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The AS-AD Model

The AS-AD 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 Supply. Captures the effects of output on the price level

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The AS-AD Model

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  1. The AS-AD 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

  2. Aggregate Supply • Captures the effects of output on the price level • It is derived from equilibrium in the labor market

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

  4. Aggregate Supply 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

  5. Aggregate Supply • The price level as a function of output instead of the unemployment rate

  6. Aggregate Supply-The price level as a function of output instead of the unemployment rate Observations • A higher expected price level leads, one for one, to a higher actual price level. • An increase in output leads to an increase in the price level.

  7. Aggregate Supply • Higher Pehigher P • PeWP • W=PeF(u,z) (PeW) • P=(1+µ)W (WP)

  8. Aggregate Supply Higher Outputhigher P YuWP Y=N(YN)

  9. Aggregate Supply Higher Outputhigher P W=PeF(u,z)(uW) P=(1+u)W(W P)

  10. 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:

  11. 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

  12. 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

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

  14. 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´

  15. 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)

  16. 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

  17. 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

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

  19. Equilibrium Output in the Short and the Medium Run

  20. 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

  21. Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level 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 Assume: Therefore: Pte = Pt-1

  22. Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level Pte = Pt-1 Given: Note: µ, z, M, G and T are assumed to be constant

  23. 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

  24. 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

  25. 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

  26. 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´´

  27. 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

  28. 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

  29. 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

  30. 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

  31. 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

  32. 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

  33. 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

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