Putting All Markets Together: The AS–AD Model Chapter 7

7-1 Aggregate Supply The aggregate supply relation captures the effects of output on the price level. The equation for wage determination: The equation for price determination. Eliminating W between the equations gives

7-1 Aggregate Supply Replacing u with 1-(Y/L) gives AS relation: The price level depends on the expected price level, the level of output, and also on the mark-up, the catchall variable and the labor force, which are taken as constant here). The first property of the AS relation is that an increase in output leads to an increase in the price level. How does the mechanism work? increase in output increase in employment decrease in unemployment rate increase in nominal wage increase in the prices set by the firms increase in the price level

7-1 Aggregate Supply The second property: An increase in the expected pricel level leads to a one-for-one increase in the price level. The effect worked through wages. Mechanism: increase in the expected price level higher wage in wage setting increase in costs increase in prices set by firms higher price level The Properties of the AS curve The AS curve is upward sloping. The AS curve goes through point A, where Y=Yn and P=Pe. Two implications: If Y> Yn, P> Pe If Y< Yn, P< Pe An increase in the expected pricel level shifts the AS curve up.

7-1 Aggregate Supply Figure 7-1 The Aggregate Supply Curve

7-1 Aggregate Supply Figure 7-2 The Effect of an Increase in the Expected Price Level on the Aggregate Supply Curve

7-2 Aggragate Demand The aggregate demand relation captures the effects of the price level on output. Equilibrium in the goods market (IS relation) Equilibrium in the financial market (LM relation) Changes in the real money stock also come from changes in the price level

7-2 Aggragate Demand The effects of a price increase. increase in price (given the nominal money stock, M) decrease in the real money stock (M/P) LM curve shifts up interest rate goes up lower demand decrease in output. The negative relation between output and the price level is called the aggregate demand relation.

7-2 Aggregate Demand Figure 7-3 The Derivation of the Aggregate Demand Curve

7-2 Aggregate Demand Any variable other then the price level that shifts either the IS curve (G and T) or the LM curve (M) shifts the AD curve. The AD relation is represented by the following equation

7-2 Aggregate Demand Figure 7-4 Shifts of the Aggregate Demand Curve

7-3 Equilibrium in the Short Run and in the Medium Run AS relation: AD relation:

7-3 Equilibrium in the Short Run and in the Medium Run Figure 7-5 The Short-Run Equilibrium In the short run, the equilibrium output level does not have to be equal to the natural level of output.

7-3 Equilibrium in the Short Run and in the Medium Run Figure 7-6 The Adjustment of Output over Time When Y > Yn, P > Pe. So wage setters revise the expected price level upward. In the next period, AS curve shifts up. The economy moves up along the AD curve leading to a decrese in output. As long as Y exceeds Yn, Pe increases, shifting the AS curve upwards.

7-3 Equilibrium in the Short Run and in the Medium Run Y> Ye P> Pe price expectations go up price level increases decrease in the real money stock increase in the interest rate decrease in output The adjustment stops when Y equals Yn. At that point P is equal to Pe. Expectations remain unchanged, and output remains at Yn. In the medium run, output returns to its natural level of output. In the short run, output can be above or below the natural level of output.

7-4 The Effects of a Monetary Expansion Figure 7-7 The Dynamic Effects of a Monetary Expansion The increase in M shifts AD curve to the right. Over time, the adjustment of price expectations comes into play. AS curve shifts up as price expectations are revised. The proportional increase in the price level is equal to the proportional increase in nominal money.

7-4 The Effects of a Monetary Expansion Figure 7-8 The Dynamic Effects of a Monetary Expansion on Output and the Interest Rate LM curve shifts down from LM to LM’ as a result of monetary expansion: Two effects: Increase in money supply shifts LM downwards. Increase in the price level shifts LM upwards. Over time price level continues to increase, shifting the LM curve downwards. Eventually, LM curve goes back to its initial position.

7-4 The Neutrality of Money In the short run, a monetary expansion leads to an increase in output, a decrease in the interest rate, and an increase in the price level. In the medium run, the increase in the nominal money is reflected in the a proportional increase in the pricel level. The increase in nominal money has no effect on the output or on the interest rate.

Focus: How Long Lasting Are the Real Effects of Money? Figure 1 The Effects of an Expansion in Nominal Money in the Taylor Model

7-5 A Decrease in the Budget Deficit Figure 7-9 The Dynamic Effects of a Decrease in the Budget Deficit

7-5 A Decrease in the Budget Deficit Figure 7-10 The Dynamic Effects of a Decrease in the Budget Deficit on Output and the Interest Rate

7-5 A Decrease in the Budget Deficit In the short run, a budget deficit reduction leads to a decrese in output and may lead to a decrease in investment. In the medium run, output returns to its natural level of output and the interest rate is lower. Investment increases.

7-6 An Increase in the Price of Oil Figure 7-11 The Nominal and the Real Price of Oil, 1970–2010

7-6 An Increase in the Price of Oil Figure 7-12 The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment

7-6 An Increase in the Price of Oil Figure 7-13 The Dynamic Effects of an Increase in the Price of Oil

7-6 An Increase in the Price of Oil Figure 7-14 Oil Price Increases and Inflation in the United States since 1970

Focus: Oil Price Increases: Why Were the 2000s so Different from the 1970s? Figure 1 The Effects of a 100% Permanent Increase in the Price of Oil on the CPI and on GDP. The effects of an increase in the price of oil on output and the price level are smaller than they used to be

7-6 An Increase in the Price of Oil Figure 7-15 Oil Price Increases and Unemployment in the United States since 1970

7-7 Conclusions Table 7-1 Short-Run Effects and Medium-Run Effects of a Monetary Expansion and a Budget Deficit Reduction on Output, the Interest Rate, and the Price Level