EC111Lecture15.docx

EC111 MACROECONOMICSSpring term 2012Lecturer: Jonathan HalketWeek 20Topic 5: AGGREGATE DEMAND AND SUPPLY(Begg, Chp 21)So far we have assumed that the price level (and implicitly the nominal wage rate) in the economy is fixed and does not depend of the level of national income. Now we want to introduce price flexibility but (for now) we keep the nominal wage fixed.Aggregate DemandWe can derive an economy-wide demand side relationship between the aggregate price level, P, and the level of real national income, Y, through the LM curve. We specified the demand for money in terms of the real money supply or money stock M/P:rAlternatively: MSMD (P2)MD (P1)MAn increase in the price level shifts out the demand for money (for transactions purposes) and, for a given income, leads to a higher interest rate.The LM curve is:rLM (P2)LM (P1)ISYThe rise in the price level shifts the LM curve to the left, moving up the downward sloping IS curve and leading to lower income (and a higher interest rate). PADYThis can be seen clearly when we solve the IS/LM system for Y.A rise in P reduces the real money supply and reduces national income. Thus we have a downward sloping relationship between P and Y. But note:This is not derived in the same way as demand curves in consumer theory.The IS curve is sometimes referred to as “Aggregate Demand” in some textbooks. Here I use it only to describe the demand side relationship between P and Y. Aggregate SupplyThe aggregate supply curve is derived from the labour market, where firms are making profit maximising decisions about output and employment in the short run. W/PW/P1W/P2LSLD E* EmploymentAggregate employment depends on the real wage, W/P. We assume that the nominal wage is fixed and there is some excess supply of labour (so we are on the economy-wide labour demand curve). With the nominal wage, W, fixed a rise in the price level, e.g. from P1 to P2 reduces the real wage inducing firms to employ more labo