Monetary Theory: The AD/AS Model – Pt. I ECO 473 – Money & Banking – Dr. D. Foster

Warning .. Warning .. Warning Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!! The “static” analysis only hints at dynamic interpretation. Ceteris Paribus assumption problematic to the point of being wholly inappropriate. Contrasting views: Classical/Monetarist vs. Keynesian Friedman vs. Keynes Non-activist vs. Activist

The Aggregate Demand Schedule P P = Price Level; CPI or GDP deflator Q = Y = Real GDP; (real output) AD = Agg. Demand; From 4 sectors – HH, Bus, G, Foreign A P2 Q1 B P1 Q2 AD1 Q or R-GDP

AS/AD, the Money Supply and Long Run Equilibrium ASLR There is a “long run” Aggregate Supply, which is perfectly vertical at the “full employment” level of Real GDP. It is unaffected by changes in the price level, but is affected by a host of real variables… P1 Classical Model of the Economy AD1 Q or R-GDP

What affects the Aggregate Supply? Labor force participation. Labor productivity. Marginal tax rates on wages. Provision of government benefits that affect household incentives w.r.t. supply labor. State of technology. Capital stock. A change in these factors can AS (shift right) or AS (shift left)

QTM & The Aggregate Demand Schedule P MD  MS MS = k * P * Q MS/(k * P) = Q AD = MS/(k * P) AD3 MS/(k*P) Increases in MS AD2 MS/(k*P) Decreases in MS AD1 Q or R-GDP

AS/AD, the Money Supply and Long Run Equilibrium MS and that increases AD. MS and that decreases AD. P AS1 Shifts in AD can only change the price level and not real output (nor employment). “Inflation is always, and everywhere, a monetary phenomenon.” -Milton Friedman P1 AD1 Q or R-GDP

Short Run Aggregate Supply – Wage Inflexibility Nominal wages are sluggish upwards: A rise in prices has delayed effect on wages. Nominal wages are inflexible downwards: A fall in prices will result in employment and income. Workers have money illusion: Higher nominal wages are viewed as real wage. So, more workers available even though real wage has not risen. e.g. if prices rise 5% and wages rise 3%…

From SR to LR Aggregate Supply ASLR Equilibrium occurs when ASLR=ASSR=AD ASSR From Short Run to Long Run: Changes in AD will move equilibrium along SR AS. As wages “catch up” to prices, the SR AS will shift along the AD to the LR AS. P1 AD Q or R-GDP Q*

Monetary Theory: The AD/AS Model – Pt. I ECO 473 – Money & Banking – Dr. D. Foster