chapter 7: the as-ad modelblanchard: macroeconomics slide #1 chapter topics aggregate supply...

Chapter 7: The AS-AD Model Slide #1Blanchard: Macroeconomics

Chapter TopicsChapter Topics

Aggregate Supply

Aggregate Demand

Equilibrium Output in Short and Medium Run

The Effects of a Monetary Expansion

A Decrease in the Budget Deficit

Changes in the Price of Oil

Chapter 7: The AS-AD Model Slide #2Blanchard: Macroeconomics

The The AS-ADAS-AD Model 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

Chapter 7: The AS-AD Model Slide #3Blanchard: Macroeconomics

Aggregate SupplyAggregate Supply

Captures the effects of output on the price level

It is derived from equilibrium in the labor market

Chapter 7: The AS-AD Model Slide #4Blanchard: Macroeconomics

The Determination of Aggregate Supply

Aggregate SupplyAggregate Supply

Recall:Recall:

The nominal wage (W) = PeF(u,z)Price level (P) = (1+)WP = Pe(1+) F (u,z)

Chapter 7: The AS-AD Model Slide #5Blanchard: Macroeconomics

According to:

Aggregate SupplyAggregate Supply

P = Pe(1+) F (u,z)

The price level (P) is a function of:• Pe: The expected price level• u: The unemployment rate

Chapter 7: The AS-AD Model Slide #6Blanchard: Macroeconomics

The price level as a function of output instead of the unemployment rate

Aggregate SupplyAggregate Supply

L

Y

L

N

L

uu 11

),()1( zuFPP e

),1()1( zL

YFPP e

Chapter 7: The AS-AD Model Slide #7Blanchard: Macroeconomics

Aggregate Supply-The price level as a function of Aggregate Supply-The price level as a function of output instead of the unemployment rateoutput instead of the unemployment rate

),1()1( zL

YFPP e

ObservationsObservations

1. A higher expected price level leads, one for one, to a higher actual price level.

2. An increase in output leads to an increase in the price level.

Chapter 7: The AS-AD Model Slide #8Blanchard: Macroeconomics

Aggregate SupplyAggregate Supply

Higher Pehigher P

PeWP

W=PeF(u,z) (PeW)

P=(1+µ)W (WP)

Chapter 7: The AS-AD Model Slide #9Blanchard: Macroeconomics

Aggregate SupplyAggregate Supply

Higher Outputhigher P

YNPuWP

Y=N(YN)

)()1( uNL

Nu

Chapter 7: The AS-AD Model Slide #10Blanchard: Macroeconomics

Aggregate SupplyAggregate Supply

Higher Outputhigher P

W=PeF(u,z)(uW)

P=(1+u)W(W P)

Chapter 7: The AS-AD Model Slide #11Blanchard: Macroeconomics

AS

Aggregate SupplyAggregate Supply

Output, Y

Pri

ce L

evel

, P

Yn

Pe

Graphically:

P >

Pe

P < Pe

A

Two characteristics:

1. Given Pe an increase in Y increases P2. At A: Y = Yn & P = Pe

Observation:Y > Yn then P > Pe

Y < Yn then P < Pe

Chapter 7: The AS-AD Model Slide #12Blanchard: Macroeconomics

AS´ (Pe´ > Pe)

AS (Pe)

Output, Y

Pri

ce L

evel

, P

Yn

Pe

A

Aggregate SupplyAggregate Supply

Pe´

A´Observation:

Given Yn: changes in Pe shift the AS curve

Illustrating the impact of an increase in Pe

Chapter 7: The AS-AD Model Slide #13Blanchard: Macroeconomics

Aggregate DemandAggregate Demand

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

Chapter 7: The AS-AD Model Slide #14Blanchard: Macroeconomics

Aggregate DemandAggregate Demand

Goods Market (IS):Goods Market (IS):

GiYITYCY ),()(

Financial Market (LM):Financial Market (LM):

