The AS-AD Model

Chapter 7: The AS-AD Model Slide #1Blanchard: Macroeconomics

The The AS-ADAS-AD Model Model

Determination of Output in the short-run and medium-run

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


The Determination of Aggregate Supply

Aggregate SupplyAggregate Supply

Recall:Recall:

The nominal wage (W) = PeF(u,z)Price level (P) = (1+)W

So

P = Pe(1+) F (u,z)


Since


L

Y

L

N

L

uu 11

),1()1( zL

YFPP e


Aggregate Supply-The price level as a function of Aggregate Supply-The price level as a function of outputoutput

),1()1( zL

YFPP e

1. A higher expected price level leads to a higher actual price level.

2. An increase in output leads to an increase in the price level.



Higher Pehigher P

PeW since W=PeF(u,z)

WP since P=(1+µ)W

Higher Outputhigher P

YNuWP

since P=(1+u)W


AS


Output, Y

Pri

ce L

evel

, P

Yn

Pe

Graphically:

P >

Pe

P < Pe

A

Two characteristics:

1. Given Pe an increase in Y increases P2. At A: Y = Yn & P = Pe

Observation:Y > Yn then P > Pe

Y < Yn then P < Pe


AS´ (Pe´ > Pe)

AS (Pe)

Output, Y

Pri

ce L

evel

, P

Yn

Pe

A


Pe´

AÓbservation:

Given Yn: changes in Pe shift the AS curve

Illustrating the impact of an increase in Pe


Aggregate DemandAggregate Demand

Goods Market (IS):Goods Market (IS):

GiYITYCY ),()(

Financial Market (LM):Financial Market (LM):

)(iYLP

M


LM´ (P´ > P)

LM (P)

Output, Y

Inte

rest

Rat

e, i

IS

Y

iA

Initial Equilibrium

Aggregate DemandAggregate DemandIS – LM Equilibrium

Aí´

Y´

• falls to P

M

´P

M

• LM shifts to LM´ (P´ > P)

• Equilibrium to A´

• i to i´ & Y to Y´

• Assume P increases to P´ & M is fixed


LM (P)

IS

Y

i

Inte

res

t R

ate

, i

Output, Y

Inte

res

t R

ate

, i

Output, Y

A

AD


Y

A

P

LM´ (P´ > P)

A´P´

Y´

Deriving Aggregate Demand (AD)

Y´

i´

A´


LM (P)

IS

Y

i

Inte

res

t R

ate

, i

Output, Y

AD

Y

Inte

res

t R

ate

, i

Output, Y

P

A

A

IS´ AD´

Aggregate DemandAggregate DemandGreater Consumer Confidence Shifts AD

Y´

A´

Y´

i´ A´


IS

LM (P)

Y

i

Inte

res

t R

ate

, i

Output, Y

AD

Y

Inte

res

t R

ate

, i

Output, Y

P

A

A

AD´


LM´ (P)

Contractionary Monetary Policy Shifts AD

Y´

i´ A´

Y´

A´


Aggregate Demand: SummaryAggregate Demand: Summary

Aggregate Demand:Aggregate Demand:

),,(

),,(

TGP

MYY

• Y is a decreasing function of P

• Shifts in IS or LM shift AD


Equilibrium Output in the Short Equilibrium Output in the Short and the Medium Runand the Medium Run

AS

Output, Y

Pri

ce L

evel

, P

AD

Y

A

EquilibriumP

Pe

Yn

B

Observation:Equilibrium Y may be greater than or less than Yn


Pt = price level in year t

Pt-1 = price level in year t-1

Pt+1 = price level in year t+1


The dynamics of output and the price levelThe dynamics of output and the price level

Assume: Pte = Pt-1

Where Pte = price level expected in year t


AS(t)

Output, Y

Price Level, P

AD(t)

Yt

Pet+1 = Pt

A

Yn

Equilibrium Year t

At A: Yt > Yn

Pt > Pet = Pt-1

Pet = Pt-1 B

AS´ (t+1)


