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AD ASmodel
AD ASmodel
1
From the short run to the medium
run
In the short run prices are either sticky (non
moving) or adjusting very slowly. We can say
that their adjustment is sluggish. Output can
be above or below its natural level.
In the medium run prices are flexible. They
adjust over time. Output returns to its natural
level, the level determined by an economy’s
productive capacity, i.e. the amount of its
factors of production (capital and labor).
2
From the short run to the medium
run
So far, by using the IS-LM model, we
have a picture of the demand side of
the economy.
To get to the medium run we also
need to get a picture of the supply
side of the economy.
3
The Labor market
4
The Labor market (Wage setting)
5
The Labor market (Wage setting)
6
The Labor market (Wage setting)
7
The Labor market (Wage setting)
8
The Labor market (Wage setting)
9
The Labor market (Wage setting)
10
The Labor market (Price setting)
11
The Labor market (Price setting)
12
The Labor market (Price setting)
13
The Labor market (Wage and Price setting
combined)
We can make an assumption that will simplify things
bit, namely that in the wage setting relation, the
nominal wage depends not on the expected price
level but on the actual price level.
This could be because e.g. workers negotiate
wages very often (say every month). In that case,
they wouldn’t need to form expectations about the
price level because since they would renegotiate
their wage very soon.
14
The Labor market (Wage and Price setting
combined)
So, if Pe = P, the wage setting relation
becomes: W = PF(u, z)
Solving for the real wage W/P, we obtain:
W/P = F(u, z)
This expression tells us that the real wage W/P
is negatively related to unemployment u and
positively related to the other factors z.
15
The Labor market (Wage and Price setting
combined)
Also solving the price setting relation for the
real wage we obtain:
P = (1 + μ)W =>
P/W = (1 + μ) =>
W/P = 1/(1 + μ)
This expression tells us that the real wage
W/P does not depend on unemployment but
only on the markup μ.
16
The Labor market (Wage and Price setting
combined)
If we equate the two expressions for the real
wage that we obtained from the wage and the
price setting relations we obtain:
F(un, z) = 1/(1 + μ)
When the real wage is in equilibrium, we say
that unemployment is at its natural rate,
which we denote by un.
17
The Labor market in equilibrium
Here we combine the wage
W/P setting relation, which tells us that
the real wage is a negative
function of the unemployment
rate, and the price setting relation,
which tells us that the real wage
does not depend on
1/(1 +μ) PS unemployment. When the labor
market clears we obtain the
equilibrium level of real wage and
the equilibrium rate of
WS unemployment, which we call the
natural rate of unemployment.
un
u
18
Deriving the AS curve
Furthermore:
u = U/L =>
u = (L – N)/L =>
u = L/L – N/L =>
u = 1 – N/L
But according to our production function Y=N.
Therefore: u = 1 – Y/L
20
Deriving the AS curve
21
Deriving the AS curve
22
Deriving the AS curve
P
Starting from the labor market
AS we have managed to establish a
positive relationship between
output and prices. The AS curve
depicts this relationship.
23
Deriving the AD curve
24
Deriving the AD curve
25
Deriving the AD curve
P
Y2 Y1 Y
26
Combining the AS and AD curves
P
Combining the AS and AD
curves we may find the
AS
equilibrium level of prices and
output in an economy.
P*
AD
Y* Y
27
Fiscal expansion
28
Fiscal expansion
29
Fiscal expansion
Moving from the short to the medium run, since prices rose,
wage setters, who are not idiotic, will increase their price
expectations. In turn, this increase in expected prices will shift
the AS curve upward, so actual prices will rise again.
The process starts again: wages setters adjust their price
expectations shifting the AS curve up and increasing actual
prices.
The process comes to an end, when output, moving along the
new AD curve returns to its natural level. When output reaches
again its natural level, wage setters have no reason to adjust
their expectations and the spiral price increase ends. Now, we
are at our new medium run equilibrium (point C). Output is the
same compared to the initial level but prices are higher.
