MORE ONTHE AS-AD MODEL

(Supplementary notes for Chapter 7)

Prof. Fei DING

The Hong Kong University of Science and Technology

PURPOSE

This set of notes aims to clarify and enhance your understanding of the medium run analysis.

Your TAs will answer any questions you may have and go over some exercises during tutorials (Nov. 2 6).

Please feel free to ask any additional questions.

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SHORT RUN VS. MEDIUM RUN EFFECTS

Table 7-1 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 Level

Interest Rate

Price Level

Output Level

Interest Rate

Price 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

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(1) MONETARY EXPANSION

Short run:

The AS-AD diagram: AD shifts right Y , P The IS-LM diagram: LM shifts down Y , i Medium run:

The AS-AD: since Y>Yn and P>Pe Revise up Pe P rises AS shifts up Y returns; P further

The IS-LM: since P , (M/P) LM shifts up back to its initial level i and Y unchanged

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YuyingTypewriterarrows along the line from the old AS to the new AS.

YuyingTypewriterneed arrows for the LM moving backto the original position also.

YuyingTypewriterhere the LM curve after shifitngdown will shift up abit as a resultof the increase in price level

YuyingTypewritercause exp price level willrevise

YuyingTypewriterand then as AS rises as a result of the increase in price, it will result in decrease in M/P and affect LM.

YuyingTypewriter"prices increased further, clearer than sr situation"

(2) BUDGET DEFICIT REDUCTION

Short run vs. Medium run (work through it!)

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YuyingTypewriterad ad, the AD will just decrease and of the ISLM, the IS will decrease and the LM will increase slightly because of the decreasein prices.

we can do the LR and SR to be in the same diagram, from the shock to the MR situation and do not need to draw the 2 diagand need to draw all the related curves

shift of AS is always because of Pe and this will result in the shifts.

the LM is because of the price level and hence, will shif down even further

increase in COP will result in an increase in mark up this will affect the natural rate of unemployment; unemployment increase,natural level of output will hence decrease and the new level of nat. output is determined.

(3) INCREASE IN OIL PRICE

The AS-AD: follow slides or textbook.

The IS-LM: effect on interest rate?

Short run: P (M/P) LM shifts up i Medium run: P further (M/P) further LM

shifts up further i further Overall: C , I , Y

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YuyingTypewriter need to have the intermediate LM and then, the finalLM curve at the natural level of output. the initial increaseis because of the price increase and the final LM is price level

YuyingTypewriternew Yn is already determined in the SR and hence, theres no further changes.

THE AD CURVE VS. DEMAND CURVES

The AD curve plots the combinations of P and Yconsistent with simultaneous equilibrium in the goods and financial markets.

It slopes down because of the effect of P on the real money supply, and hence on the interest rate, investment, and output.

The AD curve sloping down is NOT because a lower price level makes goods more attractive to people.

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THE AS CURVE VS. SUPPLY CURVES

The AS curve plots the combinations of P and Yconsistent with the equilibrium in the labor market, conditional on the expected price level.

It slopes up because higher output implies a lower unemployment rate, which leads to higher wage and higher price level.

The AS curve sloping up is NOT because firms want to supply more goods when the price level is higher.

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ANALYSIS OF SHOCKS IN THE AS-AD MODEL (1)

Unless stated otherwise, assume that the economy begins in medium-run equilibrium. This implies that output is at its natural level, unemployment is at its natural rate, and the price level equals the expected price level.

Determine whether the shock affects the natural rate of unemployment (i.e., whether the medium run outcome changes).

If the shock is to a variable in the IS-LM model, it will not affect the natural rate of unemployment.

If the shock is to a variable in the AS curve (other than the expected price level), it will affect the natural rate of unemployment and thus the natural level of output.

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ANALYSIS OF SHOCKS IN THE AS-AD MODEL (2)

Determine the initial shifts in the AS-AD diagram and IS-LM diagram. Do not neglect the secondary shift in the IS-LM diagram because of the change in price in the AS-AD diagram.

Determine whether the price level is greater than its expected level or less than its expected level.

If the economy begins in medium-run equilibrium, the expected price level is the initial price level.

Expected price level does not change in the short run, but changes as we move from short run to medium run.

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ANALYSIS OF SHOCKS IN THE AS-AD MODEL (3)

If the price level is greater than its expected level, the AS curve will shift up over time until it intersects the (possibly new) AD curve at the (possibly new) natural level of output.

As the price level increases over time, the LM curve will shift up until it intersects the (possibly new) IS curve at the (possibly new) natural level of output.

