AS & AD

Account for price movements

AGGREGATE DEMAND AND SUPPLY

• • • • • •

So far, we have assumed for simplicity that in the short-run, general Price and Wage levels are fixed. This means that changes in Demand lead to changes in real GDP, and not prices.

However, it is clear that prices and wages adjust over time, and that we have to relax the fixed-price assumption.

One way of looking at this is to derive Aggregate Supply and Demand curves, where real demand and supply (GDP) are related to the general price level We can then see how changes to demand (from fiscal and monetary policy actions, etc) interact to produce changes in Real GDP and the price level.

This will be a first step towards looking at Inflation.

CHANGING P AND M S /P

• • • • • •

Suppose the general price level changes (and nothing else changes – i.e. ceteris paribus) The immediate effect is that the Real Money Supply changes:

m s



M s

/P so as P increases, real money supply (m

s

) decreases, assuming nominal money supply is (M

s

) unchanged A lower m

s

immediately implies an excess of m

d

higher interest rate (r) over m

s

, and thus a In turn this leads to a lower level of total demand for output (i.e. aggregate demand) because: Ip = Ia + b.r (b <0) A graphical version: (note P 2 > P 1 > P 0 )

CHANGES IN P AND AGGREGATE DEMAND

•

Effect of P on AD r LM 2 LM 1 LM 0 r 2 r 1 r 0 As P increases, real m s falls, r increases, AD falls P 0 Y 2 Y 1 Y 0 IS Y P 2 P 1 P 0 0 AD Y Y 2 Y 1 Y 0

SLOPE OF IS-CURVE AND AD-CURVE

r LM 2 LM 1 LM 0 The IS-Curve shows how Y Responds to changes in r IS B is steeper than ISA Result: steeper AD B P 0 IS B IS A Y 0 AD B AD A Y

AGGREGATE DEMAND SHIFTS

• • • •

Monetary Policy: An expansion of Ms, leading to a real expansion of (Ms/P) will boost Aggregate Demand, via lower interest rates. This is depicted as a shift in the AD curve.

Later we will see that if there is an inflationary result, this will further lower the real interest rate (= nominal int rate minus inflation) Fiscal Policy: an increase in G or a reduction in T (fiscal stimulus) will increase AD at any given interest rate and price level: again a shift in the AD curve.

We can illustrate these diagrammatically:

MONETARY EXPANSION AND AD-SHIFT

•

Effect of



Ms on AD r LM 0 LM 1 As Ms increases, real m s increases, r falls, AD increases (shifts up) r 0 r 1 r 2 IS P 0 Y 0 Y 1 Y 2 P assumed constant, but the exact outcome will depend on AS as well (later) P 0 LM 2 AD 2 AD 1 AD 0 0 Y 0 Y 1 Y 2 Y Y

A FISCAL STIMULUS AND AD-SHIFT

•

Effect of



(G – T) on AD r LM r 1 r 0 As (G – T) increases, IS shifts, AD increases (shifts out) IS 0 P assumed constant, but the exact outcome will depend on AS as well (later) P 0 Y 0 Y 1 P 0 0 Y 0 Y 1 IS 1 Y AD 1 AD 0 Y

LABOUR MARKET AND AGG. SUPPLY (1)

• • • • • • • • • •

How does the Supply of Output respond to changes in the Price level?

Output (Y): Y = f(N, K) MP N : dY/dN > 0 and d

2 Y/dN 2 < 0

Firms employ labour (N) such that wage (W) = P. MP

N

or: W/P = MP

N

Next, some assumptions about price and wage flexibility.

In the short run we can assume that most prices respond to supply and demand shocks However wage rates are an exception: typically wages are viewed as being inflexible in the short-run: wage contracts are negotiated for periods of 1 to 3 years, for a variety of reasons Initially N

d

Where

= f(W/P); dN d /dw < 0 N s w



W/P = g(W/P); dN s /dw > 0

LABOUR MARKET AND AGG. SUPPLY (2)

•

Initial equilibrium at W/P 0 , etc If P increases,

W/P 1

falls , and Nd increases to N 1 W/P 1 is not a full Equilibrium: not on Ns curve. Upward pressure on W Long-run adjustment Increases W, restores W/P, and N



N 0 W/P W/P 0 W/P 1 0 Ns N 0 N 1 Nd N

SHORT-RUN AGGREGATE SUPPLY (1)

• •

If W is relatively inflexible (compared with P), then the short-run response is that Output tends to increase when P rises, because real w falls, and tends to fall when P falls (because real w increases).

