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,Chapter 7: Putting All Markets Together: The AS-AD Model,Click to edit Master title style,*,Aggregate Supply,The,aggregate supply relation,captures the effects of output on the price level.,It is derived from the behavior of wages and prices.,Recall the equations for wage and price determination from chapter 6:,7-1,1,Aggregate Supply,Step 1: Eliminate the nominal wage from:,and, then:,In words, the price level depends on the expected price level and the unemployment rate. We assume that,and,z,are constant.,2,Aggregate Supply,Step 2: Express the unemployment rate in terms of output:,Therefore, for a given labor force, the higher is output, the lower is the unemployment rate.,3,Aggregate Supply,Step 3: Replace the unemployment rate in the equation obtained in step one:,In words, the price level depends on the expected price level,P,e, and the level of output,Y,(and also,z, and,L, but we take those as constant here),.,4,Aggregate Supply,The,AS,relation has two important properties:,An increase in output leads to an increase in the price level. This is the result of four steps:,5,An increase in the expected price level leads, one for one, to an increase in the actual price level. This effect works through wages:,Aggregate Supply,The,AS,relation has two important properties:,6,Aggregate Supply,Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level.,The Aggregate Supply Curve,Figure 7 - 1,7,Aggregate Supply,The,AS,curve has three properties that will prove to be useful in what follows:,The,AS,curve is upward sloping. As explained earlier, an increase in output leads to an increase in the price level.,The,AS,curve goes through point,A, where,Y,=,Y,n,and,P,=,P,e,. This property has two implications:,When,Y,Y,n,P,P,e,.,When,Y,Y,n,P,P,e,.,An increase in,P,e,shifts the,AS,curve up, and a decrease in,P,e,shifts the AS curve down.,8,Aggregate,Supply,An increase in the expected price level shifts the aggregate supply curve up.,The Effect of an Increase in the Expected Price Level on the Aggregate Supply Curve,Figure 7 - 2,9,Aggregate Supply,Lets summarize:,Starting from,wage determination,and,price,determination,in the labor market, we have derived the,aggregate supply,relation.,This means that for a given expected price level, the price level is an increasing function of the level of output. It is represented by an upward-sloping curve, called the,aggregate supply curve.,Increases in the expected price level shift the aggregate supply curve up; decreases in the expected price level shift the aggregate supply curve down.,10,Aggregate Demand,The,aggregate demand relation,captures the,effect of the price level on output(through the real money stock).,It is derived from the equilibrium conditions in the goods and financial markets.,Recall the equilibrium conditions for the goods and financial markets,described in chapter 5:,7-2,11,T,he changes in the real money stock can either,come from changes in nominal moneysupply ,M, or changes in the price level.,Using the IS and the LM relations, we can derive the relation between the price level and the level og output implied by equilibrium in the goods and financial markets .,12,Aggregate Demand,An increase in the price level leads to a decrease in output.,The Derivation of the Aggregate Demand Curve,Figure 7 - 3,13,Aggregate Demand,Changes in monetary or fiscal policyor more generally in any variable, other than the price level, that shift the,IS,or the,LM,curvesshift the aggregate demand curve.,The,IS curve,is downward sloping, the,LM,curve is upward sloping.,The negative relation between output and the price level is drawn as the downward-sloping curve,AD,.,14,Aggregate Demand,An increase in government spending increases output at a given price level, shifting the aggregate demand curve to the right. A decrease in nominal money decreases output at a given price level, shifting the aggregate demand curve to the left.,Shifts of the Aggregate Demand Curve,Figure 7 - 4,15,Aggregate Demand,Lets summarize:,Starting from the equilibrium conditions for the goods and financial markets,we have derived the,aggregate demand relation,.,This relation implies that the level of output is a decreasing function of the price level. It is represented by a downward-sloping curve, called the,aggregate demand curve,.,Changes in monetary or fiscal policy or more generally in any variable, other than the price level, that shifts the IS or the,LM,curves shift the aggregate demand curve.,16,Equilibrium in the ShortRun and in the Medium Run,For a given value of the expected price level,P,e,and for a given values of the monetary and fiscal policy variables M,G,T, these two relations determine the equilibrium values of output ,Y,and the price level ,p.,7-3,17,Equilibrium depends on the value of,P,e,. The value of,P,e,determines the position of the aggregate supply curve, and the position of the,AS,curve affects the equilibrium.,In short run,we can take,P,e,the price level expected by wage setters when they last set wages ,as given .But ,over time, P,e,is likely to changes ,shifting the aggregate supply curve ,and changing the equilbrium .,In this way ,we can