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## Aggregate supplyIn order to determine all the variables in the AS-AD model, we need one more equilibrium condition so that we can identify a unique point on the AD curve as the unique equilibrium. This condition will come from the production side and the labor market. ## The Labor MarketIn the AS-AD model, the economy will always be on the
The response curve has a horizontal part and a downward sloping part. In the IS-LM model, we had only the horizontal since real wages where constant. We could not move beyond We can explain the response curve by examining the economy moving from point A to point C. • First, the economy is at point A, with prices P, wages W, real wages The profit-maximizing quantity of labor is LA. but firms do not choose this quantity due to lack of demand.LB • If aggregate demand increases, being affected, up to P = L To the left of point B, the IS-LM model is fully sufficient and the AS-AD model is redundant.LB. • When cannot increase without real wages falling. In the AS-AD model, real wages are reduced by an increase in L (with P constant) and we begin to move down the demand curve for labor.W • Between the points B and C, increases.P • However, we cannot increase When we are at point C, not even a price increase will help. Real wages are no so low that the LC. sets the limit - there are no more people that want to work for these low real wages.labor supply Let us summarize: • As long as may change with no change in prices. In this range, there is no relation between LB, L and L.P • When and LC, then LB increases with P.L • The chart below shows the relationship between L and P
## Aggregate supply and the AS curve
From the relationship between we can derive the relationship between P and YS as P is determined by YS by the production function (the higher L, the higher the ).L
Between points A and B prices are constant and firms produce an amount exactly equal to the aggregate demand. Here, the reversed Say’s Law and the IS-LM model apply. In this interval, the AS-AD model is redundant. Between points B and C we have a positive relation between Neither the reversed Say’s Law nor the IS-LM model apply.YS. It is, however, unreasonable to believe that there would be a "sharp edge" in the relationship between and between P and YS in the real economy. The schedules are drawn this way to simplify the explanation. A more reasonable assumption would be that the relationships are smooth curves.P
and between P and P.YS ## Determination of all the endogenous variables in the AS-AD model## Determination of P and Y
We know that for all points on the AD curve, both the goods and money market are in equilibrium. We also know that firms will always produce an amount consistent with the AS-curve.
in the AS-AD model.Y There is only one level for which is consistent with equilibrium in both markets and which is consistent with firm behavior. The price level at this point is the equilibrium price level and the GDP level at this point is the equilibrium quantity of GDP. We denote these levels by Y and P* Y*.The AS-AD model, will always move towards Y*. To justify this behavior of the economy, let us consider what will happen if Y < P*.P 1. From the graph, we see that in this case YD.2. Since we are on the upward sloping part of the AS-curve, aggregate supply will not automatically increase. But since firms can sell everything they produce and since stocks are diminishing, they will raise prices. 3. When falls and W/P increases. With more labor, firms can increase production.L 4. When will fall (the LM-curve shifts upwards).YD 5. Overall, falls when YD increases. As long P < YD, firms will continue to raise prices. Thus, prices will continue to increase until YS = YS and the economy is in equilibrium.YD ## Determination of other variablesOnce are determined, all other endogenous variables will be determined as well. The interest rate is determined by money market diagram and the components of GDP are either exogenous or they depend on Y or Y. R is constant and since W is determined, so is the real wage. Then P and the unemployment rate is determined as well.L Note that although this diagram is looks exactly like the "standard supply and demand curves" for a single good from microeconomics, the derivation and interpretation is very different. ## The equations of the AS-AD modelTo summarize the AS-AD model, we can look at its equations. The IS-LM model was "solved" by simultaneously solving the equations for Since R. was exogenous, we had two equations and two unknown and the system of equation could be solved. The solution was illustrated by the IS-LM diagram.MS In the AS-AD model, the situation is slightly more complicated because variables: three and Y, R We can no longer solveP. for Y, as we have three unknowns and only two equations. We need an additional equation in the AS-AD model. The third equation in the AS-AD model comes from the production function and the labor market. We showed that P depends on L and since P depends on YS will depend on P. Equilibrium requires that their supply equals actual production, i.e., YS(P) = Y. The three equations of the AS-AD model are thereforeL, YS These are to be solved for Y, = YD(P) Y.Note how the three different versions of the Keynesian model we have studied so far are related to the number of variables/equations. • In the = Y.YD(Y) • In the and R) and two equations: YD( Y, R) = Y and MD(Y, R, P) = Y Ms.• In the YS(P) = Y.Ms |

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