AS & AD

1. AS & AD Account for price movements

2. 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.

3. 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)

4. 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

5. 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

6. 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:

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. LRAS P AS(Pe) Y* Y

22. 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

23. THE KEYNESIAN PERSPECTIVE (4) • Here: flat LM: fiscal policy effective; monetary policy ineffective r LM1 LM2 E2 E1 IS2 IS1 0 Y1 Y2 y

24. 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

25. 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

26. 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

27. 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

28. INFLATION AND TREND OUTPUT: USA 1960-2005

29. 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)

30. 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

31. LRAS AS(Pce) P C AS(PAe) B A AD1 AD0 Y* Y

32. 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!

33. 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

34. 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

35. LRAS0 LRAS0 P AS(Pe) AS(Pe) AD0 Y1* Y* Y

36. 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

37. 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

38. LRAS P SRAS(P0e) SRAS(P1e) A B C AD0 AD1 Y* Y

39. 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

40. 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