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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
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