30
Fiscal expansion
31
Fiscal expansion
Starting at the natural level of output, an
P initial increase in G shifts the IS to the
AS2 right in Panel A. This results in a level of
Panel B output higher than the natural level and a
higher interest rate. In Panel B the AD
P’e = P3 curve shifts to the right leading to higher
C AS1
P2 output and actual prices higher than the
B expected level. The short run equilibrium
Pe = P1 A is at point B in both panels. Over time, the
AD2 higher prices induce wage setters to
AD1
increase their price expectations shifting
up the AS curve in Panel B. Shifting stops
Yn Y1 Y
i at the new medium run equilibrium at
point C along the new AD curve, where
Panel A LM2 output is back to its initial natural level and
prices are higher. Back to Panel A, the
i3 increase in prices reduces the supply of
C LM1 real money balances shifting the LM curve
i2
B to the left (up). In the medium run we end
i1 A up at point C, back to the natural level of
IS2 output but with a higher interest rate.
IS1
Yn Y1 Y
32
Fiscal expansion in the short run
So now, we have a clear picture of how all our variables moved in
the short run compared to their initial level:
a) Y: output is positively affected. It rises above its natural level.
b) C: consumption is positively affected since our disposable income
increases.
c) i: the interest rate increases.
d) I: the movement of investment is ambiguous because on the one
hand output went up and we know that this boosts I, but on the
other hand the interest rate increased and we also know that this
shrinks investment. So the net effect is ambiguous.
e) P: prices increase.
f) u: unemployment rate goes down, below its natural level, since
output goes up and we need more people employed to produce
that.
g) G: government expenditures go up by assumption.
33
Aggregate effects of a fiscal expansion in
the short run
Y i C I P u G
↑ ↑ ↑ ? ↑ ↓ ↑
34
Fiscal expansion in the medium run
We also have a clear picture of how all our variables moved in the
medium run compared to their initial level:
a) Y: output goes back to its natural level. It is unchanged compared
to the initial level.
b) C: consumption is also unchanged since output is unchanged.
c) i: the interest rate increases.
d) I: investment unambiguously decreases because the interest rate
increased, while output is unchanged. So only the negative effect
of the interest rate increase is at work.
e) P: prices increase.
f) u: unemployment rate is unchanged since we are back to the
previous level of output.
g) G: government expenditures go up by assumption. Notice that
investment goes down by as much as G goes up in order for
output to be unchanged. This is the well known crowding out
effect.
35
Aggregate effects of a fiscal expansion in
the medium run
Y i C I P u G
0 ↑ 0 ↓ ↑ 0 ↑
36
Fiscal contraction
38
Fiscal contraction
Moving from the short to the medium run, since prices fell, wage
setters will decrease their price expectations. In turn, this
decrease in expected prices will shift the AS curve downward, so
actual prices will fall again.
The process starts again: wages setters adjust their price
expectations shifting the AS curve down and decreasing actual
prices.
The process comes to an end, when output, moving along the
new AD curve returns to its natural level. When output reaches
again its natural level, wage setters have no reason to adjust
their expectations and the spiral price decrease ends. Now, we
are at our new medium run equilibrium (point C). Output is the
same compared to the initial level but prices are lower.
39
Fiscal contraction
40
Fiscal contraction
Starting at the natural level of output, an
P initial decrease in G shifts the IS to the left
in Panel A. This results in a level of output
Panel B AS1 lower than the natural level and a lower
interest rate. In Panel B the AD curve
Pe = P1 shifts to the left leading to lower output
A AS2
P2 B and actual prices lower than the expected
level. The short run equilibrium is at point
P’e = P3 C B in both panels. Over time, the lower
AD1
AD2 prices induce wage setters to decrease
their price expectations shifting down the
AS curve in Panel B. Shifting stops at the
Y1 Yn Y
i new medium run equilibrium at point C
along the new AD curve, where output is
Panel A LM1 back to its initial natural level and prices
are lower. Back to Panel A, the decrease
in prices increases the supply of real
i1 A LM2 money balances shifting the LM curve to
i2 B the right (down). In the medium run we
i3 C end up at point C, back to the natural level
IS1 of output but with a lower interest rate.
IS2
Y1 Yn Y
41
Fiscal contraction in the short run
So now, we have a clear picture of how all our variables moved in
the short run compared to their initial level:
a) Y: output is negatively affected. It falls below its natural level.
b) C: consumption is negatively affected since our disposable
income decreases.
c) i: the interest rate decreases.
d) I: the movement of investment is ambiguous because on the one
hand output went down and we know that this lowers I, but on the
other hand the interest rate decreased and we also know that this
boosts investment. So the net effect is ambiguous.
e) P: prices decrease.
f) u: unemployment rate goes up, above its natural level, since
output goes down and we need less people employed to produce
that.
g) G: government expenditures go down by assumption.
