Putting All Markets Together: The AS - AD Model

1. Putting All Markets Together: TheAS-AD Model

2. Aggregate Supply 7-1 • The aggregate supply relation captures the effects of output on the price level. It is derived from the behavior of wages and prices.

3. Aggregate Supply 7-1 • Recall the equations for wage and price determination from chapter 6:

4. Deriving the AggregateSupply Relation • How do we derive the Aggregate Supply Relation? • The key is to remember that AS is a … • … relation between the Price Level and Production • And production is related to unemployment. • So we need an equation with P on the left hand side and Y on the right hand side.

5. Deriving the AggregateSupply Relation • Step 1: Combine (by eliminating W from both equations): and to get: • This has P on the LHS and u on the RHS. • The price level depends on the expected price level and the unemployment rate. We assume that m and z are constant. • Here allow P to be different from Pe.

6. Deriving the AggregateSupply Relation • Step 2: Recall that the unemployment rate can be expressed in terms of output: Therefore, for a given labor force, the higher is output, the lower is the unemployment rate.

7. Deriving the AggregateSupply Relation • Step 3: Replace the unemployment rate (u=1-Y/L) in the equation obtained in step one: In words, the price level depends on the expected price level, Pe, and the level of output, Y (and also m, z, and L, but we take those as constant here).

8. Deriving the AggregateSupply Relation • This is an AS relation. How do we know that? • AS is a relation between P and production. • Here we have a relation between P and Y. • And Y, here, means output produced. • How do we know that? • The “Y” comes in here through a production relation, that is, through the labor market.

9. Properties of the AS Relation • The AS relation has two important properties: • An increase in output leads to an increase in the price level. This is the result of four steps: This gives the slope of the AS curve.

10. Properties of the AS Relation • Y↑  P↑. • If society wants more production, more people must be hired. • This lowers the unemployment rate. • Lower unemployment strengthens workers’ bargaining power, leading to higher nominal wages (at a given expected price level). • Higher nominal wages raises firms’ marginal cost, so prices rise.

11. Aggregate Supply The Aggregate Supply Curve Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level.

12. Wages and Unemployment W P Lower u, higher W Higher W, higher P (Pe constant) WS Pe < P u • Higher output (lower u) strengthens workers, who demand a higher nominal wage W (at given P). • Firms raise prices to keep a constant markup, so P rises above Pe (and W/P falls). So an increase in output leads to an increase in the price level. WS Pe = P u un

13. AS Curve u < un because Pe < P

14. Properties of the AS Relation What about SHIFTS of the AS curve? • An increase in the expected price level leads, one for one, to an increase in the actual price level. This effect works through wages: If prices are expected to rise, workers demand higher wages, which raises firms’ marginal cost and prices.

15. Aggregate Supply An increase in the expected price level shifts the aggregate supply curve up. The Effect of an Increase in the Expected Price Level on the Aggregate Supply Curve

16. Wages and Unemployment W P W’ P’ WS Pe > P Pe’ = P’ 1. Higher expected prices (Pe) make workers demand a higher nominal wage W. 2. Firms raise prices P until P = Pe to keep a constant m (and W/P). Now we have a higher W and P at any u, for the same W/P and un. Higher W, higher P=higher Pe So an increase in Pe leads to an increase in P for any Y. WS Pe = P u un

17. AS Curve u = un because Pe = P

18. Properties of the AS curve • The AS curve will SHIFT upward • if Pe rises, • if m rises, • m includes monopoly power, costs of inputs other than labor, etc. • if L falls, • (which would raise unemployment, given the same level of output) • if z and the function F change in ways that make the same natural unemployment rate consistent with higher wage demands.

19. Properties of the AS curve • The AS curve is upward sloping. An increase in output leads to an increase in the price level. • The AS curve goes through point A, whereY = Yn and P = Pe. This property has two implications: • When Y > Yn, P > Pe. If output is above the natural level, prices will rise above expected prices. • When Y < Yn, P < Pe. • An increase in Pe shifts the AS curve up, and a decrease in Pe shifts the AS curve down.

