AS - AD

AS - AD

• Aggregate Supply– relates output and price level– labor market

• Aggregate Demand– relates output and price level– IS - LM

Aggregate Supply

As output rises….

P = W(1 + m)W = PeF(u,z)

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

For fixed Pe, as Y rises, u falls so P rises

why?Hiring pushes up

wages.

Note: Pe fixed in the short run.

AS (in detail)

U – number of workers unemployed

N – workforce (constant)

L - workers employed

U = N - L

Unemployment rate

u = (N - L)/N

=1-L/N

Production function

Y=AL A – productivity

u = 1-Y/(AN)

AS (in detail)

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

u = 1-Y/(AN)

P = Pe(1 + m)F(1-Y/(AN),z)

AS relation,

as Y ↑ u↓

u ↓ F(u,z) ↑

F(u,z) ↑ P↑

So AS is upward sloping

AS

• Slopes up• Shifts

– Change in Pe

• Rise in expectations• Shifts AS up

– Productivity A ↑ AS shifts right/down– Markup m↑ AS shifts up– Change in z, labor market

conditions

Aggregate Demand

• How does a price increase affect equilibrium GDP on an IS – LM graph.– LM shifts up (left)– Y* falls

• AD slopes down• Shifts – anything else that

affects IS – LM– Autonomous spending– Policy (both kinds)

• Exception – supply side tax effects

Problems

• Show how an increase in the money supply would affect the equilibrium level of output, interest rates and prices using and IS – LM and AS – AD diagram.

• The 1990s saw an increase use of IT in business which improved productivity. Show the short run effect on an AS-AD graph.

Problems

Show how an decrease in government spending would affect the equilibrium level of output, interest rates and prices using and IS – LM and AS – AD diagram.

Show the effect of an increase in oil prices has on an AS-AD graph.

Medium Run

• Expectations adjust • P=Pe

• Unemployment at its natural rate

1 = (1 + m)F(un,z)

• Output at its natural rate

un = 1-Yn/(AL)

AS?

1 = (1 + m)F(1-Yn/(AL),z)

Vertical at the natural rate of output

Medium run

• What if Y* < Yn ?– P < Pe (short run)– medium run, Pe falls to P– AS shifts down/right– Y* rises to Yn

• Labor Market interpretation– u* > un

– as Pe falls, wages bid down– lower cost to production– AS shifts right

• Medium run Y* = Yn

Monetary policy: short and medium run

• Fed increase Ms

– AD shifts right– Y* and P* both rise– short run (P > Pe )

• Medium run– Pe rises– AS shifts up/left– Y* falls back to Yn

– P* rises further• Money neutrality (med run)

– changes in Ms • affect nominal variables• not real variables

Problem

Show how a decrease in the money supply would affect the equilibrium output and price levels on an AS-AD graph in the short and medium run.

What happens on the IS-LM graph in the short and medium run?

Problems AS-AD

Show the short and medium run effects of an increase in productivity.

Show the short and medium effects of a decrease in consumer confidence.

Show the short and medium run effects of an increase in oil prices.

Recessionary Gap Y* < Yn

Inflationary Gap Y* > Yn

Show an inflationary gap on an AS-AD graph, then show how the government could use tax policy to close the gap.

Show a recessionary gap on an AS-AD graphs, then show how monetary policy could be used to close the gap.

Gov’t Spending

How does an increase in government spending affect the AS-AD graph in the short & medium run?

Does Gov’t spending affect productivity?

Show the changes in the graph for both cases.

Key Equations

P = W(1 + m) (PS)

W = PeF(u,z) (WS)

1 = (1 + m)F(un,z)

u = 1-Y/(AL)

P = Pe(1 + m)F(1-Y/(AL),z) (AS)

Phillip’s Curve

Unemployment & Inflation

Inverse relationCan the Fed lower U? Increase

MS

If inflation is caused by AD shift to the rightoutput rises, unemployment falls

Fed can lower U at a cost of higher p

True? Check the data.

