ADAS

1
AD/AS

• Reading
• Objectives
• To derive the ADAS model to demonstrate the short
  and medium-run effect of external shocks and
  policy changes, bringing together everything we
  have learnt so far
• Understand the key role of expectations

2
Aggregate supply

• Labour market
• Production

3
Aggregate supply

• An increase in output leads to an increase in
  price
• An increase in expected price leads, one for one,
  to an increase in the actual price level
• P also depends on the mark-up, on the labour
  force and on z, the catch-all variable

4
Aggregate supply
5
Equilibrium in goods, financial and labour
markets short-run

• AS
• AD

6
Equilibrium in goods, financial and labour
markets short-run
7
Equilibrium in goods, financial and labour
markets medium-run
8
Monetary expansion
9
Monetary expansion
10
How long-lasting are the effects of a monetary
expansion?
11
Decrease in the budget deficit
12
Decrease in the budget deficit
13
Changes in the price of oil
14
Changes in the price of oil
15
Changes in the price of oil
16
Demand shocks
17
Economic fluctuations
18
Stabilisation policy

• How should the CB respond to a positive demand
  shock?
• How should the CB respond to a negative oil price
  shock?

19
Macroeconomic debate!

• Market adjustment vs policy action
• Classical economics
• Keynesian economics
• 1970s
• Neo-classical and post-keynesians
• In the long-run, we are all dead

20
A note on aggregate supply curves
21
REVIEW

• External shocks and policy decisions have
  different effects in the short-run and
  medium-run.
• In the medium-run, employment and output are
  determined by real factors - demand factors have
  no effect. Changes in nominal money pass through
  to prices.
• In the short-run, employment and output may
  deviate from the natural rate. Changes in demand
  have an effect.
• How rapidly the economy moves to the medium-run
  depends on how agents form expectations to be
  discussed further

22
PROBLEMS

• Blanchard, ch7, Q5
• Suppose that investment is not responsive to the
  interest-rate.
• Can you think of a situation where this may
  happen?
• What does this imply for the slope of the IS, LM
  and AD curves?
• Now suppose that the economy starts at the
  natural level of output and that due to a shock
  to z, the AS curve shifts up.
• What is the s-run effect on prices and output?
• What happens to output and prices over time?

23

• Blanchard, ch7, Q6
• Assume money demand is flat (as in the case at
  very low interest-rates)
• What does this imply for the slope of the LM, IS
  and AD curves?
• Draw the AD and AS curves, and assume that
  equilibrium is at a point where output is below
  the natural rate
• Suppose the CB increases the money stock. What
  will be the effects on output in the s-run and
  medium-run?

24
Annex AS Models
25
The Sticky-Wage Model

• Workers and firms are interested in the real
  wage, W/P but negotiate over
• nominal wages based on their expectations of
  future prices. This wage is
• then set by contract (i.e., cannot adjust)
• where w is the target real wage
• Let us assume that the target real wage is the
  real wage that equilibrates the labour market
• let us assume that workers also contract to work
  whatever is required, so labour demand
  effectively governs the labour employed
• What if actual price is not equal to expected
  price?

26

• Case 1
• The actual real wage is lower than the target, so
  firms demand more
• labour. Workers work more than they wish to at
  the actual real wage and
• there is an economic boom
• What happens in the long-run?
• contracts expire and workers re-negotiate wages
  upwards. Ceteris
• paribus, wages catch up with the price increase
  and the target real wage is
• restored together with the natural rate of
  employment and output
• Note Economic decisions are often made on the
  basis of expectations
• regarding future prices

27

• Case 2
• The actual real wage is too high and firms demand
  less than the
• equilibrium level of labour, leading to
  recession.
• What happens in the long-run in this case?

28
Deriving an upward-sloping SAS curve

• Thus, if actual price is relatively high compared
  with price expectations, in the s-run, output
  increases, until, in the long-run expectations
  are revised.
• Conversely, if price is relatively low, output
  decreases in the s-run

29
The Case of An Unexpected Price Rise
30
Whats Effect of Unanticipated Demand Shock?
31
Worker-Misperception Model

• By contrast, assume wages are perfectly flexible
  and work effort is driven by
• the supply side.
• Labour Supply
• workers do not know the actual price. One may
  re-write this as
• where Pe/P represents the degree of misperception
• Labour Demand
• assume, by contrast, firms do know the price

32
What happens if workers have no misperception,
and P rises? What happens if P rises and
workers do not observe/anticipate the change?
33

• Assuming an increase in prices
• At the nominal wage, firms demand more labour
  (movement down LD curve)
• Workers should supply less labour causing excess
  demand, which bids up the nominal wage until the
  original equilibrium is restored (i.e., no
  change).
• However, at the lower actual real wage, they
  believe nothing has changed, so effectively their
  supply schedule shifts out Misinformed, they are
  willing to supply more labour at a lower real
  wage
• The result is higher employment and output

34
In long-run, workers observe the change in prices
and shift their supply schedule back. The
natural rate is restored