ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

10. The Aggregate Demand Aggregate Supply (AD-AS) Model

1. The AD-AS Model

Goods Market AD Curve Money Market AD-AS Model

Labor Market

AS Curve

The AD-AS model allows us: o to analyze the change in real output and the price level simultaneously, so it provides insights on inflation, recession, and unemployment. So far in our short-run analysis, it is assumed price level to be fixed. o to analyze how the economy behaves in the short run and how it adjusts to the long run equilibrium. o to analyze the effects of fiscal policy and monetary policy in detail. An important assumption about the AD-AS model is that when the economy is in equilibrium, there is no ongoing inflation. o Therefore, the AD-AS model is best suited to analyze an economy with no ongoing inflation or an inflation rate so low that it is insignificant and can be ignored in the analysis. When an economy has significant ongoing inflation even when its in equilibrium, the model needs to be adjusted (to be discusses in the next topic).

2. The Connections between the Goods Market and the Money Market In our previous topics, we study how the goods market (Topic 7 8) and the money market (Topic 9) work in isolation. However, the two markets do not work independently. o Only by analyzing the two markets together we can determine the values of real output or real GDP (Y) and the interest rate (r) that are consistent with the equilibrium in both markets. There are two links between the goods market (that determines Y) and the money market (that determines r): o Interest rate and planned investment spending and consumption expenditure. Both autonomous consumption expenditure (Ca) and planned investment (Ip) increases when interest rate decreases. (Why?)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Expenditure (AE) Y = AE AE2 (r = r2) AE1 (r = r1) Ca + Ip

A2 A A1 Y1 Y2 Y = A / (1 c) Income (Y)

Real income and money demand. Money demand (MD) increases when real income (Y) increases.

Interest rate (r)

Ms

r2 r1 Md2 (Y = Y2) Md1 (Y = Y1)

M1

Money (M)

To illustrate their connection, suppose that the government conducts an expansionary fiscal policy by increasing G. o The initial increase in G would increase the planned autonomous expenditure, leading to a higher income. o A higher income increases the money demand, resulting in higher interest rate. o A higher interest rate will lower planned investment and consumption. Therefore, the final increase in Y is less than that if interest rate did not increase.

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Crowding out effect: When effects in the money market are included in the short-run analysis, an increase in government spending raises the interest rate and crowds out some private investment and consumption spending. How would the crowding out effect affect the government spending multiplier we covered in the Keynesian model, i.e. 1/(1 c)? What is the difference between the crowding out effect in the classical model?

Expenditure (E) Y = AE

AE2 (for r = r1) AE3 (for r = r2) AE1 (for r = r1)

A2 G A1 Y1 Y3 Y2 Income (Y)

Y = G / (1 c)

3. The Aggregate Demand (AD) Curve Aggregate demand curve shows the relationship between the real output that the economy demand in equilibrium and the general price level. o Understanding how the goods market and the money market connection allows us to relate the amounts of real output demanded and general price level. To derive the AD curve, we start from the money market. o How does an increase in price level affect the money market? Money demand (Md) increases when price level (P) increases. (Why?) o The initial increase in Md would increase the interest rate. o A higher interest rate will lower investment and consumption, leading to a decrease in Y. The aggregate demand (AD) curve is downward sloping o When the price level increases, the amount of real output decreases. o Note: The explanation of the negative slope of the AD curve is not the same as that for why the demand curve for a single good slopes downward (Why?)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Interest rate (r)

Ms

r2 r1

Md2 (for P = P2) Md1 (for P = P1)

M1

Money (M)

Expenditure (AE) Y=E

AE1 (for r = r1) AE2 (for r = r2)

A1 A2 Income (Y) Price Level (P)

P2

P1

AD

Y2

Y1
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Income (Y)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Other factors affecting (shifting) the AD curve: o Any factors that result in a change in real output (Y), except a change in price, will cause a shift in the AD curve. Factors inducing an increase in real output, given any price levels, will shift the AD curve rightward. Factors inducing a decrease in real output, given any price levels, will shift the AD curve leftward.

Expenditure (AE) Y = AE

AE2 AE1

A2 A1 Income (Y) Price Level (P)

P1

AD2

AD1

Y1

Y2

Income (Y)

What are these factors? Factors affecting Ca, such as wealth, household expectations about future income and future price level, net taxes (fiscal policy) Factors affecting Ip, such as expected returns to investments (what factor in turn affect expected returns?) Factors affecting G (fiscal policy) Factors affecting net exports, such as foreign income and exchange rate.