Inflation versus Unemploymentin the United States, 1948-1969

Inflation versus Unemploymentin the United States since 1970

PC relation to WS

W = PeF(u,z) (WS)P = W(1 + m)(PS)

Let F(u,z) = 1 – au + z

So WS & PS become

P = Pe(1 + m)(1 – au + z)

Do some math….

p = pe + - m au + z

inverse relation does exist

Wage – Price Spiral

Explains inverse relation• u falls• wages bid up• prices rise• workers demand higher wages

– etc. etc.• higher p

“Tight labor market” – late 1990s

Shifts in PC

• Expectations• markup

– input costs– market power

• labor market condtions• Anything that shifts AS, shifts

PC

Medium Run

PC equation in the medium run?

expectations equal inflation

un depends only on m, z, a

Monetary Policy and the PC

The Fed tries to lower u below the natural rate…..

Show on AS-AD and the PC for the short and medium run.

Review Problems

Show a Phillips curve graph and an AS-AD graph starting from an inflationary gap. Show the medium run adjustment.

If the Fed acts to close an inflationary gap, what would they do? Show the result on an AS-AD graph and a PC graph.

Story of the Great Inflation

• Productivity falls• oil prices rise

– Effect on Yn, un

– Monetary policy reaction

• Fed tried to keep u at the old level

• expectations rose

Both shifts and a return to the natural rate

Mr. Burn’s brain

What’s behind the Fed’s decisions in the 70’s?• Bad thinking

– Ignoring natural rates– Expectations– “old” PC

• Bad data– Couldn’t see the change in the

natural rates• Cared more about

unemployment than inflation

Intellectual history & the PC

• “Old” PC (1940-50s)– Empirical relationship– Use in Cowles commission

models• Edmund Phelps / Milton

Friedman (late 60s)– Argue against the permanent

output/inflation tradeoff– 70s proved them right– “Old Keynesian” econometric

models abandoned

Expectations and the PC

pt = pt e + - m aut + z

Static expectations

pt e = pt-1

Rational expectations

pt e = pt + et

et – forecast error

Policy Effectiveness

Under rational expectations, what happens when the Fed increases the money supply?

PC and AS vertical

(with an error term)

P & p rise, not real effect

Money is neutral.

Policy is ineffective. Why?

Problem

Starting from the natural rate of unemployment, if the Fed acts to lower inflation, show the SR & MR effects.

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

W = PeF(u,z)

= p pe + - m au + z

P = W(1+ )m

M/P = L(i,Y)

un = ( m + z)/a

Equations

P=Pe(1+ )m F(u,z) AS (sort of)

W = PeF(u,z) WS

= p pe + - m au + z SRPC

P = W(1+ )m PS

M/P = L(i,Y) Money Demand

un = ( m + z)/a MRPC/natural rate of u

Equations

More Review

The government becomes more aggressive about breaking up monopolies lowering the pricing power of firms. Show the impact on the following graphs.• real wage / unemployment• AS – AD• Phillips curve• IS – LM

More Review

The recent housing market decline led to an decrease in autonomous consumption and investment. Show that short run change and the medium run adjustment, assuming passive policy on the following graphs:• IS-LM• AS-AD• Phillips Curve

Review problem

Show an inflationary gap on graphs of AS-AD and IS-LM. Use the graph to explain how tax policy could be used to close the gap..

Review Problem

Show the short run effect of a tax increase on an expenditure diagram. Show the short and medium effects on IS-LM and AS-AD diagrams.

Review Problem

Keynes once advocated that the government should bury boxes of money and let people dig them up to stimulate to economy.

Starting from the natural rates or unemployment and output, show the short and medium run effects of an increase in government spending that does not change the natural rates for AS-AD and the Phillip’s curve.

Review Problem

Currently the Fed is increasing the money supply and keeping interest rates low to mitigate the recession.

Starting from a recessionary gap, show the effect of an increase in the money supply on an AS-AD graph and the Phillip’s Curve.

Practice Problem

The financial crisis has led to a decrease in lending and therefore an fall in the money supply.