42
Aggregate effects of a fiscal contraction in
the short run
Y i C I P u G
↓ ↓ ↓ ? ↓ ↑ ↓
43
Fiscal contraction in the medium run
We also have a clear picture of how all our variables moved in the
medium run compared to their initial level:
a) Y: output goes back to its natural level. It is unchanged compared
to the initial level.
b) C: consumption is also unchanged since output is unchanged.
c) i: the interest rate decreases.
d) I: investment unambiguously increases because the interest rate
decreased, while output is unchanged. So only the positive effect
of the interest rate decrease is at work.
e) P: prices decrease.
f) u: unemployment rate is unchanged since we are back to the
previous level of output.
g) G: government expenditures go down by assumption. Notice that
investment goes up by as much as G goes down in order for
output to be unchanged.
44
Aggregate effects of a fiscal contraction in
the medium run
Y i C I P u G
0 ↓ 0 ↑ ↓ 0 ↓
45
Monetary expansion
46
Monetary expansion
47
Monetary expansion
Moving from the short to the medium run, since prices rose,
wage setters will increase their price expectations. In turn, this
increase in expected prices will shift the AS curve upward, so
actual prices will rise again.
The process starts again: wages setters adjust their price
expectations shifting the AS curve up and increasing actual
prices.
The process comes to an end, when output, moving along the
new AD curve returns to its natural level. When output reaches
again its natural level, wage setters have no reason to adjust
their expectations and the spiral price increase ends. Now, we
are at our new medium run equilibrium (point C). Output is the
same compared to the initial level but prices are higher.
48
Monetary expansion
49
Monetary expansion Starting at the natural level of output, an
initial increase in money supply shifts the
P LM to the right (down) in Panel A. This
Panel B AS2 results in a level of output higher than the
natural level and a lower interest rate. In
P’e = P3 Panel B the AD curve shifts to the right
C AS1 leading to higher output and actual prices
P2 higher than the expected level. The short
B
run equilibrium is at point B in both
Pe = P1 A
AD2 panels. Over time, the higher prices
AD1 induce wage setters to increase their price
expectations shifting up the AS curve in
Yn Y1 Y Panel B. Shifting stops at the new
i medium run equilibrium at point C in
Panel B along the new AD curve, where
Panel A LM1 output is back to its initial natural level and
prices are higher. Back to Panel A, the
i1 increase in prices reduces the supply of
A LM2
i2 real money balances shifting the LM curve
B back to the left (up). In the medium run in
Panel A, we end up back at point A, back
IS
to the natural level of output but with the
same interest rate compared to the initial
level.
Yn Y1 Y
50
Monetary expansion in the short run
So now, we have a clear picture of how all our variables moved in
the short run compared to their initial level:
a) Y: output is positively affected. It rises above its natural level.
b) C: consumption is positively affected since our disposable income
increases.
c) i: the interest rate decreases.
d) I: investment unambiguously increases because we saw that the
interest rate went down (this increases investment) and also
income went up (this also increases investment). So a monetary
expansion gives a twofold boost to investment (compare that to
the fiscal expansion which had an ambiguous effect on
investment).
e) P: prices increase.
f) u: unemployment rate goes down, below its natural level, since
output goes up and we need more people employed to produce
that.
51
Aggregate effects of a monetary
expansion in the short run
Y i C I P u
↑ ↓ ↑ ↑ ↑ ↓
52
Monetary expansion in the medium run
We also have a clear picture of how all our variables moved in the
medium run compared to their initial level:
a) Y: output goes back to its natural level. It is unchanged compared
to the initial level.
b) C: consumption is also unchanged since output is unchanged.
c) i: the interest rate is unchanged.
d) I: investment is unchanged since output is unchanged and the
interest rate is unchanged.
e) P: prices increase.
f) u: unemployment rate is unchanged since we are back to the
previous level of output.
Notice that the only variable that changed in the medium run is the
level of prices. This phenomenon is the so called money neutrality.
Money in the long run (medium run) does not affect real variables
but only nominal ones.
53
Aggregate effects of a monetary
expansion in the medium run
Y i C I P u
0 0 0 0 ↑ 0
54
Monetary contraction
55
Monetary contraction
56
Monetary contraction
Moving from the short to the medium run, since prices fell, wage
setters will decrease their price expectations. In turn, this
decrease in expected prices will shift the AS curve downward, so
actual prices will fall again.