describe the changes of equilbrium output from the short run to the medium run,18,Equilibrium in the Short Run,The equilibrium is given by the intersection of the aggregate supply curve and the aggregate demand curve. At point,A, the labor market, the goods market, and financial markets are all in equilibrium.,The Short Run Equilibrium,Figure 7 - 5,19,Equilibrium in the Short Run,The aggregate supply curve,AS,is drawn for a given value of,P,e,. The higher the level of output, the higher the price level.,The aggregate demand curve,AD,is drawn for given values of,M, G, and,T,. The higher the price level is, the lower the level of output.,20,The result tells us :,In the short run ,there is no reason why output should equal the natural level of output.It all depends on the specific values of the expected price level ,and the values of the variables affecting the position of aggregate demand.,T,hen what happens over times?,21,From the Short Runto the Medium Run,At point,A,Wage setters will revise upward their expectations of the future price level. This will cause the,AS,curve to shift upward.,Expectation of a higher price level also leads to a higher nominal wage, which in turn leads to a higher price,level which leads to a decrease in the real money stock .the interest rate increases,leading to a decrease in output.,22,From the Short Runto the Medium Run,The adjustment ends onceand wage setters no,longer have a reason to change their expectations.,In the medium run, output returns to the natural level of output.,23,In words:,The fact that output initially exceeds the natural level of output,this leads to Wage setters to revise upward their expectations of the future price level,leading to a higher price level ,which in turn leads to a higher nominal wage, which leads to a decrease in the real money stock ,which leads to the interest rate increases,leading to a decrease in output.,T,he adjustment stops when output is equal to the natural level of output.At that point ,the price level is equal to the expected price level ,expectation no longer change,and so ,output remains at the natural level of output.,24,From the Short Runto the Medium Run,If output is above the natural level of output, the,AS,curve shifts up over time, until output has decreased back to the natural level of output.,The Adjustment of Output over Time,Figure 7 - 6,25,From the Short Runto the Medium Run,Lets summarize:,In the,short run, output can be above or below the natural level of output. Changes in any of the variables that enter either the aggregate supply relation or the aggregate demand relation lead to changes in output and to changes in the price level.,In the,medium run, output eventually returns to the natural level of output. The adjustment works through changes in the price level.,26,The Effects of aMonetary Expansion,In the aggregate demand equation, we can see that an increase in nominal money,M, leads to an increase in the real money stock,M/P, leading to an increase in output. The aggregate demand curve shifts to the right.,7-4,27,The Dynamics of Adjustment,The increase in the nominal money stock causes the aggregate demand curve to shift to the right.,In the short run, output and the price level increase.,28,The Dynamic Effects ofa Monetary Expansion,The difference between,Y,and,Y,n,sets in motion the adjustment of price expectations.,In the medium run, the,AS,curve shifts to,AS,and the economy returns to equilibrium at,Y,n,.,The increase in prices is proportional to the increase in the nominal money stock.,29,The Dynamics of Adjustment,A monetary expansion leads to an increase in output in the short run, but has no effect on output in the medium run.,The Dynamic Effects of a Monetary Expansion,Figure 7 - 7,30,Going Behinds the Scenes,The impact of a monetary expansion on the interest rate can be illustrated by the,IS,-,LM,model.,The short-run effect of the monetary expansion is to shift the,LM,curve down. The interest rate is lower, output is higher.,31,Going Behinds the Scenes,If the price level did not increase, the shift in the,LM,curve would be largerto,LM,.,32,Going Behinds the Scenes,Over time, the price level increases, the real money stock decreases and the,LM,curve returns to where it was before the increase in nominal money.,In the medium run, the real money stock and the interest rate remain unchanged.,33,Going Behinds the Scenes,The increase in nominal money initially shifts the LM curve down, decreasing the interest rate and increasing output. Over time, the price level increases, shifting the LM curve back up until output is back at the natural level of output.,The Dynamic Effects of a Monetary Expansion on Output and the Interest Rate,Figure 7 - 8,34,The Neutrality of Money,In the,short run, a monetary expansion leads to an increase in output, a decrease in the interest rate, and an increase in the price level.,In the,medium run, the increase in nominal money is reflected entirely in a proportional increase in the price level.,The,neutrality of money,refers to the fact that an increase in the nominal money stock has no effect on output or the interest rate in the medium run. The increase in the nominal money stock is