The AS-AD model

The AS-AD model

Aggregate DemandAggregate Supply

Policy analysis

Week 6: we examined how monetary and fiscal policy affect aggregate demand, by using different combinations of the policy mix

Remember that 2 assumptions were made: There exists excess production capacity in the

economy (unemployment, under-utilised capital) The price of goods, services and factors of production are

fixed and do not adjust

These assumptions can be restrictive and create some problems

The AS-AD model

LM’

1. Using the correct policy mix allows you to increase output and keep interest rates relatively constant

2. But what’s to stop you going on for ever ??

IS

LM

Income, Output Y

Inte

rest

rat

e i

Y1

i1

IS’

To infinity and beyond...

Y2

i2

LM’’

IS’’

The AS-AD model

Intuitively, we know there is a limit to IS-LM: As we’ve seen, in IS-LM, you can boost GDP forever using

the Policy-mix In real life, one knows that over-using these policies leads

mainly to inflation.

Why the difference? Where does this inflation come from ? Bottom line: if demand increases beyond the productive

capacity of the economy, producers have no choice but to increase prices

The purpose of the AS-AD model is to correct the predictions of IS-LM in order to account for the fact that there is not always excess productive capacity.

The AS-AD model

The AS-AD model

Modelling strategy

Aggregate supply curve

Aggregate demand curve

Model of macroeconomic

fluctuations

IS-LM model

IS Curve LM Curve

Keynesian Equilibrium

Money market equilibrium

Labour market Equilibrium

The AS-AD model

The Aggregate Demand curve

The Aggregate Supply curve

The AS-AD equilibrium

The AD curve

The AD curve shows the amount of goods and services demanded for a given price level.

The AD curve has a negative slope : a lower level of prices tends to increase the aggregate demand for goods and services Prices affect the LM curve through real money balances: a

higher price level leads to higher interest rates in IS-LM, reducing equilibrium output.

Beware: The negative slope of the AD curve is NOT linked to the negative slope of micro demand curves!!

The AD curve

i i

Y

Y

L1(Y) L1(Y)

L2(Y)

L2(Y)

LM

LM’

45° 45°

An increase in prices reduces

real money balances (M/P)

This shifts LM left

L1(Y)

L2(i)

(M/P) = L1(Y) + L2(i)

The AD curve

i

Y

LM1

Y1

P

YAD

P2

IS

P1

1. An increase in the price level from

P1 to P2 reduces real money

balances, which shifts LM

LM2

Y2

2. The AD curve plots this overall

effect

i2

i1

P

YAD

P1

3. However, a reduction in M at

constant price leads to a shift in AD

LM’

Y2

i2

AD’

1P

M2P

Mi

Y

LM1

Y1

IS

i11P

M

1

'

P

M

The AD curve

i

YY1

P

YAD

P1

IS

1. An increase in government spending shifts IS to the right,

increasing output and interest rates

LM2

Y2

2. Because prices are unchanged, this

leads to a shift of the AD curve

i2

i1

i

IS’

AD’

Rules of thumb: A shift in IS

Always leads to a similar shift in AD

A shift in LM Leads to a similar shift

in AD only if the shift is not due to changes in the price level

Changes in the price level bring movement on AD

The AS-AD model




The AS curve

The AS curve shows the amount of goods and services supplied for a given price level.

Compared to the AD curve, one has to distinguish between the short run AS (SRAS) and the long run AS (LRAS): LRAS : In the long run, the productive capacity of the

economy does not depend on prices SRAS : A change in prices changes the real cost of labour,

affecting the productive capacity of the economy.

Beware: The positive slope of the SRAS curve is NOT linked to the slope of micro supply curves !!

