LECTURE 7 The AS-AD model

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

2. 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

3. 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

4. Elements of aggregate supply and aggregate demand

5. where 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:

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

7. Example 1: A temporary negative supply shock • Temporary negative supply shock: s1 > 0 (with s2, s3, … = 0) • Shifts the SRAS vertically by s1 • 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)

8. 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

9. Example 2: A temporary positive demand shock • Temporary positive demand shock: z1 > 0 (with z2, z3, … = 0) • Shifts the AD curve vertically by ‌ z1 /  ‌ • Long-run supply is not affected (natural level of output unchanged) • Some possible interpretations: Temporary optimism about the future growth potential of the economy

10.  LRAS SRAS2 SRAS1 E1 1 E2 2 Ē AD1  z1 AD0 AD2 y y2 y0 y1 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

11. Finding the dynamic solution to the AS-AD model • Define the output gap and the inflation gap: • Set st = zt = 0 and rewrite the AS-AD model as

12. and 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

13. With plausible parameter values, the model requires about four years to adjust half the shock The adjustment to a temporary negative supply shock (s1=1). Illustration of a quarterly AS-AS model calibrated with plausible parameter values

14. 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

15. 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 s0 = 0 and thereafter st = s ≠ 0 for t = 1,2,… • Equilibrium condition: Inflation and output are stable

16. 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:

17. A permanent, positive demand shock raises the equil. real interest rate and leaves output unchanged • Example 2: A permanent demand shock: Initial equilibrium with v0 = 0 and thereafter vt = 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:

18. Illustration: A change in the natural level of output • Arbitrage

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

20. ~ ~ 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

21. Graphical comparison of actual and model fluctuations

22. Model properties compared with actual stylized business facts