The Determination of Aggregate Supply Aggregate Supply Recall: The nominal wage = W = P e F(u,z) Price level = P = (1+  )W So P = P e (1+  ) F (u,z)

Since Aggregate Supply

Aggregate Supply-The price level as a function of output 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.

Aggregate Supply Higher P e  higher P P e   W  since W = P e F(u,z) W  P  since P=(1+µ)W Higher Output  higher P Y  N  u  W  P  since P=(1+u)W

AS Aggregate Supply Output, Y Price Level, P YnYn PePe Graphically : P > P e P < P e A Two characteristics : 1. Given P e an increase in Y increases P 2. At A: Y = Yn & P = P e Observation: Y > Y n then P > P e Y < Y n then P < P e

AS´ (P e´ > P e ) AS (P e ) Output, Y Price Level, P YnYn PePe A Aggregate Supply P e´ A´ Observation : Given Y n : changes in P e shift the AS curve Illustrating the impact of an increase in P e

Aggregate Demand Goods Market (IS): Financial Market (LM):

Slide #8 LM´ (P´ > P) LM (P) Output, Y Interest Rate, i IS Y i A Initial Equilibrium Aggregate Demand IS – LM Equilibrium A´ i´ Y´ falls to 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 Interest Rate, i Output, Y Interest Rate, i Output, Y A AD Aggregate Demand Y A P LM´ (P´ > P) A´ P´ Y´ Deriving Aggregate Demand (AD) Y´ i´ A´

Slide #10 LM (P) IS Y i Interest Rate, i Output, Y AD Y Interest Rate, i Output, Y P A A IS´AD´ Aggregate Demand Greater Consumer Confidence Shifts AD Y´ A´ Y´ i´ A´

IS LM (P) Y i Interest Rate, i Output, Y AD Y Interest Rate, i Output, Y P A A AD´ Aggregate Demand LM´ (P) Contractionary Monetary Policy Shifts AD Y´ i´ A´ Y´ A´

Aggregate Demand: Summary Aggregate Demand: Y is a decreasing function of P Shifts in IS or LM shift AD

Equilibrium Output in the Short and the Medium Run AS Output, Y Price Level, P AD Y A Equilibrium P PePe YnYn B Observation: Short-run equilibrium Y may be greater than or less than Y n

P t = price level in year t P t-1 = price level in year t-1 P t+1 = price level in year t+1 Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level Assume: P t e = P t-1 Where P t e = price level expected in year t

AS (t) Output, Y Price Level, P AD (t) YtYt P e t+1 = P t A YnYn Equilibrium Year t At A: Y t > Y n P t > P e t = P t-1 P e t = P t-1 B AS´ (t+1) Equilibrium Output in the Short and the Medium Run Equilibrium Year t + 1 At A´: Y t+1 > Y n A´ P t+1 Y t+1 P t+1 > P e t+1 The dynamics of output and the price level B´ AS shifts to AS´

AS Output, Y Price Level, P AD YtYt PtPt A YnYn AS´´ Equilibrium Output in the Short and the Medium Run AS´ Y t+1 PnPn A´ A´´ P t+1 The dynamics of output and the price level Equilibrium after Y + 1 Output continues to fall Medium run equilibrium at P n, Y n Aggregate supply continues to shift to AS´´ Price level continues to increase

Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level Two Observations Short Run:Output can be above or below Y n Medium Run: Prices adjust to return output to Y n

Slide #18 AD AS Output, Y Price Level, P YnYn PnPn A AD´ The Effects of a Monetary Expansion YtYt A´ PtPt A´ equilibrium (Y t > Y n ) AS´´ A´´Pn´Pn´ AD shifts to AD´ M: Y t = Y(, G, T) AS shifts to AS´´ Equilibrium Y n at P n 10% increase in M leads to 10% increase in P

LM (P n ) YnYn PnPn AS AD IS Interest Rate, i Output, Y Interest Rate, i Output, Y A inin YnYn A LM´ (P´) A´ YtYt itit LM´´ (P n ) i Y1Y1 B AD´ The Effects of a Monetary Expansion Looking Behind the Scene: IS-LM Y1Y1 P´ A´ AS´ P´ n A´´ LM (P n ´´)

Slide #20 The Effects of a Monetary Expansion A Summary The 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

A Decrease in the Budget Deficit AD´ AS´´ AD AS Output, Y Price Level, P YnYn PnPn A Y1Y1 A´ P´ A´´ P n ´´ Assume: G & T as constant Equilibrium from A to A´ AD shifts to AD´ Y falls to Y 1 Short run P falls & AS shifts to AS´´ Equilibrium at A´´ P at P n ´´ & Y at Y n Medium run

Slide #22 AD AS YnYn PnPn A IS LM A i YnYn Output, Y Price Level, P Interest Rate, i Output, Y AD´ Y1Y1 A´ P´ IS´ Y´ i´ B LM´´ i´´ A´´ AS´´ P n ´´ A´´ LM´ Y2Y2 A´ i1´i1´ A Decrease in the Budget Deficit The Dynamic Effects of a Decrease in the Budget Deficit

A Decrease in the Budget Deficit Budget 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 Y n Interest rate is lower Investment increases Long Run I increases Y increases

Real Wage, W/P WS PS ( ) unun Unemployment Rate, u A PS´ ( ´ > ) Changes in the Price of Oil Effects on the Natural Rate of Unemployment un´un´ A´ Assume an increase in the price of oil

AS´ AS Output, Y Price Level, P AD A P t-1 YnYn Changes in the Price of Oil The Dynamics of Adjustment AS´´ A´´ P t+n A´ P´ Y´ When oil prices increase: Y n decreases to Y n ´ AS shifts up A to A´ short-run change A to A´´ medium-run change increases B Y´ n

Changes in the Price of Oil The Effects of the Increase in the Price of Oil Rate of change of petroleum price (%) Rate of change of GDP deflator (%) Rate of GDP growth (%) Unemployment rate (%) Source: Economic Report of the President, 1997.

The AD-AS Model Conclusions Short RunMedium Run OutputInterestPriceOutputInterestPrice LevelRateLevelLevelRateLevel Monetary expansionincreasedecreaseincreaseno change no change increase (small) Deficit reductiondecreasedecreasedecreaseno change decrease decrease (small) Increase in oil pricedecreaseincreaseincreasedecreaseincreaseincrease