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2.2a Aggregate Demand


2.2a Aggregate Demand Aggregate demand (AD) is comprised of all the spending that comes to a domestic market. Aggregate demand, is a schedule, which shows the amounts ... – PowerPoint PPT presentation

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Title: 2.2a Aggregate Demand

2.2a Aggregate Demand
  • Aggregate demand (AD) is comprised of all the
    spending that comes to a domestic market.
    Aggregate demand, is a schedule, which shows the
    amounts of real GDP that buyers will collectively
    buy at given average price levels in the economy.

  • Therefore we categorize the different types of
    demand like this
  • Consumer spending (C)
  • Investment (I)
  • Government spending (G)
  • Net Exports (X M)

  • The aggregate demand curve has a negative slope.
    Essentially the AD curve is the visual
    representation of the expenditure method of GDP
  • The price level is measured as the average price
    level of final goods and services (product) in
    the economy and is considered a measurement of

  • Why is the AD curve negatively sloped?
  • The first reason is called the real balances
    effect. As the price level rises, the purchasing
    power of the publics income or savings decreases
    so they can buy less as the price level rises.
    This factor is most closely associated with
    consumption (C).

  • Secondly, the interest rate effect influences the
    slope. As prices rise, there is an increase in
    demand for money and the cost of borrowing money
    (the interest rate) will rise as well. Lenders
    will charge a higher rate of interest for the
    public to borrow money to finance household
    consumption or for firms to invest in productive
    capacity. This effect is usually most visible in
    investment (I).

  • Finally there is the foreign purchases effect.
    When the price level rises, it makes the
    countrys exports more expensive to foreign
    buyers. This leads to a decrease in foreign
    purchases of the countrys exports. Moreover,
    rising domestic prices may make imported goods
    cheaper and result in citizens substituting
    imports for exports at higher price levels. This
    is effect is seen in net exports (X M).

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  • In the diagram above, the economy is producing
    output Y at the price level P.
  • Shifts in the AD curve are the result of changes
    in the components of AD or changes in the factors
    of the following equation
  • C I G (X M) AD

  • Consumption The elements that affect consumer
    spending would be changes in the following
  • Consumer wealth While changes in income will
    clearly change consumption, so will the wealth of
    households. If there is a change in the value of
    physical (real estate) or paper (stocks and
    bonds) assets, then consumers will feel more or
    less wealthy and adjust their spending

  • Consumer expectations If consumers believe that
    their real income will change in the future, they
    will increase or reduce expenditures based upon
    their expectations.
  • Personal income taxes A direct tax will affect
    disposable income which will have an impact upon
    households ability to consume.

  • Household indebtedness When households borrow
    to consume (or invest), the purchases bought with
    borrowed money will increase AD. However, when
    consumers pay back that debt, they will have to
    reduce current expenditures to pay back for
    previous consumption which will decrease AD.

  • Interest rates The cost of borrowing money will
    impact the purchase of big ticket items or
    consumer durable goods. These are goods that
    last longer than a year and are difficult for
    households to buy without borrowing moneyIf
    interest rates are low, then households would be
    willing to borrow money to buy the goods they
    desire, thereby increasing AD as noted above.

  • Investment spending Investment is the most
    volatile variable in AD because it relies upon
    future expectations of businesses and individuals
    of economic activity. The elements that affect
    business investment would be changes in the

  • Real interest rates Again, the cost of
    borrowing money can induce businesses to take or
    put off investing. If the real interest rate
    increases, then businesses will hold off
    borrowing to buy new plant and equipment. If
    real interest rates decrease, then firms would
    increase investment with a corresponding increase
    in AD.

  • Expected returns If companies believe that they
    will be able to make a good return on investment,
    then they will increase their purchases and shift
    the AD curve to the right. If businesses believe
    that business conditions will improve, then they
    will invest in new projects.

  • Business taxes Taxes will have a direct effect
    upon the profits that a firm expects to make from
    an investment. Consequently, a reduction in
    business taxes will increase investment and AD.
    An increase in such taxes will have the opposite

  • Technology Improvements in technology, which
    bring with them a corresponding increase in
    productivity, will increase returns to an
    investment. Technological change incentivizes
    firms to increase their investment, which then
    leads to an increase in AD.

