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Aggregate
Demand,
Aggregate
Supply, and the
Self-Correcting
Economy
• Assume that wages are fixed in the short run and that
prices are merely “sticky.”
• If prices rise, firms benefit because the real wage paid to
their workers falls.
• Thus, firms can increase output if the price level rises
because their profits increase!
– P Y , which yields an upward-sloping SAS curve
• How steep is the SAS curve?
– If Labor Demand is relatively inelastic, SAS will be steeper!
– Why? If P W/P LD by a little Y by a little
• Stabilizing Effects of P
– The Pigou or Real Balance Effect is the direct stimulus to AD
caused by an increase in the real money supply and does not
require a decline in the interest rate.
– The Keynes Effect is the stimulus to AD caused by a decline in the
interest rate.
• Destabilizing Effects of P
– The Expectations Effect is the decline in AD caused by the
postponement of purchases when consumers expect P.
– The Redistribution Effect is the decline in AD caused by the effect
of falling prices in redistributing income from high-spending debtors
to low-spending savers.
M sV PY (7.2)