putting all markets together: the as - ad model

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/eMacroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Prepared by:Prepared by:

Fernando Quijano and Yvonn Fernando Quijano and Yvonn QuijanoQuijano

77C H A P T E RC H A P T E R

Putting All Markets Putting All Markets Together: TheTogether: TheASAS--ADAD Model Model

© 2003 Prentice Hall Business Publishing© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Macroeconomics, 3/e Olivier BlanchardOlivier Blanchard

Aggregate SupplyAggregate Supply

The The aggregate supply relationaggregate supply relation captures the captures the effects of output on the price level. It is effects of output on the price level. It is derived from the behavior of wages and derived from the behavior of wages and prices.prices.

Recall the equations for wage and price Recall the equations for wage and price determination from chapter 6:determination from chapter 6:

7-1

W P F u ze ( , )

P W ( )1


Deriving the AggregateDeriving the AggregateSupply RelationSupply Relation

Step 1: Eliminate the nominal wage from:Step 1: Eliminate the nominal wage from:

W P F u ze ( , ) P W ( )1 andand , then:, then:

P P F u ze ( ) ( , )1

In words, the price level depends on the In words, the price level depends on the expected price level and the unemployment expected price level and the unemployment rate. We assume that rate. We assume that and and zz are constant. are constant.



Step 2: Express the unemployment rate in Step 2: Express the unemployment rate in terms of output:terms of output:

uU

L

L N

L

N

L

Y

L

1 1

Therefore, for a given labor force, the higher is Therefore, for a given labor force, the higher is output, the lower is the unemployment rate.output, the lower is the unemployment rate.



Step 3: Replace the unemployment rate in the Step 3: Replace the unemployment rate in the equation obtained in step one:equation obtained in step one:

P P FY

Lze

( ) ,1 1

In words, the price level depends on the In words, the price level depends on the expected price level, expected price level, PPee, and the level of , and the level of output, output, YY (and also (and also , , zz, and , and LL, but we take , but we take those as constant here).those as constant here).


Properties of the Properties of the ASAS Relation Relation

The The ASAS relation has two important properties: relation has two important properties:1.1. An increase in output leads to an increase in the An increase in output leads to an increase in the

price level. This is the result of four steps:price level. This is the result of four steps:1.1.

2.2.

3.3.

4.4.

P P FY

Lze

( ) ,1 1

Y N N u

u W

W P


Properties of the Properties of the ASAS Relation Relation

The The ASAS relation has two important properties: relation has two important properties:

P P FY

Lze

( ) ,1 1

P We

W P

2.2. An increase in the expected price level leads, one An increase in the expected price level leads, one for one, to an increase in the actual price level. for one, to an increase in the actual price level. This effect works through wages:This effect works through wages:1.1.

2.2.



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.

The Aggregate Supply The Aggregate Supply CurveCurve


Properties of the Properties of the ASAS curve curve

1.1. The The ASAS curve is upward sloping. As explained curve is upward sloping. As explained earlier, an increase in output leads to an increase in earlier, an increase in output leads to an increase in the price level.the price level.

2.2. The The ASAS curve goes through point curve goes through point AA, where , where YY = = YYnn

and and PP = = PPee. This property has two implications:. This property has two implications:1.1. When When YY > > YYnn, , PP > > PPee..

2.2. When When YY < < YYnn, , PP < < PPee..

3.3. An increase in An increase in PPee shifts the shifts the ASAS curve up, and a curve up, and a decrease in decrease in PPee shifts the AS curve down. shifts the AS curve down.



An increase in the expected price level shifts the aggregate supply curve up.

The Effect of an The Effect of an Increase in the Increase in the Expected Price Expected Price Level on the Level on the Aggregate Supply Aggregate Supply CurveCurve


Aggregate DemandAggregate Demand

The The aggregate demand relationaggregate demand relation captures the captures the effect of the price level on output. It is derived effect of the price level on output. It is derived from the equilibrium conditions in the goods from the equilibrium conditions in the goods and financial markets.and financial markets.

