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AS & AD. Account for price movements. AGGREGATE DEMAND AND SUPPLY. So far, we have assumed for simplicity that in the short-run, general Price and Wage levels are fixed. This means that changes in Demand lead to changes in real GDP, and not prices.

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as ad

AS & AD

Account for price movements

aggregate demand and supply
AGGREGATE DEMAND AND SUPPLY
  • So far, we have assumed for simplicity that in the short-run, general Price and Wage levels are fixed.
  • This means that changes in Demand lead to changes in real GDP, and not prices.
  • However, it is clear that prices and wages adjust over time, and that we have to relax the fixed-price assumption.
  • One way of looking at this is to derive Aggregate Supply and Demand curves, where real demand and supply (GDP) are related to the general price level
  • We can then see how changes to demand (from fiscal and monetary policy actions, etc) interact to produce changes in Real GDP and the price level.
  • This will be a first step towards looking at Inflation.
changing p and m s p
CHANGING P AND MS/P
  • Suppose the general price level changes (and nothing else changes – i.e. ceteris paribus)
  • The immediate effect is that the Real Money Supply changes:
  • ms Ms/P so as P increases, real money supply (ms) decreases, assuming nominal money supply is (Ms) unchanged
  • A lower ms immediately implies an excess of md over ms , and thus a higher interest rate (r)
  • In turn this leads to a lower level of total demand for output (i.e. aggregate demand) because: Ip = Ia + b.r (b <0)
  • A graphical version: (note P2 > P1 > P0)
changes in p and aggregate demand
CHANGES IN P AND AGGREGATE DEMAND

r

  • Effect of P on AD

LM2

LM1

LM0

r2

r1

r0

As P increases, real

ms falls, r increases,

AD falls

IS

0

Y

Y2

Y1

Y0

P

P2

P1

P0

AD

Y

0

Y2

Y1

Y0

slope of is curve and ad curve
SLOPE OF IS-CURVE AND AD-CURVE

r

LM2

LM1

LM0

The IS-Curve shows how Y

Responds to changes in r

ISA

ISB

0

Y

ISB is steeper than ISA

Result: steeper ADB

P

ADA

ADB

Y

0

aggregate demand shifts
AGGREGATE DEMAND SHIFTS
  • Monetary Policy: An expansion of Ms, leading to a real expansion of (Ms/P) will boost Aggregate Demand, via lower interest rates. This is depicted as a shift in the AD curve.
  • Later we will see that if there is an inflationary result, this will further lower the real interest rate (= nominal int rate minus inflation)
  • Fiscal Policy: an increase in G or a reduction in T (fiscal stimulus) will increase AD at any given interest rate and price level: again a shift in the AD curve.
  • We can illustrate these diagrammatically:
monetary expansion and ad shift
MONETARY EXPANSION AND AD-SHIFT

r

  • Effect of Ms on AD

LM0

LM1

LM2

r0

r1

As Ms increases, real

ms increases, r falls,

AD increases (shifts up)

r2

IS

0

Y

Y0

Y1

Y2

P

P assumed constant, but

the exact outcome will

depend on AS as well (later)

P0

AD2

AD1

AD0

0

Y

Y0

Y1

Y2

a fiscal stimulus and ad shift
A FISCAL STIMULUS AND AD-SHIFT

r

  • Effect of (G – T) on AD

LM

r1

r0

As (G – T) increases,

IS shifts, AD increases

(shifts out)

IS1

IS0

0

Y

Y0

Y1

P

P assumed constant, but

the exact outcome will

depend on AS as well (later)

P0

AD1

AD0

0

Y

Y0

Y1

labour market and agg supply 1
LABOUR MARKET AND AGG. SUPPLY (1)
  • How does the Supply of Output respond to changes in the Price level?
  • Output (Y): Y = f(N, K)
  • MPN : dY/dN > 0 and d2Y/dN2 < 0
  • Firms employ labour (N) such that wage (W) = P. MPN
  • or: W/P = MPN
  • Next, some assumptions about price and wage flexibility.
  • In the short run we can assume that most prices respond to supply and demand shocks
  • However wage rates are an exception: typically wages are viewed as being inflexible in the short-run: wage contracts are negotiated for periods of 1 to 3 years, for a variety of reasons
  • Initially Nd = f(W/P); dNd /dw < 0 Ns = g(W/P); dNs /dw > 0
  • Where w  W/P
labour market and agg supply 2
LABOUR MARKET AND AGG. SUPPLY (2)
  • Initial equilibrium at W/P0, etc

If P increases,

W/P1falls , and

Nd increases to N1

W/P

Ns

W/P1 is not a full

Equilibrium: not

on Ns curve. Upward

pressure on W

W/P0

W/P1

Long-run adjustment

Increases W, restores

W/P, and N  N0

Nd

0

N

N1

N0

short run aggregate supply 1
SHORT-RUN AGGREGATE SUPPLY (1)
  • If W is relatively inflexible (compared with P), then the short-run response is that Output tends to increase when P rises, because real w falls, and tends to fall when P falls (because real w increases).
  • Hence an upward-sloping S.R Aggregate Supply curve:

