Macro.Week6.2008 - II - 6/1 Currently, we are trying to...

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II - 6/1 Currently, we are trying to revise our model to take prices into account. We are responding to a clear gap in our model we have a model without prices, and we have been suggesting (implicitly!!) that whatever buyers want will be produced [Did we really do that?? - YES - we assumed that Y = AE] but in fact we know that if demand is high, prices will rise! also, we have had nothing to say about how the model might respond in the long run if Y * Y F So what we need to do is to renovate the model, and we need a plan: Plan #1 Introduce prices into the demand-side model Plan #2 Introduce a supply side, and talk about equilibrium Plan #3 Discuss what happens in the long run if Y * Y F
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II - 6/2 Last week, we began by introducing prices into the demand- side model We imagined an AE function like this: AE = 200 + [100 - P] + (2/3)Y Notice: Using a function like this does not “prove” that AE falls when P rises. All this kind of example does is illustrate a situation in which AE falls when P rises As we pointed out last week, the logic for why AE falls when P rises is quite subtle and complex: 1. Rise in P shrinks real value of nominal wealth and so C falls (many consumers hold assets denominated in dollars, and when P rises, the real value of these assets falls, and reductions in wealth make consumers nervous, and they tend to reduce consumption) 2. Rise in P prices us out of foreign markets, so X falls and IM rises (but of course the exchange rate will also change, so this is even more complicated than you may realize) 3. Rise in P tends to push up real interest rate and reduces Investment (to understand this you need to know how the interest rate is determined, which will happen in another few weeks; even then, this explanation is not trivial to understand!)
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II - 6/3 Anyway . .. AE = 200 + [100 - P] + (2/3)Y Notice: A rise in P reduces real AE at any given level of real GDP [ Y = real GDP, AE = real aggregate expenditure] We then solved this model for different levels of P If P = 100 Y * = 600 If P = 50 Y * = 750 If P = 150 Y * = 450 We then graphed P against Y * to get the aggregate demand curve: The AD line is defined as the equilibrium demand-side GDP associated with each price level
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II - 6/4 To emphasize the fact that the AD curve is derived from the way AE shifts when P changes, we often link the diagrams (AE-45-degree-line on top; AD on bottom): Reminder: why does intersection of AE and 45-degree-line lie immediately above the linked point on the AD diagram ???:
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Macro.Week6.2008 - II - 6/1 Currently, we are trying to...

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