Syllabus

Lecutres

Outlines

Assignments

I. THE FE (Full-Employment output) CURVE

1. Definition of FE curve:
The combination of all points in (r, Y) diagram that represent equilibrium in the labor market.

2. Derivation of FE Curve:
· Draw a production function, labor demand, and labor supply curves.
· Choose an interest rate, r0, and find its corresponding N* and Y*
· Choose another interest rate, r1, and find its corresponding N* and Y*
· Connect the two points.

Note: We assume that changes in real interest rate have no effect on NS and ND, N* and thus Y*.

3. Shifts in FE:
1. Changes in Production function due to A, and K (oil prices, weather, …)
2. Changes in labor supply (immigration, demography)

II. THE AGGREGATE SUPPLY CURVES

1. Definition of Aggregate Supply (AS)
§ Combination of all points in (P,Y) diagram where firms maximize profits.
§ The profit-maximizing levels of output at alternative values of the general price level.

2. Types of Aggregate Supply
a. Long-run aggregate supply [ LRAS]
· In the long-run, wages and prices are flexible
· A rise in p causes an rise in W; real wages and employment remain unaffected;
· Full-employment output remains unaffected;
· Output is constrained by amount of K, N, and A;
· Output does not depend on the price level.
· Thus LRAS is vertical.

b. Short-run aggregate supply [SRAS]
We assume that in the short-run
· The price level is fixed (for at least a few months).
· Firms will produce and supply more output (using overtime, if needed) to meet the demand.
· This implies that SRAS is horizontal.

3. Shifts in AS:
a. LRAS: Changes in K, A, and N which are not due to a price change.
b. SRAS: Changes in production costs which causes firms to raise prices.

III. The IS CURVE

· I = desired investment, S = desired national saving
· Commodity Market equilibrium: I = S or Y = C+I+G+NX

1. Definition of IS curve:
The combination of all points in a (r, Y) diagram that represent equilibrium in the commodity market is the IS curve.

2. Derivation of IS curve:
· Choose an income; find the real interest rate, r, which results in I = S; mark the point in (r,Y) diagram.
· Choose another income; find the real interest rate which results in I = S, mark the point in (r,Y) diagram.
· Connect the two points.

3. Slope of IS Curve:
· Downward:
· A fall in r will increase borrowing and increase desired Cd and Id, and thus total demand y=Cd+Id + G
· A rise in r does the opposite.

4. Shift the IS curve:
· Any factor that changes desired national saving and investment except r and Y.
(Note: the effect of r and Y is shown on the axis)

· They include changes in:
Ye , G, T, Wealth: which shifts the IS by shifting desired national saving curve
MPK, Pk, and tax rate on capital : which shifts the IS by shifting the desired investment curve

Example: An increase in G:
· Reduces national saving; shifts S curve to the left; raises r.
· With the same Y, now we have a higher r. Thus IS should shift to the right.

IV. THE LM CURVE:

· L = Desired Money Demand
· M = Money supply
· Money Market Equilibrium: Real money supply (M/P) = desired money demand (L(Y, r+p)

1. LM CURVE: The combination all (r, Y) points in a (r, Y) diagram which represent equilibrium in the money market.

2. Derivation of LM Curve: (Note: assume p = 0, then r = i)

· Choose an income (Y0); find the corresponding money demand L(Y0), and equilibrium real interest rate(r0); Show the (r0, Y0) point in the (r, Y) diagram.
· Choose another income (Y1); and repeat the step 1.
· Combine the points.

2. Slope of LM Curve:
· Upward
· An increase in Y results in an increase in real money demand, and an excess demand for money. People sell other assets (bonds). Price of bonds fall and the interest rate will rise. This process continues until the money market is back in equilibrium.

3. Shifts in LM:
· A change in real money demand caused by any factor other than Y will shift the LM curve.
Examples: use of credit card; inflation.
Use of credit cards (or higher inflation) reduces the demand for money, and shifts LM rightward.

· A change in real money supply (M/P) will also shift the LM curve.
Real money supply change when
(a) the Fed changes the nominal money supply (M)
(b) the price level changes (due to whatever reason)

A rise in real money supply (higher M or lower P) will shift the LM to the right.
A fall in real money supply (lower M or higher P) will shift the LM to the left.

V. THE AGGREGATE DEMAND CURVE

1. Definition of AD:
a. Total quantity of goods and services demanded (Y) at alternative values of the general price level (P), holding other things the same.
b. The combination of all points in (P,Y) diagram such that both commodity and money markets are jointly in equilibrium.

2. Derivation of AD:
a. Choose a price level; using the IS/LM diagram, find the corresponding level of output demanded (Y) such that both money and commodity markets are jointly in equilibrium (the intersection of the two curves).
b. Choose another price level; find its effect on the LM, and value of Y when both commodity and money markets are in equilibrium.
c. Connect the two points. r

3. Slope of AD:
· Downward Sloping
· A rise in price level reduces the real money supply, increases equilibrium real interest rate, reduces the demand for Cd and Id.
· A fall in price level does the opposite.

4. Shifts in AD:
· Any factor that shifts the IS will also shift the AD curve.
· Any factor that shifts the LM (except price level) will shift the AD curve.

VI. GENERAL EQUILIBRIUM ANALYSIS

· The analysis of the interactions among markets.
· It is done by combining
a. IS, LM, and FE Curves
b. AD, LRAS and SRAS
Note:
· FE curve: combination of (r,Y) points which labor market is in equilibrium
· IS curve: combination of (r,Y) points which commodity market is in equilibrium.
· LM curve: combination of (r,Y) points which money (asset) market is in equilibrium.
· The intersection of all three curves represents joint equilibrium in all three markets.
· AD curve: combination of (P, Y) points which money and commodity markets are jointly in equilibrium.
· LRAS curve: Firms' profit maximizing level of output in the long-run .
· SRAS curve: Firms' profit maximizing level of output in the short-run.

Example 1: Effect of a Temporary Supply Shock (Bad weather, increase in oil prices, or anything that adversely affect the productivity measure, A)

1. Effect on production function, labor market, FE line, and LRAS line.
2. Effect on Sd and Id diagram
3. Effect on IS-LM diagram
4. Effect on AD-AS diagram
5. Price Adjustment
6. Final Effect on Y, w, r, P, S, I, C?

Example 2: Effect of a monetary expansion:

1. Effect on IS-LM diagram.
2. Effect on Sd and Id diagram
3. Effect on AD-AS diagram
4. Price adjustment
5. Final Effect on Y, w, r, P, S, I, C?
6. Monetary Neutrality

Example 3: Effect of an increase in government spending (G)

1. Effect on FE and LRAS curves
2. Effect on Sd and Id diagram.
3. Effect on IS-LM diagram
4. Effect on AD-AS diagram
5. Price adjustment
6. Final Effect on Y, w, r, P, S, I, C?

VII. Self-Correction Process
· Classical view
· Keynesian view

Stabilization Policies
· Classical view
· Keynesian view

Short-run Analysis of Demand-side and Supply-side Shocks
Case 1. Analysis of a supply-shock: the case of a temporary adverse shock (bad weather, higher oil prices)

Short-run Analysis of Demand-side and Supply-side Shocks
Case 2. Analysis of a demand shock: the case of an increase in money supply

Short-run Analysis of Demand-side and Supply-side Shocks
Case 3. Analysis of a demand shock: the case of an increase in government spending