Building_the_SR_AD

Building_the_SR_AD - Chapter 7 Building the Short-Run Model...

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Unformatted text preview: 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: ( ) ( ) 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 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 ( ) ( ) S Y I r = r Figure 7.1: Long-run Determination of the Interest Rate real interest rate What We Already Know 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....
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This note was uploaded on 03/02/2010 for the course ECON 57 taught by Professor Woglom during the Spring '08 term at UMass (Amherst).

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Building_the_SR_AD - Chapter 7 Building the Short-Run Model...

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