Summary of Topics after midterm.

An economy’s equilibrium (General equilibrium) is a state when all markets in an economy will be in
equilibrium simultaneously. This equilibrium point will determine the level of potential (Full equilibrium
level) income, natural rate of unemployment, interest rate, wages and prices.
Two different approaches, that provide same level of information, can be used to represent this state that
are below.

 Aggregate Demand and Aggregate supply approach

Where AD is the representative of Demand side and consists of all demand expenditures in an
economy. Similarly, AS represents the supply side of an economy and is the summation of
production by all firms in this economy. This approach is helpful when we want to study the
dynamics of income and General Price level.
 IS-LM approach

Where LM represents the asset market, IS represents the goods market and FE line represents the full
employment income. This approach is helpful when we want to study the dynamics of interest rate and
income.
Both approaches represent same level of information because both provide the full employment level of
income and full employment level of income is a level where all resources of an economy are fully
employed other than those who voluntarily do not want to work. Therefore, at this level output gap (Actual
level of GDP- Potential level of GDP) and unemployment gap (Actual level of unemployment – natural
rate of unemployment) will be zero.
Let’s decompose this general equilibrium state into partial equilibrium states. Partial equilibrium is a state
in which a particular market is in equilibrium. We can divide our economy into three major markets.
1. Labor market
2. Goods market
3. Asset market/ Money market
Labor Market:
Labor market represents the labor demand and labor supply conditions. It determines the equilibrium level
of employment (unemployment) and output in an economy. In addition, it also provides the equilibrium
wage rate of an economy.
Labor market has two primary components; Labor demand and labor supply.
Labor demand means the demand for workers by producers or firm for production of goods and services.
Labor supply means the number of workers (number of hours) that are working in the market. Therefore,
firm demand for labor and household supply of labor. In the return of workers’ services firm pays them
wage rates that determine by the intersection point of labor demand and supply where quantity of labor
demand will be equal to quantity of labor supplied. In other words, whoever wants to do a job firm will hire
him/her. Thus, neither a firm nor a worker can influence the equilibrium level of wages in a perfectly
competitive market. The following graph is the representative of equilibrium in the labor market. On
vertical axis we have real wage rate and on horizontal axis we have level of employment in our economy.
In this market there is no involuntary unemployment. All workers are employed.

Y= f (k, N) This N is the equilibrium employment level of above graph. Thus, this market will also provide
us the potential level of output because our all resources are fully employed at this point.
Goods Market:
Labor market provides us the” level and way of production”, whereas, goods market will determine “how
this production is used”. This market provides us the information about factors that underlie the economy
wide demand for goods and service. We can divide demand factors into three types of agents.
1. Households
2. Firms
3. Government expenditures
Households demand:
Households demand for durable goods, non-durable goods and services. Demand means consumption of
these goods and services for which they pay for from their income that they earned in the labor market in
the form of wages. But there is always a trade-off between the consumption of current period and future
period. Because a rational person wants to secure his/her future and save a part of his/her income for future
consumption. In the result of these savings, he/she earns a return in the form of savings. Banks provide
interest rate on our deposits. Thus, households are the supplier of loanable funds because the other name of
savings is the supply of loanable funds.
Firms’ Demand:
On the other hand, Firms demand for these savings through the channel of financial institutions banks) to
purchase capital goods. Firms’ expenditures on machinery, capital, building, office equipment, and vehicles
is the demand of goods and services by firms. To finance these expenditures firms, use the channel of banks
and borrow households’ savings. In the result of these savings, firms pay interest rate to the individuals
(households). Thus, firms are the demander of loanable funds because the other name of investment is the
demand for loanable funds.
Goods market equilibrium:
This is a state where savings (supply of loanable funds) will be equal to the investment (demand for loanable
funds) and this state will determine the real interest rate of this economy.
Any change other than the changes in interest rate will changes the position of savings or investment. In
other words, saving and investment curves will be shifted in the result of any change other than the change
in interest rate. Consequently, the equilibrium level of interest rate will be change.
Note :( Apply whatever you learned in your second assignment of determination of saving,
consumption, investment, and goods market equilibrium).
Government Role:
Government expenditures includes the running cost of different Govt. expenditures, transfer payments and
interest payment on debt. Govt. finance these expenditures by imposition of taxes on firms and households.
Thus, increase in when govt. expenditures will reduce the national savings and shift the saving curve
leftward. On the other hand, decrease in taxes increases the income of households and firms which leads to
increase in savings. Thus national saving curve will shift rightward. In this way we can study the role of
Govt. in goods market equilibrium.
Note: Once again study the stud that you covered in second assignment.
We can study the goods market with the help of a single curve which represents the negative relationship
between interest rate and income where goods market is in equilibrium (Savings=investment). This curve
is called IS curve and its each point is the equilibrium point of goods market. To derive this curve, initially
we will assume a change in current level of income of this economy. Any change other than current income
and interest rate will shift this curve and direction of its shifting depends on the shifting of savings and
investment.
Note: (Apply all shifting factors of savings and investment one by one)
The summary table that contains the information of these shifting factor is below:

