# Inter Macroeconomics essay - Theories of aggregate supply seek to reconcile rational behavior with the observation that nominal shocks have real effects.

## Inter Macroeconomics essay                          ZhiyuWan

Title: theories of aggregate supply seek to reconcile rational behavior with the observation that nominal shocks have real effects.

The theory of aggregate supply helps people better understand both fiscal and monetary policies. Obviously, there are several explanations about aggregate supply such as the new classical theory and the new Keynesian theory. Generally, the new classical approach stresses market equilibrium, competitive markets and rational expectations; the new Keynesian theory stresses disequilibrium and imperfect competition, but also incorporates rational expectations. By comparing, I believe the new Keynesians’ model would probably better explain the question.

Let us look at the new classical theory first. The New Classical models developed in the 1970s combined the ‘natural rate hypothesis’ with rational expectations where it is assumed that firms know their output prices but workers from expectations about the price of the goods and services they buy. They predicted that counter-cyclical macroeconomic policies like fiscal and monetary policies designed to smooth out the business cycle would not work. New we start with the algebra of the theory. In the labour market, nd = xd − x1 (w − p)= xd + x1 (p − w)

ns = xs + x2 (w − pe) Assuming equilibrium in the labour market, we solve for the market-clearing nominal wage (w∗). so because demand equals the supply, so we get, xd + x1(p − w∗) = xs + x2(w∗ − pe), then we can get w∗, after substituting w∗ into demand function, we get n=n*+(x1x2/x1+x2)[p-pe], where n*=xd-x1(xd-xs/x1+x2) which is also the level of employment when expectations are correct, the nature level of employment, then adding time subscripts, and assume a simply production, Setting aggregate supply equal to aggregate demand and we can get the equilibrium price level :

where,is the ...