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MIT14_02F09_lec13

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Aggregate Demand Curve (AD) So far we have worked in the space {Y,r}. What happens to aggregate demand if Prices increase? The AD curve is drawn in {Y,P} space. It represents how the demand side of the economy sponds to a change in prices responds to a change in prices. As P decreases (holding everything else fixed), M s /P increases. As the supply of real oney balances increase to have an equilibrium in the money market interest rate needs money balances increase to have an equilibrium in the money market interest rate needs to fall, and hence from the equilibrium in the good market, I and C rise! Prices affect the demand side of the economy throu gh interest rates. Recall: prices do not affect C (if wages change 1 for 1 with prices PVLR will not change!) The AD curve comes directly from the IS-LM equilibrium. So, in essence, the AD curve is a representation of BOTH the IS curve AND the LM curve. 2
Constructing the AD – Part 1 Suppose P increases from P 0 to P 1 r LM r 0 IS Y Y 0 3

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Constructing the AD – Part 1 r LM Suppose P increases from P 0 to P 1 r 0 IS Y Y 1 Y 0 4
Constructing the AD – Part 2 P P 1 P 0 AD Y Y 1 Y 0 5

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What Shifts the AD curve? As the IS, the AD curve represents the demand side of the economy: Y = C+I+G+NX •A n ything that causes the IS curve to shift to the right cause the AD curve to shift to the right • Anything that causes the LM curve to shift to the right (except price changes) causes the AD curve to shift to the right. Example: Nominal money (M) increases, r will fall, I will increase, AD will shift right. With increase in money: LM shifts right Move along the IS curve Interest rates fall C and I increase AD shifts right. A change in prices cause the LM to shift, but cause only a movement along the AD curve. 6
Real interest rate, r IS 2 IS 1 AD 1 AD 2 LM F F E E Government purchases increase Government purchases increase 2 1 (a) IS-LM Output, Price level, P P 1 1 2 Output, (b) Aggregate demand curve Example: Temporary Increase in G Figure by MIT OpenCourseWare. 7

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The Supply Side Labor Market: N s (PVLR,taxes,value of leisure, population) W 0 /P 0 N d (A,K) N* What is set in this market: N* (and real wages). 8
Aggregate Supply Curve in the Long Run (LRAS) In the long run, the labor market clears and we are at N*! The full employment level of output is the level of output Y* associated with N*: Y* = A F(K, N*, Raw Materials) Define LRAS = long run aggregate supply is a curve vertical at Y* (or FE line ) In the long run, the labor market clears and (w/p) e = the real wage in labor market equilibrium N* = hours worked in labor market equilibrium

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