P

SAS

0

Y

short run aggregate supply 2
SHORT-RUN AGGREGATE SUPPLY (2)
  • P increases to P2, W1 constant: w decreases, N increases, Y increases

P

SAS

W1

P2

P1

w

Y

w2

w1

Y2

Y1

ND

N1

N2

Y=f(N, K)

N

long run aggregate supply
LONG-RUN AGGREGATE SUPPLY
  • P increases to P2, W2 eventually adjusts: SAS shifts; LAS vertical

P

LAS

SAS1

W2

W1

SAS2

P2

P1

w

Y

w1

Y1

ND

N1

Y=f(N, K)

N

response to ad shocks sr
RESPONSE TO AD SHOCKS (SR)
  • SAS  vertical as Y  Y*
  • AD1  AD2: small Pa, large Ya
  • AD3  AD4: larger Pb, smaller Yb

P

SAS

Pb

Pa

AD3

AD4

AD1

AD2

0

Y

Yb

Ya

response to ad shocks lr
RESPONSE TO AD SHOCKS (LR)
  • Initially AD-shift increases Y  Y2
  • In LR, AS  SAS2 and LAS  P3, Y1

LAS

P

SAS2

SAS1

P3

P2

P1

AD2

AD1

0

Y

Y1

Y2

keynesian versus classical views
KEYNESIAN VERSUS CLASSICAL VIEWS
  • Prior to the great Depression of the 1930s the prevailing (“Classical”) view was that the Macroeconomy tended to full-employment equilibrium
  • Deviations were viewed as short-lived, and the key to adjustment was flexibility of prices and wages
  • The experience of the 1930s shattered this view, and the Keynesian perspective became dominant
  • Much later, in the late 60s and the 70s, the Keynesian orthodoxy was obviously deficient in dealing with inflation.
  • Also with “fine-tuning” to counter relatively mild recessions was seen to be problematic: hence a revival of classical and monetarist views
  • Recently, the emergence of a very serious recession, with echoes of the 1930s prompts a renewed emphasis on Keynes
the keynesian perspective 1
THE KEYNESIAN PERSPECTIVE (1)
  • What Keynes demonstrated was that an economy could get trapped in a high-unemployment equilibrium: this necessitated government policy intervention, primarily in the form of a fiscal stimulus.
  • The experience of the 1930s stemmed from a rapid expansion of credit in the 1920s, overinvestment in housing and other assets, followed by a financial collapse. The result of this was a drastic fall in Aggregate Demand. (sounds familiar?)
  • Fiscal expansion was the only way to counter this Aggregate Demand deficiency: Monetary policy alone would not work
  • What we need to understand is why the economy might be stuck in an under-employment equilibrium and why decisive fiscal policy measures might be necessary to solve the problem
the keynesian perspective 2
THE KEYNESIAN PERSPECTIVE (2)
  • Keynes argued that Nominal Wages are relatively inflexible, even when there is high unemployment and perhaps price deflation
  • However what matters is the real wage (W/P), and if there is a need to reduce real wages (W/P), then perhaps increasing P rather than reducing W may be more effective.
  • This may be because of Money Illusion (an idea which we sometimes find troublesome): however if W is reduced, do people perceive that it may apply to them only? (i.e. relative as well as absolute W)
  • Falling P may increase (Ms/P). Result:
    • falling r boosts AD (Keynes effect)
    • increase in (Ms/P) increases real wealth and thus AD (Pigou effect)
  • But real value of Debt also increases in a Deflation
  • Also expectations of further deflation may depress AD
the keynesian perspective 3
THE KEYNESIAN PERSPECTIVE (3)
  • Keynes also argued that Md may become practically infinitely elastic at low interest rates (liquidity preference theory)
  • This effectively limits the scope for reductions in interest rates as a stimulant to AD
  • Note that even if the nominal interest rate should go to zero, deflation implies a higher real interest rate, and so monetary policy may inevitably be quite restrictive in a deflation

r = i – e

  • So if e = – 4% and i = 1%, then r = +5%
  • However there are problems:
    • information and timing of fiscal interventions financing
    • public debt accumulation
summary of as
Summary of AS
  • We have a distinction between short run and long run
  • The Short run is for fixed expectations
    • AS(Pe)
    • SRAS
    • Quite flat: Explains why ISLM works as approx
  • LR is how long it takes for real wages to adjust
    • Expectations adjust
    • Workers to act on exp
    • ISLM wont work in LR
  • In LR Y is unaffected by P
slide21

LRAS

P

AS(Pe)