The process starts again: wages setters adjust their price
expectations shifting the AS curve down and decreasing actual
prices.
The process comes to an end, when output, moving along the
new AD curve returns to its natural level. When output reaches
again its natural level, wage setters have no reason to adjust
their expectations and the spiral price decrease ends. Now, we
are at our new medium run equilibrium (point C). Output is the
same compared to the initial level but prices are lower.
57
Monetary contraction
58
Monetary contraction Starting at the natural level of output, an
initial decrease in money supply shifts the
P LM to the left (up) in Panel A. This results
AS1 in a level of output lower than the natural
Panel B
level and a higher interest rate. In Panel B
Pe = P1 the AD curve shifts to the left leading to
A AS2 lower output and actual prices lower than
P2 B the expected level. The short run
equilibrium is at point B in both panels.
P’e = P3 C AD1 Over time, the lower prices induce wage
AD2 setters to decrease their price
expectations shifting down the AS curve
Y1 Yn Y in Panel B. Shifting stops at the new
i medium run equilibrium at point C in
LM2 Panel B along the new AD curve, where
Panel A output is back to its initial natural level and
prices are lower. Back to Panel A, the
LM1 decrease in prices increases the supply of
i2 B real money balances shifting the LM curve
back to the right (down). In the medium
i1 run in Panel A, we end up back at point A,
A
back to the natural level of output but with
IS the same interest rate compared to the
initial level.
Y1 Yn Y
59
Monetary contraction in the short run
So now, we have a clear picture of how all our variables moved in
the short run compared to their initial level:
a) Y: output is negatively affected. It falls below its natural level.
b) C: consumption is negatively affected since our disposable
income decreases.
c) i: the interest rate increases.
d) I: investment unambiguously falls because we saw that the
interest rate went up (this decreases investment) and also income
went down (this also decreases investment). So a monetary
expansion gives a twofold blow to investment.
e) P: prices decrease.
f) u: unemployment rate goes up, above its natural level, since
output goes down and we need less people employed to produce
that.
60
Aggregate effects of a monetary
contraction in the short run
Y i C I P u
↓ ↑ ↓ ↓ ↓ ↑
61
Monetary contraction in the medium run
We also have a clear picture of how all our variables moved in the
medium run compared to their initial level:
a) Y: output goes back to its natural level. It is unchanged compared
to the initial level.
b) C: consumption is also unchanged since output is unchanged.
c) i: the interest rate is unchanged.
d) I: investment is unchanged since output is unchanged and the
interest rate is unchanged.
e) P: prices decrease.
f) u: unemployment rate is unchanged since we are back to the
previous level of output.
Money neutrality reaffirms itself.
62
Aggregate effects of a monetary
contraction in the medium run
Y i C I P u
0 0 0 0 ↓ 0
63
Price Shock
64
Price Shock
Let’s assume that energy prices go up. This affects the cost of
our production.
The problem is that according to our production function, we
only use labor to produce our goods.
So, the only way to incorporate the effect of the price increase
on the cost of production is to make use of the markup μ.
Remember that the markup is a percentage that tells us how
much over our marginal cost, we charge for our goods.
In our case, marginal cost is the nominal wage, so the markup
tells us how much over the nominal wage we charge. Since
the cost of production went up, this means that will charge
more over the nominal wage, i.e. the markup will increase.
65
Price Shock
66
Price Shock
W/P
The rise in the markup causes a
drop in the real wage and an
increase in the natural rate of
A unemployment. A higher natural
1/(1 +μ1) PS1
rate of unemployment translates
B to a lower natural level of output.
1/(1 +μ2) PS2
WS
un u’n
u
67
Price Shock
70
Price Shock
The energy prices shock increases the
natural rate of unemployment and lowers
P AS3 the medium run natural level of output. In
AS2 the short run the rise in the markup shifts
AS1 the AS curve up. The new short run
equilibrium is at point B where the actual
level of prices exceeds the expected level of
prices for the initial natural level of output.
P3 C Over time, the higher prices induce wage
P2 setters to increase their price expectations
B shifting the AS curve further up. Shifting
Pe = P1 A stops at the new medium run equilibrium at
point C along the AD curve, where output
AD reaches its new natural level and prices are
higher.
Y’n Y1 Yn
Y
71