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Factors affecting Interest rate (affects both Ca and Ip ) via the money market: Money supply Other factors affecting money demand, such as expected future inflation and changes in payment technologies.

4. The Aggregate Supply (AS) Curve Aggregate supply curve shows the relationship between the real output that the economy produce in equilibrium and the general price level. Although there is little disagreement among economists about how the AD curve is derived, there is a great deal of disagreement about how the AS curve is derived and the explanation about the shape of the AS curve.

4.1 The Keynesian model Sticky Nominal Wage Rates Recall that the amount of output an economy produces depends on two factors: o The amounts of inputs (such as labor and capital) utilized in the production. o The production technology to transform inputs into outputs. In understanding the supply side of the economy in the short run, John Maynard Keynes (1936) stressed the importance of stickiness in nominal wages. o The nominal wage, W, is assumed to be fixed in the short run. In the Keynesian view, the only difference of the labor market from the classical view is that the nominal wage rate, W, is assumed not to adjust to generate the real wage rate, W/P, that balances the labor demand and supply. o Moreover, it is assumed that W is fixed at a level that makes W/P higher than its marketclearing level. o The model predicts there will be unemployment in equilibrium, even when the real wage is flexible.

Real wage (W/P) Labor Supply (LS)

The natural rate of unemployment (W/P)

*

Labor Demand (LD) L (full employment)

*

Labor (L)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Why are nominal wages sticky? o For most workers, nominal wage rates are set for one or more years by the implicit between firms and employees or formal contracts between the firms and labor unions. o Wages in many large corporations are set by slow-moving bureaucracies. o Wage change can be costly to firms: It is costly to publicize the higher wages to attract new workers. Lower wages can reduce morale of workers and hence their productivity. o Firms may benefit from developing reputations for paying stable wages. Why are nominal wages set above the classical equilibrium wage? o The new-Keynesian argues that firms choose to pay a higher wage than the classical equilibrium wage because it is in their best interest to do so. This is called the efficiency wage theory. To attract high-quality applicants (adverse selection) To ensure productivity of its workers (moral hazard) To minimize turnover costs To maintain health of workers

4.2 The Labor Market and The Real Output: The AS Curve
Real wage (W/P) Labor Supply (LS)

(W/P)1 (W/P)2

Labor Demand (LD)

Labor (L) Output (Y)

Production Function Y2 Y1

L1

L2
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Labor (L)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

The above diagram shows the relationship between the labors employed and real output. o When there is a decrease in real wage, firms will find it profitable to employ more labor. o An increase in labor utilized results in higher real output.

4.3 The (Short-Run) Aggregate Supply Curve To derive the short-run AS curve, we consider the labor market (in Keynesian view): o How does an increase in price level affect the labor market? In the short run, as nominal wage level is fixed ( W ), an increase in price level (P) reduces the real wage ( W P ). Firms will find it profitable to employ more labor because the unit cost of production is lowered, other things constant. An increase in labor utilized results in higher real output (Y). When the price level increases, the amount of real output produced increases.

Therefore, the short-run aggregate supply (AS) curve is upward sloping.

Other factors affecting (shifting) the aggregate supply curve: o Any supply shocks that result in a change in real output (Y), except a change in price, will cause a shift in the AS curve. Factors inducing an increase in real output, given any price levels, will shift the AS curve rightward. Factors inducing a decrease in real output, given any price levels, will shift the AS curve leftward. o What are these factors? Technology change Other inputs (prices of other inputs) Other factors such as weather and natural disasters. Nominal wage rates

Note that our explanation of the upward sloping AS curve basically focus on the Keynesian model of sticky nominal wage. As mentioned earlier, other economists offered other models to explain the upward sloping AS curve, such as: o New-Keynesian: Sticky Prices Model (the explanation in your textbook is based on the sticky price model) o New-classical: The Price-Misperception Model In this model, households and firms sometime misinterpret changes in nominal prices and wage rates as changes in relative prices and real wage rates. Therefore, they will produce more output and supply more labor when the nominal price and wage rates increase.

