Putting All Markets Together: The - Model

CHAPTER
Putting All Markets

Together: The
AS-AD Model
Prepared by:
Fernando Quijano and Yvonn Quijano
© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

7-1 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 from chapter 6:
W  P e F (u ,z)
P  (1   )W

Deriving the Aggregate
Supply Relation
 Step 1: Eliminate the nominal wage from:

W  P e F ( u , z ) and P  ( 1   ) W , then:
P  P (1   ) F ( u , z )
e
In words, the price level depends on the

expected price level and the unemployment
rate. We assume that  and z are constant.

Supply Relation
 Step 2: Express the unemployment rate in

terms of output:
U L  N N Y
u    1   1 
L L L L
Therefore, for a given labor force, the higher is

output, the lower is the unemployment rate.

Supply Relation
 Step 3: Replace the unemployment rate in the

equation obtained in step one:
 Y 
P  P (1   ) F  1  , z 
e
 L 
In words, the price level depends on the
expected price level, Pe, and the level of
output, Y (and also , z, and L, but we take
those as constant here).

Properties of the AS Relation
 Y 
P  P (1   ) F  1  , z 
e
 L 
 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. N   u 
3. u   W 
4. W   P 

Properties of the AS Relation
 Y 
P  P (1   ) F  1  , z 
e
 L 
 The AS relation has two important properties:
2. An increase in the expected price level leads, one
for one, to an increase in the actual price level.
This effect works through wages:
1. P e   W 
2. W   P 

Aggregate Supply
The Aggregate Supply

Curve
Given the expected
price level, an increase
in output leads to an
increase in the price
level. If output is equal
to the natural level of
output, the price level is
equal to the expected
price level.

Properties of the AS curve
1. The AS curve is upward sloping. As explained

earlier, an increase in output leads to an increase in
the price level.
2. The AS curve goes through point A, where Y = Yn

and P = Pe. This property has two implications:
1. When Y > Yn, P > Pe.
2. When Y < Yn, P < Pe.
3. An increase in Pe shifts the AS curve up, and a

decrease in Pe shifts the AS curve down.

Aggregate Supply
The Effect of an
Increase in the
Expected Price
Level on the
Aggregate Supply
Curve
An increase in the
expected price level
shifts the aggregate
supply curve up.

7-2 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.
 Recall the equilibrium conditions for the goods
and financial markets described in chapter 5:
IS r e la tio n : Y  C (Y  T )  I (Y ,i )  G
M
L M r e la tio n :  Y L (i)
P

Aggregate Demand
The Derivation of the Aggregate

Demand Curve
An increase in the price level
leads to a decrease in output.
M
 P    i   d e m a n d   Y
P

Aggregate Demand
Changes in monetary or fiscal

policy—or more generally in any
variable, other than the price
level, that shift the IS or the LM
curves—shift the aggregate
demand curve.
 M 
Y  Y  ,G ,T 
 P 
(, , )

Aggregate Demand
Shifts of the Aggregate

Demand Curve
An increase in government
spending increases output
at a given price level,
shifting the aggregate
demand curve to the right.
A decrease in nominal
money decreases output at
a given price level, shifting
the aggregate demand
curve to the left.
 M 
Y  Y  ,G ,T 
 P 
( ,  ,  )
7-3 Equilibrium in the Short
Run and in the Medium Run
 Y 
A S R e la tio n P  P (1   ) F  1  , z 
e
 L 
 M 
A D R e la tio n Y  Y  ,G ,T 
 P 
 Equilibrium depends on the value of Pe. The

value of Pe determines the position of the
aggregate supply curve, and the position of
the AS curve affects the equilibrium.

Equilibrium in the Short Run
The Short Run

Equilibrium
The equilibrium is given
by the intersection of the
aggregate supply curve
and the aggregate
demand curve. At point
A, the labor market, the
goods market, and
financial markets are all
in equilibrium.

