The AS-AD Model
 Determination of Output in the short-run and
medium-run
 Requires equilibrium in the goods, financial,
and labor markets
 Aggregate supply focuses on equilibrium in
the labor market
 Aggregate demand focuses on equilibrium in
the goods and financial markets
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #1
Aggregate Supply
The Determination of Aggregate Supply
Recall:
The nominal wage (W) = PeF(u,z)
Price level (P) = (1+)W
So
P = Pe(1+) F (u,z)
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #2
Aggregate Supply
 Since
u
N
Y
u   1  1
L
L
L
Y
P  P (1   ) F (1  , z )
L
e
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #3
Aggregate Supply-The price level as a function of
output
Y
P  P (1   ) F (1  , z )
L
e
1. A higher expected price level leads
to a higher actual price level.
2. An increase in output leads to an
increase in the price level.
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #4
Aggregate Supply
 Higher Pehigher P
PeW since W=PeF(u,z)
WP since P=(1+µ)W
 Higher Outputhigher P
YNuWP
since P=(1+u)W
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #5
Aggregate Supply
Graphically:
Price Level, P
AS
Two characteristics:
1. Given Pe an increase in Y
increases P
2. At A: Y = Yn & P = Pe
A
Pe
Observation:
Y > Yn then P > Pe
Y < Yn then P < Pe
Yn
Output, Y
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #6
Aggregate Supply
Illustrating the impact of an increase in Pe
AS´ (Pe´ > Pe)
Price Level, P
AS (Pe)
A´
Pe´
Pe
Observation:
Given Yn: changes in Pe
shift the AS curve
A
Yn
Output, Y
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #7
Aggregate Demand
Goods Market (IS):
Y  C(Y  T )  I (Y , i )  G
Financial Market (LM):
M
 YL(i )
P
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #8
Aggregate Demand
IS – LM Equilibrium
LM´ (P´ > P)
Interest Rate, i
LM (P)
• Assume P increases to P´
& M is fixed
•
A´
i´
A
Initial
Equilibrium
i
M falls to M
P
P´
• LM shifts to LM´ (P´ > P)
• Equilibrium to A´
• i to i´ & Y to Y´
IS
Y´ Y
Output, Y
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #9
Aggregate Demand
Deriving Aggregate Demand (AD)
LM´ (P´ > P)
Interest Rate, i
Interest Rate, i
LM (P)
A´
i´
A
i
A´
P´
A
P
IS
Y´ Y
Y
Y´
Output, Y
Output, Y
Blanchard: Macroeconomics
AD
Chapter 7: The AS-AD Model
Slide #10
Aggregate Demand
Greater Consumer Confidence Shifts AD
A´
i´
i
Interest Rate, i
Interest Rate, i
LM (P)
A
A´
P
A
IS´
AD´
AD
IS
Y
Y Y´
Output, Y
Output, Y
Blanchard: Macroeconomics
Y´
Chapter 7: The AS-AD Model
Slide #11
Aggregate Demand
Contractionary Monetary Policy Shifts AD
LM´ (P)
i´
Interest Rate, i
Interest Rate, i
LM (P)
A´
A
i
A´
A
P
AD
AD´
IS
Y´ Y
Y´
Output, Y
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Y
Output, Y
Slide #12
Aggregate Demand: Summary
Aggregate Demand:
M
Y  Y ( ,G,T )
P
( , , )
• Y is a decreasing function of P
• Shifts in IS or LM shift AD
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #13
Equilibrium Output in the Short
and the Medium Run
Price Level, P
AS
Observation:
Equilibrium Y may be
greater than or less than Yn
A
P
Equilibrium
B
Pe
AD
Yn
Y
Output, Y
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #14
Equilibrium Output in the Short
and the Medium Run
The dynamics of output and the price level
Pt = price level in year t
Pt-1 = price level in year t-1
Pt+1 = price level in year t+1
Assume: Pte = Pt-1
Where Pte = price level expected in year t
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #15
Equilibrium Output in the Short
and the Medium Run
The dynamics of output and the price level
AS´
(t+1)
AS(t)
Price Level, P
Equilibrium Year t
At A: Yt > Yn
Pt > Pet = Pt-1
A´
Pt+1
Pet+1 = Pt
Pet =
Pt-1
Equilibrium Year t + 1
A
B´
AS shifts to AS´
At A´: Yt+1 > Yn
B
Pt+1 > Pet+1
AD(t)
Yn Yt+1 Yt
Output, Y
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #16
Equilibrium Output in the Short
and the Medium Run
