Medium Run, AS-AD Model
[ECONOMY RETURNS TO THE NATURAL LEVEL OF OUTPUT, AS
GIVEN BY THE NATURAL LEVEL OF UNEMPLOYMENT.]
Three Steps
(1) IS-LM model => AD
(2) Labor Market =>AS
(3) AS-AD Model
1
Aggregate Demand
The aggregate demand relation captures
the effect of the price level on output.
It is derived from the equilibrium conditions
in the goods and financial markets:
IS relation: Y = C(Y − T ) + I (Y , i ) + G
M
LM relation:
= L(Y)+L(i)
YL(i )
P
M

Y = Y  , G, T 
 P

(+ , + , − )
Consider an increase in the price level…
PRICES INCREASE
Real
i
Real
i
IS
LM
I
Li
Prices Increase
Real
interest
rate
E1
Y
Y
LM1
LM0
E0
S
IS0
Real GDP
S = I + G – T + NX
LY
Ms/P = Li +LY
Aggregate Demand
The aggregate demand relation captures
the effect of the price level on output.
It is derived from the equilibrium conditions
in the goods and financial markets:
IS relation: Y = C(Y − T ) + I (Y , i ) + G
M L(Y)+L(i)
LM relation:
= YL(i )
P
M

Y = Y  , G, T 
 P

(+ , + , − )
1. An increase in the price level leads
to a decrease in output.
M
↑ P→ ↓
→ i ↑ → ↓ demand → ↓ Y
P
Aggregate Demand
M

