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Chapter: Aggregate supply, the price level, and the speed of adjustment

In discussing equilibrium within the IS-LM model, it has been assumed that –prices are fixed –the supply-side of the economy can be ignored. These assumptions must now be relaxed. | Chapter 26 Aggregate supply, the price level, and the speed of adjustment David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith Introducing prices and the labour market In discussing equilibrium within the IS-LM model, it has been assumed that prices are fixed the supply-side of the economy can be ignored. These assumptions must now be relaxed. 26. The price level and aggregate demand The CLASSICAL model of macroeconomics analyses the economy when wages and prices are fully flexible. The real money supply is the key variable linking the aggregate demand for goods and the price level. The price level is the average price of all the goods produced in the economy. 26. The macroeconomic demand schedule (MDS) connects these points . MDS The macroeconomic demand schedule Real money supply is nominal money supply divided by the price level – it influences the position of LM. Income Income r P IS LM0 Y0 . | Chapter 26 Aggregate supply, the price level, and the speed of adjustment David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith Introducing prices and the labour market In discussing equilibrium within the IS-LM model, it has been assumed that prices are fixed the supply-side of the economy can be ignored. These assumptions must now be relaxed. 26. The price level and aggregate demand The CLASSICAL model of macroeconomics analyses the economy when wages and prices are fully flexible. The real money supply is the key variable linking the aggregate demand for goods and the price level. The price level is the average price of all the goods produced in the economy. 26. The macroeconomic demand schedule (MDS) connects these points . MDS The macroeconomic demand schedule Real money supply is nominal money supply divided by the price level – it influences the position of LM. Income Income r P IS LM0 Y0 P0 With price at P0, LM is located at LM0, and given IS, real income is in equilibrium at Y0. At a lower price P1, LM is at LM1, and real income at Y1. LM1 Y1 P1 26. See Section 26-1 in the main text, and Figure 26-1 NB the discussion continues on the next slide. MDS The macroeconomic demand schedule Income Income r P IS0 LM0 Y0 P0 LM1 Y1 P1 The MDS shows the different combinations of the price level and real income at which planned spending equals actual output once interest rates are set to keep money market equilibrium. Notice that a fall in price may also shift IS by increasing the value of household wealth via the real balance effect. IS1 Y2 The effect of this is to produce a flatter schedule MDS'. MDS' 26. See Section 26-1 in the main text, and Figure 26-1 NB the discussion continues on the next slide. The labour market and aggregate supply The aggregate supply schedule shows the output that firms wish to supply at each price level. Given that output depends on inputs