Money Market/ Asset Market:

We have studies two of the markets of our general equilibrium model. Now we are going to study the third
market which is asset market. The entire set of markets in which people buy and sell real and financial
assets, including for example, gold, houses, bonds and stocks.
For simplicity analysis we can divide our total assets into two major categories, monetary and non-monetary
assets. Monetary assets include only money and all remaining assets are included in non-monetary assets.
What is money? Money is anything that can be used in making payments and serves as a medium of
exchange, unit of account and store of value.
Note: (For details of this topic you have to study your third assignment).
As you know there are four characteristics that determines the demand for any asset. Among those aspects,
liquidity is the only desirable characteristic that increases the demand for money because money in hand or
pocket or in current account does not provide any return or interest rate. The only way in which money
facilitates an individual is the liquidity of money because we can purchase most of the products with the
help of money. On the other hand, nonmonetary assets provide us a return in the form of capital gain or
dividend or interest rate. For simplicity analysis we are assuming that nonmonetary assets provide us the
interest rate which is the return on these assets.
Therefore, Demand for money (holding of money) is the positively link with income of households.
Because an increase in income raises the need for transactions and to facilitate our transaction we need
more liquid asset which can be easily convert into cash. Consequently, demand for money will increase and
demand for nonmonetary assets will decreased. Similarly demand for money is proportional to price level.
Because rise in price level requires more money for transaction. On the other hand, demand for money is
inversely related with the interest rate which is the return on non-monetary assets. An increase in interest
will raise the desirability to hold nonmonetary assets and demand foe money will decrease.
Any change other than income, price level, and interest rate will shift the demand for money. The below
table contains the information of shifting factors/determinants of money demand.

But the other part of the asset/money market is the money supply which is under the control of central bank.
Money supply has no relationship with interest rate and income. Thus, it is vertical straight line curve. Only
the decision of central bank can change the position (shift) of the money supply curve.
Equilibrium in the money market:
Equilibrium of the money market is a state where money demand is equal to money supply. This point will
determine the return on other asset or interest rate in the asset market/money market. The interest rate
determined by central bank in its monetary policy announcement. Any change in the shifting factor of
money demand or money supply will change this equilibrium and interest rate.
The equilibrium of money/asset market is depicted in below figure:

LM curve:
We can study the asset market with the help of single curve that represents the positive relationship between
income and interest rate where money market is in equilibrium (Money demand=money supply). On each
point of this curve asset market will be in equilibrium.
To derive this curve, initially we will assume a change in the current level of income of an economy and
all factors remain constant. An increase in this income will increase the need of transactions. To facilitate
these transactions, we need liquid asset which is money, therefore, demand for money will increase. The
below curve represents the derivation of LM curve.

Shifting of LM curve
Any change other than current income and interest rate will shift the LM curve. All shifting factors
of Money demand and Money supply will shift LM curve. The graph of shifting LM curve is below:

Central bank increased the Money supply but people have enough money to finance their transactions.
Therefore, they will invest this money into assets and in the result of this, demand for nonmonetary assets
will rise and return on nonmonetary assets (interest rate) will decline because people are willing to purchase
them. The shock of money supply is an exogenous shock, therefore, the LM curve shift downward.
The below is the list of shifting factors of demand curve.

Once again General Equilibrium Model:

Now it is a time to combine all markets (labor market, asset market, and goods market) in a single graph
which will represent the general equilibrium of the economy, where general equilibrium reflects the
potential level of output or full employment level of output.

Now we are able to study the impact of different government policies and consumers’ preferences shock
on economy. These shocks are called demand side shock because they affect the position IS & LM curve
that are representatives of demand side of an economy.
Similarly, we can analyze the impact of supply side shocks on an economy by using this graph because FE
line is representing the supply side of the economy in above graph.
But before analyzing the impact of demand and supply side shocks we will define the environment of the
economy which refers to different assumptions of an economy. This is necessary to make analyze the
different point of views of two different school of thoughts; Classical and Keynesians.
Classical School of thought
Assumptions:
1. Wages and price are flexible
2. Wages and prices are determined by the market forces (Demand and supply)
3. There is no involuntary unemployment (ECONOMY IS ON ITS FULL EMPLOYMENT LEVEL)
4. There is complete information in the economy
Supply side shock:
Supply side shock refers to any positive or negative (adverse) shock to the production process. Positive
shock is a shock which increases productivity of labor & capital and decreases the cost of production. On
the other hand, a negative shock increases the cost of production and decreases the productivity of labor &
capital.
Examples of positive shocks:

