Chapter Topics Aggregate Supply Aggregate Demand Equilibrium Output in Short and Medium Run The Effects of a Monetary Expansion A Decrease in the Budget Deficit Changes in the Price of Oil Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #1 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 #2 Aggregate Supply Captures the effects of output on the price level It is derived from equilibrium in the labor market Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #3 Aggregate Supply The Determination of Aggregate Supply Recall: The nominal wage (W) = PeF(u,z) Price level (P) = (1+)W P = Pe(1+) F (u,z) Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #4 Aggregate Supply According to: P = Pe(1+) F (u,z) The price level (P) is a function of: • Pe: The expected price level • u: The unemployment rate Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #5 Aggregate Supply The price level as a function of output instead of the unemployment rate u N Y u 1 1 L L L P Pe (1 ) F (u, z ) Y P P (1 ) F (1 , z ) L e Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #6 Aggregate Supply-The price level as a function of output instead of the unemployment rate Y P P (1 ) F (1 , z ) L e Observations 1. A higher expected price level leads, one for one, 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 #7 Aggregate Supply Higher Pehigher P PeWP W=PeF(u,z) (PeW) P=(1+µ)W (WP) Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #8 Aggregate Supply Higher Outputhigher P YNPuWP Y=N(YN) N u (1 ) (N u ) L Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #9 Aggregate Supply Higher Outputhigher P W=PeF(u,z)(uW) P=(1+u)W(W P) Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #10 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 #11 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 #12 Aggregate Demand Aggregate Demand: • Captures the effect of the price level on output • Is derived from equilibrium in the Goods (IS) and financial (LM) markets Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #13 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 #14 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 #15 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 #16 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 #17 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 #18 Aggregate Demand 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 #19 Equilibrium Output in the Short and the Medium Run Y AS : P P (1 )F (1 , z ) L e M AD : Y Y ( ,G,T ) P Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #20 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 #21 Equilibrium Output in the Short and the Medium Run What do you think… If equilibrium Y is greater than Yn, will the economy automatically move to Yn over time? Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #22 Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level Assume: Pe = the price level last year Pt = price level in year t Pt-1 = price level in year t-1 Pt+1 = price level in year t+1 Therefore: Blanchard: Macroeconomics Pte = Pt-1 Chapter 7: The AS-AD Model Slide #23 Equilibrium Output in the Short and the Medium Run The dynamics of output and the price level Given: Pte = Pt-1 Y AS : Pt Pt 1(1 )F (1 , z ) L M AD : Yt Y ( ,G,T ) Pt Note: µ, z, M, G and T are assumed to be constant Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #24 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 #25 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 #26 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 #27 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 #28 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 #29 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 #30 How Long Lasting are the Real Effects of Money? The Taylor Model Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #31 How Long Lasting are the Real Effects of Money? The Mishkin Model Quarters 0 2 4 6 12 16 Effects on output Anticipated Unanticipated 1.3 2.0 1.9 2.3 1.8 2.2 1.3 2.0 0.7 0.5 -0.6 -0.4 Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #32 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 #33 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 #34 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 #35 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 #36 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 #37 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 #38 Why Has Japan Done So Poorly in the 1990s? Japanese Macroeconomic Variables 1992-1998 1992 1993 1994 1995 1996 1997 1998 Output growth (%) 1.0 0.3 0.6 1.5 3.9 0.8 -2.6 Inflation* (%) 1.7 0.6 0.2 -0.6 -0.5 0.6 0.7 Budget surplus (% of GDP) 1.5 -1.6 -2.3 -3.6 -4.3 -3.3 -6.1 Short-term interest rate 4.5 3.0 2.2 1.2 0.6 0.6 0.7 *Inflation: Rate of change of the GDP deflator. Source: OECD Economic Outlook December 1998. Has it been the result of a shift in AD or AS? Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #39 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 #40 The AD-AS Model Shocks and Propagation Mechanisms • The economy is impacted by AD and AS shocks • The shocks have dynamic effects on P and Y • The dynamic effects or propagation mechanisms vary in accordance to the shock Blanchard: Macroeconomics Chapter 7: The AS-AD Model Slide #41
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