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Session 12
Introduction
• The AS/AD model is the basic macroeconomic tool for studying output
fluctuations and the determination of the price level and the inflation
rate.
E1 LM2 at M/ P2
Interest rate
• At IS-LM equilibrium both
i1
goods and money market are
in equilibrium i2 E2
• AD curve plots the points
when both goods and money
market are in equilibrium at IS
different price levels
• Suppose prices decreases from Y1 Y2 Y
P1 to P2 Income, output (b)
– M/P increses from M/P1 to
M/P2 → LM shifts from LM1 P
to LM2
– Interest rates decreases from i1
to i2, and output increases P1 E1
from Y1 to Y2
• The AD schedule maps out the IS-
LM equilibrium holding
autonomous spending and the P2 E2
nominal money supply constant
and allowing prices to vary AD
Y1 Y2 Y
DERIVATION OF THE AD CURVE
Keynesian Supply Curve
• The Keynesian supply curve
is horizontal, indicating
firms will supply whatever
amount of goods is
demanded at the existing
price level
– Since unemployment
exists, firms can obtain
any amount of labor at
the going wage rate
– Since average cost of
production does not
change as output
changes, firms willing to
supply as much as is
demanded at the
existing price level
Keynesian Supply Curve
• Intellectual genesis of the Keynesian AS curve is found in the Great
Depression, when it seemed firms could increase production without
increasing P by putting idle K and N to work
• Additionally, prices are viewed as “sticky” in the short run → firms
reluctant to change prices and wages when demand shifts
– Instead firms increase/decrease output in response to demand shift → flat AS
curve in the short run
The Production Function and
Potential Output
• Y depends upon inputs (labor = N, capital = K) and technology (A)
𝑌 = 𝐹(𝐾, 𝑁, 𝐴)
• Potential output (Y*) can be defined as the output when all the
available capital stock and labor force is in full employment
Classical Supply Curve
• The classical supply
curve is vertical,
indicating that the same
amount of goods will be
supplied, regardless of
price
– Based upon the
assumption that the
labor market is in
equilibrium with full
employment of the
labor force
– The level of output
corresponding to full
employment of the
labor force =
potential GDP, Y*
Micro vs Macro: (Aggregate) Supply Curve
• In microeconomics, short run supply curve is inelastic, while the
long-run supply curve is elastic
• In macro, “price” refers to nominal price level of all the goods, and
price rise (inflation) is the general rise in prices for all goods.
– Thus, diverting labour from one sector to another only raise prices,
not the overall output in the longrun
Flexibility and Rigidity in Different Markets
• Asset market: Most flexible. Reduction in interest rate can
translate into quick changes in the bond prices/exchange
rates.
Long-run AS t = ∞
P t3
t2 P
t1 t1
t2
Price
t1
Short-run AS Price t0
t0
Y
AD
Y* Y
AS and the Price Adjustment Mechanism
Pt +1 = Pt [1 + (Y − Y * )]
• If output is above potential (Y>Y*), prices increase, higher next period
• If output is below potential (Y<Y*), prices fall, lower next period
• Prices continue to rise/fall over time until Y=Y*
– Today’s price equals tomorrow’s if output equals potential (ignoring price expectations)
The difference between GDP and potential GDP, Y-Y*, is called the output gap
AS and the Price Adjustment Mechanism
Pt +1 = Pt [1 + (Y − Y * )]
Long-run AS t = ∞
P t3
t2 P
t1
Price
Short-run AS Price t0
t0 t1
t2
t1
Y
AD
Y* Y Firms are stuck with prices that are too high
Classical Supply Curve Over Time
• Y* grows over time as the economy accumulates resources
and technology improves → AS curve moves to the right
• Y* is “exogenous with respect to the price level”
→ illustrated as a vertical line, since graphed in terms of the
price level
Labor-force, WFPR, and Unemployment
E1 LM2 at M/ P2
Interest rate
• At IS-LM equilibrium both
i1
goods and money market are
in equilibrium i2 E2
• AD curve plots the points
when both goods and money
market are in equilibrium at IS
different price levels
• Suppose prices decreases from Y1 Y2 Y
P1 to P2 Income, output (b)
– M/P increses from M/P1 to
M/P2 → LM shifts from LM1 P
to LM2
– Interest rates decreases from i1
to i2, and output increases P1 E1
from Y1 to Y2
• The AD schedule maps out the IS-
LM equilibrium holding
autonomous spending and the P2 E2
nominal money supply constant
and allowing prices to vary AD
Y1 Y2 Y
DERIVATION OF THE AD CURVE
LM1 at M1/P
Shifts in AD i M2> <M1
E1 LM2 at M2/ P
Interest rate
• At IS-LM equilibrium both
i1
goods and money market are
in equilibrium i2 E2
• AD curve plots the points
when both goods and money
market are in equilibrium at IS
different price levels
• Suppose M increases from M1 Y1 Y2 Y
to M2 Income, output (b)
– M/P increases from M/P1 to
M/P2 → LM shifts from LM1 P
to LM2
– At interest rates decreases
from i1, and output increases P1 E2