 Fall of oil process

  Favorable weather conditions
 Adoption of innovative method of production
Examples of positive shocks:

 Rise in oil process

 unfavorable weather conditions
 Adoption of innovative method of production

Adverse Supply shock:

Adverse supply is a shock which will increase the cost of production and decrease the productivity of labor.
We will analyze this shock in two different ways; A temporary adverse supply shock and permanent adverse
supply shock.
Let me clear you people that the effect of both shocks will be similar except its impact on IS curve. A
temporary adverse supply shock will increase cost of production and decrease labor productivity.
Consequently, Firms will decrease their labor demand because of this reduction people will unemployed.
Thus, FE line will shift leftward. This unemployment will only reduce the current level of income of people
and you know in the result of change in current income of the workers there will be a movement along the
IS curve. Therefore, IS curve will not shift. Price level in the economy will rise and LM(M\P) will shift
upward because prices are flexible. At new equilibrium point where ne FE line, New LM curve and old IS
curve are intersecting each other, Price level and interest rate are high than previous level. But what about
inflation? You know inflation is the growth rate of prices and Inflation will also rise but for only on period
because this is a temporary shock which affect will remove in the next year.
But in the result of a permeant adverse supply side shock FE and LM will shift backward and IS will shift
leftward (Downward). Now prices, inflation and interest rate all will rise in the economy, whereas,
Employment and Output will decline in this economy.
The graph of adverse supply shock is below.
Note: All negative supply shocks will work in similar way and all positive supply shocks will work in
opposite way.
Demand Side shocks:
All those shocks that shift IS & LM are called demand side shocks. You can analyze those shocks one by
one. Currently, I am showing the channel of Monetary and Fiscal policy only.

Monetary Policy:
Monetary policy refers to the level of money supply and interest rate. An increase in money supply
(decrease in interest rate) is called expansionary monetary policy (Lose monetary policy), whereas, decrease
in money supply (an increase in interest rate) is called contractionary monetary policy (Tight monetary
policy). In classical model, expansionary monetary policy will rise only price level in the economy and will
not affect the output (income) level of an economy because wages and prices are flexible along with
complete information.
You can observe in left figure the impact of increase in money supply (Shifting of LM curve) and in left
panel you can observe that in the result of this expansionary monetary policy the price level has increased
that shift LM curve backward to its original position. Consequently, only price level and interest rate in an
economy are at higher position but there is no change in output level.
Conclusion:
According to classical school of thought there is no need of government intervention because wages and
price are flexible and will remove any deviation of income from full employment level of income and any
unemployment from natural rate of unemployment.
Note: The working of fiscal policy will be studies by using the framework of aggregate demand and
aggregate supply.
Keynesian School of thought:
Assumptions:
1. Wages and price are rigid
2. Wages and prices are determined by firms
3. There is an involuntary unemployment (economy does nor remain on its full employment level, but
sometime below than full employment and sometime above than full employment level)
4. There is incomplete information in the economy
Dear students, because of change in assumptions the structure of economy and working of policies will
change. Due to non-existence of full employment there are chances to correct the economy and need to
bring it on its full employment level. For example, in the presence of recession, when economy lies below
than full employment level, Gov.t uses expansionary monetary policy to overcome the problem of
unemployment.
Govt. applies expansionary monetary policy to reduce employment. Expansionary (lose) monetary policy
means increase in money supply (decrease in interest rate) which will increase the demand for goods and
assets in the economy because people have extra money to spend. In the result of this firms will increase
labor demand and furthermore, because of rigid wages firms will hire more and more workers to fulfill the
demand of their products in the market. Consequently, unemployment will reduce.
The graph of monetary policy channel is below where because of rigid prices LM does not shift backward
to original position and you can observe an increase in output level along with a decrease in interest rate.

Conclusion:
According to Keynesian school of thoughts, Govt. should intervene in the economy by using monetary and
fiscal policies. The reason of this intervention is that it is not necessary that economy always lie on its full
employment level because of rigidity in wages and prices. Therefore, Govt. should intervene to control
unemployment, and inflation in an economy.
Note: The working of fiscal policy will be studied by using the framework of aggregate demand and
aggregate supply.
Now it is a time to wrap the discussion of General equilibrium by using the framework of IS & LM model.
We will study another framework which will contain the information of IS-LM and production by firms in
an economy. This framework is called aggregate demand and aggregate supply framework which we have
discussed in first paragraph of this document.
The role of demand and supply side policies by using aggregate demand and aggregate supply
framework:
The below graph is representing the framework of AD& AS.