Equilibrium Year t + 1

At A´: Yt+1 > Yn

A´

Pt+1

Yt+1

Pt+1 > Pet+1


B´ AS shifts to AS´


AS

Output, Y

Price Level, P

AD

Yt

Pt

A

Yn

AS´´


AS´

Yt+1

Pn

A´

A´´

Pt+1


Equilibrium after Y + 1

• Output continues to fall

• Medium run equilibrium at Pn, Yn

• Aggregate supply continues to shift to AS´´

• Price level continues to increase




Two ObservationsTwo Observations

Short Run: Output can be above or below Yn

Medium Run: Prices adjust to return output to Yn


AD

AS

Output, Y

Price Level, P

Yn

Pn A

AD´

The Effects of a Monetary The Effects of a Monetary ExpansionExpansion

Yt

A´Pt

• A´ equilibrium (Yt > Yn)

AS´´

A´´Pn´

• AD shifts to AD´

• M: Yt = Y( , G, T)tP

M

• AS shifts to AS´´

• Equilibrium Yn at Pn

• 10% increase in M leads to 10% increase in P


LM (Pn)

Yn

Pn

AS

AD IS

Inte

res

t R

ate

, i

Output, Y

Inte

res

t R

ate

, i

Output, Y

A

in

Yn

A

LM´ (P´)

A´

Yt

it

LM´´ (Pn)

i

Y1

BAD´


Looking Behind the Scene: IS-LMLooking Behind the Scene: IS-LM

Y1

P´ A´

AS´

PńA´´ A´´

LM (Pn´´)



A Summary

The Neutrality of MoneyThe Neutrality of Money

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


A Decrease in the Budget DeficitA Decrease in the Budget Deficit

AD´

AS´´

AD

AS

Output, Y

Price Level, P

Yn

PnA

Y1

A´P´

A´´Pn´´

Assume: G & T as constant

• Equilibrium from A to A´

• AD shifts to AD´

• Y falls to Y1

Short run

• P falls & AS shifts to AS´´

• Equilibrium at A´´ P at Pn´´ & Y at Yn

Medium run


AD

AS

Yn

PnA

IS

LM

Ai

Yn

Output, Y

Pri

ce

Le

ve

l, P

Inte

res

t R

ate

, i

Output, Y

AD´

Y1

A´P´

IS´

Y´

i´ B

LM´´

i´´ A´´

AS´´

Pn´´ A´´

LM´

Y2

Aí1´


The Dynamic Effects of a Decrease in the Budget DeficitThe Dynamic Effects of a Decrease in the Budget Deficit



Budget Deficits, Output, and Investment -A SummaryBudget 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


Rea

l W

age,

W/P

WS

11

PS ( )

un Unemployment Rate, u

A

´1

1

PS´ ( ´ > )

Changes in the Price of OilChanges in the Price of Oil

Effects on the Natural Rate of UnemploymentEffects on the Natural Rate of Unemployment

un´

A´

Assume an increase in the price of oil


AS´

AS

Output, Y

Price Level, P

AD

APt-1

Yn


The Dynamics of AdjustmentThe Dynamics of AdjustmentAS´´

A´´Pt+n

A´P´

Y´

When oil prices increase:

• Yn decreases to Yn´

• AS shifts up

• A to A´ short-run change

• A to A´´ medium-run change

• increases

B

Yń



The Effects of the Increase in the Price of Oil1973-1975

The Effects of the Increase in the Price of Oil1973-1975

1973 1974 1975

Rate of change of petroleum price (%) 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

Source: Economic Report of the President, 1997.


The The AD-AS AD-AS ModelModel

ConclusionsConclusions

Short Run Medium Run

Output Interest Price Output Interest PriceLevel Rate Level Level Rate Level

Monetary expansion increase decrease increase no change no change increase(small)

Deficit reduction decrease decrease decrease no change decrease decrease(small)

Increase in oil price decrease increase increase decrease increase increase

Documents

The AS-AD Model