Applications of the AD-AS Model

Lecture 25 – academic year 2014/15Introduction to Economics

Fabio Landini

Demand shocks

How do we model the transition from the short to the medium period in the AD-AS model?

What happens in the medium period when we increase the supply of money?

What happens in the medium period when we reduce the public deficit?

Which are the effects of demand shocks?

• Transitions from short to medium period

• Effects of an increase in money supply• Effects of a reduction in public deficit

• Effects of a demand shock

Demand shocks

Transition from the short to the medium period

Point A can be both the short and the medium period equilibrium depending on the assumptions on PE

Medium period PE=P -> u=un -> Y=Yn

PAS

AD

Y

PA

YA

A

=Yn

In the short period -> PE can be ≠ from P For instance PE<P -> YA>Yn

How do we move from the short period equilibrium A to the medium period equilibrium?

PAS

AD

Y

PA

YA

A

Yn

Transition from the short to the medium period

Is it plausible that the economy remains in equilibrium A?In A (short period equilibrium) -> Y>Yn and P>PE -> individuals underestimate prices

PAS

AD

Y

PA

YA

A

Yn

Transition from the short to the medium period

Individuals underestimates prices -> they have wrong expectations concerning prices

As times passes workers realize that PE is too low -> price expectations adjust -> PE

AS parametrically depends on PE -> If PE the

AS curve shifts upward

Transition from the short to the medium period

P

PA

PA’

A’A

Yn YA’ YA

AD

AS

AS’

PE -> AS shifts upward

New equilibrium A’ -> Y (YA -> YA’) P (PA -> PA’)

P

PA

PA’

A’A

Yn YA’ YA

AD

AS

AS’

PE -> A -> A’; Is A’ the final equilibrium of the system?In A’ -> Y>Yn and P>PE -> PE continues

P

PA

PA’ A’A

Yn YA’ YA

AD

AS

AS’

PE -> AS shifts again upwardY is still > Yn -> new PE… the process continues until Y=Yn -> PE= P

In A’’ -> Y=Yn -> PE=P -> the expectation must not be adjusted -> the adjustment process (i.e. the AS curve) stops

AS’’

A’’

When Y=Yn (point A’’) the adjustment stops

In the medium period the intersection between the AS and AD curves is always along the line Y = Yn

Conclusion: Until P>PE -> agents adjust their expectations:

PE -> P and Y

The adjustment process stops when Y = Yn and P = PE

Point A’’ -> Medium period equilibrium of the system

The dynamics is the opposite if in the short period equilibrium we have Y < Yn

Transition from the short to the medium period

We use the AD-AS model to examine: •Expansive monetary policy•Reduction of public deficit

The two cases are examples of “demand shock”

Demand shock

1) Expansive monetary policy ( MS)

Let’s assume Y = Yn

The Central Bank increases MS

MS is a component of AD:

MS -> Aggregate demand -> AD shifts rightward

T,G,

PM

YYS

Expansive monetary policy

MS -> Aggregate demand -> AD shifts rightwardAD -> AD’ -> Equilibrium -> A -> A’ -> Y (YA -> YA’) P (PA -> PA’)

Short period effects -> Y and P Is it plausible that the economy remains in A’?In A’ Y>Yn -> P>PE -> wrong expectations

P

YYA=Yn YA’

PA’

AS

AD AD’

A

A’

PE =PA

Wrong expectations -> adjustment of expectations (described before) -> PE

PE -> AS shifts upward

The adjustment process continues until Y=Yn -> AS shifts upwards until Y=Yn

When Y=Yn -> PE=P -> The adjustment process interrupts -> medium period equilibrium

Expansive monetary policy

P

PA’A’

Yn YA’

AD’

AS

After MS we are in A’; AS shifts upward until Y=Yn

AS’’

ADY

PA

During the transition -> Y and PIn the medium period -> YA’’ =Yn=YA and PA’’ >PA

PA’’

YA’’=

Total effect of the intervention:•Short period -> Y and P•Transition -> Y and P•Medium period -> Y=, P

In the medium period Y does not change. Has the composition of demand changed (Z=C+I+G) ?•Z does not change (in equilibrium Y=Z):•C hasn’t change (Y and T are not changed)•G has not changed (exogenous)•Therefore I hasn’t changed either

In the medium period money has no effects on real variables but only on prices -> medium period “neutrality” of money

Expansive monetary policy

An expansive monetary policy increases production in the short period -> It allows the economy to exit a recession( Y)

In the medium period monetary policy is neutral ->It cannot be relied on to generate permanent increases in production

Expansive monetary policy

2) Reduction of public deficit ( G , T)

Let’s assume Y = Yn

Government reduces G

G is a component of AD:

G -> Aggregate demand -> AD shifts leftward

T,G,

PM

YYS

Reduction of public deficit

AS

AD

P

Y

A

Yn

AD’

A’

YA’

PA’

G -> AD shifts leftwardEquilibrium A->A’ -> Y (YA -> YA’) P (PA -> PA’)

In A’ Y<Yn -> P<PE -> PE -> the transition starts

PE = PA

AS

AD

P

Y

A

Yn

PA

AD’

A’

YA’

AS’’

A’’PA’’PA’

PE -> AS shifts downward

When Y=Yn the adjustment process stops

=YA’’

AS

AD

P

Y

A

Yn

PA

AD’

A’

YA’

AS’’

A’’PA’’PA’

During the transition -> Y and PIn the medium period -> YA’’ =Yn=YA and PA’’ <PA

=YA’’

Total effects of the intervention:•Short period -> Y P•Transition -> Y P•Medium period -> Y= P

Is the composition of demand changed (Z=C+I+G) ?•Z is not changed (in equilibrium Y=Z)•C is not changed (Y and T are not changed)•G is changed (Government has reduced expenditure)•Therefore I has increased

Reduction of public deficit

In the short period a reduction of public expenditure causes a recession

The effect is only temporary -> In the medium period the production comes back to the “natural” level

In the short period the reduction of public deficit has an ambiguous effects on investments

In the medium period the effect on investment is certainly positive

Reduction of public deficit

The cases that we examined are examples of demand shock

Demand shock -> Variations in the values of variables that affect aggregate demand

Demand shock:•Variations in public expenditures and taxes•Variations in money supply (and related interests)•Variations in autonomous consumption (tastes, consumers’ expectations) •Variations in investments (firms’ expectations)

Effects of demand shocks

Demand shocks impact the AD curvePositive shocks ( MS, G, C0, I0) -> AD rightward

Negative shocks ( MS, G, C0, I0) -> AD leftwardAS

AD

Y

P

AD’

Effects of demand shocks

In the short period demand shocks impact on prices and production in the same direction ( P Y or P Y)

Moreover, we saw that in the medium period:•In all cases Yn does not change -> Demand shocks do not influence production in the medium period•In all cases P change -> Demand shocks affect prices in the medium period•Demand shock can change the composition of aggregate demand in the medium period

Effects of demand shocks