From the Short Run
to the Medium Run
 At point A, Y  Y n  P  P
e
 Wage setters will revise

upward their
expectations of the
future price level. This
will cause the AS curve
to shift upward.
 Expectation of a higher
price level also leads to
a higher nominal wage,
which in turn leads to a
higher price level.
From the Short Run
to the Medium Run
 The adjustment ends

onceY  Y n a n d P  P .
e
Wage setters no longer

have a reason to
change their
expectations.
 In the medium run,
output returns to the
natural level of output.

From the Short Run
to the Medium Run
The Adjustment of Output over

Time
If output is above the natural
level of output, the AS curve
shifts up over time, until output
has decreased back to the

The Effects of a
7-4
Monetary Expansion
 M 
Y  Y  ,G ,T 
 P 
 In the aggregate demand equation, we can
see that an increase in nominal money, M,
leads to an increase in the real money stock,
M/P, leading to an increase in output. The
aggregate demand curve shifts to the right.

The Dynamics of Adjustment
 The increase in the

nominal money stock
causes the aggregate
demand curve to shift to
the right.
 In the short run, output
and the price level
increase.
 The difference between
Y and Yn sets in motion
the adjustment of price
expectations.
The Dynamic Effects of
a Monetary Expansion
 In the medium run, the

AS curve shifts to AS’’
and the economy returns
to equilibrium at Yn.
 The increase in prices is
proportional to the
increase in the nominal
money stock.

The Dynamic Effects of

a Monetary Expansion
A monetary expansion leads to
an increase in output in the short
run, but has no effect on output
in the medium run.

Going Behinds the Scenes
 The impact of a
monetary expansion on
the interest rate can be
illustrated by the IS-LM
model.
 The short-run effect of
the monetary expansion
is to shift the LM curve
down. The interest rate
is lower, output is higher.

 If the price level did not

increase, the shift in the
LM curve would be larger
—to LM’’.

 Over time, the price

level increases, the real
money stock decreases
and the LM curve
returns to where it was
before the increase in
nominal money.
 In the medium run, the
real money stock and
the interest rate remain
unchanged.

The Dynamic Effects of a
Monetary Expansion on Output
and the Interest Rate
The increase in nominal money
initially shifts the LM curve
down, decreasing the interest
rate and increasing output.
Over time, the price level
increases, shifting the LM curve
back up until output is back at
the natural level of output.

The Neutrality of Money
 Over time, the price level increases, and the

effects of a monetary expansion on output and
on the interest rate disappear.
 The neutrality of money refers to the fact that
an increase in the nominal money stock has
no effect on output or the interest rate in the
medium run. The increase in the nominal
money stock is completely absorbed by an
increase in the price level.

A Decrease in
7-5
the Budget Deficit
The Dynamic Effects

of a Decrease in the
Budget Deficit
A decrease in the
budget deficit leads
initially to a decrease
in output. Over time,
output returns to the

Deficit Reduction, Output,
 Since the price level

declines in response to
the decrease in output,
the real money stock
increases. This causes a
shift of the LM curve to
LM’.
 Both output and the
interest rate are lower
than before the fiscal
contraction.

 The LM curve continues

to shift down until output
is back to to the natural
level of output.
 The interest rate is lower
than it was before deficit
reduction.

The Dynamic Effects of a
Decrease in the Budget Deficit
on Output and the Interest Rate
Deficit reduction leads in the
short run to a decrease in
output and to a decrease in the
interest rate. In the medium
run, output returns to its natural
level, while the interest rate
declines further.

 The composition of output is different than it was before

deficit reduction.
IS r e la tio n : Y n  C (Y n  T )  I (Y n , i )  G
 Income and taxes remain unchanged, thus, consumption is the
same as before.
 Government spending is lower than before; therefore,
investment must be higher than before deficit reduction—
higher by an amount exactly equal to the decrease in G.
 In the medium run, budget deficit reduction leads to a

decrease in the interest rate and an increase in
investment.
7-6 Changes in the Price of Oil
The Price of Crude

Petroleum, 1960-2001
There was two sharp
increases in the
relative price of oil in
the 1970s, followed by
a decrease in the
1980s and the 1990s.