Y*

Y

slide22
Note the Notation AS(Pe)
    • Alternative to SAS
    • Makes explicit that the SR is for fixed price expectations
    • When price expectations change workers (and others) will demand higher wages
    • SAS will shift up
  • What determines Y*?
    • Natural rate
    • Incentives
    • Technology
    • “growth”
    • Not anything that just affects price
the keynesian perspective 4
THE KEYNESIAN PERSPECTIVE (4)
  • Here: flat LM: fiscal policy effective; monetary policy ineffective

r

LM1

LM2

E2

E1

IS2

IS1

0

Y1

Y2

y

the keynesian perspective 5
THE KEYNESIAN PERSPECTIVE (5)
  • Here: inelastic IS curve: monetary policy ineffective; fiscal policy effective

r

IS1

IS2

LM1

LM2

E2

E1

0

Y1

Y2

y

the keynesian perspective 6
THE KEYNESIAN PERSPECTIVE (6)
  • The problem may also be shown in terms of AS and AD
  • Shock to AD; SAS may be slow to change

P

LAS

SAS0

AD 1931, 2009

AD 1929, 2007

0

Y0

Y*

Y

sr impact of ad and as shocks 1
SR IMPACT OF AD AND AS SHOCKS (1)
  • AD: positive shock  inflationary pressure
  • Implies positive correlation between inflation and output, etc

AS

P

AD2

AD1

0

Y

sr impact of ad and as shocks 2
SR IMPACT OF AD AND AS SHOCKS (2)
  • AS: negative shock  inflationary pressure
  • Implies negative correlation between inflation and output, etc

AS2

AS1

P

AD

0

Y

policy in as ad model
Policy in AS-AD Model
  • Suppose there is an increase in G
  • AD shifts right
    • For all P, there is higher AD, because govt component has risen
    • Could derive this from IS-LM
    • Same for MP
  • For fixed expectations i.e. SR
    • Move along AS
    • New (temp) eqm at B
    • Y increases
    • P increases (but not by much)
slide30
P rising implies real wage falling
    • P>Pe
  • Pe will adjust upwards
    • W increase
    • SRAS shifts up
  • Keep going until output returns to “natural level”
  • How long does transition take?
    • Theory: depends. Instantaneous?
    • Empirics: about 2 years – see diagram
slide31

LRAS

AS(Pce)

P

C

AS(PAe)

B

A

AD1

AD0

Y*

Y

slide32
Be clear on the reasons why there is no long run effect
    • In order to get more output need to pay more people higher wages
    • Higher wages imply firms need to charge higher prices
    • Higher prices negate the higher wages as far as workers are concerned
    • We go back to original values of real variables
    • Only affect nominal variables
  • Policy is ineffective!
slide33
We can only get an increase in Y in long run i.e. increase in Y*
    • If induce people to work more
    • Need increase in real wage
    • Technology
    • Efficiency
    • Lower taxes?
      • Reganomics
      • Supply side economics
      • Voodoo economics
reagan style tax cut
Reagan Style Tax Cut
  • Cut personal taxes
    • Idea is that this will improve incentives
    • People will work more
    • Shift the LRAS to the right
    • Increase Y* and reduce P
    • Note that SRAS shifts also as expectations adjust to the new lower level
  • But cutting taxes will shift the AD curve to right
    • SR boom
    • LR return to Y* with higher P
  • Which happened?
    • Both
    • Demand effect larger
slide35

LRAS0

LRAS0

P

AS(Pe)

AS(Pe)

AD0

Y1*

Y*

Y

dealing with shocks
Dealing With Shocks
  • The AS-AD diagram shows how an economy will automatically adjust to a shock
  • Start from LR eqm
    • Y=Y*
    • Pe=P
  • Suppose there is a fall in AD
    • Eqm moves from A to B
    • Y<Y*
  • This can only be a temporary eqm
slide37
At B, P<Pe
    • Real wages are higher than expected
      • Prices fall, but by more than nominal wages
      • See labour market diagram
    • Workers are expensive
    • Explains the decline in output
    • Over time workers will
      • Reduce price expectations
      • Reduce wage demands
      • SRAS shifts down
  • Process continues until LR eqm is restored at C
    • Real wage returns to original level
    • Y=Y*
    • Pe=P but at new lower level
slide38

LRAS

P

SRAS(P0e)

SRAS(P1e)

A

B

C

AD0

AD1

Y*

Y

slide39
So the economy will automatically work itself out of recession
  • Mechanism depends on wage adjustment
    • Mirror image of previous discussions
    • Workers respond to lower prices by demanding lower wages
    • Reasonable?
      • Yes real wages return to normal
      • No long term decline in real wages
    • Realistic?
      • No! see data
      • Nominal wages are rigid
  • Have to wait for productivity
    • Have lower wage increases than otherwise
slide40
All this takes time
    • 3+ years
  • Alternative is for Government to expand AD
    • Shift AD back
    • Return to long run equilibrium A
  • Rationale for stabilization policy
    • After WTC, cut interest rates
    • Enough? Or too much?
  • Debate over which is best
    • Policy: “long and variable lags”
    • Automatic: “long run we are all dead”
    • Calls for “flexibility” after EMU