)(iYLP

M

Chapter 7: The AS-AD Model Slide #15Blanchard: Macroeconomics

LM´ (P´ > P)

LM (P)

Output, Y

Inte

rest

Rat

e, i

IS

Y

iA

Initial Equilibrium

Aggregate DemandAggregate DemandIS – LM Equilibrium

A´i´

Y´

• falls to P

M

´P

M

• LM shifts to LM´ (P´ > P)

• Equilibrium to A´

• i to i´ & Y to Y´

• Assume P increases to P´ & M is fixed

Chapter 7: The AS-AD Model Slide #16Blanchard: Macroeconomics

LM (P)

IS

Y

i

Inte

res

t R

ate

, i

Output, Y

Inte

res

t R

ate

, i

Output, Y

A

AD

Aggregate DemandAggregate Demand

Y

A

P

LM´ (P´ > P)

A´P´

Y´

Deriving Aggregate Demand (AD)

Y´

i´

A´

Chapter 7: The AS-AD Model Slide #17Blanchard: Macroeconomics

LM (P)

IS

Y

i

Inte

res

t R

ate

, i

Output, Y

AD

Y

Inte

res

t R

ate

, i

Output, Y

P

A

A

IS´ AD´

Aggregate DemandAggregate DemandGreater Consumer Confidence Shifts AD

Y´

A´

Y´

i´ A´

Chapter 7: The AS-AD Model Slide #18Blanchard: Macroeconomics

IS

LM (P)

Y

i

Inte

res

t R

ate

, i

Output, Y

AD

Y

Inte

res

t R

ate

, i

Output, Y

P

A

A

AD´

Aggregate DemandAggregate Demand

LM´ (P)

Contractionary Monetary Policy Shifts AD

Y´

i´ A´

Y´

A´

Chapter 7: The AS-AD Model Slide #19Blanchard: Macroeconomics

Aggregate DemandAggregate Demand

Aggregate Demand:Aggregate Demand:

),,(

),,(

TGP

MYY

• Y is a decreasing function of P

• Shifts in IS or LM shift AD

Chapter 7: The AS-AD Model Slide #20Blanchard: Macroeconomics

Equilibrium Output in the Short Equilibrium Output in the Short and the Medium Runand the Medium Run

),1()1(:AS zL

YFPP e

),,(:AD TGP

MYY

Chapter 7: The AS-AD Model Slide #21Blanchard: Macroeconomics

Equilibrium Output in the Short Equilibrium Output in the Short and the Medium Runand the Medium Run

AS

Output, Y

Pri

ce L

evel

, P

AD

Y

A

EquilibriumP

Pe

Yn

B

Observation:Equilibrium Y may be greater than or less than Yn

Chapter 7: The AS-AD Model Slide #22Blanchard: Macroeconomics

If equilibrium Y is greater than Yn, will the economy automatically move to Yn over time?

Equilibrium Output in the Short Equilibrium Output in the Short and the Medium Runand the Medium Run

What do you think…What do you think…

Chapter 7: The AS-AD Model Slide #23Blanchard: Macroeconomics

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

Equilibrium Output in the Short Equilibrium Output in the Short and the Medium Runand the Medium Run

The dynamics of output and the price levelThe dynamics of output and the price level

Assume:Assume:

Therefore:Therefore: Pte = Pt-1

Chapter 7: The AS-AD Model Slide #24Blanchard: Macroeconomics

Equilibrium Output in the Short Equilibrium Output in the Short and the Medium Runand the Medium Run

The dynamics of output and the price levelThe dynamics of output and the price level

Given:Given:

Note:Note:

Pte = Pt-1

),1()1(:AS 1 zL

YFPP tt

),,(:AD TGP

MYY

tt

µ, z, M, G and T are assumed to be constant

Chapter 7: The AS-AD Model Slide #25Blanchard: Macroeconomics

AS(t)