20. Wages and Unemployment W P Lower W, lower P (Pe constant) Higher u, Lower W WS Pe > P When P= Pe, u = un. Lower output (higher u) weakens workers, who accept a lower nominal wage W. When P < Pe, u > un,so Y< Yn. Firms lower prices to keep aconstant markup, so P falls below Pe. WS Pe = P When P > Pe, u < un,so Y> Yn. u un u

21. Aggregate Supply The Aggregate Supply Curve • The AS curve is upward sloping. • The AS curve goes through point A, whereY = Yn and P = Pe. • WhenY > Yn, P > Pe. • An increase in Pe shifts the AS curve up.

22. Aggregate Demand 7-2 • The aggregate demand relation captures the effect of the price level on output. It is derived from the equilibrium conditions in the goods and financial markets. • Recall the equilibrium conditions for the goods and financial markets described in chapter 5:

23. Aggregate Demand Ms/P’ Ms/P Lower M/P, at the same level of income, raises interest rates  lower Investment. (Sure, the fall in I lowers Y, and Md falls, which moderates the rise in i. But Y still falls and i rises, for most normal parameter values.) i Md/P M/P • Now, what will happen if P rises? • At given M, M/P will contract.

24. Aggregate Demand • P   M/P  i  (LM shifts) spending falls (movement along IS) LM’ i LM • LM curves shifts up, raising interest rates and lowering equilibrium output. IS IS’ Y

25. Aggregate Demand An increase in the price level leads to a decrease in output. The Derivation of the Aggregate Demand Curve

26. Aggregate Demand • Summarizing: • A rise in P reduces real money supply MS/P, increasing interest rates. • The LM curve shifts up, for any Y. • The economy moves along the IS curve to a lower equilibrium level of Y. • Therefore, higher P means lower Y demanded: • The AD curve is downward sloping.

27. Aggregate Demand Changes in monetary or fiscal policy—or more generally in any variable, other than the price level, that shift the IS or the LM curves—shift the aggregate demand curve.

28. Aggregate Demand and Monetary Policy Ms’/P LM’ Md(Y’)/P Y’ AD’ Ms/P i i LM • Expansionary Monetary Policy lowers interest rates and raises output at any given level of prices, so the AD curve shifts right. • Higher Y raises Md a bit, which moderates the rise in i. Md(Y)/P IS Y M/P Y P AD Y

29. Aggregate Demand and Fiscal Policy Z Y Z’(T’,i’) Z’(T’,i) i’ IS’ Z(T,i) • Contractionary Fiscal Policy lowers demand for goods and lowers output at any given level of prices, so the AD curve shifts right. • Lower Y lowers Md, which reduces i. This causes I to increase (“crowding out” in reverse), which moderates the fall in Y. Y i LM i IS Y P AD AD’ Y

30. Aggregate Demand Shifts of the Aggregate Demand Curve An increase in government spending increases output at a given price level, shifting the aggregate demand curve to the right. A decrease in nominal money decreases output at a given price level, shifting the aggregate demand curve to the left.

31. AS, AD, and Causality • In the Aggregate Supply relation, causality runs from Y to P • Higher Y lowers u which raises W/P. This causes firms to raise P. • In the Aggregate Demand relation, causality runs from P to Y. • Higher P lowers M/P which lowers expenditure, lowering Y.

32. AS, AD, and Causality • In the Aggregate Supply relation, causality runs from Y to P • An exogenous change in costs causes prices to change for any output level, causing the AS curve to shift vertically. • In the Aggregate Demand relation, causality runs from P to Y. • An exogenous change in expenditure causes output to change for any price level, causing the AD curve to shift horizontally.

33. Equilibrium in the ShortRun and in the Medium Run 7-3 • Equilibrium depends on the value of Pe. The value of Pe determines the position of the aggregate supply curve, and the position of the AS curve affects the equilibrium.

