When you borrow money, you usually have to pay a fee for the loan. This fee is often called interest, particularly if the fee is proportional to the amount you borrow. The interest rate is commonly expressed as a percentage of the size of the loan per unit of time, typically per year.

An important macroeconomic variable is the total amount of labor that is used in a certain time period. The amount of labor and the amount of capital are important explanatory variables for production and GDP. Another reason for the importance of the amount of labor is that it is related to the unemployment rate – a macroeconomic variable which is clearly important.

Perhaps the most important concept in macroeconomics is Gross Domestic Product (GDP): Gross Domestic Product (GDP) is defined as the market value of all finished goods and services produced in a country during a certain period of time.

Wage inflation

In this article, we will continue to develop the Keynesian model removing the assumption of fixed nominal wages. We define wage inflation πw as the percentage average increase in wages. Wages and wage inflation are still exogenous, i.e. they are not determined within the model. One justification for this assumption is that wages often are determined by agreements which often last for several years.

The problem with the IS-LM model

The starting point of the Aggregate Demand - Aggregate Supply or AD-AS model is an assumption in the IS-LM model (and in the cross model) that limits its usefulness. This is the assumption that if firms where to choose the profit maximizing quantity of L (LOPT), they would produce more than the aggregate demand. In the IS-LM, YOPT > YD must hold as discussed in section Aggregate supply.

To realize why this is a problem in the IS-LM model, we gradually increase the aggregate demand byincreasing G. We can illustrate the process using figure 12.6 in Section The Labor Market

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