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Real wage (W/P) Labor Supply (LS)

W P1
W P2

Labor Demand (LD)

Labor (L) Output (Y)

Production Function Y2 Y1

L1 Price Level (P)

L2 AS

Labor (L)

P2

P1

Y1

Y2

Income (Y)

ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

4.4 The New-Keynesian model Sticky Prices Model One of the major flaw about the Keynesian explanation of the upward-sloping AS curve is that the Keynesian model predicts real wage to be low (high) when employment and output is high (low), which seems inconsistent with the real-world observations. o One of the major motivations for the new Keynesian model is that it eliminates this problem. o The formal new Keynesian model relies on sticky nominal prices, but many economists believe that sticky nominal wage rates are more important in real world. Nonetheless, the assumption of sticky nominal wage rates can be incorporated into the formal model easily. The sticky prices model relies on two main assumptions: o Many markets are imperfect competition, so that the typical firm sets the price of the good instead of price-taking. o When choosing the price to set, each firm takes into account a cost of change prices, i.e. the menu cost. Price setting under imperfect competition: o As what we have learnt in microeconomics, a price setting firm sets the price of its product above its marginal cost (or unit costs). o For any individual firm,
Markupratio Price Nominalunit costs

The average markup ratio (or percentage markup) in the economy is determined by competitive structure of the economy, which changes very slowly. Therefore, it is assumed that the average percentage markup to be constant from year to year (over the short run). Therefore, for the economy as a whole,
Pricelevel Markupratio Nominalunit costs

In the short run, the price level rises when there is an increase in nominal unit costs.

The relationship between real output (Y) and nominal unit costs: o Diminishing marginal returns: As the output increases, greater amount of labors are needed to produce a unit of output, resulting in higher unit costs. o Nonlabor input prices: An increase in output results in the demand for some scarce resources or inputs, such as land and natural resources, resulting in higher unit costs. The nominal wage rates: Greater output means higher employment, leaving fewer unemployed workers searching for jobs. To compete for these increasingly scarce workers, firms have to pay a higher nominal wage.

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ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

There are a few important notes regarding the new-Keynesian approach to the AS curve: o In the formal sticky price theory, the assumption of sticky nominal wage rates is not necessary to derive the upward-sloping short-run AS curve. However, here we incorporate the assumption of fixed nominal wage in the short run (following your textbook approach and make it more consistent throughout our analysis). Therefore, we will assume in our following discussion that the short-run AS curve is upward sloping due to the first two reasons in the short run. And nominal wage will adjust only in the long run. Another important note is that in the new-Keynesian model, the AS curve shows how changes in output affect the general price level (unlike the Keynesian model).

Other factors affecting (shifting) the aggregate supply curve: o Any supply shocks that result in a change in unit costs, hence price level (P), except a change in output, will cause a shift in the AS curve. Factors inducing an increase in price level, given any output, will shift the AS curve upward. Factors inducing a decrease in in price level, given any output, will shift the AS curve downward. o What are these factors? Basically the same factors as in the Keynesian approach mentioned earlier (why?)

4.5 The Long-Run Aggregate Supply Curve In the long run, nominal wages fully adjust to changes in price level to maintain the labor market equilibrium. o How does an increase in price level affect the labor market in the long run? In the long run, when there is an increase in price level (P), the nominal wage level is flexible (W) to adjust. It will also increase correspondingly to maintain the labor market equilibrium. The amount of labor utilized remains at the full employment level, and the corresponding real output remains unchanged at the full employment output level or potential GDP (Yf).

Therefore, the long-run aggregate supply (LRAS) curve is vertical (at the full employment output level). Note that the long-run supply curve will shift as the potential output grows, i.e. the long-run economic growth. o Whether a supply shocks would shift LRAS depends on whether the supply shocks are temporary or permanent.

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ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Real wage (W/P) Labor Supply (LS)

W2/P2 = W1/P1

Labor Demand (DL)

Labor (L) Output (Y) Production Function

Yf

Lf Price Level (P) LRAS

Labor (L)

P2

P1

Yf

Income (Y)

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ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

5. The Short-Run Equilibrium The short-run equilibrium in the AD-AS model is the combination of price level and output level consistent with the general equilibrium in the macroeconomy.

