ECONOMICS 3012
Notes III: Symbols and basic Macroeconomic Algebra
Prices and Output
PART A: Medium-Run Aggregate Supply: MAS curve
The textbook is slightly incoherent at this point, because it deals with Prices and Output, rather
than inflation and Output. It does do inflation and Output in Chapters 11 and 12. That analysis
is tricky and we don’t have time for it this semester. Economics 4012 deals with that analysis.
BJ don’t actually draw the MAS curve, but it is there, implicit but obvious, in the analysis of
Chapter 10. The MAS curve is constructed from two facts: 1) The first fact is that there is a limit
to output; this limit was the first thing you learned in an economics class: the Production
Possibilities Curve (or Frontier). In the “medium-run”, resources are fixed, which sets a clear
limit to the maximum level of output. 2) The second fact is that Aggregate Prices, our variable,
P, don’t fall. The last time Prices fell was the Great Depression, and the macroeconomic
experience of all industrial nations since is that it would take very large levels of unemployment,
and corresponding losses of output, for P to fall.
So the MAS curve is a backwards-L, the bold line shown in Figure 1 below. The MAS curve is
perfectly vertical at the level of Output, Yn , associated with the “natural” level of Employment,
Nn . But Prices can not fall. So the MAS curve is horizontal at Pt-1 . Pt-1 is not only Prices
lagged one time period; since Prices cannot fall, Pt-1 is also the previous highest level of Prices.
There are three types of possible changes when we use this model, three “Cases”:
Case 1: This is shifts in the AD curve that have the AD curve intersecting the MAS curve in
the horizontal part of the curve both before and after the shift. With these shifts Prices remain
constant at Pt-1. This is old-hat for you now; this is what we did with IS and LM alone, where we
held Prices constant.
Case 2: This is shifts in the AD curve to the right that have the AD curve intersect the MAS
curve in the vertical part of the curve after the shift. (Note: since Pt-1 is the previous highest
Price level, the AD curve can not intersect the MAS in it’s vertical part before the shift.) This is
what is now new.
--------------------------------------------------------------------------To know if you have Case 1 or 2 using algebra, proceed as follows:
First, you will always begin with an AD curve and a Price level, Pt-1. The change will be a new
AD curve. IF the new AD curve is to the left of the original one, then the policy change is
contractionary and you have Case 1. Find the new level of Output, Y, from the new AD curve,
with P = Pt-1 . Note that because we always begin with P = Pt-1 , all contractionary policy will
reduce Output, Y, while Prices, P, remain constant.
IF the new AD curve is to the right of the original one, use the new AD curve, AD1 on Figures 1
and 2, keep P = Pt-1 , and find the value of Output, Y, from the new AD curve. This is the
transitory value of Y; I call it Yr. It is “transitory” because the economy can’t stay there, given
the limit to output, Yn.
IF Yr is less than or equal to Yn , you have Case 1:
The new equilibrium value of Output is Yr ; Y1 = Yr. Prices don’t change; P remains at Pt-1.
This is shown on Figure 1.
There AD shifts from AD0 to AD1 [or from AD1 to AD0] because of either an expansionary [or
contractionary] fiscal policy or an expansionary [or contractionary] monetary policy. Y changes
from Y0 to Y'1[or from Y1 to Y0] and P remains constant at Pt-1 .
You can now see that our earlier IS and LM analysis was a special case: the case for situations
in which Output, Y, is always less than Yn .
Figure 1
P
MAS
AD0 AD1
Pt-1
Y0
Yr = Y1 Yn
Y
-----------------------------------------------------------------IF Yr is greater than Yn , you have Case 2:
The new equilibrium value of Output, in the medium run, is Yn ; Y1 = Yn.
Now substitute the value of Yn for Y in the new AD curve, AD1, and solve for P. This is shown
on Figure 2.
There AD shifts from AD0 to AD1 because of either an expansionary fiscal policy or an
expansionary monetary policy. That is, either A has increased because G has increased or T
has decreased, OR M, the nominal money stock, has increased. Since Y began at Yn, it cannot
increase in the medium run. Only Prices can increase, from Pt-1 to Pt. If Prices remained
constant, Y would increase to Yr. This is a move from point “0” to point “1r” But Yr is greater
than Yn, so Yr can not be a true value of Y. To find the new medium-run equilibrium, move up
AD1 to point “1”. Point “1” is the new equilibrium point: it is the intersection between the new AD
curve, AD1, and the MAS curve.
Figure 2
P
MAS
MAS1
AD0
AD1
1
Pt = new Pt-1
1r
Pt-1
0
MAS0
Yn=Y1
Yr
Y
These two cases are what you do in Problem Set #6.
NOTE: The new value of P found in Case 2, Pt , becomes Pt-1 in the new MAS curve.
------------------------------------------------------------------------------Case 3: This is a shift of the MAS curve up. This is called a “price shock”. The price shock is
imposed from outside the model, so in this type of change, Prices are exogenous.
The analysis of Case 3 using algebra is simple. Just put the new value of P into the AD curve,
and solve for Y. This is shown in Figure 3 below.
There, given the initial AD curve, AD0, output would fall from Yn to Y1 . Since Prices are
exogenous in this type of change, all that happens is that the economy moves up the AD curve.
Figure 3 begins with full employment: Y0 = Yn . But note that this is not necessary. The analysis
is identical no matter what the initial value of Y is, as long as it is less than or equal to Yn. Since
Y can not be greater than Yn in the medium run, we must always start with the initial value of Y 
Yn .
Figure 3
P
MAS
AD0
MAS1
Pt
Pt-1
MAS0
Y1
This case is what you do in Problem Set #5, Part II.
Yn
Y