Putting All Markets Together

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Chapter 7

• Putting All Markets Together
• The AS-AD Model

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Chapter Topics

• Aggregate Supply
• Aggregate Demand
• Equilibrium Output in the Short and Medium Run
• The Effects of a Monetary Expansion
• A Decrease in the Budget Deficit
• Changes in the Price of Oil
• Conclusions

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The AS-AD Model

• Determination of Output in the short-run and
  medium-run
• Requires equilibrium in the goods, financial, and
  labor markets
• Aggregate supply focuses on equilibrium in the
  labor market
• Aggregate demand focuses on equilibrium in the
  goods and financial markets

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Aggregate Supply

• Captures the effects of output on the price level
• It is derived from equilibrium in the labor market

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Aggregate Supply

• The Determination of Aggregate Supply

Recall
The nominal wage (W) PeF(u,z) Price level (P)
(1?)W P Pe(1?) F (u,z)
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Aggregate Supply

• According to

P Pe(1?) F (u,z)

• The price level (P) is a function of
• Pe The expected price level
• u The unemployment rate

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Aggregate Supply

• The price level as a function of output instead
  of the unemployment rate

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Aggregate Supply-The price level as a function of
output instead of the unemployment rate
Observations

• A higher expected price level leads, one for one,
  to a higher actual price level.
• An increase in output leads to an increase in the
  price level.

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Aggregate Supply

• Higher Pe?higher P
• Pe??W??P?
• WPeF(u,z) ?(Pe??W?)
• P(1µ)W ?(W??P?)

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Aggregate Supply

• Higher Output?higher P
• Y??NP?u??W??P?
• YN?(Y??N?)

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Aggregate Supply

• Higher Output?higher P
• WPeF(u,z)?(u??W?)
• P(1u)W?(W ? ?P?)

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Aggregate Supply
Graphically
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Aggregate Supply
Illustrating the impact of an increase in Pe
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Aggregate Demand
Aggregate Demand

• Captures the effect of the price level on output
• Is derived from equilibrium in the Goods (IS)
  and financial (LM) markets

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Aggregate Demand
Goods Market (IS)
Financial Market (LM)
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Aggregate Demand
IS LM Equilibrium

• Assume P increases to P
• M is fixed

• LM shifts to LM (P gt P)

• Equilibrium to A

• i to i Y to Y

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Aggregate Demand
Deriving Aggregate Demand (AD)
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Aggregate Demand
Greater Consumer Confidence Shifts AD
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Aggregate Demand
Contractionary Monetary Policy Shifts AD
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Aggregate Demand

• Y is a decreasing function of P
• Shifts in IS or LM shift AD

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Equilibrium Output in the Short and the Medium Run
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Equilibrium Output in the Short and the Medium Run
Price Level, P
Output, Y
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Equilibrium Output in the Short and the Medium Run
What do you think

• If equilibrium Y is greater than Yn, will the
  economy automatically move to Yn over time?

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Equilibrium Output in the Short and the Medium Run
The dynamics of output and the price level

• Pe the price level last year
• Pt price level in year t
• Pt-1 price level in year t-1
• Pt1 price level in year t1

Assume
Therefore
Pte Pt-1
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Equilibrium Output in the Short and the Medium Run
The dynamics of output and the price level
Pte Pt-1
Given
Note
µ, z, M, G and T are assumed to be constant
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Equilibrium Output in the Short and the Medium Run
The dynamics of output and the price level
Equilibrium Year t 1
Pt1
AS shifts to AS
At A Yt1 gt Yn
Pt1 gt Pet1
Yt1
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Equilibrium Output in the Short and the Medium Run
The dynamics of output and the price level
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Equilibrium Output in the Short and the Medium Run
The dynamics of output and the price level
Two Observations
Short Run Output can be above or below
YnMedium Run Prices adjust to return
output to Yn
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The Effects of a Monetary Expansion

• AD shifts to AD

• A equilibrium (Yt gt Yn)

• AS shifts to AS

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The Effects of a Monetary Expansion
Looking Behind the Scene IS-LM
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The Effects of a Monetary Expansion
The Neutrality of Money
A Summary
Short-run ?M? Y? and P? The relative change in
P and Y depends on the slope of AS Medium
run Prices continue to increase until P and Y
return to their original level, i.e., money is
neutral
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How Long Lasting are the Real Effects of Money?
The Taylor Model
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How Long Lasting are the Real Effects of Money?
The Mishkin Model
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A Decrease in the Budget Deficit
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A Decrease in the Budget Deficit
The Dynamic Effects of a Decrease in the Budget
Deficit
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A Decrease in the Budget Deficit
Budget Deficits, Output, and Investment -A Summary

• Short Run
• Will lead to a decrease in output and
  investment assuming no complementary monetary
  policy
• Medium Run
• Y returns to Yn
• Interest rate is lower
• Investment increases
• Long Run
• I increases
• Y increases

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Changes in the Price of Oil
The Effects of the Increase in the Price of
Oil1973-1975
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Why Has Japan Done So Poorly in the 1990s?
Japanese Macroeconomic Variables1992-1998
Has it been the result of a shift in AD or AS?
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The AD-AS Model
Conclusions
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The AD-AS Model
Shocks and Propagation Mechanisms

• The economy is impacted by AD and AS shocks
• The shocks have dynamic effects on P and Y
• The dynamic effects or propagation mechanisms
  vary in accordance to the shock

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End of Chapter

• Putting All Markets Together
• The AS-AD Model