# ch10b - Long vs short-run models Consider the homework...

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slide 0 Long vs. short-run models Consider the homework question from chapter 3: Let the following equations characterize an economy: Y = C + I + G, Y = 5000, C = 250 + 0.75(Y – T), I = 1000 – 50r, G = 1000, T = 1000. Let’s solve for the equilibrium level of interest rate. Using the equilibrium condition, we get r=5. CHAPTER 10 Aggregate Demand I

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slide 1 Long vs. short-run models Underlined assumptions of this exercise: GDP is predetermined by inputs and technology. That’s why we know Y = 5000. The real interest rate adjusts to make sure that all savings are channeled through the financial market to the hands of investors – this ensures the equilibrium of both the goods market and the saving-investment market. CHAPTER 10 Aggregate Demand I
slide 2 CHAPTER 10 Aggregate Demand I Long vs. short-run models In the short-run, GDP is not predetermined. We will have to modify our model as follows: Y = C + I + G, C = 250 + 0.75(Y – T), I = 1000, G = 1000, T = 1000. Differences: GDP is not predetermined I have replaced the investment equation with a number.

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slide 3 Long vs. short-run models Solve for equilibrium GDP: Y = C+I+G = 250 + 0.75(Y-1000) + 1000 + 1000 Y = 6000 CHAPTER 10 Aggregate Demand I
slide 4 Long vs. short-run models This is the Keynesian cross model. The only reason we could solve for Y is that the investment equation is simplified to be a constant I = 1000. CHAPTER 10 Aggregate Demand I

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slide 5 Long vs. short-run models Instead of the simplified I, now let’s use the old investment equation I = 1000 – 50r Let’s try to solve for the equilibrium again: Y = C+I+G = 250 + 0.75(Y-1000) + 1000-50r + 1000 0.25 Y = 1500 – 50r We cannot solve for Y because there are two unknowns. CHAPTER 10 Aggregate Demand I
Long vs. short-run models We got 0.25Y = 1500 – 50r This equation says that when the goods market is in equilibrium, the level of GDP is not yet known. It depends on the level of the real interest rate. The lower the r, the higher the GDP. This is the IS curve. In order to determine Y, we need to know what determines r. We need to bring in the financial market to

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ch10b - Long vs short-run models Consider the homework...

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