Recall the equilibrium conditions for the goods Recall the equilibrium conditions for the goods and financial markets described in chapter 5:and financial markets described in chapter 5:

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IS re la tio n: Y C Y T I Y i G( ) ( , )

L M rela tio n: M

PY L i( )



An increase in the price level leads to a decrease in output.

PM

Pi dem and Y

The Derivation of the Aggregate The Derivation of the Aggregate Demand CurveDemand Curve



Changes in monetary or fiscal Changes in monetary or fiscal policy—or more generally in any policy—or more generally in any variable, other than the price variable, other than the price level, that shift the level, that shift the ISIS or the or the LMLM curves—shift the aggregate curves—shift the aggregate demand curve.demand curve.

Y YM

PG T

, ,

( , , )



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.

Y YM

PG T

, ,

( , , )

Shifts of the Aggregate Shifts of the Aggregate Demand CurveDemand Curve


Equilibrium in the ShortEquilibrium in the ShortRun and in the Medium RunRun and in the Medium Run

Equilibrium depends on the value of Equilibrium depends on the value of PPee. The . The value of value of PPee determines the position of the determines the position of the aggregate supply curve, and the position of aggregate supply curve, and the position of the the ASAS curve affects the equilibrium. curve affects the equilibrium.

7-3

A S R ela tio P FY

Lzen P

( ) ,1 1

A D R ela tio YM

PG Tn Y

, ,


Equilibrium in the Short RunEquilibrium in the Short Run

The equilibrium is given by the intersection of the aggregate supply curve and the aggregate demand curve. At point A, the labor market, the goods market, and financial markets are all in equilibrium.

The Short Run The Short Run EquilibriumEquilibrium


From the Short RunFrom the Short Runto the Medium Runto the Medium Run

At point At point AA,,Y Y P Pne

Wage setters will revise Wage setters will revise upward their upward their expectations of the expectations of the future price level. This future price level. This will cause the will cause the ASAS curve curve to shift upward.to shift upward.

Expectation of a higher Expectation of a higher price level also leads to price level also leads to a higher nominal wage, a higher nominal wage, which in turn leads to a which in turn leads to a higher price level.higher price level.



The adjustment ends The adjustment ends once .once .Wage setters no longer Wage setters no longer have a reason to have a reason to change their change their expectations.expectations.

In the medium run, In the medium run, output returns to the output returns to the natural level of output.natural level of output.

Y Y Pne and P



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 The Adjustment of Output over TimeTime


The Effects of aThe Effects of aMonetary ExpansionMonetary Expansion

In the aggregate demand equation, we can In the aggregate demand equation, we can see that an increase in nominal money, see that an increase in nominal money, MM, , leads to an increase in the real money stock, leads to an increase in the real money stock, M/PM/P, leading to an increase in output. The , leading to an increase in output. The aggregate demand curve shifts to the right.aggregate demand curve shifts to the right.

7-4

Y YM

PG T

, ,


The Dynamics of AdjustmentThe Dynamics of Adjustment

The increase in the The increase in the nominal money stock nominal money stock causes the aggregate causes the aggregate demand curve to shift to demand curve to shift to the right.the right.

In the short run, output In the short run, output and the price level and the price level increase.increase.

The difference between The difference between YY and and YYnn sets in motion sets in motion

the adjustment of price the adjustment of price expectations.expectations.


The Dynamic Effects ofThe Dynamic Effects ofa Monetary Expansiona Monetary Expansion

In the medium run, the In the medium run, the ASAS curve shifts to curve shifts to AS’’AS’’ and the economy returns and the economy returns to equilibrium at to equilibrium at YYnn..

The increase in prices is The increase in prices is proportional to the proportional to the increase in the nominal increase in the nominal money stock.money stock.