Output, Y

Price Level, P

AD(t)

Yt

Pet+1 = Pt

A

Yn

Equilibrium Year t

At A: Yt > Yn

Pt > Pet = Pt-1

Pet = Pt-1 B

AS´ (t+1)

Equilibrium Output in the Short Equilibrium Output in the Short and the Medium Runand the Medium Run

Equilibrium Year t + 1

At A´: Yt+1 > Yn

A´

Pt+1

Yt+1

Pt+1 > Pet+1

The dynamics of output and the price levelThe dynamics of output and the price level

B´ AS shifts to AS´

Chapter 7: The AS-AD Model Slide #26Blanchard: Macroeconomics

AS

Output, Y

Price Level, P

AD

Yt

Pt

A

Yn

AS´´

Equilibrium Output in the Short Equilibrium Output in the Short and the Medium Runand the Medium Run

AS´

Yt+1

Pn

A´

A´´

Pt+1

The dynamics of output and the price levelThe dynamics of output and the price level

Equilibrium after Y + 1

• Output continues to fall

• Medium run equilibrium at Pn, Yn

• Aggregate supply continues to shift to AS´´

• Price level continues to increase

Chapter 7: The AS-AD Model Slide #27Blanchard: Macroeconomics

Equilibrium Output in the Short Equilibrium Output in the Short and the Medium Runand the Medium Run

The dynamics of output and the price levelThe dynamics of output and the price level

Two ObservationsTwo Observations

Short Run: Output can be above or below Yn

Medium Run: Prices adjust to return output to Yn

Chapter 7: The AS-AD Model Slide #28Blanchard: Macroeconomics

AD

AS

Output, Y

Price Level, P

Yn

Pn A

AD´

The Effects of a Monetary The Effects of a Monetary ExpansionExpansion

Yt

A´Pt

• A´ equilibrium (Yt > Yn)

AS´´

A´´Pn´

• AD shifts to AD´

• M: Yt = Y( , G, T)tP

M

• AS shifts to AS´´

• Equilibrium Yn at Pn

• 10% increase in M leads to 10% increase in P

Chapter 7: The AS-AD Model Slide #29Blanchard: Macroeconomics

LM (Pn)

Yn

Pn

AS

AD IS

Inte

res

t R

ate

, i

Output, Y

Inte

res

t R

ate

, i

Output, Y

A

in

Yn

A

LM´ (P´)

A´

Yt

it

LM´´ (Pn)

i

Y1

BAD´

The Effects of a Monetary The Effects of a Monetary ExpansionExpansion

Looking Behind the Scene: IS-LMLooking Behind the Scene: IS-LM

Y1

P´ A´

AS´

P´nA´´ A´´

LM (Pn´´)

Chapter 7: The AS-AD Model Slide #30Blanchard: Macroeconomics

The Effects of a Monetary The Effects of a Monetary ExpansionExpansion

A Summary

The Neutrality of MoneyThe Neutrality of Money

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

Chapter 7: The AS-AD Model Slide #31Blanchard: Macroeconomics

How Long Lasting are the Real How Long Lasting are the Real Effects of Money?Effects of Money?

The Taylor ModelThe Taylor Model

Chapter 7: The AS-AD Model Slide #32Blanchard: Macroeconomics

How Long Lasting are the Real How Long Lasting are the Real Effects of Money?Effects of Money?

