the as-ad model
DESCRIPTION
The AS-AD model. Aggregate Demand Aggregate Supply Policy analysis. The AS-AD model. Week 6: we examined how monetary and fiscal policy affect aggregate demand, by using different combinations of the policy mix Remember that 2 assumptions were made: - PowerPoint PPT PresentationTRANSCRIPT
The AS-AD model
Aggregate DemandAggregate Supply
Policy analysis
Week 6: we examined how monetary and fiscal policy affect aggregate demand, by using different combinations of the policy mix
Remember that 2 assumptions were made: There exists excess production capacity in the
economy (unemployment, under-utilised capital) The price of goods, services and factors of production are
fixed and do not adjust
These assumptions can be restrictive and create some problems
The AS-AD model
LM’
1. Using the correct policy mix allows you to increase output and keep interest rates relatively constant
2. But what’s to stop you going on for ever ??
IS
LM
Income, Output Y
Inte
rest
rat
e i
Y1
i1
IS’
To infinity and beyond...
Y2
i2
LM’’
IS’’
The AS-AD model
Intuitively, we know there is a limit to IS-LM: As we’ve seen, in IS-LM, you can boost GDP forever using
the Policy-mix In real life, one knows that over-using these policies leads
mainly to inflation.
Why the difference? Where does this inflation come from ? Bottom line: if demand increases beyond the productive
capacity of the economy, producers have no choice but to increase prices
The purpose of the AS-AD model is to correct the predictions of IS-LM in order to account for the fact that there is not always excess productive capacity.
The AS-AD model
The AS-AD model
Modelling strategy
Aggregate supply curve
Aggregate demand curve
Model of macroeconomic
fluctuations
IS-LM model
IS Curve LM Curve
Keynesian Equilibrium
Money market equilibrium
Labour market Equilibrium
The AS-AD model
The Aggregate Demand curve
The Aggregate Supply curve
The AS-AD equilibrium
The AD curve
The AD curve shows the amount of goods and services demanded for a given price level.
The AD curve has a negative slope : a lower level of prices tends to increase the aggregate demand for goods and services Prices affect the LM curve through real money balances: a
higher price level leads to higher interest rates in IS-LM, reducing equilibrium output.
Beware: The negative slope of the AD curve is NOT linked to the negative slope of micro demand curves!!
The AD curve
i i
Y
Y
L1(Y) L1(Y)
L2(Y)
L2(Y)
LM
LM’
45° 45°
An increase in prices reduces
real money balances (M/P)
This shifts LM left
L1(Y)
L2(i)
(M/P) = L1(Y) + L2(i)
The AD curve
i
Y
LM1
Y1
P
YAD
P2
IS
P1
1. An increase in the price level from
P1 to P2 reduces real money
balances, which shifts LM
LM2
Y2
2. The AD curve plots this overall
effect
i2
i1
P
YAD
P1
3. However, a reduction in M at
constant price leads to a shift in AD
LM’
Y2
i2
AD’
1P
M2P
Mi
Y
LM1
Y1
IS
i11P
M
1
'
P
M
The AD curve
i
YY1
P
YAD
P1
IS
1. An increase in government spending shifts IS to the right,
increasing output and interest rates
LM2
Y2
2. Because prices are unchanged, this
leads to a shift of the AD curve
i2
i1
i
IS’
AD’
Rules of thumb: A shift in IS
Always leads to a similar shift in AD
A shift in LM Leads to a similar shift
in AD only if the shift is not due to changes in the price level
Changes in the price level bring movement on AD
The AS-AD model
The Aggregate Demand curve
The Aggregate Supply curve
The AS-AD equilibrium
The AS curve
The AS curve shows the amount of goods and services supplied for a given price level.
Compared to the AD curve, one has to distinguish between the short run AS (SRAS) and the long run AS (LRAS): LRAS : In the long run, the productive capacity of the
economy does not depend on prices SRAS : A change in prices changes the real cost of labour,
affecting the productive capacity of the economy.
Beware: The positive slope of the SRAS curve is NOT linked to the slope of micro supply curves !!
