment , Yn shifts in
2. Unemployment stays high
3. Supports activism
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Vietnam War Buildup: 1964–70
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Negative Supply Shocks: 1973–75 and 1978–80
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Phillips Curve and AS
Phillips Curve
w/w = – h (U – Un)
Implication: When U > Un, i.e., Y < Yn w , AS shifts in
Expectations Augmented Phillips Curve
w/w – e = – h (U – Un)
or
w/w = – h (U – Un) + e
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Phillips Curve
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Implications of ExpectationsAugmented Phillips Curve
1. When e , Phillips Curve shifts up
2. U deviates from Un only when there are surprises about inflation
Solving above for U
U = Un – (w/w – e)/h
substituted for w/w cause move together
U = Un – ( – e)/h
3. Can’t buy U permanently below Un by higher
In long-run = e: so from eq. above, U = Un