The Mishkin ModelThe Mishkin Model

Quarters 0 2 4 6 12 16

Effects on outputAnticipated 1.3 1.9 1.8 1.3 0.7 -0.6Unanticipated 2.0 2.3 2.2 2.0 0.5 -0.4

Chapter 7: The AS-AD Model Slide #33Blanchard: Macroeconomics

A Decrease in the Budget DeficitA Decrease in the Budget Deficit

AD´

AS´´

AD

AS

Output, Y

Price Level, P

Yn

PnA

Y1

A´P´

A´´Pn´´

Assume: G & T as constant

• Equilibrium from A to A´

• AD shifts to AD´

• Y falls to Y1

Short run

• P falls & AS shifts to AS´´

• Equilibrium at A´´ P at Pn´´ & Y at Yn

Medium run

Chapter 7: The AS-AD Model Slide #34Blanchard: Macroeconomics

AD

AS

Yn

PnA

IS

LM

Ai

Yn

Output, Y

Pri

ce

Le

ve

l, P

Inte

res

t R

ate

, i

Output, Y

AD´

Y1

A´P´

IS´

Y´

i´ B

LM´´

i´´ A´´

AS´´

Pn´´ A´´

LM´

Y2

A´i1´

A Decrease in the Budget DeficitA Decrease in the Budget Deficit

The Dynamic Effects of a Decrease in the Budget DeficitThe Dynamic Effects of a Decrease in the Budget Deficit

Chapter 7: The AS-AD Model Slide #35Blanchard: Macroeconomics

A Decrease in the Budget DeficitA Decrease in the Budget Deficit

Budget Deficits, Output, and Investment -A SummaryBudget 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

Chapter 7: The AS-AD Model Slide #36Blanchard: Macroeconomics

Rea

l W

age,

W/P

WS

11

PS ( )

un Unemployment Rate, u

A

´1

1

PS´ ( ´ > )

Changes in the Price of OilChanges in the Price of Oil

Effects on the Natural Rate of UnemploymentEffects on the Natural Rate of Unemployment

un´

A´

Assume an increase in the price of oil

Chapter 7: The AS-AD Model Slide #37Blanchard: Macroeconomics

AS´

AS

Output, Y

Price Level, P

AD

APt-1

Yn

Changes in the Price of OilChanges in the Price of Oil

The Dynamics of AdjustmentThe Dynamics of AdjustmentAS´´

A´´Pt+n

A´P´

Y´

When oil prices increase:

• Yn decreases to Yn´

• AS shifts up

• A to A´ short-run change

• A to A´´ medium-run change

• increases

B

Y´n

Chapter 7: The AS-AD Model Slide #38Blanchard: Macroeconomics

Changes in the Price of OilChanges in the Price of Oil

The Effects of the Increase in the Price of Oil1973-1975

The Effects of the Increase in the Price of Oil1973-1975

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.

Chapter 7: The AS-AD Model Slide #39Blanchard: Macroeconomics

Why Has Japan Done So Poorly in Why Has Japan Done So Poorly in the 1990s?the 1990s?

Japanese Macroeconomic Variables1992-1998

Japanese Macroeconomic Variables1992-1998

1992 1993 1994 1995 1996 1997 1998

Output growth (%) 1.0 0.3 0.6 1.5 3.9 0.8 -2.6

Inflation* (%) 1.7 0.6 0.2 -0.6 -0.5 0.6 0.7

Budget surplus (% of GDP) 1.5 -1.6 -2.3 -3.6 -4.3 -3.3 -6.1

Short-term interest rate 4.5 3.0 2.2 1.2 0.6 0.6 0.7

*Inflation: Rate of change of the GDP deflator.Source: OECD Economic Outlook December 1998.

Has it been the result of a shift in AD or AS?Has it been the result of a shift in AD or AS?

Chapter 7: The AS-AD Model Slide #40Blanchard: Macroeconomics

The The AD-AS AD-AS ModelModel

ConclusionsConclusions

Short Run Medium Run

Output Interest Price Output Interest PriceLevel 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

Chapter 7: The AS-AD Model Slide #41Blanchard: Macroeconomics

The The AD-AS AD-AS ModelModel

Shocks and Propagation MechanismsShocks and Propagation Mechanisms

• The economy is impacted by AD and AS shocks

• The shocks have dynamic effects on P and Y

• The dynamic effects or propagation mechanisms vary in accordance to the shock