The AS curve
The short run AS is derived from the WS-PS/Phillips curve framework we examined in the previous weeks. The Phillips curve already identifies a negative
trade-off between unemployment and inflation. But what we need is a trade-off between
prices/inflation and output
So how do we bridge this gap ? We use Okun’s law, the empirical relation
between output and unemployment
The AS curve
inflation rate π
Unemployment rate u
β
un
Πe
Reminder of the Phillips curve
1
ne uu
The AS curve
- 1
0
1
2
3
4
5
- 15 - 10 - 5 0 5 10 15 20
Perc
enta
ge
cgan
e in
rea
l GD
P
Change in the rate of unemployment
The AS curve
Δy = - 0,070 Δu + 2,345
R² = 0,239
- 1
0
1
2
3
4
5
- 15 - 10 - 5 0 5 10 15 20
Perc
enta
ge
cgan
e in
rea
l GD
P
Change in the rate of unemployment
nn uuYY Okun’s Law:
The Phillips curve is the negative empirical relation between inflation and unemployment (It can be obtained with the WS – PS model) :
Okun’s law is a similar negative empirical relation :
Disregarding the random shocks, one can combine these two to obtain a short run aggregate supply (SRAS) equation:
vuu ne
nn uuYY
enYY
The AS curve
Negative Relations
Positive Relation
inflation rate π
Unemployment rate u
β
un
Πe
1
ne uu inflation rate π
Output Y
γ
Y n
1
ne YY
The AS curve
The AS curve
SRAS
Y
π
π *
Y
LRAS
Workers will adjust their expectations π e and negotiate higher nominal wages. This increases the real labour costs and shifts the SRAS to the left, until the long run equilibrium is reached again
π’
If a shock increases prices, then the real cost of labour W/P will drop, pushing output Y above potential output and unemployment u below the natural rate.
Yn
In the long run, π* = π e, and the economy is at its potential output Yn, which corresponds to the natural rate of unemployment un.
The AS curve
π
Y
The long run aggregate supply is vertical at Yn.
This means that the Y=Yn condition is equivalent to u=un and π = π e
LRAS
Yn
This does NOT mean that the potential level of output Yn is fixed in time
Fall in LRAS
Increase in LRAS
It means that Yn is a function of other variables than price
The AS-AD model
The Aggregate Demand curve
The Aggregate Supply curve
The AS-AD equilibrium
The AS-AD equilibrium
SRAS
π
π *
Y
AD
LRAS
Yn
In the long run macroeconomic equilibrium, price expectations are fulfilled (π* = π e), and demand in the economy is equal to the long run productive capacity (Y =Yn).
The AS-AD equilibrium
Shocks to demand and supply lead to fluctuations at the macroeconomic level.
By “shocks” economists mean exogenous variations to supply and demand A demand shock modifies aggregate demand: increase in
G or T, change in M, etc. A supply shock modifies aggregate supply: increase in oil
prices, change in technology, etc.
Stabilisation policies are policies that attempt to keep output, inflation and employment around their long run equilibrium levels The aim is to minimise the fluctuations around equilibrium
Y1
A negative demand shock shifts the AD curve to the left, which reduces output and prices
AD2
π 1
B
The AS-AD equilibrium
SRAS
π
π *
Y
AD
LRAS
Yn
How can we return to the long run equilibrium ?
Demand-side policy :
Stimulate AD with an IS-LM policy-mix to return to point A.
Preferred solution as it stimulates a depressed
demand. Consistent with the IS-LM framework
A
SRAS2
π 2
Supply-side policy:
Stimulate the SRAS by reducing the effective cost of factors (wages) and get to C
C
π 2
π 1
Y1
The AS-AD equilibrium
SRAS
π
π *
Y
AD
LRAS
Yn
A negative supply shock (increase in production costs) causes an increase in prices and a fall in output in the short run: This is called stagflation
SRAS2
Demand-side policy :
A demand-side policy can avoid the recession, but at the cost of high inflation: this is what happened in the late 70’s
AD2 Supply-side policy:
It is preferable to carry out a supply-side policy aiming to increase the SRAS, through a reduction of inflation expectations and a policy of wage moderation.
The AS-AD equilibrium
The AS-AD model allows a better understanding of how to coordinate stabilisation policiesThe best response to a demand shock is
a demand policy (such as a fiscal stimulus policy)
The best response to a supply shock is a supply side policy (such as wage moderation and reduction of inflation expectations)