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## The goods and the money market in the AS-AD modelWe begin by studying the goods market and the money market when prices are no longer constant. First up is the goods market. ## The goods market and aggregate demand
and (negatively) on Y and we continue to write R = YD(Y, R) in the AS-AD model. Let us justify this assumption.YD Remember that aggregate demand is the sum of the demand for consumption goods, investments, government consumption and net exports. None of these components will depend on and Y are held constant in the AS-AD model.R • Consumption. Suppose that is unchanged.C • Investment demand. As long as we keep the nominal interest rate (and thereby the real interest rates) constant, there is no reason for the demand for real investment to change. We would expect nominal investments to increase by the same percentage as the price level. • Government consumption. by the same argument as for private consumption.P • Exports and imports. This is more difficult to justify due to the exchange rate. Suppose that we have a flexible exchange rate (see Section 8.2.5) and that the price level is constant in the foreign country. Say that It is important to understand that in the AS-AD model. YD indirectly does not affect P directly if we keep YD and Y constant. But R may very well affect P and/or Y, and thereby indirectly affect R In fact, this is exactly what will happen in the AS-AD model as we will describe later.YD. ## The money market
When is affected by MD if we keep P and Y constant. In the AS-Ad model, R increases as MD increases (and vice versa).P Imagine that and Y are constant. All nominal variables such as nominal GDP, nominal consumption and nominal income will then increase by 10%. This means that you will need to hold more R to pay for the increase in consumption. Therefore, the demand for money is denoted by money in the AS-AD model.MD(Y, R, P) ## The money market and price changes
Money supply is an exogenous variable controlled by the central bank so there is no automatic mechanism that will change changes. Remember that the money market diagram shows the supply and the demand for money as functions of P everything else held fixed. Therefore, we can still use the money market diagram in AS-AD model as long as we keep R fixed.P We must now figure out how to analyze changes in constant at two different levels, P = 10 and P2 = 20. We know that P depends positively on MD and P P2) > MD(Y, R, P1). The demand for money increases when MD(Y, R, increases if P and Y do not change.R
If This means that the demand curve must be shifted outwards to the right when for all interest rates. increases. Note that with a fixed P and a fixed money supply, if Y increases, P must increase for the money market to remain in equilibrium.R |

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