from Y1 to Y2 E1
M M
→ r → I → AD → r → I → AD
P P
M
• For a given level of M , high prices result in lowP OR high prices mean that
the real value of the number of available dollars is low and thus a high P = low
level of real AD
• Lower prices for a given money stock can also translate into wealth effect (to
the extent money is part of portfolio)
AD and the Money Market
• For the moment, ignore the goods market and focus on the money market
and the determination of AD
• The quantity theory of money offers a simple explanation of the link
between the money market and AD
– The total number of dollars spent in a year, NGDP, is P*Y
– The total number of times the average dollar changes hands in a year is the
velocity of money, V
– The central bank provides M dollars
In short run you look at the rightward shift, in the long run you look at the upward shift
• To begin with,
economy is at the
AD Policy & the
full employment Keynesian Supply Curve
• An adverse
demand shock
Long-run AS
shifts the AD
Price
t=∞
leftward
• The firms respond
by cutting
production, output P SRAS
declines
• The government
may wait for AD
market to correct
on its own, by firm Pt
cutting the wages
AD’
and costs in the
long-run
Y’ Y
Y*
• To begin with,
economy is at the AD Policy & the
full employment
Keynesian Supply Curve
• An adverse
demand shock
Long-run AS
shifts the AD
Price
t=∞
leftward
• The firms respond
by cutting
production, output P SRAS
declines
• The government
respond by raising AD
the AD ↑ 𝐺, ↓ 𝑇, ↑ 𝑀 𝑆
AD’’
AD’
Y’ Y
Y*
• In the classical case, AS
schedule is vertical at FE
AD Policy & the Long-Run
level of output Supply Curve
– Unlike the Keynesian case,
the price level is not given,
but depends upon the
interaction between AS Long-run AS t = ∞
and AD P
• Suppose AD increases to
AD’
– Spending increases to E’
BUT firms can not obtain
the N required to meet the E’’
increased demand in the
long-run Price
– Firms hire more workers
& wages and costs of Short-run AS
production rise → firms E’ t0
must charge higher price
– The increase in price from
the increase in AD
reduces the real money
stock, P , and leads
M
to a reduction in spending
AD AD’
– Move up AS and AD
curves to E’’ where AS = Y* Y
AD’
Adjustment
Paths of Price
Level and
Output
Price
t=∞
• The firms respond by
cutting production,
output declines
R
• From the initial P SRAS
point of recession
(R), prices will
AD
decrease overtime,
while the output
Pt
will increase
towards potential AD’
output level
Y’ Y
Y*
Supply Side Economics
• Supply side economics focuses on AS as the driver in the economy
• Potential GDP changes every year, but the changes do not depend on the price
level
• Thus, the potential output is exogenous to price level
• Changes in the potential output over a short-period are relatively small, a few
percent a year
Supply Side Economics
• Supply side policies are those that encourage growth in potential
output → shift AS to right.
– Such policy measures include:
– Removing unnecessary regulation, Maintaining efficient legal
system, Encouraging technological progress
– These measures will improve resource allocation and marginal
product of labor and capital
• Many economists support cutting taxes for the incentive effect, but
with a simultaneous reduction in government spending
– Tax collections fall, but the reduction in government spending minimizes
the impact on the deficit
AS and AD in the Long Run
• In the LR, AS curve moves to the
right at a slow, but steady pace
• Movements in AD over long
periods can be large or small,
depending largely on
movements in money supply
– Movements in AS slightly
higher after 1990
– Big shifts in AD between 1970
and 1980
– Prices increase when AD moves
out more than AS
– Output determined by AS, while
prices determined by the
relative shifts in AS and AD
AS and AD in the medium-run
• Aggregate supply curve describes, for each given price level, the quantity
of output firms are willing to supply
– Upward sloping since firms are willing to supply more output at higher prices
(while the AS is flat in the short-run, the counterclockwise curves represent
the medium-run)
• Aggregate demand curve shows the combinations of the price level and
the level of output at which the goods and money markets are
simultaneously in equilibrium
– Downward sloping since higher prices reduce the value of the money supply,
which reduces the demand for output
• However, as the
economy approaches
full employment,
policymakers must be
wary of too much
stimulus to avoid
running the aggregate
demand curve up the
vertical portion of the
aggregate supply
curve
AS, AD, and Equilibrium
• Shifts in either the AS or AD
schedule result in a change
in the equilibrium level of
prices and output
– Increase in AD → increase
in P and Y
– Decrease in AD → decrease
in P and Y
– Increase in AS → decrease
in P and increase in Y
– Decrease in AS → increase
in P and decrease in Y