  • Government spending The elements that affect
    government spending would be changes in the
  • Changes in political priorities If a government
    decides to change spending due to a perceived
    threat or crisis then the G variable will impact
    AD. An example might be a change in defense

  • Changes in economic priorities In the case of a
    recessionary environment, the government may
    increase expenditures to make up for the loss of
    AD or employment that occurs in a downturn. An
    example of this might be increasing expenditures
    on infrastructure such as roads.

Net Export spending would be affected by the
  • National income abroad When trade partners
    incomes rise, they have a tendency to buy more
    imports, which could mean an increase in
    purchases of our exports. The opposite is true if
    their incomes decrease.

  • Exchange rates When our countrys currency
    depreciates, it makes our exports cheaper to
    foreign buyers as it takes fewer units of their
    currency to pay for the goods or services we sell
    them. This will increase AD. Conversely, we may
    see the opposite effect if our currency
    appreciates against that of our trade partners.

  • Levels of protectionism If there is increased
    protectionism (import tariffs or quotas)
    practiced by trade partners, this can reduce
    exports and thereby AD.

2.2b Aggregate supply
  • Aggregate supply (AS) is a schedule of real
    domestic output that is produced at each possible
    price level.
  • Unlike aggregate demand, aggregate supply is more
    complex in its measurement. This is due to the
    fact that producers cannot adjust quickly to
    changes in the average price level.

  • The short run is defined as the timeframe in
    which wages and input prices cannot adjust to
    changes in the average price level.
  • The long run is considered to be the time in
    which wages and input prices can adjust to
    changes in the average price level.

Movements along the SRAS curve
  • Due to what we call a recognition lag, wages and
    factor input costs do not respond immediately to
    changes in the price level so it takes time for
    these prices to adjust.
  • While an increase in the price level might allow
    a firm to increase its product prices, the factor
    input costs will respond much more slowly.

  • Remember that the largest cost for most firms is
    labor and so the nominal wage rate plays a
    dominant role in firms operations.
  • Wage rate changes often lag changes in the price
    level in an economy as it takes time for workers
    to realize that their purchasing power has
  • When the price level rises, firms are able to
    increase their final goods prices and make larger
    profits as their wage bill remains unchanged.

  • Subsequently, a firm will increase its output
    when the price level is rising to capture more
  • Consequently, the firms increase output and can
    push the economy beyond full employment as they
    hire unemployed workers and encourage employees
    to work overtime or to move to full time work.

  • The situation is illustrated in the diagram below
    at point b in which the Y level of RGDP at the
    P price level demonstrates a rise up along the
    SRAS curve.

  • Firms respond to falls in the price level by
    lowering their final goods prices as they attempt
    to clear inventory.
  • This reduction in sales revenues will reduce
    profits and put firms in a position to decrease
    production or even lay off workers. The increase
    in unemployment will correspond to a decrease in
  • This condition corresponds to the Y level of
    RGDP at the P price level or at point c on the
    diagram below.

  • The movements along the SRAS curve described
    above originate at point a.

  • Production costs are the primary factor in
    changes in AS. However, there are several
    determinants of AS

  • Resource costs All factor input prices will
    play a role in the final product price,
    consequently any change in resource costs will
    shift the curve. If for example, there is a
    decrease in the price of oil, then the AS curve
    will shift out to the right as we can produce
    more output with the same expenditure as before
    the price change. Conversely, a rise in wages
    will push the curve up and to the left.

  • Resource costs are not just domestic in nature.
    While labor is a domestic expense, some raw
    materials are imported. As a result, exchange
    rates and control over the supply of the needed
    resource can complicate prices firms.

  • If one particular trade partner has inordinate
    market power over a commodity, then it can
    increase the price and thereby impact our AS due
    to our use of the input in our production.
    Furthermore, if our exchange rate depreciates, we
    will have to pay more for imports of a critical
    factor input.