The AS curve

The short run AS is derived from the WS-PS/Phillips curve framework we examined in the previous weeks. The Phillips curve already identifies a negative

trade-off between unemployment and inflation. But what we need is a trade-off between

prices/inflation and output

So how do we bridge this gap ? We use Okun’s law, the empirical relation

between output and unemployment

The AS curve

inflation rate π

Unemployment rate u

β

un

Πe

Reminder of the Phillips curve

1

ne uu

The AS curve

- 1

0

1

2

3

4

5

- 15 - 10 - 5 0 5 10 15 20

Perc

enta

ge

cgan

e in

rea

l GD

P

Change in the rate of unemployment

The AS curve

Δy = - 0,070 Δu + 2,345

R² = 0,239

- 1

0

1

2

3

4

5

- 15 - 10 - 5 0 5 10 15 20

Perc

enta

ge

cgan

e in

rea

l GD

P

Change in the rate of unemployment

nn uuYY Okun’s Law:

The Phillips curve is the negative empirical relation between inflation and unemployment (It can be obtained with the WS – PS model) :

Okun’s law is a similar negative empirical relation :

Disregarding the random shocks, one can combine these two to obtain a short run aggregate supply (SRAS) equation:

vuu ne

nn uuYY

enYY

The AS curve

Negative Relations

Positive Relation

inflation rate π

Unemployment rate u

β

un

Πe

1

ne uu inflation rate π

Output Y

γ

Y n

1

ne YY

The AS curve

The AS curve

SRAS

Y

π

π *

Y

LRAS

Workers will adjust their expectations π e and negotiate higher nominal wages. This increases the real labour costs and shifts the SRAS to the left, until the long run equilibrium is reached again

π’

If a shock increases prices, then the real cost of labour W/P will drop, pushing output Y above potential output and unemployment u below the natural rate.

Yn

In the long run, π* = π e, and the economy is at its potential output Yn, which corresponds to the natural rate of unemployment un.

The AS curve

π

Y

The long run aggregate supply is vertical at Yn.

This means that the Y=Yn condition is equivalent to u=un and π = π e

LRAS

Yn

This does NOT mean that the potential level of output Yn is fixed in time

Fall in LRAS

Increase in LRAS

It means that Yn is a function of other variables than price

The AS-AD model





SRAS

π

π *

Y

AD

LRAS

Yn

In the long run macroeconomic equilibrium, price expectations are fulfilled (π* = π e), and demand in the economy is equal to the long run productive capacity (Y =Yn).


Shocks to demand and supply lead to fluctuations at the macroeconomic level.

By “shocks” economists mean exogenous variations to supply and demand A demand shock modifies aggregate demand: increase in

G or T, change in M, etc. A supply shock modifies aggregate supply: increase in oil

prices, change in technology, etc.

Stabilisation policies are policies that attempt to keep output, inflation and employment around their long run equilibrium levels The aim is to minimise the fluctuations around equilibrium

Y1

A negative demand shock shifts the AD curve to the left, which reduces output and prices

AD2

π 1

B


SRAS

π

π *

Y

AD

LRAS

Yn

How can we return to the long run equilibrium ?

Demand-side policy :

Stimulate AD with an IS-LM policy-mix to return to point A.

Preferred solution as it stimulates a depressed

demand. Consistent with the IS-LM framework

A

SRAS2

π 2

Supply-side policy:

Stimulate the SRAS by reducing the effective cost of factors (wages) and get to C

C

π 2

π 1

Y1


SRAS

π

π *

Y

AD

LRAS

Yn

A negative supply shock (increase in production costs) causes an increase in prices and a fall in output in the short run: This is called stagflation

SRAS2

Demand-side policy :

A demand-side policy can avoid the recession, but at the cost of high inflation: this is what happened in the late 70’s

AD2 Supply-side policy:

It is preferable to carry out a supply-side policy aiming to increase the SRAS, through a reduction of inflation expectations and a policy of wage moderation.


The AS-AD model allows a better understanding of how to coordinate stabilisation policiesThe best response to a demand shock is

a demand policy (such as a fiscal stimulus policy)

The best response to a supply shock is a supply side policy (such as wage moderation and reduction of inflation expectations)

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The AS-AD model