Lecture 22
THE COMPLETE MODEL

1. The two elements of the model

• Income-expenditure diagram
• DD and SS curves
• Obtain eqbm values of GDP and the price level
• Recessionary and inflationary gaps

• M^d and M^s curves
• Obtain eqbm interest rate

2. Link between the two markets

• Consider the effect of an increase in interest rates on aggregate demand

• An increase in R will cause C and I to [increase / decrease]...
  ... causing aggregate expenditure to [increase / decline]
  

• The [higher / lower] aggregate demand will lead to:
  
  • [Higher / lower] GDP and
    
  • [Higher / lower] price level

• Effect of Y and P on money demand

• Increase in Y or P will lead to higher M^d (why?) and ...
  ... higher interest rates

3. Exercises

• Suppose the Fed increases money supply
  [How does the Fed actually manage to do this?]

• Interest rates will [rise / fall]

• From the goods market diagram:
  • DD curve shifts to the right (why?)

• Results:
  • GDP [increases / decreases]
  • The price level [falls / rises ]
  • Decrease in interest rates

• Consider a decrease in G
• What are the corresponding changes in Y, P and R?

4. Use the model to analyze:

• Monetary policy
• Fiscal policy
• Supply-side shocks

• GDP, Price level, Interest rates
• Disposable income, Consumption, Saving
• Investment, Budget deficit
• Exchange Rates, Net exports