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


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


Aggregate SupplyAggregate Supply

Captures the effects of output on the price level

It is derived from equilibrium in the labor market


The Determination of Aggregate Supply


Recall:Recall:

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


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


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


L

Y

L

N

L

uu 11

),()1( zuFPP e

),1()1( zL

YFPP e


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.



Higher Pehigher P

PeWP

W=PeF(u,z) (PeW)

P=(1+µ)W (WP)



Higher Outputhigher P

YNPuWP

Y=N(YN)

)()1( uNL

Nu



Higher Outputhigher P

W=PeF(u,z)(uW)

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


AS


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


AS´ (Pe´ > Pe)

AS (Pe)

Output, Y

Pri

ce L

evel

, P

Yn

Pe

A


Pe´

A´Observation:

Given Yn: changes in Pe shift the AS curve

Illustrating the impact of an increase in Pe


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



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

GiYITYCY ),()(

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

)(iYLP

M


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


LM (P)

IS

Y

i

Inte

res

t R

ate

, i

Output, Y

Inte

res

t R

ate

, i

Output, Y

A

AD


Y

A

P

LM´ (P´ > P)

A´P´

Y´

Deriving Aggregate Demand (AD)

Y´

i´

A´


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´


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´


LM´ (P)

Contractionary Monetary Policy Shifts AD

Y´

i´ A´

Y´

A´



Aggregate Demand:Aggregate Demand:

),,(

),,(

TGP

MYY

• Y is a decreasing function of P

• Shifts in IS or LM shift AD


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



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


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


What do you think…What do you think…


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


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

Assume:Assume:

Therefore:Therefore: Pte = Pt-1




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


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 Year t + 1

At A´: Yt+1 > Yn

A´

Pt+1

Yt+1

Pt+1 > Pet+1


B´ AS shifts to AS´


AS

Output, Y

Price Level, P

AD

Yt

Pt

A

Yn

AS´´


AS´

Yt+1

Pn

A´

A´´

Pt+1


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




Two ObservationsTwo Observations

Short Run: Output can be above or below Yn

Medium Run: Prices adjust to return output to Yn


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


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´


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

Y1

P´ A´

AS´

P´nA´´ A´´

LM (Pn´´)



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


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

The Taylor ModelThe Taylor Model


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


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


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´


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


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


AS´

AS

Output, Y

Price Level, P

AD

APt-1

Yn


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



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.


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?


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


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

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

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