applications of the ad-as model lecture 25 – academic year 2014/15 introduction to economics fabio...
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Applications of the AD-AS Model
Lecture 25 – academic year 2014/15Introduction to Economics
Fabio Landini
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Demand shocks
How do we model the transition from the short to the medium period in the AD-AS model?
What happens in the medium period when we increase the supply of money?
What happens in the medium period when we reduce the public deficit?
Which are the effects of demand shocks?
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• Transitions from short to medium period
• Effects of an increase in money supply• Effects of a reduction in public deficit
• Effects of a demand shock
Demand shocks
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Transition from the short to the medium period
Point A can be both the short and the medium period equilibrium depending on the assumptions on PE
Medium period PE=P -> u=un -> Y=Yn
PAS
AD
Y
PA
YA
A
=Yn
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In the short period -> PE can be ≠ from P For instance PE<P -> YA>Yn
How do we move from the short period equilibrium A to the medium period equilibrium?
PAS
AD
Y
PA
YA
A
Yn
Transition from the short to the medium period
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Is it plausible that the economy remains in equilibrium A?In A (short period equilibrium) -> Y>Yn and P>PE -> individuals underestimate prices
PAS
AD
Y
PA
YA
A
Yn
Transition from the short to the medium period
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Individuals underestimates prices -> they have wrong expectations concerning prices
As times passes workers realize that PE is too low -> price expectations adjust -> PE
AS parametrically depends on PE -> If PE the
AS curve shifts upward
Transition from the short to the medium period
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P
PA
PA’
A’A
Yn YA’ YA
AD
AS
AS’
PE -> AS shifts upward
New equilibrium A’ -> Y (YA -> YA’) P (PA -> PA’)
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P
PA
PA’
A’A
Yn YA’ YA
AD
AS
AS’
PE -> A -> A’; Is A’ the final equilibrium of the system?In A’ -> Y>Yn and P>PE -> PE continues
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P
PA
PA’ A’A
Yn YA’ YA
AD
AS
AS’
PE -> AS shifts again upwardY is still > Yn -> new PE… the process continues until Y=Yn -> PE= P
In A’’ -> Y=Yn -> PE=P -> the expectation must not be adjusted -> the adjustment process (i.e. the AS curve) stops
AS’’
A’’
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When Y=Yn (point A’’) the adjustment stops
In the medium period the intersection between the AS and AD curves is always along the line Y = Yn
Conclusion: Until P>PE -> agents adjust their expectations:
PE -> P and Y
The adjustment process stops when Y = Yn and P = PE
Point A’’ -> Medium period equilibrium of the system
The dynamics is the opposite if in the short period equilibrium we have Y < Yn
Transition from the short to the medium period
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We use the AD-AS model to examine: •Expansive monetary policy•Reduction of public deficit
The two cases are examples of “demand shock”
Demand shock
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1) Expansive monetary policy ( MS)
Let’s assume Y = Yn
The Central Bank increases MS
MS is a component of AD:
MS -> Aggregate demand -> AD shifts rightward
T,G,
PM
YYS
Expansive monetary policy
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MS -> Aggregate demand -> AD shifts rightwardAD -> AD’ -> Equilibrium -> A -> A’ -> Y (YA -> YA’) P (PA -> PA’)
Short period effects -> Y and P Is it plausible that the economy remains in A’?In A’ Y>Yn -> P>PE -> wrong expectations
P
YYA=Yn YA’
PA’
AS
AD AD’
A
A’
PE =PA
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Wrong expectations -> adjustment of expectations (described before) -> PE
PE -> AS shifts upward
The adjustment process continues until Y=Yn -> AS shifts upwards until Y=Yn
When Y=Yn -> PE=P -> The adjustment process interrupts -> medium period equilibrium
Expansive monetary policy
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P
PA’A’
Yn YA’
AD’
AS
After MS we are in A’; AS shifts upward until Y=Yn
AS’’
ADY
PA
During the transition -> Y and PIn the medium period -> YA’’ =Yn=YA and PA’’ >PA
PA’’
YA’’=
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Total effect of the intervention:•Short period -> Y and P•Transition -> Y and P•Medium period -> Y=, P
In the medium period Y does not change. Has the composition of demand changed (Z=C+I+G) ?•Z does not change (in equilibrium Y=Z):•C hasn’t change (Y and T are not changed)•G has not changed (exogenous)•Therefore I hasn’t changed either
In the medium period money has no effects on real variables but only on prices -> medium period “neutrality” of money
Expansive monetary policy
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An expansive monetary policy increases production in the short period -> It allows the economy to exit a recession( Y)
In the medium period monetary policy is neutral ->It cannot be relied on to generate permanent increases in production
Expansive monetary policy
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2) Reduction of public deficit ( G , T)
Let’s assume Y = Yn
Government reduces G
G is a component of AD:
G -> Aggregate demand -> AD shifts leftward
T,G,
PM
YYS
Reduction of public deficit
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AS
AD
P
Y
A
Yn
AD’
A’
YA’
PA’
G -> AD shifts leftwardEquilibrium A->A’ -> Y (YA -> YA’) P (PA -> PA’)
In A’ Y<Yn -> P<PE -> PE -> the transition starts
PE = PA
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AS
AD
P
Y
A
Yn
PA
AD’
A’
YA’
AS’’
A’’PA’’PA’
PE -> AS shifts downward
When Y=Yn the adjustment process stops
=YA’’
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AS
AD
P
Y
A
Yn
PA
AD’
A’
YA’
AS’’
A’’PA’’PA’
During the transition -> Y and PIn the medium period -> YA’’ =Yn=YA and PA’’ <PA
=YA’’
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Total effects of the intervention:•Short period -> Y P•Transition -> Y P•Medium period -> Y= P
Is the composition of demand changed (Z=C+I+G) ?•Z is not changed (in equilibrium Y=Z)•C is not changed (Y and T are not changed)•G is changed (Government has reduced expenditure)•Therefore I has increased
Reduction of public deficit
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In the short period a reduction of public expenditure causes a recession
The effect is only temporary -> In the medium period the production comes back to the “natural” level
In the short period the reduction of public deficit has an ambiguous effects on investments
In the medium period the effect on investment is certainly positive
Reduction of public deficit
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The cases that we examined are examples of demand shock
Demand shock -> Variations in the values of variables that affect aggregate demand
Demand shock:•Variations in public expenditures and taxes•Variations in money supply (and related interests)•Variations in autonomous consumption (tastes, consumers’ expectations) •Variations in investments (firms’ expectations)
Effects of demand shocks
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Demand shocks impact the AD curvePositive shocks ( MS, G, C0, I0) -> AD rightward
Negative shocks ( MS, G, C0, I0) -> AD leftwardAS
AD
Y
P
AD’
Effects of demand shocks
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In the short period demand shocks impact on prices and production in the same direction ( P Y or P Y)
Moreover, we saw that in the medium period:•In all cases Yn does not change -> Demand shocks do not influence production in the medium period•In all cases P change -> Demand shocks affect prices in the medium period•Demand shock can change the composition of aggregate demand in the medium period
Effects of demand shocks