ECON 102 –Macroeconomic Theory Discussion Sessions F and G, Musa Orak1WEEK # 9AGGREGATE DEMAND – Revisited From IS-LM to Aggregate Demand: head2rightUp to now, when building IS-LM model and analyzing the effects of different shocks, we had a very crucial assumption: “price level is fixed”. head2rightAlso, in Chapter 10, we said AD is downward sloping but we did not give an intuition why this should be the case. Instead, we used the mathematical equality MV=PY to show that P and Y moves in opposite directions. head2rightNow we are ready to build AD based on IS-LM framework. head2rightAssume that we built IS-LM for price level P* and we obtained Y* as the equilibrium output. head2rightFor any P’>P*, we have M/P’<M/P* and thus, this is a shift of LM curve to the left. This, as we know, results in a lower Y (say Y’). Thus, we have another pair of price and output: P’ & Y’. This is a movement along the aggregate demand curve to the northwest. head2rightSimilarly, for any P”<P*, we have M/P”>M/P* and thus, this is a shift of LM curve to the right, which increases output to some Y”>Y*. Again, we have another pair: P’’ & Y’’. This is a movement along the aggregate demand curve to the southeast. head2rightTherefore, the downward slope of AD curves comes from the dynamics of the IS-LM model. Monetary Policy & Fiscal Policy checkbldMonetary policyis the acts of central banks (Fed) to change the money supply to affect the interest rates (remember the tools central banks have to do this such as OMOs, discount rates etc.).checkbldWhat makes interest rate important? When Central Bank increases (decreases) the interest rates, this discourages (stimulates) the investment and hence curbs (expands) demand for goods and services, thereby affecting the price level and output. This whole process is called as “monetary transmission mechanism”. checkbldA central bank may have different policies. Most common policy choices are:1.Keep money supply constant2.Keep interest rate constant3.Keep income constant (I think this is the least common one during normal times. However, during large crises such as the one we experienced in 2008, this was more pronounced).
1This is a preliminary version. Please let me know for any mistakes you figure out.