The AD-AS Model : Policy Analysis

Aggregate DemandAggregate Supply

EquilibriumMacroeconomic Policy Analysis

The AD-AS Model : Policy Analysis

Bilgin Bari

Bilgin Bari The AD-AS Model : Policy Analysis



AD-AS analysis is a powerful tool for studying short-runfluctuations in the macroeconomy.

We can analyze how aggregate output and inflation rate aredetermined in the short-run.




1 Aggregate DemandAggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve

2 Aggregate SupplyAggregate Supply CurveAggregate Supply and Phillips Curve

3 EquilibriumShort-Run EquilibriumChanges in Equilibrium

4 Macroeconomic Policy AnalysisThe Objectives of Macroeconomic PolicyAnalyzing Policy Effects




Aggregate ExpendituresMonetary Policy and Aggregate DemandAD Curve

Aggregate Demand

Aggregate Demand : The total amount of outputdemanded in the economy.

Keynes proposed that low aggregate demand is responsible forlow income and high employment.

In the short-run, economy’s total income was determinedlargely by the spending of plans of households, firms, and thegovernment.

Planned expenditure (PE): the amount households, firms andthe government would like to spend on goods and services.

Planned Expenditure = Aggregate Demand

Ype = C + I + G + NX





Goods Market Equilibrium

Y = Ype

Y = C + I + G + NXY = C + (mpc × YD)− cr + I − dr + G + NX − xrY = C + I + G + NX + (mpc × Y )− (mpc × T )− (c + d + x)r

subtracting mpc × Y from both dies of equation

Y − (mpc × Y ) = Y (1−mpc) =C + I + G + NX − (mpc × T )− (c + d + x)r

dividing both sides of equation (1−mpc)

Y = [C + I + G + NX − (mpc × T )]× 11−mpc −

c+d+x1−mpc r





Y = [C + I + G + NX − (mpc × T )]× 1

1−mpc︸︷︷︸−c + d + x

1−mpcr︸︷︷︸

The equation shows how to determine aggregate output whengoods market is in equilibrium.

It shows the relationship between aggregate output and thereal interest rate when the goods market is in equilibrium.

First component of the equation explains shifts in IS curve(given interest rate)

Second component of the equation explains movements on IScurve (changes in real interest rate)





Monetary Policy

We need real interest rate : r = i − πe- changes in nominal interest rate → changes in real interestrate (only if actual and expected inflation remain unchangedin the short-run)- We know prices are sticky in the short-run.

Central bank can determine the real interest rate in theshort-run.not long run, because prices are flexible in the long-run.

In the long-run, real interest rate is determined by theinteraction of saving and investment.





MP Curve

MP curve indicates the relationship between the real interestrate which central bank sets and the inflation rate.

r = r + λπ

MP has an upward slope :- Policy makers follow Taylor principle to stabilise inflation.- Interest rate is raised more than any rise in expectedinflation.- Real interest rate rise if there is a rise in inflation.





AD Curve

MP curve

shows how central bank respond to changes in inflation withsetting interest rate

IS curve

shows how changes in interest rate affects equilibrium output.

AD curve

shows the relationship between the quantity of aggregate outputand inflation rate(given inflation expectations and stance ofmonetary policy)

π ↑⇒ r ↑⇒ I ↓,C ↓,NX ↓⇒ Y ↓





Shifts in AD Curve




Aggregate Supply CurveAggregate Supply and Phillips Curve

Aggregate Supply

Aggregate supply behaves differently in the short-run than in thelong-run.

In the long-run, prices are flexible, and the aggregate supplycurve is vertical.

shifts in aggregate demand curve affect the price level andoutput remains its natural level.

In the short-run, prices are sticky, and the aggregate supplycurve is not vertical.

shifts in aggregate demand curve affect the output and docause fluctuations in output.

Some prices are sticky and others not.This is the better reflection of the real world.





Aggregate Supply Curve

We get the inflation equation :

π = πe + γ(Y − Yp) + ρ

whereπe = π−1

γ : how inflation respond to the output gap

higher γ → more flexible wages (ω ↑) → steeper PC → steeper AS





Shifts in AD Curve

π = πe + γ(Y − Yp) + ρ




Short-Run EquilibriumChanges in Equilibrium

Short-Run Equilibrium





Adjustment to Long-Run Equilibrium





Adjustment to Long-Run Equilibrium





Changes in Equilibrium: Aggregate Demand Shocks

Positive demand shock





Changes in Equilibrium: Aggregate Demand Shocks

Negative demand shock





Changes in Equilibrium: Aggregate Supply Shocks

Negative supply shock





Changes in Equilibrium: Aggregate Supply Shocks

Negative permanent supply shock





Changes in Equilibrium: Aggregate Demand and SupplyShocks

Negative demand and supply shock: Economic Crisis





Changes in Equilibrium: Aggregate Demand and SupplyShocks




The Objectives of Macroeconomic PolicyAnalyzing Policy Effects

The Policy Objectives

There are two primary objectives:

Stabilizing economic activity

Achieving natural rate of unemployment is equivalent tostabilizing the economy.At the natural level of unemployment, the economy moves toits natural level of output, which we refer to more commonlyas potential output.Minimizing output gap: Y − Yp

Stabilizing inflation around a low level

Price stabilityMaintanig inflation (π) close to a target level (πT )Minimizing inflation gap: π − πT





Hierarchical Versus Dual Mandates

Hierarchical mandates require stable inflation as a condition ofpursuing other goals.

Dual mandates are referred as price stability and maximumsustainable employment

Loss Function: L = α(π − πT )2 + (1− α)(Y − Yp)2





The Framework





Aggregate Demand Shock

Aggregate demand shock: no policy response





Aggregate Demand Shock

Aggregate demand shock: policy stabilize output in the short-run





Aggregate Supply Shock

Aggregate supply shock: no policy response






Aggregate supply shock: policy stabilize inflation in the short-run






Aggregate supply shock: policy stabilize output in the short-run





Policy Results

For demand shocks, policy that stabilizes inflation will alsostabilize economic activity.

The Divine Coincidence : stabilizing inflation also stabilizeoutput.

For supply shocks, central bank must choose between the twoobjectives.

There is trade-off for the supply shocks





References

Mishkin, Macroeconomics: Policy and Practice,Chapter 12 and 13


Documents

The AD-AS Model : Policy Analysis