Topic 4: Aggregate DemandTHE DERIVATION FROM THE IS-LM MODEL
THE AE MODEL V IS-LM MODEL•The AE model shows the determination of Y•The IS-LM model shows the determination of Y and i•Both were constructed assuming a fixed P•Of course, P is not constant•We must therefore allow P to be flexible
•P is determined by the interaction of AD and AS•Generally speaking:–as AD and/or AS change so does P (andY)–so P andY are jointly determined•We need to deriveAD and AS and integratethem into our current understanding of the determination of Y and i, and also explain what causes them to shift position and change slope.
Aggregate Demand•AD by definition shows the amount of real output that will be purchased by society at each general price level.•Y = AD = C + I + G + X - M = -vef(P)•Compare with AE = C + I + G + X - M = +vef(Y)•We need to explain how P causes AD via causing changes in C, I, G, X and/or M.
•We’ve already suggested a negative relationship between P and Y. Why?•There are 3 reasons:–the interest rate effect–the real balance or wealth effect–the foreign purchases or international substitution effect•We can use the IS-LM framework to demonstrate these and then look at AE, IS-LM and AD-AS together.
•The major reason why AD has a negative slope is because of an interest rate effect.•When P changes there will be a change in Y because of the effect of P on i.