Economics with Prof. Sanjay Paul
Lecture 22
THE COMPLETE MODEL
1. The two elements of the model
1.1 Equilibrium in the goods market
- Income-expenditure diagram
- DD and SS curves
- Obtain eqbm values of GDP and the price level
- Recessionary and inflationary gaps
1.2 Equilibrium in the money market
- Md and Ms curves
- Obtain eqbm interest rate
2. Link between the two markets
2.1 From money market to goods market
- 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
2.2 From goods market to money market
- Effect of Y and P on money demand
- Increase in Y or P will lead to higher Md (why?) and ...
... higher interest rates
3. Exercises
3.1 Expansionary monetary policy
- 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
3.2 Contractionary fiscal policy
- 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
Effects of each on:
- GDP, Price level, Interest rates
- Disposable income, Consumption, Saving
- Investment, Budget deficit
- Exchange Rates, Net exports