Economics test.

𝐶 = 𝐶0 + 𝑚(𝑌 − 𝑇)

𝐼(𝑝𝑙𝑎𝑛𝑛𝑒𝑑) = 𝐼𝑜 − 𝑗𝑟

AE = C + I + G + NX and Y = AE, so combining with the above we get:

(Investment = Savings) 𝐼𝑆: 𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋

(Liquidity = Money)𝐿𝑀: 𝑀𝑠

𝑃 = 𝐿(𝑟, 𝑌) [think L is similar to

𝑘𝑌

𝑟 ]

AD: Aggregate Demand: Combine IS + LM

– what is Y’s intersection as P changes (change in P moves LM)?

LRAS: Long-Run Aggregate Supply: YN = A x F (K, L, N, H)

SRAS: Short-run Aggregate Supply: Y = YN + z (P – Pe)

**: if Pe ≠ P then Pe will move toward P over time (SRAS shifts)

Colors:

 Yellow: Exogenous

 Blue: Endogenous variables, appear on axis, link equations together

 Green: Other endogenous variables, have exogenous components

 Gray: Long-run GDP, technically endogenous, only changes if LRAS components change

Endogenous:

 P – Price level

 r – Real interest rate

 Y – Real GDP

 YN – Long-run GDP / “natural level” of GDP

 C – Consumption (parts of it are exogenous)

 I – Investment (parts of it are exogenous)

 Long-run Pe (Can change exogenously in the short run)

Exogenous: I could ask you to change ANY of these,

all else are held constant unless noted (ceteris paribus)

 G – Government purchases

 T – Taxes (more complex model – tax rate is exogenous but total taxes are endogenous

based on t x Y)

 NX – Net Exports (Exports minus Imports, each exogenous)

 Io – Autonomous Investment - Investment that does not depend on interest rates

 C0 – Autonomous consumption – the amount of consumption that does not depend on

GDP (part of the Y intercept of the consumption function) is exogenous. Largely

depends on wealth.

 m – MPC – Marginal propensity to consume is exogenous, though usually fixed.

 Ms – Money supply – exogenous, largely controlled by the Fed

 A – Technology

 K – Physical capital (factories, tools, etc.)

 L – Labor (number of workers or hours worked). This is NOT the “L” in the LM function.

 N – Natural resources (can be obtained through trade)

 H – Human capital (education, experience, health, etc. – requires resources to build, and

lost if the worker dies)

 Pe – Expected price level (exogenous in the short run)

We also have a few exogenous parameters that, while they could change, I will not ask you to

alter for the exam:

 j – parameter for the sensitivity of business investment to interest rates. Will not be

changed on the exam.

 z – Businesses sensitivity to price changes in the short-run.

Graphing the linked IS-LM and AS-AD model – Follow the 7 steps: 1) Identify the variable that’s changing and so which line is moving & what direction (IS: Y = C + I + G + NX LM: MS/P = L(r,Y) AD: Combine IS & LM, so never the initial change if IS-LM is available LRAS: Yn= A x F(K,L,N,H) SRAS: Y = Yn + a (P – Pe) where Pe is expected price level (Bold/Yellow are the initial possible changes – more detail in the 2 sheets above) 2) Move the line. 3a) if you moved LRAS, move SRAS with LRAS it because SRAS always intersects LRAS where P = Pe 3b) If you moved IS or LM, move AD to the new temporary Y (where IS crosses LM) AT THAT ORIGINAL PRICE LEVEL. You should NOT be crossing SRAS at this new temporary Y. 4) Find the point where the lines cross. Where AD crosses SRAS, that’s the short-run answer. Find where it crosses LRAS, that’s the long-run answer. 5) If prices changed (which they should have), then move LM to cross IS (new IS, if you moved IS) – it should cross at the same Y so you get the same short-run Y on the top and bottom graph. If you can’t do step 5 because you’re already where you need to be, it’s probably because you did step 3b wrong. END OF SHORT RUN 6) If P =/= Pe (so if SRAS is not crossing LRAS where AD crosses), move SRAS to where AD hits LRAS (the answer for long run in #5 above). Expected price level is adjusting here toward the actual price level, which is moving SRAS, and this continues until P = Pe, which only can happen where AD crosses LRAS. 7) If P changed, move LM again as in step #5 (same long-run Y on both graphs). END OF LONG RUN That’s the whole procedure. Then analyze what happened to the following variables: Y (on graph) r (on graph) P (on graph) Pe (on graph, doesn’t move in short run unless it’s the initial change, moves in long run) C – based on what happened to Y I – based on what happened to r Unemployment (should be opposite move to what happens with Y unless labor force was the initial change, then it can be ambiguous)