34. Equilibrium in the Short Run The Short Run Equilibrium The equilibrium is given by the intersection of the aggregate supply curve and the aggregate demand curve.

35. Equilibrium in the Short Run The Short Run Equilibrium At point A,the labor market,the goods market, and financial markets are all in equilibrium.

36. Equilibrium in the Short Run The Short Run Equilibrium Notice that at point A, P > Pe. What will happen over time?

37. From the Short Runto the Medium Run P’ Pe B • At point A, • Wage setters will revise upward their expectations of the future price level. This will cause the AS curve to shift upward. • Expectation of a higher price level also leads to a higher nominal wage, which in turn leads to a higher price level. =Pe’ P > Pe leads to higher Pe, which raises W. This raises P above Pe, which eventuallyleads to higher Pe, which …

38. From the Short Runto the Medium Run B’ • The adjustment ends once .Wage setters no longer have a reason to change their expectations. • In the medium run, output returns to the natural level of output. B’’= Notice that as AS shifts and P rises, we move along the AD curve. (Higher P reduces M/P and lowers Y.)

39. From the Short Runto the Medium Run If output is above the natural level of output, the AS curve shifts up over time, until output has decreased back to the natural level of output. The Adjustment of Output over Time

40. From the Short Runto the Medium Run • To Summarize: • In the short run , output can be below or above the natural level of output. • The reason is that in the short run, price expectations are sticky and therefore wages are sticky. • In the medium run, output returns to its natural level. • The reason is that prices adjust: • Prices P fall if Y<Yn, lowering wages (shift AS down) and raising M/P (move along AD). • Prices P rise if Y>Yn, raising wages (shift AS up) and lowering M/P (move along AD).

41. The Effects of aMonetary Expansion 7-4 • In the aggregate demand equation, we can see that an increase in nominal money, M, leads to an increase in the real money stock, M/P, leading to an increase in output. The aggregate demand curve shifts to the right.

42. The Dynamics of Adjustment • The increase in the nominal money stock causes the aggregate demand curve to shift to the right. • In the short run, output and the price level increase. • The difference between Y and Yn sets in motion the adjustment of price expectations.

43. The Dynamics of Adjustment • Stop for a second. • Assume an economy where dollar bills are used only once a year (velocity = 1); and where annual real GDP = 10 million houses. • Suppose Ms=$10bn. What will P be? • MV = PY • $10bn x 1 = P x 10 million houses • P = $1 thousand / house

44. The Dynamics of Adjustment • Now suppose Ms=$20bn. What will P be? • MV = PY • $20bn x 1 = P x 10 million houses • P = $2 thousand / house • If M doubles, P doubles. M/P doesn’t change. • Why doesn’t this happen in the short run? • Because M affects P through the goods, money, and labor market, over time, esp. through changes in Pe.

45. The Dynamic Effects ofa Monetary Expansion • In the medium run, the AS curve shifts to AS’’ and the economy returns to equilibrium at Yn. • The increase in prices is proportional to the increase in the nominal money stock.

46. The Dynamics of Adjustment A monetary expansion leads to an increase in output in the short run, but has no effect on output in the medium run. The Dynamic Effects ofa Monetary Expansion

47. Going Behinds the Scenes • The impact of a monetary expansion on the interest rate can be illustrated by the IS-LM model. • The short-run effect of the monetary expansion is to shift the LM curve down. The interest rate is lower, output is higher.

48. Going Behinds the Scenes LM’’ • Notice that, even in the short run, prices change slightly. • If the price level had not increased at all, the shift in the LM curve would have been larger—to LM’’.

49. Going Behinds the Scenes • Over time, the price level increases, the real money stock decreases and the LM curve returns to where it was before the increase in nominal money. • In the medium run, the real money stock and the interest rate remain unchanged.

50. Going Behinds the Scenes The Dynamic Effects of a Monetary Expansion on Output and the Interest Rate The increase in nominal money initially shifts the LM curve down, decreasing the interest rate and increasing output. Over time, the price level increases, shifting the LM curve back up until output is back at the natural level of output.