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The AS-AD 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 Supply. - PowerPoint PPT Presentation
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Chapter 7: The AS-AD Model Slide #1Blanchard: 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 #2Blanchard: Macroeconomics
The Determination of Aggregate Supply
Aggregate SupplyAggregate Supply
Recall:Recall:
The nominal wage (W) = PeF(u,z)Price level (P) = (1+)W
So
P = Pe(1+) F (u,z)
Chapter 7: The AS-AD Model Slide #3Blanchard: Macroeconomics
Since
Aggregate SupplyAggregate Supply
L
Y
L
N
L
uu 11
),1()1( zL
YFPP e
Chapter 7: The AS-AD Model Slide #4Blanchard: Macroeconomics
Aggregate Supply-The price level as a function of Aggregate Supply-The price level as a function of outputoutput
),1()1( zL
YFPP e
1. A higher expected price level leads 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 #5Blanchard: Macroeconomics
Aggregate SupplyAggregate Supply
Higher Pehigher P
PeW since W=PeF(u,z)
WP since P=(1+µ)W
Higher Outputhigher P
YNuWP
since P=(1+u)W
Chapter 7: The AS-AD Model Slide #6Blanchard: 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 #7Blanchard: 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 #8Blanchard: 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 #9Blanchard: 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 #10Blanchard: 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 #11Blanchard: 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 #12Blanchard: 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 #13Blanchard: Macroeconomics
Aggregate Demand: SummaryAggregate Demand: Summary
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 #14Blanchard: 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 #15Blanchard: Macroeconomics
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: Pte = Pt-1
Where Pte = price level expected in year t
Chapter 7: The AS-AD Model Slide #16Blanchard: 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 #17Blanchard: 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 #18Blanchard: 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 #19Blanchard: 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 #20Blanchard: 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 #21Blanchard: 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 #22Blanchard: 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 #23Blanchard: 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 #24Blanchard: 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 #25Blanchard: 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 #26Blanchard: 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 #27Blanchard: 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 #28Blanchard: 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