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The AS-AD Model

The AS-AD 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 . Aggregate Supply.

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The AS-AD Model

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  1. The AS-AD 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

  2. Aggregate Supply The Determination of Aggregate Supply Recall: The nominal wage (W) = PeF(u,z) Price level (P) = (1+)W So P = Pe(1+) F (u,z)

  3. Aggregate Supply • Since

  4. Aggregate Supply-The price level as a function of output • A higher expected price level leads to a higher actual price level. • An increase in output leads to an increase in the price level.

  5. Aggregate Supply • Higher Pehigher P PeW since W=PeF(u,z) WP since P=(1+µ)W • Higher Outputhigher P YNuWP since P=(1+u)W

  6. AS Two characteristics: 1. Given Pe an increase in Y increases P P > Pe Price Level, P 2. At A: Y = Yn & P = Pe A Observation: Pe Y > Yn then P > Pe Y < Yn then P < Pe P < Pe Yn Output, Y Aggregate Supply Graphically:

  7. AS´ (Pe´ > Pe) AS (Pe) A´ Price Level, P Observation: Given Yn: changes in Pe shift the AS curve Pe Pe´ A Yn Output, Y Aggregate Supply Illustrating the impact of an increase in Pe

  8. Aggregate Demand Goods Market (IS): Financial Market (LM):

  9. LM´ (P´ > P) LM (P) A A´ Interest Rate, i • falls to Initial Equilibrium i i´ IS Y´ Y Output, Y Aggregate Demand IS – LM Equilibrium • Assume P increases to P´ • & M is fixed • LM shifts to LM´ (P´ > P) • Equilibrium to A´ • i to i´ & Y to Y´

  10. LM´ (P´ > P) LM (P) Interest Rate, i Interest Rate, i A´ P´ A´ i´ A i A P AD IS Y´ Y Y Y´ Output, Y Output, Y Aggregate Demand Deriving Aggregate Demand (AD)

  11. LM (P) A´ A Interest Rate, i Interest Rate, i P i´ A´ A i IS AD´ AD IS´ Y´ Y Y Y´ Output, Y Output, Y Aggregate Demand Greater Consumer Confidence Shifts AD

  12. LM´ (P) LM (P) A´ A Interest Rate, i Interest Rate, i P A´ i´ A i AD´ AD IS Y Y´ Y Y´ Output, Y Output, Y Aggregate Demand Contractionary Monetary Policy Shifts AD

  13. Aggregate Demand: Aggregate Demand: Summary • Y is a decreasing function of P • Shifts in IS or LM shift AD

  14. AS Observation: Equilibrium Y may be greater than or less than Yn A B P Equilibrium Pe AD Y Yn Equilibrium Output in the Short and the Medium Run Price Level, P Output, Y

  15. Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level Pt = price level in year t Pt-1 = price level in year t-1 Pt+1 = price level in year t+1 Assume: Pte = Pt-1 WherePte = price level expected in year t

  16. AS´ (t+1) AS(t) Price Level, P Equilibrium Year t At A: Yt > Yn Pt > Pet= Pt-1 A´ A B´ Pet+1 = Pt Pet = Pt-1 B AD(t) Yt Yn Output, Y Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level Equilibrium Year t + 1 Pt+1 AS shifts to AS´ At A´: Yt+1 > Yn Pt+1 > Pet+1 Yt+1

  17. AS´´ AS´ AS Price Level, P Equilibrium after Y + 1 A´´ Pn • Aggregate supply • continues to shift to AS´´ A´ Pt+1 • Price level continues • to increase A Pt • Output continues to • fall • Medium run • equilibrium at Pn, Yn AD Yt Yn Yt+1 Output, Y Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level

  18. Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level Two Observations Short Run: Output can be above or below YnMedium Run: Prices adjust to return output to Yn

  19. M: Yt = Y( , G, T) AS´´ AS Price Level, P Pn´ A´´ A´ Pt • Equilibrium Ynat Pn A Pn • 10% increase in M • leads to 10% • increase in P AD´ AD Yn Yt Output, Y The Effects of a Monetary Expansion • AD shifts to AD´ • A´ equilibrium (Yt > Yn) • AS shifts to AS´´

  20. LM (Pn) AS´ LM´ (P´) LM (Pn´´) AS LM´´ (Pn) A´´ A´´ Interest Rate, i Interest Rate, i P´n A in P´ A´ it A´ A Pn B i AD´ AD IS Y1 Yn Y1 Yt Yn Output, Y Output, Y The Effects of a Monetary Expansion Looking Behind the Scene: IS-LM

  21. The Effects of a Monetary Expansion The Neutrality of Money A Summary 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

  22. Assume: G & T as constant AS AS´´ Price Level, P Short run • AD shifts to AD´ • Equilibrium from • A to A´ A A´´ Pn • Y falls to Y1 A´ P´ Medium run Pn´´ • P falls & AS shifts to • AS´´ • Equilibrium at A´´ • P at Pn´´ & Y at Yn AD AD´ Y1 Yn Output, Y A Decrease in the Budget Deficit

  23. AS´´ AS LM LM´ A LM´´ A´´ P´ Pn Interest Rate, i A i Price Level, P A´ Pn´´ i´ i1´ A´ B i´´ A´´ AD IS´ AD´ IS Y´ Y2 Yn Y1 Yn Output, Y Output, Y A Decrease in the Budget Deficit The Dynamic Effects of a Decrease in the Budget Deficit

  24. A Decrease in the Budget Deficit Budget 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

  25. A PS ( ) Real Wage, W/P A´ PS´ ( ´ > ) WS un´ un Unemployment Rate, u Changes in the Price of Oil Effects on the Natural Rate of Unemployment Assume an increase in the price of oil

  26. AS´´ AS´ AS Price Level, P A´´ Pt+n • increases A´ P´ A Pt-1 B AD Yn Y´ Y´n Output, Y Changes in the Price of Oil The Dynamics of Adjustment When oil prices increase: • Yndecreases to Yn´ • AS shifts up • A to A´ short-run • change • A to A´´ medium-run • change

  27. 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. Changes in the Price of Oil The Effects of the Increase in the Price of Oil1973-1975

  28. Short RunMedium Run Output Interest Price Output Interest Price Level 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 The AD-AS Model Conclusions

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