practical4 - B01 ECONOMICS MACROECONOMICS Practical Lecture...

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1 B01 ECONOMICS: MACROECONOMICS Practical Lecture 4: The AS-AD Model Recap : Goods Market IS-LM Framework Money Market Short Run Analysis So far, we have limited our study to the short run and taken prices as exogenous. Goods Market AS-AD Framework Money Market Medium Run Analysis Labour Market P e = P in equilibrium
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2 In the medium run , prices are now endogenously determined. Equilibrium in the medium run occurs when: (1) All markets: Goods, Financial and Labour, are in equilibrium (2) Expected prices equal actual prices: P e = P
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3 Derivation of Aggregate Demand Relation IS Relation (Equilibrium in the Goods Market): Y = [ ] G i b b T c c b c + + 2 0 1 0 1 1 1 1 LM relation (Equilibrium in the Money Market): i d Y d P M 2 1 = Equilibrium in the IS-LM Framework: Y = + + + + G P M d b b T c c d d b b c 2 2 0 1 0 2 1 2 1 1 1 1 1
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4 Aggregate Demand Relation: = + + G T P M Y Y , , The AD curve plots combination of Price and Output consistent with simultaneous equilibrium in the Goods and Financial Markets E.g. Consider the diagram below. At a given price P 0 , the, the economy is in equilibrium at point A with equilibrium in both the goods market and the financial market. Suppose that we get an increase in prices to P 1 . Then, as prices have increased, real money supply in the economy falls so that the money supply curve shifts to the left and so does the LM curve. New equilibrium is reached at point B.
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5 i LM 1 i IS LM 0 B B A A Y m 1 m 0 P B P 1 P 0 A AD Y
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6 Derivation of Aggregate Supply Relation Wage Setting and Price Setting Relations: µ + = = + 1 1 ) , ( P W z u F P W e PS WS Aggregate Supply Relation: + = z L Y F P P e , 1 ) 1 ( µ Equilibrium unemployment rate (medium run concept with P e =P) determined by: ( ) z u F P P n , ) 1 ( µ + = ) 1 ( 1 , µ + = + z u F n
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7 P AS P 1 P 0 Y 0 Y 1 Y
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