The ASAD model Aggregate Demand Aggregate Supply Policy

The AS-AD model Aggregate Demand Aggregate Supply Policy analysis

The AS-AD model ¢ ¢ Week 6: we examined how monetary and fiscal policy affect aggregate demand, by using different combinations of the policy mix Remember that 2 assumptions were made: l l ¢ There exists excess production capacity in the economy (unemployment, under-utilised capital) The price of goods, services and factors of production are fixed and do not adjust These assumptions can be restrictive and create some problems

The AS-AD model 1. Using the correct policy mix allows you to increase output and keep interest rates relatively constant Interest rate i To infinity and beyond. . . LM 2. But what’s to stop you going on for ever ? ? LM’’ i 2 i 1 IS Y 1 Y 2 IS’ Income, Output Y IS’’

The AS-AD model ¢ Intuitively, we know there is a limit to IS-LM: l l ¢ Why the difference? Where does this inflation come from ? l ¢ As we’ve seen, in IS-LM, you can boost GDP forever using the Policy-mix In real life, one knows that over-using these policies leads mainly to inflation. Bottom line: if demand increases beyond the productive capacity of the economy, producers have no choice but to increase prices The purpose of the AS-AD model is to correct the predictions of IS-LM in order to account for the fact that there is not always excess productive capacity.

The AS-AD model ¢ Modelling strategy Keynesian Equilibrium Money market equilibrium IS Curve LM Curve Labour market Equilibrium IS-LM model Aggregate supply curve Aggregate demand curve Model of macroeconomic fluctuations

The AS-AD model The Aggregate Demand curve The Aggregate Supply curve The AS-AD equilibrium

The AD curve ¢ ¢ The AD curve shows the amount of goods and services demanded for a given price level. The AD curve has a negative slope : a lower level of prices tends to increase the aggregate demand for goods and services l ¢ Prices affect the LM curve through real money balances: a higher price level leads to higher interest rates in IS-LM, reducing equilibrium output. Beware: The negative slope of the AD curve is NOT linked to the negative slope of micro demand curves!!

The AD curve i This shifts LM left i LM’ LM L 2(i) L 2(Y) Y L 1(Y) An increase in prices reduces real money balances (M/P) L 1(Y) (M/P) = L 1(Y) + L 2(i) 45° Y 45° L 2(Y)

The AD curve 2. The AD curve plots this overall effect P 3. However, a reduction in M at constant price leads to a shift in AD P P 2 P 1 AD AD’ Y LM 2 i AD Y LM’ i LM 1 i 2 i 1 Y 2 Y 1 1. An increase in the price level from P 1 to IS P 2 reduces real Y money balances, which shifts LM i 1 IS Y 2 Y 1 Y

The AD curve P 2. Because prices are unchanged, this leads to a shift of the AD curve P 1 AD ¢ ¢ l AD’ Y ¢ i LM 2 i i 2 i 1 IS Y 1 Y 2 Rules of thumb: A shift in IS Y Always leads to a similar shift in AD A shift in LM 1. An increase in government spending shifts IS to the right, increasing output and interest rates l IS’ l Leads to a similar shift in AD only if the shift is not due to changes in the price level Changes in the price level bring movement on AD

The AS-AD model The Aggregate Demand curve The Aggregate Supply curve The AS-AD equilibrium

The AS curve ¢ ¢ The AS curve shows the amount of goods and services supplied for a given price level. Compared to the AD curve, one has to distinguish between the short run AS (SRAS) and the long run AS (LRAS): l l ¢ LRAS : In the long run, the productive capacity of the economy does not depend on prices SRAS : A change in prices changes the real cost of labour, affecting the productive capacity of the economy. Beware: The positive slope of the SRAS curve is NOT linked to the slope of micro supply curves !!

The AS curve ¢ The short run AS is derived from the WSPS/Phillips curve framework we examined in the previous weeks. l l ¢ The Phillips curve already identifies a negative trade-off between unemployment and inflation. But what we need is a trade-off between prices/inflation and output So how do we bridge this gap ? l We use Okun’s law, the empirical relation between output and unemployment

The AS curve Reminder of the Phillips curve inflation rate π β 1 Πe un Unemployment rate u

The AS curve

The AS curve l Okun’s Law:

The AS curve ¢ The Phillips curve is the negative empirical relation between inflation and unemployment (It can be obtained with the WS – PS model) : Negative Relations ¢ ¢ Okun’s law is a similar negative empirical relation : Disregarding the random shocks, one can combine these two to obtain a short run aggregate supply (SRAS) equation: Positive Relation

The AS curve inflation rate π β γ 1 1 Πe un Unemployment rate u Yn Output Y

The AS curve π LRAS In the long run, π* = π e, and the economy is at its potential output Yn, which corresponds to the natural rate of unemployment un. SRAS If a shock increases prices, then the real cost of labour W/P will drop, pushing output Y above potential output and unemployment u below the natural rate. π’ π* Workers will adjust their expectations π e and negotiate higher nominal wages. This increases the real labour costs and shifts the SRAS to the left, until the long run equilibrium is reached again Yn Y Y

The AS curve π LRAS The long run aggregate supply is vertical at Yn. This means that the Y=Yn condition is equivalent to u=un and π = π e Fall in LRAS Increase in LRAS This does NOT mean that the potential level of output Yn is fixed in time It means that Yn is a function of other variables than price Yn Y

The AS-AD model The Aggregate Demand curve The Aggregate Supply curve The AS-AD equilibrium

The AS-AD equilibrium π LRAS SRAS In the long run macroeconomic equilibrium, price expectations are fulfilled (π* = π e), and demand in the economy is equal to the long run productive capacity (Y =Yn). π* AD Yn Y

The AS-AD equilibrium ¢ ¢ Shocks to demand supply lead to fluctuations at the macroeconomic level. By “shocks” economists mean exogenous variations to supply and demand l l ¢ A demand shock modifies aggregate demand: increase in G or T, change in M, etc. A supply shock modifies aggregate supply: increase in oil prices, change in technology, etc. Stabilisation policies are policies that attempt to keep output, inflation and employment around their long run equilibrium levels l The aim is to minimise the fluctuations around equilibrium

The AS-AD equilibrium π A negative demand shock shifts the AD curve to the left, which reduces output and prices LRAS SRAS 2 How can we return to the long run equilibrium ? Supply-side policy: A π* π1 Stimulate the SRAS by reducing the effective cost of factors (wages) and get to C B Demand-side policy : C π2 Stimulate AD with an IS-LM policy-mix to return to point A. AD 2 Y 1 Yn AD Y Preferred solution as it stimulates a depressed demand. Consistent with the IS-LM framework

The AS-AD equilibrium π LRAS SRAS 2 SRAS A negative supply shock (increase in production costs) causes an increase in prices and a fall in output in the short run: This is called stagflation π2 Demand-side policy : π1 A demand-side policy can avoid the recession, but at the cost of high inflation: this is what happened in the late 70’s π* AD 2 Supply-side policy: It is preferable to carry out a supplyside policy aiming to increase the SRAS, through a reduction of inflation expectations and a policy of wage moderation. AD Y 1 Yn Y

The AS-AD equilibrium ¢ The AS-AD model allows a better understanding of how to coordinate stabilisation policies l The best response to a demand shock is a demand policy (such as a fiscal stimulus policy) l The best response to a supply shock is a supply side policy (such as wage moderation and reduction of inflation expectations)