1

EC111 MACROECONOMICS Spring term 2012

Lecturer: Jonathan Halket
Week 20
Topic 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 Demand
We 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:

Alternatively: _____________________











An 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.

r
M
D
(P
1
)
M
D
(P
2
)
M
S

M
2

The LM curve is:













The 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).











This can be seen clearly when we solve the IS/LM system for Y.
r
LM (P
2
)
LM (P
1
)
IS
Y
Y
P
AD
3


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 Supply
The aggregate supply curve is derived from the labour market, where firms are making
profit maximising decisions about output and employment in the short run.











Aggregate 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 P
1
to P
2
reduces the real wage inducing firms to employ more labour and produce
more output.
For a given nominal wage, the higher is the price level (and the lower the real wage), the
higher is national income as firms find it profitable to produce more output.



E* Employment
W/P


W/P
1


W/P
2
L
S
L
D
4











Note that beyond the point of full employment, E* and Y*, a higher price level (lower
real wage) will not generate more employment.
Question: why does it slope backwards after Y*?
The aggregate price level (and national income) is now determined by the equilibrium
of supply and demand.













Y* Y
AS
P
Y
AS
P
AD
5

Fiscal Policy











Shifting the IS curve to the right increases income and the interest rate. The shift in
aggregate demand pushes up the price level, which reduces the real money supply
causing some leftward shift in the LM curve. So the expansionary effect is somewhat
less than when the price level was fixed.












r
LM (P
2
)
LM (P
1
)
IS
2
Y
Y
AS
P
AD
1
IS
1
AD
2
6

Monetary Policy











Increasing the (nominal) money supply shifts the LM curve to the right. Aggregate
demand shifts to the right, pushing up the price level. The rise in the price level offsets
some of the increase in money, so there is some shift of the LM curve back to the left.
The expansionary effect is less than when the price level was fixed.












LM
2
r
LM
1

LM
3
IS

Y
Y
AS
P
AD
1
AD
2
7

An increase in the wage rate










A supply side shift. If the nominal wage increased, firms would be willing to produce less
output and employ less labour at a given price level because their costs have risen. The
aggregate supply curve shifts to the left leading to lower output and a higher price level.
The real money supply M/P falls with the increase in the price level, shifting the LM
curve to the left.













Y
AS
1
P
AD

AS
2
LM
1
r
LM
2

IS

Y
8

Topic 6: THE CLASSICAL MODEL
So far we have taken the nominal wage to be fixed. The classical economists assumed
that wages were flexible, so that we have equilibrium in the labour market. This was
also a challenge for the Keynesian view of the economy. Nominal wage flexibility is the
key difference between the Keynesian (fixed wage) and the Classical (flexible wage)
approaches to macroeconomics. But note: these are both extreme cases.











In the classical case, the nominal wage, W, always adjusts to ensure labour market
equilibrium. If the price level rises from P
1
to P
2
the nominal wage increases, leaving the
real wage unchanged at (W/P)* and employment at E*.









E* Employment
W/P




W/P
1
=W/P
2

L
S
L
D
Y* Y
AD
2
P
AD
1
AS

9

A change in the price level has no effect on national income. In the classical model the
aggregate supply curve is vertical and national income will always be at its full
employment level.
Fiscal Policy
An increase in government expenditure, G, shifts the aggregate demand curve to the
right (as above) and it shifts the IS curve to the right (below). But the rise in the price
level reduces the real money supply, M/P, which shifts the LM curve to the left.
Remember, that according to the LM curve, a rise in the price level increases the
interest rate for a given level of income.













The LM curve shifts to the left, restoring the original level of income, Y*. So fiscal
policy is completely ineffective for Y, but P and r have increased. Government
expenditure has increased but the rise in the interest rate has caused investment to fall
by exactly the same amount. There has been complete crowding out of private
investment by government spending.
Question: How do we know this?



Y* Y
LM
1
r
LM
2

IS
2
IS
1
10

Monetary Policy
An increase in the nominal money supply shifts the aggregate demand curve to the
right, raising the price level. The price level rises by the same proportion as the money
supply, so the rightward shift of the LM curve to LM is completely reversed by the rise
in the price level. So the LM curve remains in the original position. The interest rate is
unchanged and there is no change in G, I, or Y.











This is the key result of classical monetary economics; it is the Quantity Theory result.
The effect of increasing the money supply is to increase the price level by the same
proportion with nothing else changed.
In the classical model both fiscal and monetary policy are ineffective in influencing the
level of real national incomein sharp contrast with the Keynesian economy. But in the
classical case, the economy is already at full employment and so policy aimed at
increasing employment is not necessary.

A shift in aggregate supply
In the classical model the supply side plays a more important role. Changes in the
labour force or in labour productivity will influence the level of national income. If
there was an increase in productivity due, say, to the introduction of new technology,
then the marginal productivity schedule (the economy-wide labour demand curve)
would shift to the right. Firms find that costs have fallen relative to the price of their
output for any given real wage. This will increase output for a given labour input and
may increase equilibrium employment (if the labour supply curve is upward sloping).
Y* Y
LM

r
LM
IS

11












The aggregate supply curve will shift to the right (not shown) and, with no change in
aggregate demand, the price level will fall. Because the real money supply (M/P) has
increased, the LM curve shifts to the right. As a result, the interest rate is lower and
Investment and output are higher.











An increase in the labour force (a shift in L
S
), would also increase national income
unlike the case of a Keynesian economy. Try tracing through the effects of this as an
exercise.
E*
1
E*
2
Employment
W/P



(W/P)*
2

(W/P)*
1
L
S
L
D
1
L
D
2
Y*
1
Y*
2
Y
LM
2
r
LM
1
IS

12

The New Classical model
The classical economy is an extreme case of perfect wage and price adjustment. In the
so-called new classical model there can be some short-run effects of changes in
aggregate demand on the real economy. It distinguishes between anticipated and
unanticipated changes in aggregate demand.
One possible mechanism is where a rise in price, due to an unanticipated shift in
aggregate demand, is perceived by firms as affecting only their own output price. They
do not recognise it as a general rise in prices (and wages), but as a favourable relative
price change. They expand their output in the short run, moving along an upward
sloping supply curve. In the long run, it is recognised as an aggregate price change and
firms adjust back to the original level of output.











In the long run the supply curve is vertical, but it is upward sloping for surprise, or
unanticipated, shocks. It may be written as:

Where P is the actual price and P
e
is the aggregate price that firms expect or perceive. If
the actual price exceeds the expected price then actual output supply exceeds long run
supply Y*. When P = P
e
there is no surprise and Y = Y*. We shall look at expectations
in more detail in the context of the labour market.

Y* Y
1
Y
AD
2
P
AD
1
LRAS

SRAS