The goods and the money market in the AS-AD model
We begin by studying the goods market and the money market when prices are no longer constant. First up is the goods market.
The goods market and aggregate demand
Aggregate demand is not affected by P in the AS-AD model as long as Y and R are held constant
YD still depends (positively) on Y and (negatively) on R and we continue to write YD = YD(Y, R) in the AS-AD model. Let us justify this assumption.
Remember that aggregate demand is the sum of the demand for consumption goods, investments, government consumption and net exports. None of these components will depend on P if Y and R are held constant in the AS-AD model.
• Consumption. Suppose that P increases by say 10% while real GDP (Y) is constant. Nominal GDP and nominal national will now have increased by 10%. If your income increases by 10% and prices increase by 10%, it is reasonable to assume that your consumption (in nominal terms) will increase by 10% (nothing has changed in real terms). This means that the demand for real consumption C is unchanged.
• Investment demand. As long as we keep the nominal interest rate (and thereby the real interest rates) constant, there is no reason for the demand for real investment to change. We would expect nominal investments to increase by the same percentage as the price level.
• Government consumption. G is an exogenous real variable and we expect no dependence on P by the same argument as for private consumption.
• Exports and imports. This is more difficult to justify due to the exchange rate. Suppose that we have a flexible exchange rate (see Section 8.2.5) and that the price level is constant in the foreign country. Say that P increases by 10%. It is reasonable to assume that the exchange rate will then depreciate by 10% (see xxx). The price of domestically produced goods in the foreign market will then be unaffected (in their currency) and so will exports. Due to the depreciation of the exchange rate, the price of imported goods will increase by 10% as well it makes sense to assume that the demand for real imports will not change.
It is important to understand that P may affect YD indirectly in the AS-AD model. P does not affect YD directly if we keep Y and R constant. But P may very well affect R and/or Y, and thereby indirectly affect YD. In fact, this is exactly what will happen in the AS-AD model as we will describe later.
The money market
The demand for money depends negatively on R, positively on Y and positively on P in AS-AD model
When P is no longer exogenous, we must figure out how MD is affected by P if we keep Y and R constant. In the AS-Ad model, MD increases as P increases (and vice versa).
Imagine that P is increased by 10% while Y and R are constant. All nominal variables such as nominal GDP, nominal consumption and nominal income will then increase by 10%. This means that you will need to hold more money to pay for the increase in consumption. Therefore, the demand for money is denoted by MD(Y, R, P) in the AS-AD model.
The money market and price changes
The money demand curve will shift to the right (left) in the money market diagram if P increases (decreases).
Money supply is an exogenous variable controlled by the central bank so there is no automatic mechanism that will change MS when P changes. Remember that the money market diagram shows the supply and the demand for money as functions of R everything else held fixed. Therefore, we can still use the money market diagram in AS-AD model as long as we keep P fixed.
We must now figure out how to analyze changes in P in the money market. To do this, keep P constant at two different levels, P = 10 and P2 = 20. We know that MD depends positively on P and MD(Y, R, P2) > MD(Y, R, P1). The demand for money increases when P increases if Y and R do not change.
Fig. 13.2: Money market diagram with different prices.
If P increases, the demand for money will increase for all interest rates. This means that the demand curve must be shifted outwards to the right when P increases. Note that with a fixed Y and a fixed money supply, if P increases, R must increase for the money market to remain in equilibrium.