Hence an upward-sloping S.R Aggregate Supply curve: P SAS 0 Y

SHORT-RUN AGGREGATE SUPPLY (2)

•

P increases to P 2 , W 1 constant: w decreases, N increases, Y increases w N D W 1 P P 2 P 1 w 1 w 2 N N 1 N 2 SAS Y 1 Y 2 Y

Y=f(N, K)

LONG-RUN AGGREGATE SUPPLY

•

P increases to P 2 , W 2 eventually adjusts: SAS shifts; LAS vertical w ND W 2 W 1 P P 2 P 1 w 1 N N 1 LAS SAS 1 SAS 2 Y 1 Y

Y=f(N, K)

RESPONSE TO AD SHOCKS (SR)

• • •

SAS



AD 1



AD 3



vertical as Y



Y* AD 2 : small



Pa, large



Ya AD 4 : larger



Pb, smaller



Yb



Pb P



Pa SAS 0



Ya AD 1 AD 2



Yb AD 3 AD 4 Y

RESPONSE TO AD SHOCKS (LR)

• •

Initially AD-shift increases Y



In LR, AS



SAS 2 and LAS



P 3 Y , Y 2 1 P LAS SAS 2 P 3 P 2 P 1 SAS 1 0 Y 1 Y 2 AD 1 AD 2 Y

KEYNESIAN VERSUS CLASSICAL VIEWS

• • • • • •

Prior to the great Depression of the 1930s the prevailing (“Classical”) view was that the Macroeconomy tended to full-employment equilibrium Deviations were viewed as short-lived, and the key to adjustment was flexibility of prices and wages The experience of the 1930s shattered this view, and the Keynesian perspective became dominant Much later, in the late 60s and the 70s, the Keynesian orthodoxy was obviously deficient in dealing with inflation. Also with “fine-tuning” to counter relatively mild recessions was seen to be problematic: hence a revival of classical and monetarist views Recently, the emergence of a very serious recession, with echoes of the 1930s prompts a renewed emphasis on Keynes

THE KEYNESIAN PERSPECTIVE (1)

• • • •

What Keynes demonstrated was that an economy could get trapped in a high-unemployment equilibrium: this necessitated government policy intervention, primarily in the form of a fiscal stimulus.

The experience of the 1930s stemmed from a rapid expansion of credit in the 1920s, overinvestment in housing and other assets, followed by a financial collapse. The result of this was a drastic fall in Aggregate Demand. (sounds familiar?) Fiscal expansion was the only way to counter this Aggregate Demand deficiency: Monetary policy alone would not work What we need to understand is why the economy might be stuck in an under-employment equilibrium and why decisive fiscal policy measures might be necessary to solve the problem

THE KEYNESIAN PERSPECTIVE (2)

• • • • • •

Keynes argued that Nominal Wages are relatively inflexible, even when there is high unemployment and perhaps price deflation However what matters is the real wage (W/P), and if there is a need to reduce real wages (W/P), then perhaps increasing P rather than reducing W may be more effective.

This may be because of Money Illusion (an idea which we sometimes find troublesome): however if W is reduced, do people perceive that it may apply to them only? (i.e. relative as well as absolute W) Falling P may increase (Ms/P). Result:

–

falling r boosts AD (Keynes effect)

–

increase in (Ms/P) increases real wealth and thus AD (Pigou effect) But real value of Debt also increases in a Deflation Also expectations of further deflation may depress AD

THE KEYNESIAN PERSPECTIVE (3)

• • • • •

Keynes also argued that Md may become practically infinitely elastic at low interest rates (liquidity preference theory) This effectively limits the scope for reductions in interest rates as a stimulant to AD Note that even if the nominal interest rate should go to zero, deflation implies a higher real interest rate, and so monetary policy may inevitably be quite restrictive in a deflation

r = i –



e

So if



e

= – 4% and i = 1%, then r = +5% However there are problems:

– –

information and timing of fiscal interventions financing public debt accumulation

Summary of AS

• • • • We have a distinction between short run and long run The Short run is for fixed expectations – – – AS(P e ) SRAS Quite flat: Explains why ISLM works as approx LR is how long it takes for real wages to adjust – – Expectations adjust Workers to act on exp – ISLM wont work in LR In LR Y is unaffected by P

P LRAS AS(P e ) Y * Y

• •

Note the Notation AS(Pe)

– – Alternative to SAS Makes explicit that the SR is for fixed price expectations – When price expectations change workers (and others) will demand higher wages – SAS will shift up

What determines Y

*

?