  • Productivity Improvements in productivity will
    increase output at all price levels and push the
    AS out and to the right.
  • By improving the quality of factor inputs, either
    in the case of new machines or increasing the
    skill level of workers, we can produce more
    output at current prices and shift out the AS

  • Business Environment This addresses many
    variables such as
  • Business taxes Higher direct and indirect taxes
    increase costs in the short run and can lead to a
    reduction in output at every price level with a
    corresponding leftward shift in the AS curve.

  • Subsidies Payments by the government to firms
    to encourage the production of specific goods can
    lower production costs and encourage companies to
    expand their output.
  • Regulation - The costs associated with complying
    with government regulations can divert funds from
    production and decrease output for firms. An
    increase in government regulation may shift the
    AS curve to the left.

2.2c Controversy over aggregate supply
  • Aggregate supply is a source of debate among
    different schools of economic thought. Most
    economists agree that the long run AS (LRAS)
    curve is vertical and that it represents the full
    employment/potential level of output.

  • Neo- Classical economists (Friedrich Hayek and
    Milton Friedman) argue that production levels are
    determined through the efficient operation of
    markets. Therefore, there is no SRAS as the
    economy is always just at full employment
    operating on or near the LRAS curve.

  • If there is a temporary downturn, then laid off
    workers will quickly adjust their wage demands or
    change their location and be reemployed very
    soon. There is no need for the government to
  • Neo-classical economists believe that any policy
    to address instability in the economy will
    interfere with the self-correcting mechanism of
    markets and result in price distortions

  • In essence, the neo-classical perspective
    believes that AS in the long run is independent
    of prices as markets will act to push the economy
    back towards equilibrium.

  • The neo-classical school is often associated with
    non-interventionist and market based policies. By
    reducing the role of government in the economy
    and regulating the rate of growth in the money
    supply (more on this later), markets will
    self-correct and the economy will grow more

  • Consequently, neo-classical economists focus on
    the long run and as a result they will push for
    supply-side policies which reduce impediments to
    competition as well as reduce government
    intervention in the economy.

  • Neo-classical attitudes are connected to mostly
    right leaning political parties. Policies
    promoted in Ireland in the period after the 2009
    financial crisis which reduced government
    spending and encouraged austerity in general,
    could be considered to be neo-classical in

  • However, Keynesian economists believe that
    markets are imperfect and that macroeconomic
    instability is the result of different forms of
    market failure.
  • Consequently, the Keynesians believe in the AS
    curve which has three regions.

  • They believe that output can fall at such as rate
    that it falls into the horizontal range of the AS
    curve. This means that there could be a decrease
    in output with no change in the price level.
  • This is due to the belief that resource costs and
    final product prices are sticky downwards.
    This perspective is rooted in the belief that
    workers do not adjust their wage demands as
    rapidly as they will attempt to find employment
    at their previous income.

  • Moreover, from this perspective, producers do not
    adjust their product prices until absolutely
    necessary to clear inventory.
  • When both of these scenarios are in play, there
    is plenty of spare capacity for the economy to
    put back to work without putting upward pressure
    on the price level.

  • Horizontal range this is substantially below
    full employment implies that the economy is in
    recession or worse, a depression. There are
    plenty of unemployed resources and there is
    upward pressure on prices. This is characterized
    by a flat portion of the AS curve.

  • Intermediate range as the economy starts to
    grow, there is increased demand for labor and
    other resources. This results in upward pressure
    on factor input prices and requires firms to
    increase their product prices to maintain
    profitability. There will begin to be shortages
    of resources, which will further drive up prices.
    This region is where most of the short run
    analysis is done and is upward sloping.

  • Vertical range when the economy reaches its
    potential output or full employment, the curve
    becomes vertical. This is because the economy is
    at full capacity. Any efforts by firms to
    increase output will only bid resources away from
    other firms and drive up prices in the process.
    This is due to the finite resources in the

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  • Keynesian economists believe that markets are
    imperfect and that macroeconomic instability is
    the result of different forms of market failure.
  • They believe that output can fall at such as rate
    that it falls into the horizontal range of the AS
    curve. This means that there could be a decrease
    in output with no change in the price level.

  • This is due to the belief that resource costs and
    final product prices are sticky downwards.
    This perspective is rooted in the belief that
    workers do not adjust their wage demands as
    rapidly as they will attempt to find employment
    at their previous income.