Starting from the natural rates of output and unemployment, show the resulting change on AS-AD and Phillips curve graphs in the short run.

A small macro model

Goals

• Connect output, unemployment and inflation

• Use equations• Explain both short and medium

runs

y, u and pActually,

we’ll use gy – growth rate

The U.S. unemployment rate, 1890–2002

Okun’s law in the U.S.: 1951–2002

Okun’s Law

Connects u and y

ut – ut-1 = - b(gy,t – gn)

gn - “normal” or natural growth rate of output

- growth rate of potential GDP

Phillips Curve

Connects p and u

p= pe + - m au + z

or pt - pet = (a un - ut)

Related to AS

p and Y

Focus on AD and monetary policy

M/P rises, LM & AD shift right

Y rises

Let Y = g(M/P)

Assumes fiscal policy and autonomous expenditures are fixed.

Log differencing the equation:

gy,t = gm,t - pt

small macro model

ut – ut-1 = - b(gy,t – gn)

pt - pet = (a un - ut)

gy,t = gm,t – pt

MR implications:p= pe ; u = un ; gy,t = gn

pt = gm,t – gn

Problem

Let gn = 3%, un = 6%, gm,t = 8% = 1.0, = 0.5a b

Find the medium run values of gy,t , ut and pt

Using those as starting values, find the short run (one period) values if gm,t rises to 9%.

Find the new medium run values after expectations adjust to the new gm,t.

Problem

Let gn = 3%, un = 6%, gm,t = 7% = 1.0, = 0.5a b

Find the medium run values of gy,t , ut and pt

Using those as starting values, if the Fed wants to lower inflation to 2% in the medium run, to what level should they set gm,t ? Find the short run (after one period) values if they make this change.

Show these changes including the medium run adjustment on a graph of AS-AD and a PC graph.

Sacrifice Ratio

• Lowering pt in the MR has a cost of higher ut in the SR.

• To measure this cost

Sacrifice Ratio = -Du/Dp=excess unemployment/

decrease in inflation

For the previous problem….

Credibility

Problem

Let gn = 3%, un = 5%, gm,t = 5%

= 1.0, = 0.5a b

Find the medium run values of gy,t , ut and pt

Using those as starting values, the Fed increases gm,t to 8%. Find the new SR values (one period).

Find the new medium run values.

Show these changes on a graph of AS-AD and a PC graph.

Time Consistency

TC problem: conflict between long term plan/policy and short term incentive

- grading- dieting- shutting down failed banks- monetary policy

Long term goal: maintain inflation target

Short term incentive: lower unemployment

Reason for an independent Fed.

Expectations and the PC

pt - pet = (a un - ut)

Static expectations

pt e = pt-1

Rational expectations

pt e = pt + et

et – forecast error

Policy Ineffectiveness

Policy does not have real effects if• Expectations are rational.• Wages and prices adjust

immediately.– MR is short– Contracts?

• Sacrifice ratio?– Credibility– Evidence?

Problem

Let gn = 2%, un = 7%, gm,t = 8%

= 1.0, = 0.5a b

Find the medium run values of gy,t , ut and pt

The Fed wants to reduce inflation to 2% in the medium run. What value should they choose for gm,t ? Find the new SR values (one period) if they do this.

Find the new medium run values.

Show these changes on a PC graph.

What is the sacrifice ratio?

Review Questions

• The strong growth in the 1990s is often attributed to technology use by firms. Show the short and medium run changes on an AS-AD graph.

• One story explaining the Great Depression is the stock market crash reduced consumer spending. The government then tried to boost the economy with increased spending. Show both changes on an AS-AD graph explaining changes in equilibrium prices and output.

• Show how a change in the markup would affect the graph of the Phillip’s curve in the short and medium run.

