[e]

First Term Summary:
Christmas Tree

This is the christmas tree, everything else is a decoration which you hang on the christmas tree.

			(ASAD) X1,X2,X3,X4->Y
	(AD) X1,X2,P->Y				(AS) X3,X4,Y->P
(IS) X1,i->Y		(LM) X2,P,Y->i		(WS) X3,Y,P->W		(PS) X4,W->P

How the christmas tree works

1. The ASAD model is a way of understanding the relationships between different aggregate economic variables. It is a combination of four different models, each of which represents a different part of the economy. Each of the individual models can be used by themselves, but when you do that you're always saying "assuming that other things are constant." By combining the different models you get a reasonable feel for how all the main variables interact.
2. The IS model (Y) shows how total demand is determined; the two important mechanisms are the multiplier effect and the investment-stimulation effect of interest rates.
3. The LM model (i) represents the money market, where the interest rate is the price of money, and is determined by supply of and demand for money.
4. The WS model (W) represents the labour market, and the influences on wages.
5. The PS model (P) represents firms' pricing decisions
6. Diagrams show the relationship between two variables in a model. For a line to shift, one of the exogenous variables must have changed.

Decorations to add to the christmas tree

1. Short-run vs Medium-run. There are two ways of drawing the AS curve. For the short-run curve (SRAS) you assume price expectations are fixed, so it is upward sloping. For the medium-run curve (MRAS) you assume P^e=P, so you can cancel both terms, and the curve is vertical. The MRAS is also called the natural level of output (Y_n). In general a change in supply conditions will shift both curves horizontally. The two curves always intersect where P=P^e. If price expectations are adaptive then you can draw a set of short-run curves which show the gradual adjustment to the medium-run, each curve uses the old price level as the new level of price expectations.
2. Open Economy. To deal with an open economy you add three things: (a) a condition that local interest rates equal global interest rates, i=i*; (b) an NX(ε) term in the IS equation; (c) an adjustment mechanism, either fixed (LM effectively flat), or floating (IS effectively flat).
3. Growth Rates. In the ASAD model everything is static, but in reality Y, P, P^e, and M are all growing. We can rewrite the models in terms of growth rates instead:
   • AD <=> g_Y = g_M - π
   • AS <=> π = π^e - α(u_t - u_n) [Phillips Curve]
   • Y=(1-u)AN <=> u_t - u_t-1=β(g_yt- g_y) [Okun's law]
4. Expectations. For the aggregate supply modelling, in the short-run, the nature of expectations matter. There are three simple ways of modelling them: (a) adaptive, where you expect whatever happened last time; (b) perfect foresight, where you already know what will happen (so no short-run effects); and (c) rational expectations, where you use all the information you can, but it's still possible to be wrong.

Tips for Answering Questions

1. If the question describes a real-world change, think about which exogenous variables you can use to represent that change. If the question says an endogenous variable has changed (e.g. the interest rate), think what exogenous change could cause that. And if the question says that some exogenous variable has changed (e.g. marginal propensity to consume), try to think what real-world change could cause that.
2. Always try to use all three things in answering a question: diagrams, algebra, and intuition.
3. Generally there are two types of change in these models: changes in quantity (e.g. m₀), and changes in sensitivity (e.g. m₁). For the first type of change, you should be able to show all the effects on the diagrams. For the second type of change the slopes of lines change, and sometimes it's difficult to see the answer on the diagram. In the second type of change the question will generally ask about effectiveness of fiscal and monetary policy (ΔY/ΔG & ΔY/ΔM), which you can solve for algebraically, using the ISLM system. When you have an open economy this is actually slightly simpler, because i is constant, so you only need to use the IS equation (if fixed exchange rates), or the LM equation (if floating).
4. A good way to study: cut out all the questions from problemsets, homeworks, and exams. Stick them on separate pieces of paper, and sort them into topics. Write out answers for each one. Compare your answers with someone else's.