Price Level (P) AS

P1

P*

AD

Y*

Y1

Income (Y)

The short-run equilibrium occurs at the combination of price and output at which the aggregate demand equals aggregate supply. o Short-run equilibrium requires that the economy be operating on its AD curve AND AS curve. o What would happen at point A? What would happened at point B? Note that in the adjustment process, output and price level tend to adjust together.

6. Explaining Short-Run Fluctuations Short-run fluctuations can be explained by changes in the (short-run) equilibrium of the ADAS model. Demand Shocks o Decrease in AD: Output is falling and price level is falling Cyclical Unemployment and (once-off) deflation o Increase in AD: Output is rising and price level is rising Expansion (when the economy has excess capacity) Demand-pull inflation (especially when the economy is facing capacity constraints) Supply Shocks o Decrease in AS:
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ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Output is falling and price level is rising (stagflation) Cost-push inflation

Increase in AS: Output is rising and price level is falling

Price Level (P) LRAS AS

P1 AD1

P2

AD2 Y2 Yf Income (Y)

Price Level (P) LRAS AS2 AS1

P2 P1 AD

Y2

Yf

Income (Y)

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ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

7. Analyzing the Effects of Fiscal Policy with the AD-AS Model Effects of Expansionary Fiscal Policy o Suppose the economy is initially operating at point A (below full employment), at which the real GDP is Y1, which is below the potential GDP, Yf. o To simulate the economy, the government can pursue an expansionary fiscal policy to shift the AD curve rightward.

Price Level (P) LRAS AS

B P2 P1 A AD2 AD1

Y1

Yf

Income (Y)

Note that an increase in G results in a higher price level. o The higher price level increases the money demand and leads to a higher interest rate. o It reduces the Ca and Ip, and therefore lowers output level, thus making the rise in output smaller than it would be when the price is fixed. o The partial crowding out caused by the rise in price level decreases the size of the multiplier further (in addition to the crowding out effect described earlier even when the price is fixed, which results in the AD curve shifting outward by a size less than the full multiplier effect). How about a contractionary fiscal policy?

8. Analyzing the Effects of Monetary Policy with the AD-AS Model Effects of an Decrease in Money Supply o Suppose the economy is initially operating at point A (above full employment), at which the real GDP is Y1 and price level is P1. o To lower the price level, the central bank can pursue a contractionary monetary policy to shift the AD curve leftward. A decrease in the money supply raises the interest rate, which lowers the planned investment and consumption.

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ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

How about an expansionary monetary policy: an increase in money supply?

Price Level (P) LRAS AS

A P1 P2 B AD1 AD2

Yf

Y1

Income (Y)

9. Adjustment to the Long-Run Equilibrium In the short run, nominal wage is assumed to be fixed. But in the long run, nominal wage can change. What would happen over time if output is above full employment? o With employment higher than the natural rate of employment level, firms will have to compete to hire scarce workers, driving up their wage rate in the long run. o The short-run AS curve, which is derived based on the fixed nominal wage will be adjusted. A rise in nominal wage rate means an increase in unit cost (which implies a higher price level given the fixed markup ratio), resulting in an upward shift of AS curve. A fall in nominal wage rate means a decrease in unit cost (which implies a lower price level given the fixed markup ratio), resulting in an upward shift of AS curve.

In the long run, changes in nominal wage rate and the price level will eventually cause the economy to correct itself and return to full-employment output. o It is often called the self-correcting mechanism. o The long-run equilibrium occurs at the price level at which the aggregate demand equals the long-run aggregate supply. The self-correcting mechanism implies that in the long run, the economy will eventually behave as the classical model predicts. o Demand shocks cannot change the long-run potential GDP. o Complete crowding out an increase in government purchases.

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ECON 1220 Principles of Macroeconomics

Second Semester, 2011/12

Price Level (P) LRAS AS1 AS2

A P1 P2 P3 B AD1 C AD2

Y2

Yf

Income (Y)

The long-run adjustment to the supply shocks depends whether the shocks are temporary or permanent. o A temporary supply shock causes only temporary shift of the AS curve and it will return back to its original position over the long run. o In a supply shock can last for an extended period (say, persists for several years) the logrun adjustment is analogous to that of the demand shocks. o If there is a permanent supply shocks that causes an economic growth, wage rate will adjust analogously but the long-run equilibrium of the macroeconomy ends up at the intersection of the AD and the new LRAS curve.

Readings: Chapters 26 (including Appendix), 27

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