In first stage, we will derive the aggregate demand curve then we analyze the effects of demand and supply
side policies. Recall your class lecture that AD represents the demand side of an economy because it reflects
the economy wide demand. Economy wide demand means the expenditures on goods and services by
households, firms, and government inn an economy. AD explains how we will consume all production
produced in an economy.
To derive AD curve, we will shift LM curve because of change in Prices. Any other factor that will shift IS
and LM curves other than price level will shift AD demand curve accordingly.
Shifting of AD curve:
All shifting factors of AD are below;

Fiscal policy under classical school of thoughts

All assumption will be same as above. Fiscal policy refers to the level of Government expenditures or
Taxes. But taxes are also considered as supply side factors. Anyway, currently we will discuss only
Government expenditures.
A rise in government expenditures decreases the level of national savings, consequently, national savings
curve shifts backward and in the result of this shift, IS curve will shift rightward. This shift in IS curve will
ultimately shift the AD curve. But according to classical school of thought, economy is already on its
potential level because of no involuntary unemployment. Any involuntary unemployment will remove by
demand and supply because of flexibility of prices and wages. Therefore, there is no need of Govt. policies.
In addition, when wages and prices are flexible then there is no short run rather there is always a long run
in the economy. The below graph is the representation of fiscal policy in classical school of thought by
using the aggregate demand and supply curve. You can observe that there is no change in output level but
price level has increased.
Monetary policy under classical school of thoughts:
The effect of monetary policy is same as of fiscal policy on prices and income where price level will rise
but income level will remain constant. The only difference is that AD will shift because of shifting of LM
curve due to increase in Money supply.

AD & AS framework under the Keynesian school of thoughts:

Fiscal Policy under the Keynesian school of thought:
All assumption will be same as above. Fiscal policy refers to the level of Government expenditures or
Taxes. But taxes are also considered as supply side factors. Anyway, currently we will discuss only
Government expenditures.
A rise in government expenditures decreases the level of national savings, consequently, national savings
curve shifts backward and in the result of this shift, IS curve will shift rightward. This shift in IS curve will
ultimately shift the AD curve. But according to this school of thought because of wages and prices rigidity
an economy may lay below or above the full employment level.
Suppose currently economy is suffering from recession (unemployment) which implies that economy is
below than its full employment level. Now the purpose of Govt. is to remove unemployment from the
economy. Govt. will increase the Expenditures in the way of construction of roads, bridges, buildings etc.
In the result of this people will get employment and consume the earning on consumption of goods and
services that ultimately increase the demand for goods and services produced by firm. Therefore, firms will
increase the labor demand and unemployment will remove.
Below graph is representing the imposition of fiscal policy. We can observe that Although price level has
raised, income level of our economy also raised. Thus, fiscal policy is effective and Govt. role is positive.

Monetary policy:
In the presence of recession (unemployment) Govt. will raise the level of money supply in the
economy.
Expansionary (lose) monetary policy means increase in money supply (decrease in interest rate) which will
increase the demand for goods and assets in the economy because people have extra money to spend. In the
result of this firms will increase labor demand and furthermore, because of rigid wages firms will hire more
and more workers to fulfill the demand of their products in the market. Consequently, unemployment will
reduce. Therefore, AD curve will shift rightward.
You can observe the similar impact of monetary policy.
The channel of monetary and fiscal policy:
The channel of monetary policy is the working of interest rate. Because an increase in the money supply
will reduce the interest rate and that reduction in interest rate will increase consumption and investment
level in an economy.
On the other hand, fiscal policy works through the channel of income. When Govt. increase its expenditures
by construction of infrastructure then more people become employed and their income level will also rise.
In the result of this rise, people will consume their income and firms will increase their production which
ultimately reduce the unemployment in an economy.
This was all about a close economy. This hand out is explaining the structure and performance and the use
of Govt. policies to affect the performance of the economy by using two different approaches; IS&LM and
AD&AS approaches. Both represents the same level of information but we can use them according tour
requirements. If we want to know the dynamic of saving and interest rate then we will use IS&LM
framework, whereas., of we want to know the dynamics of unemployment and inflation then we will use
AD&AS framework.
Note: This is the summary of all that we covered in the class after midterm exam. But two important
topics are still missing. I will upload another file that will incorporate the INFLATION, PHILIPS
CURVE, and Open economy. One more thing, this document is written in so simple form to make it
easy to understand for you.