  • Moreover, producers do not adjust their product
    prices until absolutely necessary to clear
  • When both of these scenarios are in play, there
    is plenty of spare capacity for the economy to
    put back to work without putting upward pressure
    on the price level.

  • Keynesian policies to address economic
    instability are often a mix of fiscal (government
    driven) and monetary (central bank directed)
    policies. These policies often affect the economy
    through the demand or AD side.
  • These tactics can be interventionist as in
    increasing government spending to make up for a
    decrease in AD or cutting taxes to increase
    investment. Or the central bank could increase
    the money supply to lower interest rates to
    promote investment.

  • Unfortunately, both of these policies often
    result in inflation, which we will discuss in
    more detail in the future.
  • An example of such Keynesian government driven
    policies was the 819 billion stimulus package of
    increased spending and continuation of tax cuts
    passed by Congress in the U.S. in 2009.

2.2d Long run aggregate supply
  • Despite their differences, both Keynesians and
    neo-classical economists agree on the LRAS being
    vertical at the potential output of the economy
    and the goal of shifting the LRAS to the right.
  • The LRAS corresponds to the full-employment
    output (Yfe) of the economy. This is basically
    when the economy is operating at its potential.

  • Another way of saying this is that the economy is
    operating at the natural rate of unemployment
    (NRU). This point occurs when the number of job
    applicants is equal to the number of vacancies.
  • The economy can operate below the NRU or at time
    beyond the NRU. How the economy adjusts to these
    two conditions is the subject of much controversy
    and we will discuss this dispute in more detail
    in section 2.3.

  • Shifting the LRAS is another way of demonstrating
    economic growth through expanding the potential
    or full employment output of the economy.
  • In this case it is very similar to the how the
    PPC operates.

  • Notice how the PPC is pushed out demonstrating
    economic growth and how this matches the increase
    from Yfe to Yfe in the LRAS on the AD/AS model
    on the right.

  • Two sources of expansion of the LRAS are
    increasing the quantity and quality of factor
  • If there is an increase in the factors of
    production we can shift the potential of full
    employment output.

  • For example, we can add more to our labor force
    via population growth or increase labor force
    participation. By having formerly unemployed
    workers or more women enter the labor force, we
    have increased our potential output.

  • If we increase our stock of physical capital
    through investment, we have pushed out our
    potential. When firms put in place more
    machinery, it will increase the productivity of
    labor and consequently potential output.

  • A new natural resources discovery will push the
    LRAS to the right reflecting an increase in land
    as a factor of production. An example of this
    might be Brazils oil discovery in 2006, which
    added to its potential GDP.

  • By improving the quality of inputs, we can push
    the LRAS outward as well. This is usually
    associated with improvements in training and
    education for labor to increase productivity.
    Highly trained labor can be more capable of
    suggesting cost saving ideas to increase output.

  • Technological advances associated with capital
    equipment will make labor more productive and
    thereby push the LRAS out as well. For example,
    new machines in a metal fabrication plant, which
    use raw materials more efficiently, will increase
    potential output.

  • Finally, we can improve our allocative efficiency
    by more effectively organizing our productive
    resources. Companies endeavor to do this by
    continually examining production processes to
    decrease wasted movements or procedures.

2.2e SRAS/AD equilibrium
  • Similar to equilibrium in microeconomics,
    macroeconomic equilibrium occurs when AD and the
    SRAS behave in a manner to move towards
    equilibrium in which
  • P level AD SRAS

Real Output Demanded (AD) Price level (Index Number) Real Output Supplied (AS)
440 110 453
443 105 450
447 100 447
450 95 444
453 90 441
The table makes evident that macroeconomic
equilibrium will occur at a price level of 100
with a real output of 447 billion. Lets look
at a diagram.
As the diagram makes clear, the equilibrium level
of output is at 447 billion at the price index
of 100.
  • Arriving at a new equilibrium in the short run
    can be achieved through the demand side or the
    supply side. Lets examine the demand side
  • Whenever one of the determinants of aggregate
    demand (CIG(X-M)) changes, the result will be
    a shift in the AD curve.

