# 14a - A summary of what we learned how to incorporate...

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11/28/10 1 how to incorporate dynamics into the AD-AS model we previously studied how to use the dynamic AD-AS model to illustrate long-run economic growth how to use the dynamic AD-AS model to trace out the effects over time of various shocks and policy changes on output, inflation, and other endogenous variables 1 CHAPTER 1 The Science of Macroeconomics A summary of what we learned We have learned the following relationships that jointly determine the macroeconomic equilibrium: The aggregate supply curve The IS curve and the LM curve The IS-LM can be used to derive the AD curve 2 CHAPTER 1 The Science of Macroeconomics The AS curve natural rate of output a positive parameter expected price level actual price level agg. output Other things equal, Y and P are positively related, so the SRAS curve is upward-sloping. 3 CHAPTER 1 The Science of Macroeconomics The AS curve The AS curve also suggests that higher expected price will lead to lower output: Sticky price model: sticky-price firms expect higher costs, and will set a higher price at any given level of output, which will increase the price level. Incomplete information model: incomplete-info firms will reduce output at each price level because they realize their relative prices do not increase as much as before. The AS curve shifts up. 4 CHAPTER 1 The Science of Macroeconomics The IS curve Tells us how the real interest rate and output are related when the goods market is in equilibrium. An example of the IS curve in mathematical form that we derived in chapter 10: 0.25 Y = 1500 – 50 r Intuition: lower real interest rates boost investment spending, therefore increases GDP. 5 CHAPTER 1 The Science of Macroeconomics The LM curve Tells us how the real interest rate and output are related when the money market is in equilibrium. An example of the LM curve in mathematical form: 25 r = 0.5 Y – 1250 Intuition: higher output increases money demand, leads to sales of interest-bearing assets, and therefore higher interest rates (equivalent to lower prices for interest-bearing assets).

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11/28/10 2 6 CHAPTER 1 The Science of Macroeconomics The AD curve The AD curve tells us that higher price level leads to lower output demanded. Intuition: higher prices lower the value of existing
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14a - A summary of what we learned how to incorporate...

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