Building_the_SR_AD - Chapter7 WhatWeAlreadyKnow ,theeconomy...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Chapter 7 Building the Short-Run Model of Aggregate Demand  We have seen that in the long run with prices perfectly flexible, the economy  remains at the natural rate of output. Given this level of income, the supply of saving is  given, so its position along with the investment demand curve determines the equilibrium  real interest rate.  In this case, the real interest rate is simply determined by the equation: 0 ( ) ( ) S Y I r = , as is shown in the Figure 7.1. Income is at its long-run equilibrium, Y , so the saving function’s position is determined. The intersection  of the saving function and the investment demand function determines the long-run, real interest rate,  r 0 In the Introduction to this section, though, we saw that a number of factors can  lead to inflexible prices.  With prices not being able to adjust fully in the short-run, the  actual income level is not always at the long-run, natural level,  Y . Hence, we need to  explain how both the short-run income level and the real interest rate are determined. We  know the income level around which the economy fluctuates, the natural rate of output,     r S, I ( ) S Y I D 0 ( ) ( ) S Y I r = r 0 Figure 7.1:  Long-run Determination of the Interest Rate real  interest  rate What We Already Know
Image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
but now we will use our model to explain the fluctuations. This chapter explains how  goods market equilibrium, along with actions by the central bank (CB), can determine the  short-run equilibrium levels of income and the real interest rate. In order to do that,  though, we have to introduce and examine the mechanics of the goods market and the  money market. 2 Overview of the Chapter In the short-run, output can differ from its natural level, so that the goods market,  by itself, cannot determine the short-run level of income. The locus of pairs of income and the real interest rate yielding goods market  equilibrium is a very important curve called the IS curve. In the short-run, the Central Bank conducts monetary policy by adjusting the  money supply in order to peg the nominal interest rate. By pegging the nominal interest rate, monetary policy controls the real interest  rate in the short run. Given the real interest rate set by monetary policy, the IS   curve determines the  short-run level of income. Fiscal policy works by shifting the IS curve. Monetary policy works by changing the real interest rate and moving along a  stationary IS curve.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern