The Determination of Aggregate Supply Aggregate Supply Recall: The nominal wage = W = P e F(u,z)...

The Determination of Aggregate Supply

Aggregate Supply

Recall:Recall:

The nominal wage = W = PeF(u,z)Price level = P = (1+)WSo

P = Pe(1+) F (u,z)

Since

Aggregate Supply

L

Y

L

N

L

uu 11

),1()1( zL

YFPP e

Aggregate Supply-The price level as a function of output

),1()1( zL

YFPP 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.

Aggregate Supply

Higher Pehigher PPe W since W = PeF(u,z) W P since P=(1+µ)W

Higher Outputhigher P

YNuWP

since P=(1+u)W

AS

Aggregate Supply

Output, Y

Pri

ce L

evel

, P

Yn

Pe

Graphically:

P >

Pe

P < Pe

A

Two characteristics:

1. Given Pe an increase in Y increases P2. At A: Y = Yn & P = Pe

Observation:Y > Yn then P > Pe

Y < Yn then P < Pe

AS´ (Pe´ > Pe)

AS (Pe)

Output, Y

Pri

ce L

evel

, P

Yn

Pe

A

Aggregate Supply

Pe´

A´Observation:

Given Yn: changes in Pe shift the AS curve

Illustrating the impact of an increase in Pe

Aggregate Demand

Goods Market (IS):Goods Market (IS):

GiYITYCY ),()(

Financial Market (LM):Financial Market (LM):

)(iYLP

M

Slide #8

LM´ (P´ > P)

LM (P)

Output, Y

Inte

rest

Rat

e, i

IS

Y

iA

Initial Equilibrium

Aggregate DemandIS – LM Equilibrium

A´i´

Y´

• falls to P

M

´P

M

• LM shifts to LM´ (P´ > P)

• Equilibrium to A´

• i to i´ & Y to Y´

• Assume P increases to P´ & M is fixed

LM (P)

IS

Y

i

Inte

res

t R

ate

, i

Output, Y

Inte

res

t R

ate

, i

Output, Y

A

AD

Aggregate Demand

Y

A

P

LM´ (P´ > P)

A´P´

Y´

Deriving Aggregate Demand (AD)

Y´

i´

A´

Slide #10

LM (P)

IS

Y

i

Inte

res

t R

ate

, i

Output, Y

AD

Y

Inte

res

t R

ate

, i

Output, Y

P

A

A

IS´ AD´

Aggregate DemandGreater Consumer Confidence Shifts AD

Y´

A´

Y´

i´ A´

IS

LM (P)

Y

i

Inte

res

t R

ate

, i

Output, Y

AD

Y

Inte

res

t R

ate

, i

Output, Y

P

A

A

AD´

Aggregate Demand

LM´ (P)

Contractionary Monetary Policy Shifts AD

Y´

i´ A´

Y´

A´

Aggregate Demand: Summary

Aggregate Demand:Aggregate Demand:

),,(

),,(

TGP

MYY

• Y is a decreasing function of P

• Shifts in IS or LM shift AD

Equilibrium Output in the Short and the Medium Run

AS

Output, Y

Pri

ce L

evel

, P

AD

Y

A

EquilibriumP

Pe

Yn

B

Observation:Short-run equilibrium Y may be greater than or less than Yn

Pt = price level in year t

Pt-1 = price level in year t-1

Pt+1 = price level in year t+1

Equilibrium Output in the Short and the Medium Run

The dynamics of output and the price levelThe dynamics of output and the price level

Assume: Pte = Pt-1

Where Pte = price level expected in year t

AS(t)

Output, Y

Price Level, P

AD(t)

Yt

Pet+1 = Pt

A

Yn

Equilibrium Year t

At A: Yt > Yn

Pt > Pet = Pt-1

Pet = Pt-1 B

AS´ (t+1)

Equilibrium Output in the Short and the Medium Run

Equilibrium Year t + 1

At A´: Yt+1 > Yn

A´

Pt+1

Yt+1

Pt+1 > Pet+1

The dynamics of output and the price levelThe dynamics of output and the price level

B´ AS shifts to AS´

AS

Output, Y

Price Level, P

AD

Yt

Pt

A

Yn

AS´´

Equilibrium Output in the Short and the Medium Run

AS´

Yt+1

Pn

A´

A´´

Pt+1

The dynamics of output and the price levelThe dynamics of output and the price level

Equilibrium after Y + 1

• Output continues to

fall• Medium run equilibrium at Pn, Yn

• Aggregate supply continues to shift to AS´´

• Price level continues to increase

Equilibrium Output in the Short and the Medium Run

The dynamics of output and the price levelThe dynamics of output and the price level

Two ObservationsTwo Observations

Short Run: Output can be above or below Yn

Medium Run: Prices adjust to return output to Yn

Slide #18

AD

AS

Output, Y

Price Level, P

Yn

Pn A

AD´

The Effects of a Monetary Expansion

Yt

A´Pt

• A´ equilibrium (Yt > Yn)

AS´´

A´´Pn´

• AD shifts to AD´

• M: Yt = Y( , G, T)

tP

M

• AS shifts to AS´´

• Equilibrium Yn at Pn• 10% increase in M

leads to 10% increase in P

LM (Pn)

Yn

Pn

AS

AD IS

Inte

res

t R

ate

, i

Output, Y

Inte

res

t R

ate

, i

Output, Y

A

in

Yn

A

LM´ (P´)

A´

Yt

it

LM´´ (Pn)

i

Y1

BAD´

The Effects of a Monetary Expansion

Looking Behind the Scene: IS-LMLooking Behind the Scene: IS-LM

Y1

P´ A´

AS´

P´nA´´ A´´

LM (Pn´´)

Slide #20

The Effects of a Monetary Expansion

A Summary

The Neutrality of MoneyThe Neutrality of Money

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

A Decrease in the Budget Deficit

AD´

AS´´

AD

AS

Output, Y

Price Level, P

Yn

PnA

Y1

A´P´

A´´Pn´´

Assume: G & T as constant

• Equilibrium from A to A´

• AD shifts to AD´

• Y falls to Y1

Short run

• P falls & AS shifts to

AS´´• Equilibrium at A´´ P at Pn´´ & Y at Yn

Medium run

Slide #22

AD

AS

Yn

PnA

IS

LM

Ai

Yn

Output, Y

Pri

ce

Le

ve

l, P

Inte

res

t R

ate

, i

Output, Y

AD´

Y1

A´P´

IS´

Y´

i´ B

LM´´

i´´ A´´

AS´´

Pn´´ A´´

LM´

Y2

A´i1´

A Decrease in the Budget Deficit

The Dynamic Effects of a Decrease in the Budget DeficitThe Dynamic Effects of a Decrease in the Budget Deficit

A Decrease in the Budget Deficit

Budget Deficits, Output, and Investment -A SummaryBudget 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

Rea

l W

age,

W/P

WS

11

PS ( )

un Unemployment Rate, u

A

´1

1

PS´ ( ´ > )

Changes in the Price of Oil

Effects on the Natural Rate of UnemploymentEffects on the Natural Rate of Unemployment

un´

A´

Assume an increase in the price of oil

AS´

AS

Output, Y

Price Level, P

AD

APt-1

Yn

Changes in the Price of Oil

The Dynamics of AdjustmentThe Dynamics of AdjustmentAS´´

A´´Pt+n

A´P´

Y´

When oil prices increase:

• Yn decreases to Yn´

• AS shifts up

• A to A´ short-run change• A to A´´ medium-

run change

• increases

B

Y´n

Changes in the Price of Oil

The Effects of the Increase in the Price of Oil1973-1975

The Effects of the Increase in the Price of Oil1973-1975

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.

The AD-AS Model

ConclusionsConclusions

Short Run Medium Run

Output Interest Price Output Interest PriceLevel Rate Level Level Rate Level

Monetary expansion increase decrease increase no change no change increase(small)

Deficit reduction decrease decrease decrease no change decrease decrease(small)

Increase in oil price decrease increase increase decrease increase increase