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Macroeconomics ECO 403
VU
LESSON 29
AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued...)
IS-LM and Aggregate Demand
·  So far, we've been using the IS-LM model to analyze the short run, when the price
level is assumed fixed.
·  However, a change in P would shift the LM curve and therefore affect Y.
·  The aggregate demand curve captures this relationship between P and Y
Deriving the AD curve
Intuition for slope of AD curve:
P
⇒ ↓(M/P)
LM shifts left
⇒ ↑r
⇒ ↓I
⇒ ↓Y
LM(P2)
r
LM(P1)
r2
r1
IS
Y1
Y
Y2
P
P2
P1
AD
Y
Y2
Y1
Monetary policy and the AD curve
The central bank can increase aggregate demand:
M LM shifts right
⇒ ↓r
⇒ ↑I
⇒ ↑Y at each value of P
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Macroeconomics ECO 403
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LM(M1/P1)
r
LM(M2/P1)
r1
r2
IS
Y2
Y
Y1
P
P1
AD2
AD1
Y
Y1
Y2
Fiscal policy and the AD curve
Expansionary fiscal policy (G and/or T) increases aggregate demand:
T ⇒ ↑C
IS shifts right
⇒ ↑Y at each value of P
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Macroeconomics ECO 403
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r
LM
r2
r1
IS2
IS1
Y2
Y
Y1
P
P1
AD2
AD1
Y
Y2
Y1
IS-LM and AD-AS in the short run & long run
Recall: The force that moves the economy from the short run to the long run is the gradual
adjustment of prices.
In the short-run equilibrium,
then over time, the price
if
level will
Y>Y
Rise
Y<Y
Fall
Y=Y
remain constant
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Macroeconomics ECO 403
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The SR and LR effects of an IS shock
A negative IS shock shifts IS and AD left, causing Y to fall.
LRAS
r
LM(P1)
IS1
IS2
Y
Y
P
LRAS
SRAS1
P1
AD1
AD2
Y
Y
In the new short-run equilibrium, Y < Y.
Over time, P gradually falls, which causes
·  SRAS to move down
·  M/P to increase, which causes LM to move down
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Macroeconomics ECO 403
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r
LRAS
LM(P2)
IS1
IS2
Y
Y
P
LRAS
SRAS1
P1
SRAS2
P2
AD1
AD2
Y
Y
This process continues until economy reaches a long-run equilibrium with Y = Y.
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Macroeconomics ECO 403
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r
LRAS
LM(P1)
LM(P2)
IS1
IS2
Y
Y
P
LRAS
SRAS1
P1
SRAS2
P2
AD1
AD2
Y
Y
Short Run Impacts
Now it's time to determine the effects on the variables in the economy.
Y
+, because Y moved
P
0, because prices are sticky in the SR.
+, because a +ΔY leads to a rise in r as IS slides along the LM curve.
r
+, because a + ΔY increases the level of consumption (C=C(Y-T)).
C
I
­ , since r increased, the level of investment decreased.
Long Run Impacts
Y
0, because rising P shifts LM to left, returning Y to Y* as required by long-run LRAS.
P
+, in order to eliminate the excess demand at P0.
+, reflecting the leftward shift in LM due to + ΔP
r
C
0, since both Y and T are back to their initial levels (C=C(Y-T))
­ ­ , since r has risen even more due to the + ΔP.
I
Analyze SR & LR effects of ΔM
·  We Have IS-LM and AD-AS diagrams as shown here.
·  Suppose central bank increases M.
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Macroeconomics ECO 403
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LM(M1/P1)
r
LRAS
LM(M2/P1)
IS1
Y
Y
P
LRAS
SRAS1
P1
AD2
AD1
Y
Y
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Macroeconomics ECO 403
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·
The Graph below Shows the Short run effects of the change in M and what happens in
the transition from the short run to the long run.
LM(M1/P1)
r
LRAS
LM(M2/P1)
IS1
IS2
Y
Y
P
LRAS
SRAS2
P1
SRAS1
AD2
AD1
Y
Y
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Macroeconomics ECO 403
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·
The new long-run equilibrium values of the endogenous variables as compared to their
initial values
LM(M1/P1)
r
LRAS
LM(M2/P1)
IS1
IS2
Y
Y
P
LRAS
SRAS2
P1
SRAS1
AD2
AD1
Y
Y
Short Run Impacts
Now it's time to determine the effects on the variables in the economy.
Y
+, because Y moved
P
0, because prices are sticky in the SR.
-, because a +ΔY leads to a decrease in r as LM slides along the IS curve.
r
+, because a + ΔY increases the level of consumption (C=C(Y-T)).
C
I
+ , since r decreased, the level of investment increased.
Long Run Impacts
Y
0, because rising P shifts LM to left, returning Y to Y* as required by long-run LRAS.
P
+, in order to eliminate the excess demand at P0.
0, reflecting the leftward shift in LM due to + ΔP restoring r to its original level
r
C
0, since both Y and T are back to their initial levels (C=C(Y-T))
I
0 , since Y or r has not changed.
Notice that the only LR impact of an increase in the money supply was an increase in the price
level.
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