– – Natural rate Incentives – – – Technology “growth” Not anything that just affects price

THE KEYNESIAN PERSPECTIVE (4)

•

Here: flat LM: fiscal policy effective ; monetary policy ineffective r LM 1 LM 2 0 E 1 E 2 Y 1 Y 2 IS 1 IS 2 y

THE KEYNESIAN PERSPECTIVE (5)

•

Here: inelastic IS curve: monetary policy ineffective; fiscal policy effective r IS 1 IS 2 LM 1 LM2 E 1 E 2 0 Y 1 Y 2 y

THE KEYNESIAN PERSPECTIVE (6)

• •

The problem may also be shown in terms of AS and AD Shock to AD; SAS may be slow to change P LAS SAS 0 AD 1931, 2009 AD 1929, 2007 0 Y 0 Y* Y

SR IMPACT OF AD AND AS SHOCKS (1)

• •

AD: positive shock



inflationary pressure Implies positive correlation between inflation and output, etc P AD 1 AD 2 AS 0 Y

SR IMPACT OF AD AND AS SHOCKS (2)

• •

AS: negative shock



inflationary pressure Implies negative correlation between inflation and output, etc P AS 2 AS 1 AD 0 Y

INFLATION AND TREND OUTPUT: USA 1960-2005

Policy in AS-AD Model

• • • Suppose there is an increase in G AD shifts right – For all P, there is higher AD, because govt component has risen – Could derive this from IS-LM – Same for MP For fixed expectations i.e. SR – Move along AS – New (temp) eqm at B – Y increases – P increases (but not by much)

• • • •

P rising implies real wage falling

– P>P e

P

e

will adjust upwards

– W increase – SRAS shifts up

Keep going until output returns to “natural level” How long does transition take?

– Theory: depends. Instantaneous?

– Empirics: about 2 years – see diagram

P LRAS C A B AS(P c e ) AS(P A e ) Y * AD 0 Y AD 1

• •

Be clear on the reasons why there is no long run effect

– In order to get more output need to pay more people higher wages – Higher wages imply firms need to charge higher prices – Higher prices negate the higher wages as far as workers are concerned – We go back to original values of real variables – Only affect nominal variables

Policy is ineffective!

•

We can only get an increase in Y in long run i.e. increase in Y

* – If induce people to work more – Need increase in real wage – Technology – Efficiency – Lower taxes?

• Reganomics • Supply side economics • Voodoo economics

Reagan Style Tax Cut

• • • Cut personal taxes – Idea is that this will improve incentives – People will work more – Shift the LRAS to the right – Increase Y * and reduce P – Note that SRAS shifts also as expectations adjust to the new lower level But cutting taxes will shift the AD curve to right – SR boom – LR return to Y * with higher P Which happened?

– Both – Demand effect larger

P LRAS 0 LRAS 0 Y * Y 1 * AD 0 Y AS(P e ) AS(P e )

Dealing With Shocks

• • • •

The AS-AD diagram shows how an economy will automatically adjust to a shock Start from LR eqm

– Y=Y * – P e =P

Suppose there is a fall in AD

– Eqm moves from A to B – Y

This can only be a temporary eqm

• • At B, P

P LRAS SRAS(P 0 e ) SRAS(P 1 e ) B C A Y * AD 1 Y AD 0

• • • So the economy will automatically work itself out of recession Mechanism depends on wage adjustment – Mirror image of previous discussions – Workers respond to lower prices by demanding lower wages – Reasonable? • Yes real wages return to normal • No long term decline in real wages – Realistic?

• No! see data • Nominal wages are rigid Have to wait for productivity – Have lower wage increases than otherwise

• • • • All this takes time – 3+ years Alternative is for Government to expand AD – Shift AD back – Return to long run equilibrium A Rationale for stabilization policy – After WTC, cut interest rates – Enough? Or too much?

Debate over which is best – Policy: “long and variable lags” – Automatic: “long run we are all dead” – Calls for “flexibility” after EMU