LECTURE 2

SUPPLY OF MONEY DECREASE

THE MACRO ECONOMIC MODEL

Introduction to Economics

Charles R. Plott

California Institute of Technology

Y

Yiii

Spending

aI a1 I1

aI

I1

I1+a1

Y1 Y2

i

MDTMDT

Y

Y

P P

M/P

M/P

M/P

M*/P*

P*

W/P

Y

P

UNKNOWNS.Y income.C consumption.I investment.i interest rate.P price level.L employment.MD money demand.MDT transaction demand for money.MDS speculative demand for money.w nominal wages levelGIVENSG Government spendingX net exportsM nominal money supplyb marginal propensity to consume

EQUATIONS.Y=C+I+G+X.C=a(i)+bY.I=I(i).M/P = MD.MD=MDT+MDS

.MDT = MDT(Y)

.MDS = MDS(i)

.DL(w/P)-SL(w/P)=0

.L=SL(w/P)

.Y=F(L,..)

EXERCISE #2

A SHIFT IN THE MONEY SUPPLY.

THE MONEY SUPPLY DECREASES

A MONETARY INDUCED RECESSION

Y

Yiii

Spending

aI a1 I1

aI

I1

I1+a1

Y1 Y2

i

MDTMDT

Y

Y

P P

M/P

M/P

M/P

M*/P*

P*

W/P

Y

P

Aggregate supply exceeds aggregate demand. Price decreases have two effects.

1. Real wages increase causing unemployment.This causes aggregate supply to fall in line with aggregate demand. As money wages decrease, real wages fall increasing employment and aggregate supply.

2. The fall in prices is an increase in the real money supply. This decreases interest rates and stimulates spending and aggregate demand. Aggregate demand expands to accommodate the increasing aggregate supply.

Y

Yiii

Spending

aI a1 I1

aI

I1

I1+a1

Y1 Y2

i

MDTMDT

Y

Y

P P

M/P

M/P

M/P

M*/P*

P*

W/P

Y

P