1. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard1 of 49 The Price of Crude Petroleum since 1960 There were two sharp increases in the relative price of oil in the 1970s, followed by a decrease in the 1980s and the 1990s. 7-6

2. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 49 The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment The higher price of oil causes an increase in the markup and a downward shift of the price-setting line.

3. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 49 The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment An increase in the markup, , caused by an increase in the price of oil, results in an increase in the price level, at any level of output, Y. The aggregate supply curve shifts up.

4. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 49 The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment After the increase in the price of oil, the new AS curve goes through point B, where output equals the new lower natural level of output, Y’ n, and the price level equals P e. The economy moves along the AD curve, from A to A’. Output decreases from Y n to Y’.

5. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 49 The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment Over time, the economy moves along the AD curve, from A’ to A”. At point A”, the economy has reached the new lower natural level of output, Y’ n, and the price level is higher than before the oil shock.

6. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 49 The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment An increase in the price of oil leads, in the short run, to a decrease in output and an increase in the price level. Over time, output decreases further and the price level increases further.

7. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 49 The Dynamics of Adjustment The combination of negative growth and high inflation, or stagnation accompanied by inflation, is called stagflation. Table 7-1 The Effects of the Increase in the Price of Oil, 1973-1975 1973 19741975 Rate of change of petroleum price (%)10.451.815.1 Rate of change of GDP deflator (%)5.69.09.4 Rate of GDP growth (%)5.8  0.6  0.4 Unemployment rate (%)4.95.68.5

8. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 49 Conclusions The Short Run Versus the Medium Run Table 7-2 Short-Run Effects and Medium-Run Effects of a Monetary Expansion, a Budget Deficit Reduction, and an Increase in the Price of Oil on Output, the Interest Rate, and the Price Level Short RunMedium Run Output Level Interest Rate Price Level Output Level Interest Rate Price Level Monetary expansion increasedecrease increase (small)no change increase Deficit reduction decrease decrease (small)no changedecrease Increase in oil price decreaseincrease decreaseincrease 7-7

9. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 49 Conclusions Output fluctuations (sometimes called business cycles) are movements in output around its trend. The economy is constantly hit by shocks to aggregate supply, or to aggregate demand, or to both. Each shock has dynamic effects on output and its components. These dynamic effects are called the propagation mechanism of the shock. Shocks and Propagation Mechanisms