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Chapter 7: Putting All Markets Together: The AS-AD Model The Dynamics of Adjustment M Y Y , G, T P The increase in the nominal money stock causes the aggregate demand curve to shift to the right. In the short run, output and the price level increase. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 1 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Dynamic Effects of a Monetary Expansion The difference between Y and Yn sets in motion the adjustment of price expectations. In the medium run, the AS curve shifts to AS’’ and the economy returns to equilibrium at Yn. The increase in prices is proportional to the increase in the nominal money stock. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 2 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Dynamic Effects of a Monetary Expansion A monetary expansion leads to an increase in output in the short run, but has no effect on output in the medium run. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 3 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model Going Behinds the Scenes The impact of a monetary expansion on the interest rate can be illustrated by the IS-LM model. The short-run effect of the monetary expansion is to shift the LM curve down. The interest rate is lower, output is higher. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 4 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model Going Behinds the Scenes Over time, the price level increases, the real money stock decreases and the LM curve returns to where it was before the increase in nominal money. In the medium run, the real money stock and the interest rate remain unchanged. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 5 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Dynamic Effects of a Monetary Expansion on Output and the Interest Rate The increase in nominal money initially shifts the LM curve down, decreasing the interest rate and increasing output. Over time, the price level increases, shifting the LM curve back up until output is back at the natural level of output. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 6 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Neutrality of Money In the short run, a monetary expansion leads to an increase in output, a decrease in the interest rate, and an increase in the price level. In the medium run, the increase in nominal money is reflected entirely in a proportional increase in the price level. The neutrality of money refers to the fact that an increase in the nominal money stock has no effect on output or the interest rate in the medium run. The increase in the nominal money stock is completely absorbed by an increase in the price level. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 7 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model 7-5 Dynamic Effects of a Decrease in the Budget Deficit A decrease in the budget deficit leads initially to a decrease in output. Over time, output returns to the natural level of output. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 8 of 49 How Long Lasting Are the Real Effects of Money? Chapter 7: Putting All Markets Together: The AS-AD Model Figure 1 The Effects of an Expansion in Nominal Money in the Taylor Model Macroeconometric models are larger-scale versions of the aggregate supply and aggregate demand model in this chapter. They are used to answer questions such as how long the real effects of money last. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 9 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model Deficit Reduction (fiscal contraction), Output, and the Interest Rate Since the price level declines in response to the decrease in output, the real money stock increases. This causes a shift of the LM curve to LM’. Both output and the interest rate are lower than before the fiscal contraction. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 10 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model Deficit Reduction (fiscal contraction), Output, and the Interest Rate The LM curve continues to shift down until output is back to to the natural level of output. The interest rate is lower than it was before deficit reduction. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 11 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model Deficit Reduction (fiscal contraction), Output, and the Interest Rate A deficit reduction leads in the short run to a decrease in output and to a decrease in the interest rate. In the medium run, output returns to its natural level, while the interest rate declines further. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 12 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model Deficit Reduction (fiscal contraction), Output, and the Interest Rate The composition of output is different than it was before deficit reduction. IS relation: Yn C(Yn T ) I (Yn , i) G Income and taxes remain unchanged, thus, consumption is the same as before. Government spending is lower than before; therefore, investment must be higher than before deficit reduction—higher by an amount exactly equal to the decrease in G. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 13 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model Budget Deficits, Output, and Investment Let’s summarize: In the short run, a budget deficit reduction, if implemented alone leads to a decrease in output and may lead to a decrease in investment. In the medium run, output returns to the natural level of output, and the interest rate is lower. A deficit reduction leads unambiguously to an increase in investment. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 14 of 49 7-6 Changes in the Price of Oil Chapter 7: Putting All Markets Together: The AS-AD Model Figure 7 - 11 The Price of Crude Petroleum since 1960 There were two sharp increases in the relative price of oil in the 1970s, followed by a decrease in the 1980s and the 1990s. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 15 of 49 The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment Chapter 7: Putting All Markets Together: The AS-AD Model Figure 7 - 12 The higher price of oil causes an increase in the markup and a downward shift of the price-setting line. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 16 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment Y P P (1 ) F 1 , z L An increase in the markup, , caused by an increase in the price of oil, results in an increase in the price level, at any level of output, Y. The aggregate supply curve shifts up. © 2006 Prentice Hall Business Publishing e Macroeconomics, 4/e Olivier Blanchard 17 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment After the increase in the price of oil, the new AS curve goes through point B, where output equals the new lower natural level of output, Y’n, and the price level equals Pe. The economy moves along the AD curve, from A to A’. Output decreases from Yn to Y’. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 18 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment Over time, the economy moves along the AD curve, from A’ to A”. At point A”, the economy has reached the new lower natural level of output, Y’n, and the price level is higher than before the oil shock. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 19 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment An increase in the price of oil leads, in the short run, to a decrease in output and an increase in the price level. Over time, output decreases further and the price level increases further. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 20 of 49 The Dynamics of Adjustment Chapter 7: Putting All Markets Together: The AS-AD Model Table 7-1 The Effects of the Increase in the Price of Oil, 1973-1975 1973 1974 1975 10.4 51.8 15.1 Rate of change of GDP deflator (%) 5.6 9.0 9.4 Rate of GDP growth (%) 5.8 0.6 0.4 Unemployment rate (%) 4.9 5.6 8.5 Rate of change of petroleum price (%) The combination of negative growth and high inflation, or stagnation accompanied by inflation, is called stagflation. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 21 of 49 Conclusions 7-7 Chapter 7: Putting All Markets Together: The AS-AD Model The Short Run Versus the Medium Run Table 7-2 Short-Run Effects and Medium-Run Effects of a Monetary Expansion, a Budget Deficit Reduction, and an Increase in the Price of Oil on Output, the Interest Rate, and the Price Level Short Run Output Level Monetary expansion increase Medium Run Interest Rate Price Level Output Level Interest Rate Price Level decrease increase (small) no change no change increase no change decrease decrease decrease increase increase Deficit reduction decrease decrease decrease (small) Increase in oil price decrease increase increase © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 22 of 49 Conclusions Chapter 7: Putting All Markets Together: The AS-AD Model Shocks and Propagation Mechanisms Output fluctuations (sometimes called business cycles) are movements in output around its trend. The economy is constantly hit by shocks to aggregate supply, or to aggregate demand, or to both. Each shock has dynamic effects on output and its components. These dynamic effects are called the propagation mechanism of the shock. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 23 of 49