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 ofThe Dynamic Effects ofa Monetary Expansiona Monetary Expansion


Going Behinds the ScenesGoing Behinds the Scenes

The impact of a The impact of a monetary expansion on monetary expansion on the interest rate can be the interest rate can be illustrated by the illustrated by the ISIS--LMLM model.model.

The short-run effect of The short-run effect of the monetary expansion the monetary expansion is to shift the is to shift the LMLM curve curve down. The interest rate down. The interest rate is lower, output is higher.is lower, output is higher.



If the price level did not If the price level did not increase, the shift in the increase, the shift in the LMLM curve would be larger curve would be larger—to —to LM’’LM’’..



Over time, the price Over time, the price level increases, the real level increases, the real money stock decreases money stock decreases and the and the LMLM curve curve returns to where it was returns to where it was before the increase in before the increase in nominal money.nominal money.

In the medium run, the In the medium run, the real money stock and real money stock and the interest rate remain the interest rate remain unchanged.unchanged.



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.

The Dynamic Effects of a The Dynamic Effects of a Monetary Expansion on Output Monetary Expansion on Output and the Interest Rateand the Interest Rate


The Neutrality of MoneyThe Neutrality of Money

Over time, the price level increases, and the Over time, the price level increases, and the effects of a monetary expansion on output and effects of a monetary expansion on output and on the interest rate disappear.on the interest rate disappear.

The The neutrality of moneyneutrality of money refers to the fact that refers to the fact that an increase in the nominal money stock has an increase in the nominal money stock has no effect on output or the interest rate in the no effect on output or the interest rate in the medium run. The increase in the nominal medium run. The increase in the nominal money stock is completely absorbed by an money stock is completely absorbed by an increase in the price level.increase in the price level.


A Decrease inA Decrease inthe Budget Deficitthe Budget Deficit

The Dynamic Effects The Dynamic Effects of a Decrease in the of a Decrease in the Budget DeficitBudget Deficit

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A decrease in the budget deficit leads initially to a decrease in output. Over time, output returns to the natural level of output.


Deficit Reduction, Output,Deficit Reduction, Output,and the Interest Rateand the Interest Rate

Since the price level Since the price level declines in response to declines in response to the decrease in output, the decrease in output, the real money stock the real money stock increases. This causes a increases. This causes a shift of the shift of the LMLM curve to curve to LM’LM’..

Both output and the Both output and the interest rate are lower interest rate are lower than before the fiscal than before the fiscal contraction.contraction.



The The LMLM curve continues curve continues to shift down until output to shift down until output is back to to the natural is back to to the natural level of output.level of output.

The interest rate is lower The interest rate is lower than it was before deficit than it was before deficit reduction.reduction.



Deficit reduction leads in the short run to a decrease in output and to a decrease in the interest rate. In the medium run, output returns to its natural level, while the interest rate declines further.

The Dynamic Effects of a The Dynamic Effects of a Decrease in the Budget Deficit Decrease in the Budget Deficit on Output and the Interest Rateon Output and the Interest Rate



The composition of output is different than it was before The composition of output is different than it was before deficit reduction.deficit reduction.

IS re la tio n : Yn n nC Y T I Y i G ( ) ( , )

Income and taxes remain unchanged, thus, consumption is the Income and taxes remain unchanged, thus, consumption is the same as before.same as before.

Government spending is lower than before; therefore, Government spending is lower than before; therefore, investment must be higher than before deficit reduction—investment must be higher than before deficit reduction—higher by an amount exactly equal to the decrease in higher by an amount exactly equal to the decrease in GG..

In the medium run, budget deficit reduction leads to a In the medium run, budget deficit reduction leads to a decrease in the interest rate and an increase in decrease in the interest rate and an increase in investment.investment.


Changes in the Price of OilChanges in the Price of Oil

The Price of Crude The Price of Crude Petroleum, 1960-2001Petroleum, 1960-2001

7-6

There was two sharp increases in the relative price of oil in the 1970s, followed by a decrease in the 1980s and the 1990s.