If the price level is less than its expected level, the AS and LM curves will shift down (just the opposite).

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CLARIFICATION

The short- and medium-run distinction is an analytical aid to help economists analyze the effects of shocks occurring at some point in time.

In the real world, the economy is always experiencing short-run shocks and responding to previous shocks.

The medium-run equilibrium describes a point to which the economy will tend to return to in the absence of further shocks.

The actual path of the economy, however, will depend on the sequence of shocks it receives.

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PRICE ADJUSTMENT AND SHORT-RUN EQUILIBRIUM

Chapters 3 to 5 discussed the short run in the context of a fixed price level.

In this chapter, the short-run equilibrium is the intersection of the AD and AS curves.

Prices are now allowed to change in the short run.

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PRICE ADJUSTMENT AND SHORT-RUN EQUILIBRIUM

The previous IS-LM model (Ch 5) adopts the assumption that the price level is fixed as a simplification.

Chapter 7 shows, what is true in the short run is that prices can change but may not adjust fully to restore the natural level of output, and more generally, that the actual price level may not equal the expected price level in the short run.

Going deeper, the fundamental assumption is that nominal wages do not adjust to actual prices but to expected ones. So we abandon the fixed price assumption in the short run (Ch 5), but we still need the assumption that the expected price level does not change in the short run (Ch 7).

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ABOUT INTEREST RATE

In the medium run, the interest rate is determined by the intersection of the IS curve and the natural level of output.

Effectively, conditional on the natural level of output, the interest rate is determined by fiscal policy.

Regardless of the value of money supply, the price level will adjust so that the LM curve intersects the IS curve at the natural level of output. Thus, monetary policy has no effect on the interest rate in the medium run.

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(TEXTBOOK Q4) AD SHOCKS AND MEDIUM RUN

Suppose the economy begins with output equal to its natural level. Then, there is a reduction in income taxes.

(a) Using the AS-AD model developed in this chapter, show the effects of a reduction in income taxes on the position of the AD, AS, IS, and LM curves in the medium run.

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(TEXTBOOK Q4) AD SHOCKS AND MEDIUM RUN

Suppose the economy begins with output equal to its natural level. Then, there is a reduction in income taxes.

(a) Using the AS-AD model developed in this chapter, show the effects of a reduction in income taxes on the position of the AD, AS, IS, and LM curves in the medium run.

Answer: (1) in the AS-AD:

T (similar to G ), AD shifts right; P , P > Pe increase Pe AS shifts up. (2) In the IS-LM:

T demand IS shifts right; Since P in the AS-AD, (M/P) LM shifts up.

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(TEXTBOOK Q4) AD SHOCKS AND MEDIUM RUN

(b) What happens to output, the interest rate, and the price level in the medium run? What happens to consumption and investment in the medium run?

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(TEXTBOOK Q4) AD SHOCKS AND MEDIUM RUN

(b) What happens to output, the interest rate, and the price level in the medium run? What happens to consumption and investment in the medium run?

Answer: from part (a), you know that Y returns to Yn, P (from the AS-AD), and i (from the IS-LM).

T , (Yn T) C , G is unchanged, Investment I

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TRUE, FALSE, UNCERTAIN?

a. The aggregate supply relation implies that an increase in output leads to an increase in the price level.

b. The natural level of output can be determined by looking solely at the aggregate supply relation.

c. The aggregate demand relation is downward sloping because at a higher price level, consumers wish to purchase fewer goods.

d. In the absence of changes in fiscal or monetary policy, the economy will always remain at the natural level of output.

e. Expansionary monetary policy has no effect on the level of output in the medium run.

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(TEXTBOOK Q2) AS SHOCKS AND MEDIUM RUN

Consider an economy with output equal to the natural level of output. Show the effects of an increase in unemployment benefits on the position of the AD and AS curves in the short run and in the medium run.

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(TEXTBOOK Q2) AS SHOCKS AND MEDIUM RUN

Consider an economy with output equal to the natural level of output. Show the effects of an increase in unemployment benefits on the position of the AD and AS curves in the short run and in the medium run.

SR: short run WS: wage-setting curve

MR: medium run PS: price-setting curve

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b. How will the increase in unemployment benefits affect output and the price level in the short run and in the medium run?

(TEXTBOOK Q2) AS SHOCKS AND MEDIUM RUN

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b. How will the increase in unemployment benefits affect output and the price level in the short run and in the medium run?

(TEXTBOOK Q2) AS SHOCKS AND MEDIUM RUN

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