A small macro model

Goals

• Connect output, unemployment and inflation

• Use equations• Explain both short and medium

runs

y, u and pActually,

we’ll use gy – growth rate

The U.S. unemployment rate, 1890–2002

Okun’s law in the U.S.: 1951–2002

Okun’s Law

Connects u and y

ut – ut-1 = - b(gy,t – gn)

gn - “normal” or natural growth rate of output

- growth rate of potential GDP

Phillips Curve

Connects p and u

p= pe + - m au + z

or pt - pet = (a un - ut)

Related to AS

p and Y

Focus on AD and monetary policy

M/P rises, LM & AD shift right

Y rises

Let Y = g(M/P)

Assumes fiscal policy and autonomous expenditures are fixed.

Log differencing the equation:

gy,t = gm,t - pt

small macro model

ut – ut-1 = - b(gy,t – gn)

pt - pet = (a un - ut)

gy,t = gm,t – pt

MR implications:p= pe ; u = un ; gy,t = gn

pt = gm,t – gn

Problem

Let gn = 3%, un = 6%, gm,t = 8% = 1.0, = 0.5a b

Find the medium run values of gy,t , ut and pt

Using those as starting values, find the short run (one period) values if gm,t rises to 9%.

Find the new medium run values after expectations adjust to the new gm,t.

Problem

Let gn = 3%, un = 6%, gm,t = 7% = 1.0, = 0.5a b

Find the medium run values of gy,t , ut and pt

Using those as starting values, if the Fed wants to lower inflation to 2% in the medium run, to what level should they set gm,t ? Find the short run (after one period) values if they make this change.

Show these changes including the medium run adjustment on a graph of AS-AD and a PC graph.

Sacrifice Ratio

• Lowering pt in the MR has a cost of higher ut in the SR.

• To measure this cost

Sacrifice Ratio = -Du/Dp=excess unemployment/

decrease in inflation

For the previous problem….

Credibility

Problem

Let gn = 3%, un = 5%, gm,t = 5%

= 1.0, = 0.5a b

Find the medium run values of gy,t , ut and pt

Using those as starting values, the Fed increases gm,t to 8%. Find the new SR values (one period).

Find the new medium run values.

Show these changes on a graph of AS-AD and a PC graph.

Time Consistency

TC problem: conflict between long term plan/policy and short term incentive

- grading- dieting- shutting down failed banks- monetary policy

Long term goal: maintain inflation target

Short term incentive: lower unemployment

Reason for an independent Fed.

Expectations and the PC

pt - pet = (a un - ut)

Static expectations

pt e = pt-1

Rational expectations

pt e = pt + et

et – forecast error

Policy Ineffectiveness

Policy does not have real effects if• Expectations are rational.• Wages and prices adjust

immediately.– MR is short– Contracts?

• Sacrifice ratio?– Credibility– Evidence?

Problem

Let gn = 2%, un = 7%, gm,t = 8%

= 1.0, = 0.5a b

Find the medium run values of gy,t , ut and pt

The Fed wants to reduce inflation to 2% in the medium run. What value should they choose for gm,t ? Find the new SR values (one period) if they do this.

Find the new medium run values.

Show these changes on a PC graph.

What is the sacrifice ratio?

Review Questions

• The strong growth in the 1990s is often attributed to technology use by firms. Show the short and medium run changes on an AS-AD graph.

• One story explaining the Great Depression is the stock market crash reduced consumer spending. The government then tried to boost the economy with increased spending. Show both changes on an AS-AD graph explaining changes in equilibrium prices and output.

• Show how a change in the markup would affect the graph of the Phillip’s curve in the short and medium run.

Problem

Starting from the natural rate of output, show the short and medium run effects of a tax cut that leads to increased productivity. Is it possible that the equilibrium price level rises?

Do tax cuts pay for themselves?

Taxes & Revenue

Laffer Curve

• Tax revenue vs. tax rates– Tax rate = 0%?– Tax rate = 100%?

• Laffer curve peaks somewhere in between.

Cross country analysis says ~50%

Tax Cuts

• Can pay for themselves if rates are very high

• Can improve productivity– Labor incentives

• Less effective as short run stimulus than spending increases– Some is saved