Transcript Chapter 7

The AS-AD Model
 Requires equilibrium in the goods, financial,
and labor markets
 Aggregate supply focuses on equilibrium in
the labor market
 Aggregate demand focuses on equilibrium in
the goods and financial markets
Econ 302
The AS-AD Model
Slide #1
Aggregate Supply
 Captures the effects of output on the
price level
 It is derived from equilibrium in the labor
market
Econ 302
The AS-AD Model
Slide #2
Aggregate Supply
The Determination of Aggregate Supply
The nominal wage (W) = PeF(u,z)
Price level (P) = (1+)W
P = Pe(1+) F (u,z)
Econ 302
The AS-AD Model
Slide #3
Aggregate Supply
According to:
P = Pe(1+) F (u,z)
The price level (P) is a function of:
• Pe:
The expected price level
• u:
The unemployment rate
Econ 302
The AS-AD Model
Slide #4
Aggregate Supply
 The price level as a function of output
instead of the unemployment rate
u
N
Y
u   1  1
L
L
L
P  Pe (1   ) F (u, z)
Y
P  P (1   ) F (1  , z )
L
e
Econ 302
The AS-AD Model
Slide #5
Aggregate Supply-The price level as a function of
output instead of the unemployment rate
Y
P  P (1   ) F (1  , z )
L
e
Observations
1. A higher expected price level leads, one for
one, to a higher actual price level.
2. An increase in output leads to an increase in
the price level.
Econ 302
The AS-AD Model
Slide #6
Aggregate Supply
 Higher Pehigher P
 PeWP
 W=PeF(u,z) (PeW)
 P=(1+µ)W (WP)
Econ 302
The AS-AD Model
Slide #7
Aggregate Supply
Higher Outputhigher P
YuWP
Y=N(YN)
N
u  (1  )  (N  u )
L
Econ 302
The AS-AD Model
Slide #8
Aggregate Supply
Higher Outputhigher P
W=PeF(u,z)(uW)
P=(1+u)W(W  P)
Econ 302
The AS-AD Model
Slide #9
Aggregate Supply
Graphically:
Price Level, P
AS
Two characteristics:
1. Given Pe an increase in Y
increases P
2. At A: Y = Yn & P = Pe
A
Pe
Observation:
Y > Yn then P > Pe
Y < Yn then P < Pe
Yn
Output, Y
Econ 302
The AS-AD Model
Slide #10
Aggregate Supply
Illustrating the impact of an increase in Pe
AS´ (Pe´ > Pe)
Price Level, P
AS (Pe)
A´
Pe´
Pe
Observation:
Given Yn: changes in Pe
shift the AS curve
A
Yn
Output, Y
Econ 302
The AS-AD Model
Slide #11
Aggregate Demand
Aggregate Demand:
• Captures the effect of the price level on output
• Is derived from equilibrium in the Goods (IS) and
financial (LM) markets
Econ 302
The AS-AD Model
Slide #12
Aggregate Demand
Goods Market (IS):
Y  C(Y  T )  I (Y , i )  G
Financial Market (LM):
M
 YL(i )
P
Econ 302
The AS-AD Model
Slide #13
Aggregate Demand
IS – LM Equilibrium
LM´ (P´ > P)
Interest Rate, i
LM (P)
• Assume P increases to P´
& M is fixed
•
A´
i´
A
Initial
Equilibrium
i
M falls to M
P
P´
• LM shifts to LM´ (P´ > P)
• Equilibrium to A´
• i to i´ & Y to Y´
IS
Y´ Y
Output, Y
Econ 302
The AS-AD Model
Slide #14
Aggregate Demand
Deriving Aggregate Demand (AD)
LM´ (P´ > P)
Interest Rate, i
Interest Rate, i
LM (P)
A´
i´
A
i
A´
P´
A
P
IS
Y´ Y
Y
Y´
Output, Y
Output, Y
Econ 302
AD
The AS-AD Model
Slide #15
Aggregate Demand
Greater Consumer Confidence Shifts AD
A´
i´
i
Interest Rate, i
Interest Rate, i
LM (P)
A
A´
P
A
IS´
AD´
AD
IS
Y
Y Y´
Output, Y
Output, Y
Econ 302
Y´
The AS-AD Model
Slide #16
Aggregate Demand
Contractionary Monetary Policy Shifts AD
LM´ (P)
i´
Interest Rate, i
Interest Rate, i
LM (P)
A´
A
i
A´
A
P
AD
AD´
IS
Y´ Y
Y´
Output, Y
Econ 302
The AS-AD Model
Y
Output, Y
Slide #17
Aggregate Demand
Aggregate Demand:
M
Y  Y ( ,G,T )
P
( , ,  )
• Y is a decreasing function of P
• Shifts in IS or LM shift AD
Econ 302
The AS-AD Model
Slide #18
Equilibrium Output in the Short
and the Medium Run
Y
AS : P  P (1   )F (1  , z )
L
e
M
AD : Y  Y ( ,G,T )
P
Econ 302
The AS-AD Model
Slide #19
Equilibrium Output in the Short
and the Medium Run
Price Level, P
AS
Observation:
Equilibrium Y may be
greater than or less than Yn
A
P
Equilibrium
B
Pe
AD
Yn
Y
Output, Y
Econ 302
The AS-AD Model
Slide #20
