Where z includes economic factors other than y and p

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where Z includes economic factors (other than Y and P ) that lie outside our model and are likely to vary from period to period in ways that are hard to predict. Equilibrium Values of the Interest Rate and Output In the Fed rule, the Fed raises the interest rate as output increases, other things being equal. Along the IS curve, output falls as the interest rate increases because planned investment depends negatively on the interest rate. The intersection of the two curves gives the equilibrium values of output and the interest rate for given values of government spending ( G ), the price level ( P ), and the factors in Z . Deriving the AD Curve The AD curve is not a market demand curve, and it is not the sum of all market demand curves in the economy . Because many prices rise together when the overall price level rises, we cannot use the ceteris paribus assumption to draw the AD curve. AD falls when P increases because the higher P leads the Fed to raise r , which decreases I and thus Y . The higher interest rate causes aggregate output to fall. The Final Equilibrium Aggregate output and the aggregate price level are determined by the intersection of the AS and AD curves. These two curves embed within them decisions of households, firms, and the government.
Other Reasons for a Downward-Sloping AD Curve The AD curve slopes down because the Fed raises the interest rate ( r ) when P increases and because I depends negatively on r . A real wealth effect on consumption also contributes to a downward-sloping AD curve. Real wealth effect - the change in consumption brought about by a change in real wealth that results from a change in the price level. Potential GDP The vertical portion of the short-run AS curve exists because there are physical limits to the amount that an economy can produce in any given time period. Potential output, or potential GDP - the level of aggregate output that can be sustained in the long run without inflation. Short-Run Equilibrium below Potential Output Economists have different opinions on how to determine whether an economy is operating at or above potential output. Those who believe the AS curve is vertical in the long run believe that output will tend to rise when wages fall with high unemployment. NOTES An increase in the price level yields a higher demand for money, a higher interest rate, and consequently less planned investment and decreased consumption. Less investment and decreased consumption with no change in government purchases produces a downward shift in the AE curve. Whenever demand rises and supply falls, the result is a clear-as-can-be price increase. When the economy is operating at near full capacity, the intersection of AD0 and AS0 occurs where aggregate supply is very steep and almost vertical. In this situation, an i ncrease in consumer confidence and business optimism will shift aggregate demand to the right . As a result, both GDP and prices will rise in the new equilibrium . But prices will

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