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ESG
ESM
II EDG
i ESG IV
ESM
EDM
EDG
EDM
III IS
O Y
Y
Region Goods Market Money Market
Disequilibrium Output Disequilibrium Output
I ESG Falls ESM Falls
II EDG Rises ESM Falls
III EDG Rises EDM Rises
IV ESG Falls EDM Rises
IS-LM Framework- Monetary Policy
i
LM Increase in real money supply
Shift in LM curve
LM’ Portfolio dis equilibrium
Buying of financial assets – and
declining yields
Fall in interest rate (i2)
Increase in investments
i0 E Increase in consumption
Increase in aggregate demand
i1 E’ Increase in income (Y1)
Increase in interest rate from initial
i2 E1 high level
New equilibrium
IS
Y
0
Y0 Y1
IS-LM Framework- Fiscal Policy
i Increase in government spending
LM Increase in aggregate demand (IS’)
Increase in income (Y1)
i1 Money market dis equilibrium
E’ (EDM)
i0 Increase in demand for money
E E” Increase in interest rate
Decrease in investment
Decrease in aggregate demand from
IS’ initial high level
IS Decrease in income (Y0’)
Y
O
Y0 Yo’ Y1
IS-LM Framework- Crowding Out
i
Increase in government
LM spending crowds out
investment spending
LM’ Crowding out occurs when
expansionary fiscal policy
causes interest rates to rise,
thereby reducing private
E” spending, particularly private
i0 investment
Crowing out can be reduced by
i1 E E’ following a policy of
increasing money supply along
with increased government
E1
spending
IS’
IS Y
0
Y0 Y” Y1
The Keynesian Approach to Demand for Money
LM’
Aggregate demand
E LM = M/P0 curve shows the
LM’ = M/P1
E’
combinations of the
price level and the
level of output at
IS which the goods and
money markets are
0 Y
Y Y’ simultaneously in
equilibrium
P
AD
0 Y’ Y
Y
Aggregate Demand Curve – Fiscal Policy
i LM
E’
I1
E
I0 -Initial equilibrium E
IS’
-Increase in government
IS
spending
-Shift in IS curve
Y
0 Y0 Y’ -At given price there is
high income and high
interest rate at new
equilibrium point E’
P E’ -Shift in AD curve
E
AD’
AD
0 Y0 Y’ Y
Aggregate Demand Curve – Monetary Policy
i LM
LM’
I0 E -Increase in
E’
I1 nominal stock of
money
IS
-Shift in LM curve
Y
0 Y0 Y’ -Increase in real
income Y
-Shift in AD curve
P1 K
P P0 E’
E
AD’
AD
0 Y0 Y’ Y
Aggregate Supply Curve
In the short run, the interaction between aggregate demand and
aggregate supply determines the level of output, employment and
capacity utilization as well as the price level (the source of
inflation)
In the long run a decade or more say, aggregate supply is
considered as the major factor behind economic development as
well being of a nation.
Aggregate Supply in the Short Run
Production take place in the business sector on the basis of expected
price of its output
Costs are incurred in anticipation of sales.
If the actual prices are higher than expected price, firms will
experience a higher level of profit and this will encourage an increase
in production
This implies that short run supply curve slopes upward from left to
right for part of its range because at any point in time there us a limit
on the output of goods and services
This limit increase with increased production, the availability of ideal
resources and this limit is reached when the production reaches full
employment level of output
When the resources available are fully employed the short run
aggregate curve will become vertical.
At this point, further increase in price level will have no effect on
output
Aggregate Supply in the Long Run
In the long run , if all other things remain the same, the higher
price level will come to be accurately expected by firms,
narrowing down the difference between expected and actual
price levels.
In the long run cost incurred by the firms rise as economic
agents react to higher prices
As soon as cost increases in line with final prices, the incentives
to produce higher level of output disappear and production
reverts to its original level
Factors responsible for changes in aggregate
demand
A change in income
Rate of interest
Government policy
A change in exchange rate
Change in the expected rate of inflation
Change in business expectations
Factors responsible for changes in aggregate
Supply
With increase
Y2
Y = f (N)
in the level of
Y1 employment ,
Yo
the level of
output
increases but
at a
diminishing
rate
0 No N1 N2 Employment
The Demand for Labour Function
Under a condition of perfect competition, a profit
maximizing firm hires workers until the average wages
is equal to the general price level multiplied by the
marginal product of labour
W = P * MPL
So long as the cost of hiring additional workers is less
than the revenue gained, firm will demand additional
workers.
As firm hires additional workers, the marginal product
of labour declines
W/P (Real wage) = MPL (Marginal product of labour)
The Demand for Labour Function
Demand for labour function is a
W/P
relationship between real wage and
the amount of labour demanded
Real
Wages The amount of labour demanded is
inversely related with real wages
(W/P)0 A
Marginal product of labour curve is
derived from the production function,
it shifts with shift in production
B
(W/P)1 function
O N0 N1 Employment
The Supply of Labour Function
Supply of labour depends on real wages (W/P)
The amount of labour supplied is assumed to be positively related to
real wages so that increase in real wages results in increase in the
amount of labour supplied.
Ns = f (W/P)
(W/P)1
(W/P)0
O Employment
N0 N1
W/P
O N
Employment
Output
O
N
Employment
Price Level
O Output
Y
The Keynesian Aggregate Supply Model
P4’
AD
P4
AD
P3
P2 AD
AD
AD AD
Output - Y
O Y Y1 Y2 Y3 Y4
The Keynesian Aggregate Supply Model