Effects on the NaturalEffects on the NaturalRate of UnemploymentRate of Unemployment

The higher price of oil causes an increase in the markup and a downward shift of the price-setting line.

The Effects of an The Effects of an Increase in the Price Increase in the Price of Oil on the Natural of Oil on the Natural Rate of Rate of UnemploymentUnemployment



An increase in the markup, An increase in the markup, , caused by an , caused by an increase in the price of oil, results in an increase in the price of oil, results in an increase in the price level, at any level of increase in the price level, at any level of output, output, YY. The aggregate supply curve shifts . The aggregate supply curve shifts up.up.

P P FY

Lze

( ) ,1 1



After the increase in the After the increase in the price of oil, the new price of oil, the new ASAS curve goes through point curve goes through point BB, where output equals , where output equals the new lower natural the new lower natural level of output, level of output, Y’Y’nn, and , and

the price level equals Pthe price level equals Pee.. The economy moves The economy moves

along the along the ADAD curve, from curve, from AA to to A’A’. Output . Output decreases from decreases from YYnn to to Y’Y’..



Over time, the economy Over time, the economy moves along the moves along the ADAD curve, from curve, from A’A’ to to A”.A”.

At point At point A”,A”, the economy the economy has reached the new has reached the new lower natural level of lower natural level of output, output, Y’Y’nn, and the price , and the price

level is higher than level is higher than before the oil shock.before the oil shock.



An increase in the price of oil leads, in the short run, to a decrease in output and an increase in the price level. Over time, output decreases further and the price level increases further.

The Dynamic Effects of an The Dynamic Effects of an Increase in the Price of OilIncrease in the Price of Oil



The combination of negative growth and high inflation, The combination of negative growth and high inflation, or stagnation accompanied by inflation, is called or stagnation accompanied by inflation, is called stagflationstagflation..

Table 7-1The Effects of the Increase in the Price of Oil,1973-1975

1973 1974 1975

Rate of change of petroleum price (%)Rate of change of petroleum price (%) 10.410.4 51.851.8 15.115.1

Rate of change of GDP deflator (%)Rate of change of GDP deflator (%) 5.65.6 9.09.0 9.49.4

Rate of GDP growth (%)Rate of GDP growth (%) 5.85.8 0.60.6 0.40.4

Unemployment rate (%)Unemployment rate (%) 4.94.9 5.65.6 8.58.5


ConclusionsConclusions

The Short Run Versus the Medium RunThe Short Run Versus the Medium Run

7-6

Table 7-2 Short-Run Effects and Medium-Run Effects of a Monetary Expansion, a Budget Deficit Reduction, and an Increase in the Price of Oil on Output, the Interest Rate, and the Price Level

Short RunShort Run Medium RunMedium Run

Output Output LevelLevel

Interest Interest RateRate

Price Price LevelLevel

Output Output LevelLevel

Interest Interest RateRate

Price Price LevelLevel

Monetary expansion increase decrease

increase(small) no change no change increase

Deficit reduction decrease decrease

decrease(small) no change decrease decrease

Increase in oil price decrease increase increase decrease increase increase


Shocks and Propagation MechanismsShocks and Propagation Mechanisms

Output fluctuationsOutput fluctuations (sometimes called (sometimes called business cyclesbusiness cycles) are movements in output ) are movements in output around its trend.around its trend.

The economy is constantly hit by The economy is constantly hit by shocksshocks to to aggregate supply, or to aggregate demand, or aggregate supply, or to aggregate demand, or to both.to both.

Each shock has dynamic effects on output and Each shock has dynamic effects on output and its components. These dynamic effects are its components. These dynamic effects are called the called the propagation mechanismpropagation mechanism of the of the shock.shock.


Key TermsKey Terms

aggregate supply relation,aggregate supply relation, aggregate demand relation,aggregate demand relation, neutrality of money,neutrality of money, stagflation,stagflation,

output fluctuations, business cycles, shocks, propagation mechanism,

putting all markets together: the as - ad model

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