Effects on the Natural
Rate of Unemployment
The Effects of an
Increase in the Price
of Oil on the Natural
Rate of
Unemployment
The higher price of oil
causes an increase in
the markup and a
downward shift of the
price-setting line.

 Y 
P  P (1   ) F  1  , z 
e
 L 
 An increase in the markup, , caused by an

increase in the price of oil, results in an
increase in the price level, at any level of
output, Y. The aggregate supply curve shifts
up.

 After the increase in the

price of oil, the new AS
curve goes through point
B, where output equals
the new lower natural
level of output, Y’n, and
the price level equals Pe.
 The economy moves
along the AD curve, from
A to A’. Output
decreases from Yn to Y’.

 Over time, the economy

moves along the AD
curve, from A’ to A”.
 At point A”, the economy
has reached the new
lower natural level of
output, Y’n, and the price
level is higher than
before the oil shock.

The Dynamic Effects of an

Increase in the Price of Oil
An increase in the price of oil
leads, in the short run, to a
decrease in output and an
increase in the price level. Over
time, output decreases further
and the price level increases
further.

The Effects of the Increase in the Price of Oil,

Table 7-1
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
 The combination of negative growth and high inflation,
or stagnation accompanied by inflation, is called
stagflation.

7-6 Conclusions
The Short Run Versus the Medium Run
Table 7-2 Short-Run Effects and Medium-Run Effects of a Monetary
Expansion, a Budget Deficit Reduction, and an Increase in
the Price of Oil on Output, the Interest Rate, and the Price
Level
Short Run Medium Run
Output Interest Price Output Interest Price
Level Rate Level Level Rate Level
Monetary increase
expansion increase decrease (small) no change no change increase
Deficit decrease
reduction decrease decrease (small) no change decrease decrease
Increase
in oil price decrease increase increase decrease increase increase

Shocks and Propagation Mechanisms
 Output fluctuations (sometimes called

business cycles) are movements in output
around its trend.
 The economy is constantly hit by shocks to
aggregate supply, or to aggregate demand, or
to both.
 Each shock has dynamic effects on output and
its components. These dynamic effects are
called the propagation mechanism of the
shock.
Key Terms
 aggregate supply relation,  output fluctuations,

 aggregate demand relation,  business cycles,
 neutrality of money,  shocks,
 stagflation,  propagation mechanism,

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CHAPTER

Putting All Markets

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 The aggregate supply relation captures the

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Step 1: Eliminate the nominal wage from:

In words, the price level depends on the

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Step 2: Express the unemployment rate in

Therefore, for a given labor force, the higher is

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Step 3: Replace the unemployment rate in the

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

The Aggregate Supply

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

1. The AS curve is upward sloping. As explained

2. The AS curve goes through point A, where Y = Yn

3. An increase in Pe shifts the AS curve up, and a

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 The aggregate demand relation captures the

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

The Derivation of the Aggregate

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Changes in monetary or fiscal

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

Shifts of the Aggregate

 Equilibrium depends on the value of Pe. The

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

The Short Run

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Wage setters will revise

 The adjustment ends

Wage setters no longer

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

The Adjustment of Output over

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 The increase in the

 In the medium run, the

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

The Dynamic Effects of

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 If the price level did not

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Over time, the price

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Over time, the price level increases, and the

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

The Dynamic Effects

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 Since the price level

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 The LM curve continues

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

© 2003 Prentice Hall Business Publishing Macroeconomics, 3/e Olivier Blanchard

 The composition of output is different than it was before

 In the medium run, budget deficit reduction leads to a

The Price of Crude