The AS-AD Model

The AS-AD Model Slide #1Econ 302

The The AS-ADAS-AD Model 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


Aggregate SupplyAggregate Supply

Captures the effects of output on the price level

It is derived from equilibrium in the labor market


The Determination of Aggregate Supply


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


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


The price level as a function of output instead of the unemployment rate


L

Y

L

N

L

uu 11

),()1( zuFPP e

),1()1( zL

YFPP e


Aggregate Supply-The price level as a function of Aggregate Supply-The price level as a function of output instead of the unemployment rateoutput instead of the unemployment rate

),1()1( zL

YFPP e

ObservationsObservations

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.



Higher Pehigher P

PeWP

W=PeF(u,z) (PeW)

P=(1+µ)W (WP)



Higher Outputhigher P

YuWP

Y=N(YN)

)()1( uNL

Nu



Higher Outputhigher P

W=PeF(u,z)(uW)

P=(1+u)W(W P)


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

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



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: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

),1()1(:AS zL

YFPP e

),,(:AD TGP

MYY



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


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


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

Assume:Assume:

Therefore:Therefore: Pte = Pt-1




Given:Given:

Note:Note:

Pte = Pt-1

),1()1(:AS 1 zL

YFPP tt

),,(:AD TGP

MYY

tt

µ, z, M, G and T are assumed to be constant


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

Changes in the Price of OilChanges in the Price of Oil

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

Documents

The AS-AD Model