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  • The increase in investment described above will
    lead to an increase in aggregate demand from AD
    to AD. This results in a new equilibrium level
    of output Y at a higher price level of P.
  • While the economy experiences higher output, the
    challenge here is that there is a rise in the
    price level, which is associated with demand pull

  • Suffice it to say, if we see a decline in any of
    the AD variables, the new equilibrium would be at
    a lower output and a lower price level (all
    things being equal).
  • Drops in various components of AD may be the
    result of higher interest rates resulting in
    businesses reducing Investment or Consumers
    income stagnating so they buy fewer goods and

  • One final note here is that a natural or man-made
    event can reduce Consumption (as well as
    Investment) due to the disruption in peoples
    lives. An example of this might be the terrorist
    attacks in Spain in 2004 and in England in 2005
    leading to less train travel by citizens or a
    decline in consumption due to the earthquake in
    Haiti in 2010.
  • Do you think that you can draw the correct
    diagram for a decline in AD?

  • Decreases in SRAS are usually associated with
    supply shocks. These events are often the result
    of the disruption of a segment in the supply
    chain due to a natural or man-made disaster.
  • The 2011 earthquake and tsunami in Japan lead to
    a decrease in the SRAS in Japan as well as
    impacting the supply chain of firms in other

  • The classic explanation of a supply shock is an
    increase in oil prices that is so dramatic as to
    make every unit of output that much more
    expensive to produce that the economy creates
    less output at a higher price.
  • In the 1970s when oil prices tripled in a very
    short period of time, the U.S. economy in
    particular, production costs soared and the
    result was what is called cost push inflation.

The lower output was at a higher price and the
diagram below illustrates the conundrum.
  • With an increase in factor input costs (such as
    oil in this case), producers can make fewer goods
    and services for a given budget.
  • The scenario leads to a shift in the SRAS curve
    to SRAS.
  • This results in a decrease in output form Y to
    Y, yet with prices increasing from P to P
    accounting for the corresponding increase of
    resource costs.

  • There are occasions when the both AD increases
    and the SRAS curve shifts out as well. This
    results in low inflation and strong economic
  • Unfortunately, this sort of benign environment
    is not always seen in the real economythe U.S.
    experienced this scenario between 1996 and 2000.
  • The diagram below will illustrate this favorable

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  • As the diagram makes evident, the growing economy
    shows a shift in the AD curve from AD to AD.
    The new equilibrium shows a corresponding output
    of Y at the price level P.
  • However, as a result of increased worker
    productivity, the SRAS curve shifts out to SRAS.
    The shift in the SRAS curve increases output
    even further to Y at a lower price level of P.

2.2f LRAS-SRAS-AD equilibrium
  • Short run and long run equilibrium can come
    together at full employment.
  • Remember that the full employment level of output
    corresponds to the LRAS. This is because nominal
    wages adjust in response to changes in the price
    level over time.

  • In the long run, the SRAS goes through a series
    of adjustments to changes in the price level.
  • As we will see shortly, these adjustments can
    lead to a recessionary or inflationary gap in the
    short run.
  • Corrections can result in AD-SRAS-LRAS
    equilibrium, as demonstrated by the diagram

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  • In the scenario above, the economy starts in a
    recessionary environment at Y output at the P
    price level. Now suppose that prices have fallen
    far enough to induce firms to invest in new
    machinery and hire workers to operate the
  • The increase in I, leads to a shift in the AD
    curve to AD at the P price level and Yfe level
    of output. This happened to be in long run
    equilibrium for the economy.

  • The neo-classical school believes that the
    economy always self-corrects, so therefore we
    only need to worry about policies that push out
    the LRAS.
  • The neo-classical analysis shown below starts at
    full employment output (Yfe) at the price level Y
    or point a.

  • If there is an unanticipated increase in
    aggregate demand shown by the shift in the AD
    curve from AD to AD, then this will push
    equilibrium beyond the full employment level of
    output corresponding to Y at point b.

  • However, owners of resources/factor inputs are
    quick to realize that the price level has
    increased and they will demand higher prices or
    wages to restore lost purchasing power.