Equilibrium Output in the Short
and the Medium Run
The dynamics of output and the price level
Assume:
Pe = the price level last year
Pt = price level in year t
Pt-1 = price level in year t-1
Pt+1 = price level in year t+1
Therefore:
Econ 302
Pte = Pt-1
The AS-AD Model
Slide #21
Equilibrium Output in the Short
and the Medium Run
The dynamics of output and the price level
Given:
Pte = Pt-1
Y
AS : Pt  Pt 1(1   )F (1  , z )
L
M
AD : Yt  Y ( ,G,T )
Pt
Note:
Econ 302
µ, z, M, G and T are assumed to be
constant
The AS-AD Model
Slide #22
Equilibrium Output in the Short
and the Medium Run
The dynamics of output and the price level
AS´
(t+1)
AS(t)
Price Level, P
Equilibrium Year t
At A: Yt > Yn
Pt > Pet = Pt-1
A´
Pt+1
Pet+1 = Pt
Pet =
Pt-1
A
B´
Equilibrium Year t + 1
AS shifts to AS´
At A´: Yt+1 > Yn
B
Pt+1 > Pet+1
AD(t)
Yn Yt+1 Yt
Output, Y
Econ 302
The AS-AD Model
Slide #23
Equilibrium Output in the Short
and the Medium Run
The dynamics of output and the price level
AS´´
AS´
AS
Price Level, P
Pn
Equilibrium after Y + 1
A´´
• Aggregate supply
continues to shift to AS´´
A´
Pt+1
• Price level continues
to increase
A
Pt
• Output continues to
fall
AD
• Medium run
equilibrium at Pn, Yn
Yn Yt+1 Yt
Output, Y
Econ 302
The AS-AD Model
Slide #24
Equilibrium Output in the Short
and the Medium Run
The dynamics of output and the price level
Two Observations
Short Run: Output can be above or below Yn
Medium Run: Prices adjust to return output
to Yn
Econ 302
The AS-AD Model
Slide #25
The Effects of a Monetary
Expansion
AS´´
AS
Price Level, P
•
M: Yt = Y(
M
Pt
, G, T)
• AD shifts to AD´
Pn´
• AS shifts to AS´´
A´
Pt
Pn
• A´ equilibrium (Yt > Yn)
A´´
• Equilibrium Yn at Pn
A
• 10% increase in M
leads to 10%
AD´ increase in P
AD
Yn Y t
Output, Y
Econ 302
The AS-AD Model
Slide #26
The Effects of a Monetary
Expansion
Looking Behind the Scene: IS-LM
LM (Pn)
AS´
A´´
A´
P´
Pn
Interest Rate, i
Interest Rate, i
P´n
A
AD´
in
it
Y n Y1
LM´´ (Pn)
A´´
A
A´
B
i
AD
IS
Y1
Yn Yt
Output, Y
Output, Y
Econ 302
LM´ (P´)
LM (Pn´´)
AS
The AS-AD Model
Slide #27
The Effects of a Monetary
Expansion
The Neutrality of Money
A Summary
Short-run:
M Y and P
The relative change in P and Y
depends on the slope of AS
Medium run:
Prices continue to increase until P and
Y return to their original level, i.e.,
money is neutral
Econ 302
The AS-AD Model
Slide #28
A Decrease in the Budget Deficit
AS
Assume: G & T as constant
AS´´
Price Level, P
• Equilibrium from
A to A´
• Y falls to Y1
A
Pn
Short run
• AD shifts to AD´
A´
P´
Medium run
Pn´´
A´´
AD
AD´
Y1
Econ 302
Yn
The AS-AD Model
• P falls & AS shifts to
AS´´
• Equilibrium at A´´
P at Pn´´ & Y at Yn
Output, Y
Slide #29
A Decrease in the Budget Deficit
The Dynamic Effects of a Decrease in the Budget Deficit
AS
LM
LM´
Interest Rate, i
Price Level, P
AS´´
A
Pn
P´
A´
Pn´´
A´´
AD
AD´
Y1
Yn
A
i
i´
i1´
B
A´
i´´
A´´
IS
IS´
Y´ Y2 Yn
Output, Y
Output, Y
Econ 302
LM´´
The AS-AD Model
Slide #30
A Decrease in the Budget Deficit
Budget Deficits, Output, and Investment -A Summary
Short Run
• Will lead to a decrease in output and investment
assuming no complementary monetary policy
Medium Run
• Y returns to Yn
• Interest rate is lower
• Investment increases
Long Run
• I increases
• Y increases
Econ 302
The AS-AD Model
Slide #31
Changes in the Price of Oil
Effects on the Natural Rate of Unemployment
Real Wage, W/P
Assume an increase in the price of oil
1
1 
A
A´
1
1  ´
PS´ (´ >  )
WS
un
Econ 302
PS ( )
The AS-AD Model
u n´
Unemployment Rate, u
Slide #32
Changes in the Price of Oil
The Dynamics of Adjustment
AS´´
AS´
Price Level, P
AS
When oil prices increase:
Pt+n
• Yn decreases to Yn´
A´
P´
Pt-1
•  increases
A´´
• AS shifts up
A
B
AD
Y´n Y´ Yn
Econ 302
The AS-AD Model
• A to A´ short-run
change
• A to A´´ medium-run
change
Output, Y
Slide #33