Macroeconomics

F I G U R E

1 2 - 1 3

Real exchange 

rate,

e

Price level, P

2. ... 

lowering

the real

exchange

rate ...

3. ... and

raising

income Y.

(a) The Mundell–Fleming Model

(b) The Aggregate Demand Curve

4. The AD curve

summarizes the

relationship

between P and Y.

LM*(P

1

)

IS*

LM*(P

2

)

Y

1

Y

2

Y

1

Y

2

1. A fall in the price

level P shifts the LM*

curve to the right, ...

P

1

P

2

e

1

e

2

AD

Income, output, Y

Income, output, Y

Mundell–Fleming as a

Theory of Aggregate

Demand

Panel (a) shows that

when the price level falls, the

LM* curve shifts to the right.

The equilibrium level of income

rises. Panel (b) shows that this

negative relationship between P

and Y is summarized by the

aggregate demand curve.

---

events that raise income for a given price level shift the aggregate demand curve

to the right; policies and events that lower income for a given price level shift

the aggregate demand curve to the left.

We can use this diagram to show how the short-run model in this chapter is

related to the long-run model in Chapter 5. Figure 12-14 shows the short-run

and long-run equilibria. In both panels of the figure, point K describes the short-

run equilibrium, because it assumes a fixed price level. At this equilibrium, the

demand for goods and services is too low to keep the economy producing at its

natural level. Over time, low demand causes the price level to fall. The fall in the

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P A R T   I V

Business Cycle Theory: The Economy in the Short Run