  • As per unit production costs increase, aggregate
    supply will decrease leading to a shift in the
    curve from AS to AS. Hence the economy
    self-corrects to point c back at the full
    employment output (Yfe) but at a higher price
    level (P).

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  • Neo-classical economists believe that people
    behave rationally and therefore take action
    rapidly to protect their self-interest.
  • Even though the economy will slip out of long run
    equilibrium, individuals and firms interacting in
    the market place will automatically push it back
    to Yfe.
  • For these reasons, there is no need for the
    government to invoke any changes in fiscal policy
    or for the central bank to take monetary
    actionlet the markets work.

  • Keynesian economists have a different perspective
    on how an economy falls into, and for how long
    the economy can be in, disequilibrium.
  • The basic belief here is that the economy is in
    equilibrium wherever AS ADwhether at full
    employment or not.

  • The Keynesian school of thought focuses on the
    role that aggregate demand plays in economic
  • Rapid changes in any of the variables of AD will
    lead to the economy reaching a new equilibrium
    often above or below full employment.

  • Remember that another key to the Keynes
    perspective is that individuals and firms take a
    longer time to recognize and adjust their wage
    and price demands.
  • For example, a dramatic drop in Consumption in an
    economy where consumption plays a large role can
    push the economy into recession.

  • However, the most destabilizing variable is wide
    swings in Investment.
  • Due to investment relying upon real interest
    rates and expected rates of return, optimism (or
    pessimism) can lead to big booms (or busts) in

2.2g Keynesian perspective on equilibrium.
  • A recessionary gap is defined as a level of
    macroeconomic equilibrium below the full
    employment level of output as show in the diagram
    of the Malaysian economy below.
  • This gap corresponds to the point when actual
    economic growth falls below potential economic
    growth in the business cycle.

  • The result of this decline is unemployed
    resources whether it be labor or capital in the
    form of plant and machinery being idle.
  • In the Keynesian system, the economy can
    experience long periods of recession due to the
    downward rigidity in wages and prices. In this
    view, individuals do not adjust their wage
    demands as rapidly as they will attempt to find
    employment at their previous income.

  • As noted earlier, from this perspective,
    producers do not adjust their product prices
    until absolutely necessary to clear inventory.
  • An equation for this might be
  • AD AS lt LRAS/Yfe

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  • This diagram of the Malaysian economy shows a
    recessionary gap where equilibrium is reached at
    a price level of 100 equaling a RGDP of 447
  • However, this point is below the full employment
    level of potential output at 450 billion.

  • This model also allows for an inflationary gap to
    occur in which the economy reaches equilibrium
    beyond full employment.
  • In this case, we might be able to write this as
    an equation
  • AD SRAS gt LRAS/Yfe

  • If an economy starts to grow rapidly and
    overheat, there can be a reduction in spare
    manufacturing capacity and very tight labor
  • Wage rates will be bid up as firms try to secure
    scarce labor to meet the growing demand for their

  • Natural resource and other factor input prices
    will increase as firms continue to compete for
    scarce resources as most producers of natural
    resources cannot quickly increase supply to meet
    growing demand.
  • These input price increases will lead to higher
    final goods and services prices as shown below.

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  • In this scenario it is evident that the Malaysian
    economy is overheating reaching equilibrium at a
    price level of 105 with RGDP beyond full
    employment at 453 billion.

  • Finally, unlike neo-classical economists, Keynes
    did not believe that increases in AD had to be
  • It is a core belief of the Keynesians that the
    economy can operate for long periods of time in
    the horizontal range of the Keynesian AS curve.

  • Because of the large amount of unused resources
    (labor, capital or natural resources), there are
    plenty of factor inputs available for production.
  • These unemployed resources can be engaged without
    worry for bottlenecks or shortages leading to
    wage and price increases.
  • Therefore, increases in AD can result in growth
    and output can be increased with little or no
    upward pressure on the overall price level.

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  • In the economy above, equilibrium is deep in the
    horizontal zone of the AS curve and there is
    enough excess capacity and surplus labor that AD
    can increase to AD with no impact upon the
    overall price level as RGDP moves from Y to Y.
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