The AS-AD Model

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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

• The Determination of Aggregate Supply

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

• Since

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Aggregate Supply-The price level as a function of
output

1. A higher expected price level leads to a higher
   actual price level.
2. An increase in output leads to an increase in the
   price level.

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Aggregate Supply

• Higher Pe?higher P
• Pe??W? since WPeF(u,z)
• W??P? since P(1µ)W
• Higher Output?higher P
• Y??N??u??W??P?
• since P(1u)W

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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
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 Summary

• 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
Price Level, P
Output, Y
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Equilibrium Output in the Short and the Medium Run
The dynamics of output and the price level

• Pt price level in year t
• Pt-1 price level in year t-1
• Pt1 price level in year t1

Assume Pte Pt-1 Where Pte price level
expected in year t
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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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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
Effects on the Natural Rate of Unemployment
Assume an increase in the price of oil
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Changes in the Price of Oil
The Dynamics of Adjustment
When oil prices increase

• Yn decreases to Yn

• AS shifts up

• A to A short-run
• change

• A to A medium-run
• change

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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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The AD-AS Model
Conclusions