Putting All Markets Together: The AS-AD Model

Prepared by: Fernando Quijano and Yvonn Quijano © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard

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Aggregate Supply

The

aggregate supply relation

captures the effects of output on the price level. It is derived from the behavior of wages and prices.

Recall from chapter 6 the equations for: wage setting relation:

W



e

( , )

price determination :

P

 ( 1   )

W

W = P/1+ μ

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Aggregate Supply

Step 1: Eliminate the nominal wage from: W = P e F(u,z) and W = P/1+μ To get: P/1+μ = P e F(u,z) Or P = P e (1+μ) F(u,z) In words, the price level depends on the expected price level and the unemployment rate . We assume that



and z are constant.

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Aggregate Supply

Step 2: We know that Y=AN (production function). If we assume A (output per worker) to be equal to one, then we can write Y=N. As a result, we can express the unemployment rate in terms of output:

u



U L



L



N L N L Y L

Therefore,

for a given labor force, the higher is output, the lower is the unemployment rate

.

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Aggregate Supply

Step 3: Replace the unemployment rate in the equation obtained in step one:

P



P e

( 1   )

F

  1 

Y L

,

z

  In words,

the price level depends on:



the expected price level, P

e

,



the level of output, Y ,



and also



, z, and L

, but we take these are assumed to be constant here.

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Aggregate Supply

P



P e

( 1   )

F

  1 

Y L

,

z

  The

AS

relation has two important properties: 1.

An increase in output leads to an increase in the price level. This is the result of four steps : 1.

2.

3.

4.

Y

 

N



N u

 

W



W

 

P



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Aggregate Supply

P



P e

( 1   )

F

  1 

Y L

,

z

  The

AS

relation has two important properties:

1.

An increase in output leads to an increase in the price level. This is the result of four steps 2.

An increase in the expected price level leads, one for one, to an increase in the actual price level. This effect works through wages :

1.

2.

P e

 

W

 

W P

 

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Aggregate Supply

Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level.

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Aggregate Supply

The

AS

curve has

three properties

prove to be useful in what follows: that will 1.

2.

3.

The level.

AS

curve is upward sloping . An increase in output leads to an increase in the price The

AS

curve goes through point

A

, where

Y (actual output)

=

Y n

(

natural level of output=level of output at the natural rate of unemployment/unemployment

) and

P ( price level)

=

P e (expected price level)

.

This property has two implications:  When

P

>

P e

,

Y

>

Y n

.

 When down .

P

<

P e

,

Y

<

Y n

.

An increase in

P e

shifts the

AS

and a decrease in

P e

curve up shifts the AS curve ,

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Aggregate SupplyThe Effect of an Increase in the Expected Price Level on the Aggregate Supply Curve

An increase in the expected price level shifts the aggregate supply curve up.

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Aggregate Supply

Let’s summarize:  Starting from wage determination and price determination in the labor market, we have derived the

aggregate supply relation.

 This means that for a given expected price level, the price level is an increasing function of the level of output. It is represented by an upward-sloping curve, called the

aggregate supply curve.

 Increases in the expected price level shift the aggregate supply curve up; decreases in the expected price level shift the aggregate supply curve down.

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