LECTURE 7 The AS-AD model Øystein Børsum 28 th February 2006

Overview of forthcoming lectures Lecture 7: Aggregate demand and aggregate supply  Macroeconomic dynamics in the AS-AD model Lecture 8: Stabilization policies  Goals for stabilization policies: Stable output and inflation  Optimal policy rule: Demand and supply shocks Lecture 9: Limits to stabilization policies  Rational expectations and the Policy Ineffectiveness Proposition, the Ricardian Equivalence Theorem and the Lucas Critique  Policy rules versus discretion: Credibility of economic policy  Real business cycles (section 19.4) Lecture 10: Open economy

Overview of the AS-AD model with endogenous monetary policy On a compact form, the SRAS-LRAS-AD model can be analyzed as a two-equation model in the (y;  ) space A temporary, negative supply shock increases inflation and lowers output. Adjustment to equilibrium is gradual A temporary, positive demand shock increases inflation and temporarily increases output. Output “undershoots” its long-run value in a gradual adjustment to equilibrium These dynamic development of the model after a temporary shock can be computed by two first-order difference equations Permanent shocks may change the long-run equilibrium values of output and the real interest rate Simulations show that a modified version of this AS-AD model can reproduce stylized business cycle facts

Elements of aggregate supply and aggregate demand

Compact form of the AS-AD model The AD curve can be re-written on a more compact form: Replacing expected inflation in the short-run AS curve gives: where

Graphical illustration of the AD-SRAS-AS relationships Illustration of a short-run macroeconomic equilibrium where output below its natural, long-run value

Example 1: A temporary negative supply shock Temporary negative supply shock: s 1 > 0 (with s 2, s 3, … = 0) Shifts the SRAS vertically by s 1 The long-run AS is not affected (natural level of output unchanged) Some possible interpretations: Industrial conflict, bad harvest, (exogenous increase in production costs) or temporary producer cartel (e.g. OPEC)

The path to long-run equilibrium after a temporary negative supply shock is gradual Illustration of the path from short to long-run macroeconomic equilibrium after a negative supply shock

Example 2: A temporary positive demand shock Temporary positive demand shock: z 1 > 0 (with z 2, z 3, … = 0) Shifts the AD curve vertically by ‌ z 1 /  ‌ Long-run supply is not affected (natural level of output unchanged) Some possible interpretations: Temporary optimism about the future growth potential of the economy

SRAS 1 SRAS 2 LRAS AD 0 AD 2 AD 1 z1z1 Ē E2E2 E1E1  22 11  y0y0 y1y1 y2y2 y A temporary positive demand shock is followed by a period of recession in order to curb inflation Illustration of the path from short to long-run macroeconomic equilibrium after a positive demand shock

Finding the dynamic solution to the AS-AD model Define the output gap and the inflation gap: Set s t = z t = 0 and rewrite the AS-AD model as

The dynamic solution to the AS-AD model Rearranged, this gives to linear first-order difference equations: Solutions: 0 < β < 1 assures a stable long-run equilibrium and

With plausible parameter values, the model requires about four years to adjust half the shock The adjustment to a temporary negative supply shock (s 1 =1). Illustration of a quarterly AS-AS model calibrated with plausible parameter values

After a temporary demand shock, the model “overshoots” the long-run equilibrium output The adjustment to a temporary negative demand shock (z1= -1). Illustration of a quarterly AS-AS model calibrated with plausible parameter values

Permanent shocks and long-run equilibrium values Permanent shocks may change the long-run equilibrium values of y and r The AS-AD model relative to the initial values of natural output and the natural interest rate: Example 1: A permanent supply shock: Initial equilibrium with s 0 = 0 and thereafter s t = s ≠ 0 for t = 1,2,… Equilibrium condition: Inflation and output are stable

A permanent, negative supply shock reduces equil. output and raises the equil. real interest rate The effect of a permanent supply shock on natural output: To equate demand and supply, the equilibrium real interest rate changes The effect of a permanent supply shock on the equilibrium real interest rate:

A permanent, positive demand shock raises the equil. real interest rate and leaves output unchanged Example 2: A permanent demand shock: Initial equilibrium with v 0 = 0 and thereafter v t = v ≠ 0 for t = 1,2,… The permanent demand shock does not affect natural output. The equilibrium real interest rate changes to curb the demand shock. The effect of a permanent demand shock on the equilibrium real interest rate:

Illustration: A change in the natural level of output Arbitrage

The Frisch-Slutzky paradigm Stylized facts on business cycles (chpt. 14) raise two key questions: o Why do movements in economic activity display persistence? o Why do these movements tend to follow a cyclical pattern? Our exposition of the AS-AD model follows the Frisch-Slutzky paradigm o Unsystematic impulses (demand and supply shocks) initiate the business cycles o The structure of the economy generate systematic fluctuations (propagation mechanism)

Illustration: Simulations on the AS-AD model with a simple stochastic shock process Demand and supply shocks follow stable first-order stochastic processes with positive persistence: The innovations to the shock processes are independent and identically distributed according to the normal distribution ~ ~

Graphical comparison of actual and model fluctuations

Model properties compared with actual stylized business facts