the ad-as model : policy analysis
TRANSCRIPT
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The AD-AS Model : Policy Analysis
Bilgin Bari
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
AD-AS analysis is a powerful tool for studying short-runfluctuations in the macroeconomy.
We can analyze how aggregate output and inflation rate aredetermined in the short-run.
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
1 Aggregate DemandAggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve
2 Aggregate SupplyAggregate Supply CurveAggregate Supply and Phillips Curve
3 EquilibriumShort-Run EquilibriumChanges in Equilibrium
4 Macroeconomic Policy AnalysisThe Objectives of Macroeconomic PolicyAnalyzing Policy Effects
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve
Aggregate Demand
Aggregate Demand : The total amount of outputdemanded in the economy.
Keynes proposed that low aggregate demand is responsible forlow income and high employment.
In the short-run, economy’s total income was determinedlargely by the spending of plans of households, firms, and thegovernment.
Planned expenditure (PE): the amount households, firms andthe government would like to spend on goods and services.
Planned Expenditure = Aggregate Demand
Ype = C + I + G + NX
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve
Goods Market Equilibrium
Y = Ype
Y = C + I + G + NXY = C + (mpc × YD)− cr + I − dr + G + NX − xrY = C + I + G + NX + (mpc × Y )− (mpc × T )− (c + d + x)r
subtracting mpc × Y from both dies of equation
Y − (mpc × Y ) = Y (1−mpc) =C + I + G + NX − (mpc × T )− (c + d + x)r
dividing both sides of equation (1−mpc)
Y = [C + I + G + NX − (mpc × T )]× 11−mpc −
c+d+x1−mpc r
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve
Y = [C + I + G + NX − (mpc × T )]× 1
1−mpc︸ ︷︷ ︸−c + d + x
1−mpcr︸ ︷︷ ︸
The equation shows how to determine aggregate output whengoods market is in equilibrium.
It shows the relationship between aggregate output and thereal interest rate when the goods market is in equilibrium.
First component of the equation explains shifts in IS curve(given interest rate)
Second component of the equation explains movements on IScurve (changes in real interest rate)
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve
Monetary Policy
We need real interest rate : r = i − πe- changes in nominal interest rate → changes in real interestrate (only if actual and expected inflation remain unchangedin the short-run)- We know prices are sticky in the short-run.
Central bank can determine the real interest rate in theshort-run.not long run, because prices are flexible in the long-run.
In the long-run, real interest rate is determined by theinteraction of saving and investment.
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve
MP Curve
MP curve indicates the relationship between the real interestrate which central bank sets and the inflation rate.
r = r + λπ
MP has an upward slope :- Policy makers follow Taylor principle to stabilise inflation.- Interest rate is raised more than any rise in expectedinflation.- Real interest rate rise if there is a rise in inflation.
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve
AD Curve
MP curve
shows how central bank respond to changes in inflation withsetting interest rate
IS curve
shows how changes in interest rate affects equilibrium output.
AD curve
shows the relationship between the quantity of aggregate outputand inflation rate(given inflation expectations and stance ofmonetary policy)
π ↑⇒ r ↑⇒ I ↓,C ↓,NX ↓⇒ Y ↓
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve
Shifts in AD Curve
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate Supply CurveAggregate Supply and Phillips Curve
Aggregate Supply
Aggregate supply behaves differently in the short-run than in thelong-run.
In the long-run, prices are flexible, and the aggregate supplycurve is vertical.
shifts in aggregate demand curve affect the price level andoutput remains its natural level.
In the short-run, prices are sticky, and the aggregate supplycurve is not vertical.
shifts in aggregate demand curve affect the output and docause fluctuations in output.
Some prices are sticky and others not.This is the better reflection of the real world.
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate Supply CurveAggregate Supply and Phillips Curve
Aggregate Supply Curve
We get the inflation equation :
π = πe + γ(Y − Yp) + ρ
whereπe = π−1
γ : how inflation respond to the output gap
higher γ → more flexible wages (ω ↑) → steeper PC → steeper AS
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Aggregate Supply CurveAggregate Supply and Phillips Curve
Shifts in AD Curve
π = πe + γ(Y − Yp) + ρ
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Short-Run EquilibriumChanges in Equilibrium
Short-Run Equilibrium
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Short-Run EquilibriumChanges in Equilibrium
Adjustment to Long-Run Equilibrium
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Short-Run EquilibriumChanges in Equilibrium
Adjustment to Long-Run Equilibrium
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Short-Run EquilibriumChanges in Equilibrium
Changes in Equilibrium: Aggregate Demand Shocks
Positive demand shock
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Short-Run EquilibriumChanges in Equilibrium
Changes in Equilibrium: Aggregate Demand Shocks
Negative demand shock
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Short-Run EquilibriumChanges in Equilibrium
Changes in Equilibrium: Aggregate Supply Shocks
Negative supply shock
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Short-Run EquilibriumChanges in Equilibrium
Changes in Equilibrium: Aggregate Supply Shocks
Negative permanent supply shock
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Short-Run EquilibriumChanges in Equilibrium
Changes in Equilibrium: Aggregate Demand and SupplyShocks
Negative demand and supply shock: Economic Crisis
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
Short-Run EquilibriumChanges in Equilibrium
Changes in Equilibrium: Aggregate Demand and SupplyShocks
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The Objectives of Macroeconomic PolicyAnalyzing Policy Effects
The Policy Objectives
There are two primary objectives:
Stabilizing economic activity
Achieving natural rate of unemployment is equivalent tostabilizing the economy.At the natural level of unemployment, the economy moves toits natural level of output, which we refer to more commonlyas potential output.Minimizing output gap: Y − Yp
Stabilizing inflation around a low level
Price stabilityMaintanig inflation (π) close to a target level (πT )Minimizing inflation gap: π − πT
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The Objectives of Macroeconomic PolicyAnalyzing Policy Effects
Hierarchical Versus Dual Mandates
Hierarchical mandates require stable inflation as a condition ofpursuing other goals.
Dual mandates are referred as price stability and maximumsustainable employment
Loss Function: L = α(π − πT )2 + (1− α)(Y − Yp)2
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The Objectives of Macroeconomic PolicyAnalyzing Policy Effects
The Framework
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The Objectives of Macroeconomic PolicyAnalyzing Policy Effects
Aggregate Demand Shock
Aggregate demand shock: no policy response
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The Objectives of Macroeconomic PolicyAnalyzing Policy Effects
Aggregate Demand Shock
Aggregate demand shock: policy stabilize output in the short-run
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The Objectives of Macroeconomic PolicyAnalyzing Policy Effects
Aggregate Supply Shock
Aggregate supply shock: no policy response
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The Objectives of Macroeconomic PolicyAnalyzing Policy Effects
Aggregate Supply Shock
Aggregate supply shock: policy stabilize inflation in the short-run
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The Objectives of Macroeconomic PolicyAnalyzing Policy Effects
Aggregate Supply Shock
Aggregate supply shock: policy stabilize output in the short-run
Bilgin Bari The AD-AS Model : Policy Analysis
Aggregate DemandAggregate Supply
EquilibriumMacroeconomic Policy Analysis
The Objectives of Macroeconomic PolicyAnalyzing Policy Effects
Policy Results
For demand shocks, policy that stabilizes inflation will alsostabilize economic activity.
The Divine Coincidence : stabilizing inflation also stabilizeoutput.
For supply shocks, central bank must choose between the twoobjectives.
There is trade-off for the supply shocks
Bilgin Bari The AD-AS Model : Policy Analysis