Y = Y
, G, T 
 P

(+ , + , − )
1. An increase in the price level leads
to a decrease in output.
M
↑ P→ ↓
→ i ↑ → ↓ demand → ↓ Y
P
2. Monetary Policy (from M to M’)
e.g. Contraction => AD to the left
A decrease in nominal Ms decreases output
at a given price level, shifting the aggregate
demand curve to the left.
3. Fiscal Policy (from G to G’ or from T to T’)
e.g. Expansion => AD to the right
An increase in G increases output at a given
price level, shifting the aggregate demand
curve to the right.
LM
(for M’)
LM
(for
M)
IS
(for G’)
2
Wage Determination
Common forces at work in the determination of wages include:
A tendency for the wage to exceed the reservation wage, or
the wage that make them indifferent between working or
becoming unemployed.
Dependency of wages on worker’s bargaining power.
How much bargaining power a worker has depends on two factors:
How costly it would be for the firm to replace him
(the nature of the job)
How hard it would be for him to find another job
(labor market conditions)
Wage Determination
W = P e F ( u, z )
( − ,+ )
The aggregate nominal wage, W, depends on three factors:
The Expected Price Level (Pe) Both workers and firms care about
(expected ) real wages (W/Pe), not nominal wages (W):
Workers
do not care
about
dollars
receivewage
but about
The
Unemployment
Rate
(u)how
Alsomany
affecting
thethey
aggregate
is
how many goods they can buy with those
dollars. They care
W/P.
the unemployment
rateabout
u.
not care
nominal wages
they paythen
but about
IfweFirms
think do
of wages
asabout
beingthe
determined
by bargaining,
higherthe
nominal
wages (W)
pay
to the
of thevariable
goods they
The
Other Factors
(z)they
The
thirdrelative
variable,
Z,power,
isprice
a catchall
thatsell
unemployment
weakens
workers
bargaining
forcing
them
to
(P). They also care stands
about W/P.
for all the factors
affect
wages
given
accept lower wages. Higher
unemployment
alsothat
allows
firms
to pay
lower
the expected
level and the unemployment rate.
wages and still keep workers
willingprice
to work.
E.g. Unemployment insurance is the payment of
unemployment benefits to workers who lose their jobs.
Wage Determination
W = P e F ( u, z )
( − ,+ )
Price Determination
Firms set their price according to:
The term µ is the markup of the price over the cost of production. If all
markets were perfectly competitive, µ = 0, and P = W.
Medium Run Equilibrium
P = Pe, nominal wages depends on the actual price level, P,
rather than on the expected price level, Pe.
P = Pe => u = natural level of unemployment un
Y = natural level of output Yn
Medium Run Equilibrium
Pe = P, nominal wages depends on the actual price level, P,
rather than on the expected price level, Pe.
Earlier, we stated that the nominal wage
rate was determined as follows:
W = P e F ( u, z )
( − ,+ )
Dividing both sides by P, then:
This relation between the real wage
and the rate of unemployment is
called the wage-setting relation.
The price-determination equation is:
If we divide both sides by W, we get:
To state this equation in
terms of the wage rate,
we invert both sides:
W
Pe
= F ( u, z )
P
( − ,+ ) P
The wagesetting
relation
P = (1 + µ )W
P
= (1 + µ )
W
W
1
=
P (1 + µ )
The pricesetting
relation
Medium Run Equilibrium
By equaling Pe to P and by
eliminating W/P from the wagesetting and the price-setting
relations, we can obtain the
equilibrium unemployment rate,
or natural rate of unemployment,
un :
e
W
P
= F ( u, z )
P
( − ,+ ) P
The wagesetting
relation
W
1
=
P (1 + µ )
The pricesetting
relation
1
F ( un , z ) =
1+ µ
The equilibrium unemployment
rate (un) is called the
natural rate of unemployment.
The natural rate of unemployment is the unemployment rate such that the real
wage chosen in wage setting is equal to the real wage implied by price setting
and expected price level equals actual price level.
Medium Run Equilibrium
Wages, Prices, and the Natural
Rate of Unemployment
e
W
P
= F ( u, z )
P
( − ,+ ) P
The wagesetting
relation
Note that the real wage implied by
price setting is 1/(1 - µ);
thus depends on competition
and not on the unemployment rate.
W
1
=
P (1 + µ )
The pricesetting
relation
The natural rate of unemployment is the unemployment rate such that the
real wage chosen in wage setting is equal to the real wage implied by price
setting and expected price level equals actual price level.
Equilibrium Real Wages and
Natural Level of Unemployment
An increase in unemployment
benefits leads to an increase in
the natural rate of unemployment.
The wage-setting relation
W
Pe
= F ( u, z )
P
( − ,+ ) P
The positions of the wage-setting
and price-setting curves, and thus
the equilibrium unemployment rate,
depend on both z and u.
At a given unemployment rate,
higher unemployment benefits
lead to a higher WS curve. A
higher unemployment rate is
needed to bring the real wage
back to what firms are able to
pay.
By letting firms increase their
prices given the wage, less
stringent enforcement of antitrust
legislation or more government
The price-setting relation
protection of incumbents leads
W
1
to a decrease in the real wage.
=
P (1 + µ ) (next page graph)
Equilibrium Real Wages and
Natural Level of Unemployment
An increase in unemployment
benefits leads to an increase in
the natural rate of unemployment.
The wage-setting relation
W
Pe
= F ( u, z )
P
( − ,+ ) P
The price-setting relation
W
1
=
P (1 + µ )
An increase in markups decreases the real
wage, and leads to an increase in
the natural rate of unemployment.
Aggregate Supply
The aggregate supply relation captures the effects of output on the
price level. It is derived from the behavior of wages and prices.
Recall the equations for wage
and price determination :
W = P e F ( u, z )
P = (1 + µ )W
P = P e (1 + µ ) F (u, z)
Step 1: Eliminate the nominal wage from:
In words, the price level depends on the
expected price level and the
unemployment rate. We assume that µ
and z are constant.
Step 2: Express the unemployment rate
U L−
in terms of output:
u=
=
Y <=> N
L
L
N
N
Y
= 1−
= 1−
L
L
Therefore, for a given labor force,
the higher is output, the lower is the unemployment rate.
Aggregate Supply
Step 3: Replace the
unemployment rate in the
Y 

e
P = P (1 + µ ) F  1 − , z
equation obtained in step

L 
one: In words, the price level depends
on the expected price level, Pe, and the level of output, Y
(and also µ, z, and L, but we take those as constant here).
The AS relation has two important properties:
1. An increase in output leads to an increase in the price level.
This is the result of four steps:
1. Y ↑ ⇒ N ↑
2.
3.
4.
N↑ ⇒ u ↓
u↓ ⇒ W ↑
W↑ ⇒ P ↑