The dynamics of output and the price level
AS´´
AS´
AS
Price Level, P
Pn
Equilibrium after Y + 1
A´´
• Aggregate supply
continues to shift to AS´´
A´
Pt+1
• Price level continues
to increase
A
Pt
• Output continues to
fall
AD
• Medium run
equilibrium at Pn, Yn
Yn Yt+1 Yt
Output, Y
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #17
Equilibrium Output in the Short
and the Medium Run
The dynamics of output and the price level
Two Observations
Short Run: Output can be above or below Yn
Medium Run: Prices adjust to return output
to Yn
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #18
The Effects of a Monetary
Expansion
AS´´
AS
Price Level, P
•
M: Yt = Y(
M
Pt
, G, T)
• AD shifts to AD´
Pn´
• AS shifts to AS´´
A´
Pt
Pn
• A´ equilibrium (Yt > Yn)
A´´
• Equilibrium Yn at Pn
A
• 10% increase in M
leads to 10%
AD´ increase in P
AD
Yn Y t
Output, Y
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #19
The Effects of a Monetary
Expansion
Looking Behind the Scene: IS-LM
LM (Pn)
AS´
A´´
A´
P´
Pn
Interest Rate, i
Interest Rate, i
P´n
A
AD´
in
it
A´
B
i
Y n Y1
LM´´ (Pn)
A´´
A
AD
IS
Y1
Yn Yt
Output, Y
Output, Y
Blanchard: Macroeconomics
LM´ (P´)
LM (Pn´´)
AS
Chapter 7: The AS-AD Model
Slide #20
The Effects of a Monetary
Expansion
The Neutrality of Money
A Summary
Short-run:
M Y and P
The relative change in P and Y
depends on the slope of AS
Medium run:
Prices continue to increase until P and
Y return to their original level, i.e.,
money is neutral
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #21
A Decrease in the Budget Deficit
AS
Assume: G & T as constant
AS´´
Price Level, P
• Equilibrium from
A to A´
• Y falls to Y1
A
Pn
A´
P´
Medium run
Pn´´
A´´
AD
AD´
Y1
Blanchard: Macroeconomics
Short run
• AD shifts to AD´
Yn
• P falls & AS shifts to
AS´´
• Equilibrium at A´´
P at Pn´´ & Y at Yn
Output, Y
Chapter 7: The AS-AD Model
Slide #22
A Decrease in the Budget Deficit
The Dynamic Effects of a Decrease in the Budget Deficit
AS
LM
LM´
Interest Rate, i
Price Level, P
AS´´
A
Pn
P´
A´
Pn´´
A´´
AD
AD´
Y1
LM´´
i´
i1´
B
A´
i´´
Yn
A´´
IS
IS´
Y´ Y2 Yn
Output, Y
Output, Y
Blanchard: Macroeconomics
A
i
Chapter 7: The AS-AD Model
Slide #23
A Decrease in the Budget Deficit
Budget Deficits, Output, and Investment -A Summary
Short Run
• Will lead to a decrease in output and investment
assuming no complementary monetary policy
Medium Run
• Y returns to Yn
• Interest rate is lower
• Investment increases
Long Run
• I increases
• Y increases
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #24
Changes in the Price of Oil
Effects on the Natural Rate of Unemployment
Real Wage, W/P
Assume an increase in the price of oil
1
1 
A
A´
1
1 ´
PS´ (´ >  )
WS
un
Blanchard: Macroeconomics
PS ( )
u n´
Unemployment Rate, u
Chapter 7: The AS-AD Model
Slide #25
Changes in the Price of Oil
The Dynamics of Adjustment
AS´´
AS´
Price Level, P
AS
When oil prices increase:
Pt+n
• Yn decreases to Yn´
A´
P´
Pt-1
•  increases
A´´
• AS shifts up
A
B
AD
Y´n Y´ Yn
Blanchard: Macroeconomics
• A to A´ short-run
change
• A to A´´ medium-run
change
Output, Y
Chapter 7: The AS-AD Model
Slide #26
Changes in the Price of Oil
The Effects of the Increase in the Price of Oil
1973-1975
1973
1974
1975
Rate of change of petroleum price (%)
10.4
51.8
15.1
Rate of change of GDP deflator (%)
5.6
9.0
9.4
Rate of GDP growth (%)
5.8
-0.6
-0.4
Unemployment rate (%)
4.9
5.6
8.5
Source: Economic Report of the President, 1997.
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Slide #27
The AD-AS Model
Conclusions
Short Run
Medium Run
Output
Level
Interest
Rate
Price
Level
Output
Level
Monetary expansion
increase
decrease
increase
(small)
no change
no change
increase
Deficit reduction
decrease
decrease
decrease
(small)
no change
decrease
decrease
Increase in oil price
decrease
increase
increase
decrease
increase
increase
Blanchard: Macroeconomics
Chapter 7: The AS-AD Model
Interest
Rate
Price
Level
Slide #28