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3. MODELS OF AGGREGATE DEMAND (AD) AND SUPPLY (AS)
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1. Quantity theory(Long run)
• MV =PY AD(P) = Y(P)= MV/P
• LRAS: ത𝑌 = 𝐹 ഥ𝐾, ത𝐿 – full employment or natural level of output
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2. IS-LM model(Short run)
(Kenyes (1936): The General Theory of Employment, Interest, and Money. – formalized by Hicks (1937))
• Keynes: the problem is inadequate spending –underutilized resources
• IS curve (Investment = Saving) Keynesian cross– The slope of IS
– Shifts of the IS
• LM curve (Liquidity = Money) real money balances (E 𝜋 ≗ 𝜋𝑒=0) i=r
– The slope of LM
– Shits of the LM
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Elements of IS curve 1Consumption (C, G)
𝐶 𝑌𝐷𝐼 = 𝐶0 + Ƹ𝑐 𝑌 − 𝑇 + 𝑇𝑅
• 𝑀𝑃𝐶 ≐ Ƹ𝑐 =𝑑𝐶 𝑌𝐷𝐼
𝑑𝑌𝐷𝐼marginal propensity to consume
• C0 = autonomous consumption
• T = tax; TR = transfer
• YDI = disposable income
• G = government-purchases
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Elements of IS curve 2Investment (I)
• I(r, η)= I0–ar, (a>0), r = real interest rate = i–πe
(E 𝜋 = 𝜋𝑒=0) i=r
• η: profit optimism (η>0) and pessimism (η<0)
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Market equilibrium– Keynesian cross –
F(K,L) = Y = E = C0 + (Y – T + TR) + I0 – a·i + G
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c
0 0 0 0
1ˆ ˆ
ˆ1Y C I G cT cTR ai
c
SUPPLYDEMAND
IS curve
• IS (Investment=Saving): Each point on the IS curve represents equilibrium in the goods market
• The slope of IS:
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ˆ10
di c
dY a
LM curve
• LM (Liquidity=Money): Each point on the LM curve represents equilibrium in the money market real money balances
•𝑀𝑆
𝑃= 𝑀𝐷 𝑌, 𝑖, 𝜋𝑒 = 𝐿 𝑌, 𝑖, 𝜋𝑒 = 𝑚𝑌 − 𝑘𝑖
• The slope of LM:
• Theory of Liquidity Preference– Transaction– Safety– Speculation
• Monetary transmission mechanism– Monetary transmission mechanism: how a monetary expansion induces
greater spending on goods and services (Mankiw 2015, 341)
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0di m
dY k
The multipliers
• INVESTMENT, CONSUMPTION
• FISCAL
– Government-purchases multiplier
– Tax multiplier
• MONETARY
– Money multiplier
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Simple (goods-market’s) multipliers(interest rate is constant)
• Government-purchases:
• Consumption:
• Tax/Transfer:
• Investment:
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0
10
ˆ1
dY
dG c
0
ˆ0
ˆ1
dY c
dT c
0
10
ˆ1
dY
dI c
0
10
ˆ1
dY
dC c
0
ˆ0
ˆ1
dY c
dTR c
Special cases
• Liquidity trap – LM horizontal
• Investment trap – IS vertical
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IS-LM and AD=Y(P)
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• AD(P)=Y(P) IS-LM system’s equilibrium
• IS:
• LM:
0 0 0 0
1ˆ ˆ
ˆ1Y C I G cT cTR ai
c
1 Sm Mi Y
k k P
4. SHOCKS AND STABILIZATION POLICIES – IN THE IS-LM MODEL
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• Stabilization policy refer to policy actions aimed at reducing the severity of short-run economic fluctuations, keeping output end employment as close to their natural levels as possible
• Government is acting as the demander of last resort
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The potential effects of falling prices
• Keynesian Effect: P↓M/P↑ Y ↑
• Pigou effect: P↓ C(YDI, A/P)↑ Y ↑
• Debt-deflation theory: unexpected P↓Y↓
– Redistribute wealth
– Debtors have higher propensities to spend than creditors: MPCDeptors > MPCCreditors
• Expected deflation: P ↓= πe<0 I(i –πe) Y↓
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5. CONCLUSION
• IS-LM AD are the main functions of economic policies