Aggregate Supply

1
Aggregate Supply
2
IS/LM Fixed Prices
So far, our analysis has assumed that the price
level is fixed. We studied the effects on
aggregate demand without looking at what might
happen to the price level. One important
limitations of this approach is that there is no
limit to the amount of output the economy can, in
theory, produce.
3
Deriving the AD
What happens to the LM curve when the price level
falls? Well , the stock of real money balances
rises, and shifts out the LM curve, interest
rates fall, and investment rises. Output then
goes up by a multiplier amount.
P?,M/P?,LM?,i?,I?,AD?,Y? .
This sequence of events is called the real
balance effect.
4
LM Shift from a Change in P
As we see in the graph, we can derive a diagram
in P,Y space as we move the price level down and
shift out the LM in panel (a). The more
responsive the economy is to changes in real
balances, the flatter is the AD schedule in panel
(b).
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Change in M Shifts the AD
A change in nominal money balances for a given
price level, though, will shift the AD.
In the panel on the left, we hold the price level
constant and shift out the supply of nominal
money balances to M'. At the same price level P1,
we have a higher aggregate demand, Y2. At P2, we
would also have a higher level of output, Y3.
When we redraw the AD, it has shifted.
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Locating the Shift in the AD
How do we find the price level P0 that would
restore AD back to its previous level given the
higher money supply? This is the increase in the
price level necessary to deflate the increase in
nominal money balances back to the old real
level. Suppose the money supply was 500 and the
price level 10, and then the Fed increased M to
600, real balances would go to 60, hence shifting
out the LM. Then we find P0 at 500/10600/x, x12.
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A Shift in G Shifts the AD
A shift in the IS is much simpler. At the old
price level we simply find the new higher
equilibrium level of output. A shift in the IS
function (say from an increase in G) will also
shift out the AD function. At each price level,
there will be a higher level of equilibrium AD
and Y.
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Numerical Example
After some manipulation, we find the goods and
money market equilibrium conditions,
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Model Not Closed
Notice that we can't simply substitute the LM
into the IS and arrive at a numerical solution.
Instead, we will derive output as a function of
prices, ADYf(P).
Why is this a decreasing function in P? Because
as P rises, real money balances fall, i rises,
and I falls, etc.
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Factors Affecting Slope of AD

• The multiplier The larger is the multiplier, the
  larger a given change in real money balances
  affects output. Therefore, the larger is the
  multiplier, the flatter is the AD.
• The interest sensitivity of investment, b The
  larger is b, the more I will change for a given
  change in i. The flatter is AD.
• The interest elasticity of the demand for money,
  h The larger is h, the larger the change needed
  in M/P to change the interest rate. AD steeper.
• The income elasticity of the demand for money, k
  The larger is k, the larger are feedback effects
  from the increase in output. AD steeper.

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Summary of Parameters
12
Vertical AD
An important special case is when the aggregate
demand curve is vertical. There are two potential
causes(i) The liquidity trap In this case our
LM is
As h gets very large, no matter how large the
change in M/P, there is no change in i. Hence, i
i. Hence, Y does not vary with P.
(ii) No response of investment to interest rates
(b0) This corresponds to a vertical IS. Even
though i falls, I doesn't change. Same picture,
different causes.
Note that monetary policy will not be effective
here. We will have a permanent recession without
fiscal policy (a la the Great Depression.) A
failure of prices to adjust a market (the
classical adjustment mechanism).