completely absorbed,by an increase in the price level.,35,A Decrease inthe Budget Deficit,The Dynamic Effects of a Decrease in the Budget Deficit,A decrease in the budget deficit leads initially to a decrease in output. Over time, output returns to the natural level of output.,7-5,Figure 7 - 9,36,How Long Lasting Are the Real Effects of Money?,Figure 1,The Effects of an Expansion in Nominal Money in the Taylor Model,Macroeconometric models,are larger-scale versions of the aggregate supply and aggregate demand model in this chapter. They are used to answer questions such as how long the real effects of money last.,37,Deficit Reduction, Output,and the Interest Rate,Since the price level declines in response to the decrease in output, the real money stock increases. This causes a shift of the,LM,curve to,LM,.,Both output and the interest rate are lower than before the fiscal contraction.,38,Deficit Reduction, Output,and the Interest Rate,The,LM,curve continues to shift down until output is back to to the natural level of output.,The interest rate is lower than it was before deficit,reduction.,39,Deficit Reduction, Output,and the Interest Rate,A deficit reduction leads in the short run to a decrease in output and to a decrease in the interest rate. In the medium run, output returns to its natural level, while the interest rate declines further.,The Dynamic Effects of a Decrease in the Budget Deficit on Output and the Interest Rate,Figure 7 - 10,40,Deficit Reduction, Output,and the Interest Rate,The composition of output is different than it was before deficit reduction.,Income and taxes remain unchanged, thus, consumption is the same as before.,Government spending is lower than before; therefore, investment must be higher than before deficit reductionhigher by an amount exactly equal to the decrease in,G,.,41,Budget Deficits, Output, and Investment,Lets summarize:,In the,short run, a budget deficit reduction, if implemented alone leads to a decrease in output and may lead to a,decrease,in investment.,In the,medium run, output returns to the natural level of output, and the interest rate is lower. A deficit reduction leads unambiguously to an,increase,in investment.,42,Changes in the Price of Oil,The Price of Crude Petroleum since 1960,There were two sharp increases in the relative price of oil in the 1970s, followed by a decrease in the 1980s and the 1990s.,7-6,Figure 7 - 11,43,Effects on the NaturalRate of Unemployment,The higher price of oil causes an increase in the markup and a downward shift of the price-setting line.,The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment,Figure 7 - 12,44,The Dynamics of Adjustment,An increase in the markup, caused by an increase in the price of oil, results in an increase in the price level, at any level of output,Y,. The aggregate supply curve shifts up.,45,The Dynamics of Adjustment,After the increase in the price of oil, the new,AS,curve goes through point,B, where output equals the new lower natural level of output,Y,n, and the price level equals P,e,.,The economy moves along the,AD,curve, from,A,to,A,. Output decreases from,Y,n,to,Y,.,46,The Dynamics of Adjustment,Over time, the economy moves along the AD curve, from A to A.,At point A, the economy has reached the new lower natural level of output, Yn, and the price level is higher than before the oil shock.,47,The Dynamics of Adjustment,An increase in the price of oil leads, in the short run, to a decrease in output and an increase in the price level. Over time, output decreases further and the price level increases further.,The Dynamic Effects of an Increase in the Price of Oil,Figure 7 - 13,48,The Dynamics of Adjustment,The combination of negative growth and high inflation, or stagnation accompanied by inflation, is called,stagflation,.,Table 7-1,The Effects of the Increase in the Price of Oil,1973-1975,1973,1974,1975,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 (%),4.9,5.6,8.5,49,Conclusions,The Short Run Versus the Medium Run,Table 7-2,Short-Run Effects and Medium-Run Effects of a Monetary Expansion, a Budget Deficit Reduction, and an Increase in the Price of Oil on Output, the Interest Rate, and the Price Level,Short Run,Medium Run,Output Level,Interest Rate,Price Level,Output Level,Interest Rate,Price Level,Monetary expansion,increase,decrease,increase(small),no change,no change,increase,Deficit reduction,decrease,decrease,decrease(small),no change,decrease,decrease,Increase in oil price,decrease,increase,increase,decrease,increase,increase,7-7,50,Conclusions,Output fluctuations,(sometimes called,business cycles,) are movements in output around its trend.,The economy is constantly hit by,shocks,to aggregate supply, or to aggregate demand, or to both.,Each shock has dynamic effects on output and its components. These dynamic effects are called the,propagation mechanism,of the shock.,Shocks and Propagation Mechanisms,51,Key Terms,aggregate supply relation,aggregate demand relation,neutrality of money,stagflation,output fluctuations,business cycles,shocks,propagation mechanism,52,Exercises,Olivier Blanchard :,Macroeconomics,Chap7: questions and problems 5,7,53,
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