Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #1 Chapter Topics Aggregate Supply Aggregate Demand Equilibrium Output in Short and Medium Run The Effects of a Monetary Expansion A Decrease in the Budget Deficit Changes in the Price of Oil

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #2 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #3 Aggregate Supply Captures the effects of output on the price level It is derived from equilibrium in the labor market

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #4 The Determination of Aggregate Supply Aggregate Supply Recall: The nominal wage (W) = P e F(u,z) Price level (P) = (1+  )W P = P e (1+  ) F (u,z)

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #5 According to: Aggregate Supply P = P e (1+  ) F (u,z) The price level (P) is a function of: P e : The expected price level u:The unemployment rate

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #6 The price level as a function of output instead of the unemployment rate Aggregate Supply

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #7 Aggregate Supply-The price level as a function of output instead of the unemployment rate Observations 1.A higher expected price level leads, one for one, to a higher actual price level. 2.An increase in output leads to an increase in the price level.

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #8 Aggregate Supply Higher P e  higher P P e  W  P  W=P e F(u,z)  (P e  W  ) P=(1+µ)W  (W  P  )

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #9 Aggregate Supply Higher Output  higher P Y  NP  u  W  P  Y=N  (Y  N  )

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #10 Aggregate Supply Higher Output  higher P W=P e F(u,z)  (u  W  ) P=(1+u)W  (W   P  )

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #11 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #12 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #13 Aggregate Demand Aggregate Demand: Captures the effect of the price level on output Is derived from equilibrium in the Goods (IS) and financial (LM) markets

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #14 Aggregate Demand Goods Market (IS): Financial Market (LM):

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #15 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #16 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´

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #17 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´

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #18 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´

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #19 Aggregate Demand Aggregate Demand: Y is a decreasing function of P Shifts in IS or LM shift AD

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #20 Equilibrium Output in the Short and the Medium Run

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #21 Equilibrium Output in the Short and the Medium Run AS Output, Y Price Level, P AD Y A Equilibrium P PePe YnYn B Observation: Equilibrium Y may be greater than or less than Y n

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #22 If equilibrium Y is greater than Yn, will the economy automatically move to Yn over time? Equilibrium Output in the Short and the Medium Run What do you think…

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #23 P e = the price level last year 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: Therefore: P t e = P t-1

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #24 Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level Given: Note: P t e = P t-1 µ, z, M, G and T are assumed to be constant

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #25 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´

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #26 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #27 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #28 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #29 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 ´´)

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #30 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #31 How Long Lasting are the Real Effects of Money? The Taylor Model

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #32 How Long Lasting are the Real Effects of Money? The Mishkin Model Quarters Effects on output Anticipated Unanticipated

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #33 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #34 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #35 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #36 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #37 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #38 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.

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #39 Why Has Japan Done So Poorly in the 1990s? Japanese Macroeconomic Variables Output growth (%) Inflation* (%) Budget surplus (% of GDP) Short-term interest rate *Inflation: Rate of change of the GDP deflator. Source: OECD Economic Outlook December Has it been the result of a shift in AD or AS?

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #40 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

Chapter 7: The AS-AD ModelBlanchard: Macroeconomics Slide #41 The AD-AS Model Shocks and Propagation Mechanisms The economy is impacted by AD and AS shocks The shocks have dynamic effects on P and Y The dynamic effects or propagation mechanisms vary in accordance to the shock