Assumptions

Chapter 7. Putting All Markets Together

The AS-AD Model

I. Motivating Question

How Are Output, the Unemployment Rate, and the Interest Rate Determined in the Short and Medium Run?

Output, the unemployment rate, and the interest rate are determined by simultaneous equilibrium in the goods, financial, and labor markets. Simultaneous equilibrium in the goods and financial markets is summarized in an aggregate demand relation; equilibrium in the labor market is summarized in an aggregate supply relation. Labor market equilibrium is conditional on the expected price level. In the short run, the expected price level may not equal the actual price level, and thus the unemployment rate may not equal the natural rate. Over time, the expected price level will tend to converge to the actual price level, and the unemployment rate will tend to return to the natural rate.

II. Why the Answer Matters

This chapter integrates the goods, financial, and labor markets in short-run and medium-run equilibrium. It maintains the assumption that changes in monetary policy are discrete changes in the level of nominal money. The next two chapters introduce money growth and inflation into the analysis and begin to discuss the economy in terms of growth rates (except for the unemployment rate) rather than levels of variables.

III. Key Tools, Concepts, and Assumptions

Tools and Concepts

i. The chapter introduces the aggregate demand and aggregate supply relations.

ii. The chapter makes extensive use of dynamic analysis, introduces the term business cycle, and distinguishes between shocks and propagation mechanisms.

Assumptions

The chapter assumes that the expected price level adjusts to differences between the actual and (previously) expected price levels. If the actual price level is greater (less) than the expected price level, wage setters are assumed to increase (decrease) their expected price level in the future. This adjustment mechanism is essential for the dynamic analysis presented in the text.

Date: 2015-02-16; view: 923