1. Monetary Theory: The AD/AS Model – Pt. I
ECO 473 – Money & Banking – Dr. D. Foster

2. Warning .. Warning .. Warning
Aggregate Supply and Aggregate Demand are not like market supply & demand !!!!!
The “static” analysis only hints at dynamic interpretation.
Ceteris Paribus assumption problematic to the point of being wholly inappropriate.
Contrasting views:
Classical/Monetarist vs. Keynesian
Friedman vs. Keynes
Non-activist vs. Activist

3. The Aggregate Demand ScheduleP
P = Price Level;
CPI or GDP deflator
Q = Y = Real GDP; (real output)
AD = Agg. Demand;
From 4 sectors – HH, Bus, G, Foreign A P2 Q1 B P1 Q2
AD1
Q or R-GDP

4. Aggregate Demand
The price level and real output demanded are inversely related.
A fall in the price level will increase quantity demanded.
Why? -- the Real Balances Effect
All prices and wages change.
But, our fixed money holdings are … well, still fixed!
So, with lower prices we feel wealthier. Woo Hoo!
And, so we want to buy more stuff.

5. Can’t do “all else equal.”
Aggregate Demand
Can’t do “all else equal.”
e.g. Price of apples - QD for apples ... and the QD for oranges.
But, Price of everything and their isn’t anything else to hold constant!
What about:
Interest effect
Foreign trade effect
Exchange rate effect
AD can shift to the left or right.
Increase AD – shift to the right.
Decrease AD – shift to the left.
Whenever C, I, G, net X increase/decrease.
Why? Due to changes in the money supply!

6. The Aggregate Demand ScheduleP
AD3
AD2
Increases in
C, I, G, net X
Decreases in
C, I, G, net X
AD1
Q or R-GDP

7. Money and Aggregate Demand
Equation of exchange:
An accounting identity:
MS * V = P * Y
Quantity theory of money:
People hold money for transactions purposes.
Velocity (V) is constant, or, at least, stable (=1/k).
Real output (Y) is constant w.r.t. labor supply.
Therefore, changes in MS will only change P.
Aggregate Demand for output (AD) - derived from the demand for money, or - derived from the real balance effect.
MD = k * P * Y

8. QTM & The Aggregate Demand ScheduleP
MD = MS
MS = k * P * Y
MS/(k * P) = Y
AD = MS/(k * P)
AD3 MS/(k*P)
Increases in MS
AD2 MS/(k*P)
Decreases in MS
AD1
Q or R-GDP

9. The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply
ASLR
There is a “long run” Aggregate Supply, which is perfectly vertical at the “full employment” level of Real GDP.
It is unaffected by changes in the price level, but is affected by a host of real variables… P1
Classical Model of the Economy
AD1
Q or R-GDP

10. “Inflation is always, and everywhere, a monetary phenomenon.”
The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply P
MS and that increases AD. MS and that decreases AD.
AS1
Shifts in AD can only change the price level and not real output (nor employment).
“Inflation is always, and everywhere, a monetary phenomenon.”
-Milton Friedman P1
AD1
Q or R-GDP

11. What affects the Aggregate Supply?
Labor force participation.
Labor productivity.
Marginal tax rates on wages.
Provision of government benefits that affect household incentives w.r.t. supply labor.
State of technology.
Capital stock.
A change in these factors can AS (shift right) or AS (shift left)

12. Short Run Aggregate Supply – Wage Inflexibility
Nominal wages are sluggish upwards:
A rise in prices has delayed effect on wages.
Nominal wages are inflexible downwards:
A fall in prices will result in employment and y.
Workers have money illusion:
Higher nominal wages are viewed as real wage.
So, more workers available even though real wage has not risen.
e.g. if prices rise 5% and wages rise 3%…

13. Short Run Aggregate Supply
What about:
Sticky prices
Misperception
Intertemporal substitution
Unnecessary complications to explain the SR AS. Inflexible wages is all we need.
What happens if there is a AD?
The Short Run will adjust to the Long Run:
An AD will P and Q, but only in the SR.
Prices rise but wages lag. Firms employment and output.
Eventually, workers realize their real wages (W/P) are falling, get comparable wage, AS.
The temporary profit motive has been eliminated.

14. From SR to LR Aggregate Supply
An increase in AD triggers events.
AS3
AS2 P
ASLR
AD2
AS1
Prices rise,
wages lag,
output rises.
Eventually,
wages catch up
and AS declines.
In LR, only prices rise. P3 P2 Q2 P1
AD1
Q or R-GDP Q*

15. Monetary Theory: The AD/AS Model – Pt. I
ECO 473 – Money & Banking – Dr. D. Foster