The AD-AS model
Lecture 24 – academic year 2014/15
Introduction to Economics
Fabio Landini
Questions of the day…
• How do we describe the functioning of the
economy in the medium period?
• Which are the features of the equilibrium in
the medium period?
• What differentiates the medium period
equilibrium from the short period one?
What do we do today?
• Premise: short vs. medium period
• Construction of the AS curve
• Construction of the AD curve
• Equilibrium in the short and medium
period
Premise: short vs. medium period
In Lecture 17 we distinguished three different time
horizons: short, medium and long period
What differentiates short and medium period?
1) Degree of price flexibility
• Short period -> prices are partially flexible
• Medium (and long) period -> prices are fully
flexible
Flexible prices -> Price adjustment mechanism
Premise: short vs. medium period
2) Accuracy of expectations
In deriving the equilibrium of the labour market
using the WS – PS model we assumed P=PE.
P=PE is correct in the medium period because
workers have time to adjust expectations.
If P=PE then u=un e Y = YN
Premise: short vs. medium period
In the short period, however, workers can have
wrong expectations : P can differ from PE.
The real wage that workers seek on the basis of
wrong expectation can differ from the real wage
that is set by firms while fixing the prices.
Premise: short vs. medium period
When this happens:
•P differ from PE
•u differ from un
•Y differ from Yn
In the short-period this is possible… in the medium
period, however, the economy tends to go back
to its natural values
The AD-AS model will explain us why…
Premise: short vs. medium period
WS
W/PE = F(u,z)
PS
W/P= 1/ 1+ m
If P differ from PE -> W/P differ from da W/PE
-> F(u,z) differ from 1/1+ m -> u differ from da un
In the short-period, the unemployment rate, the
employment level and the level of production can
differ from the natural values
The AS/AD model
Our aim is to build a model to determine
production in the medium period.
In this model prices are flexible.
To achieve the economic equilibrium we need to
have: equilibrium of good market + equilibrium of
financial market + equilibrium of labour market
where prices are formed
The AS/AD model
To build this model we start by constructing the AS
curve, which reflects the equilibrium in the labour
market (this curve captures the effect of
production on prices).
Then, we will build the AD curve, which reflects
the equilibrium of both the good market and the
financial market (this curve captures the effect of
prices on production).
Construction of the AS curve
AS curve -> equilibrium in the labour market
Labour market
• WS -> W = PE F(u,z)
• PS -> P = W(1+m) ->
P
1+ m
=W
Labour market equilibrium -> WS and PS
simultaneously verified
P
By substituting PS in WS ->
1+ m
= PE F(u,z)
from which we get
P= PE (1+ m) F(u,z)
Construction of the AS curve
In the model of the labour market (WS – PS) we
assumed P=PE
Under this Hp., u=un where un is the natural rate of
unemployment
The Hp. P=PE is correct in the medium period -> un
is the rate of unemployment in the medium
period
From the definition of unemployment:
Unemployed U
u=
=
Labour force L
Construction of the AS curve
We know that, Unemployed = Labour Forces 
Employed U = L – N
Therefore, u 
U
L

LN
L
1
N
L
Finally, the assumption Y=N implies u  1 
Yn
Y
L
When P=PE we have u=un and u n  1 
where Yn
L
is the natural level of production
PE=P -> u=un -> Y=Yn
Construction of the AS curve
Y
By substituting u  1 
L
get
in P = PE (1+m) F(u,z) we
P= PE (1+m) F( 1 -
Y
, z)
L
 +
which is called equation of aggregate supply (AS)
The equation shows a positive relationship
between P and Y
Y
Y
Y -> 1 ->
F( 1 - , z) -> P
L
L
Costruzione della curva AS
Economic intuition (labour market):
•
Y ->
•
Employment N ->
•
u ->
•
Workers’ bargaining power ->
•
W (via mark up) ->
•
P
The relationship between P and Y is increasing ->
the AS equation is an increasing curve in a (Y,P)
diagram
P
AS
Y
AS curve -> Equilibrium in the labour market
Important: the curve is not necessarily a straight line
What happens if the expected prices vary?
AS -> P = PE (1+m) F( 1 - Y , z)
L
PE ->
P
P -> AS curve shifts upward
AS’
AS
Y
The AS curve, expected and
effective level of prices
The aggregate supply (AS) curve passes through a
specific point in which the level of expected prices
is equal to the level of effective prices and the
level of production is equal to the natural level of
production.
P
P=PE
AS
A
YN
In A and only in A P=PE and Y=YN
To the right of A P>PE and Y>YN
To the left of A P<PE and Y<YN
Y
Construction of the AD curve
The curve represent the equilibrium on both the
good market and the financial market with flexible
prices.
It allows one to examine the effects of the level of
prices on production.
The AD curve is built starting from the IS-LM curves
Construction of the AD curve
Let’s consider now the goods market and the
financial markets together
IS-LM model : IS -> Y= C(YT) + I(Y,i) + G;
LM -> MS/P = YL(i)
i
Pair (i,Y) for which both
markets are in equilibrium
LM
E
IS
Y
So far we considered a model with fixed P
What happens if P varies (medium period)?
P affects the position of the LM curve
P -> MS/P -> same as MS -> LM shifts leftward
Effects: E-> E’ and YE-> YE’ -> Y
In equilibrium: P ->
Y
i
LM’
LM
E’
E
IS
Y E’
YE
Y
Decreasing relationship between Y and P -> AD curve
P
AD
Y
AD curve -> Equilibrium in goods market and financial markets
Important: The curve is not necessarily a straight line
What happens when we vary Ms/P, G e T ?
a)
Ms/P (expansionary monetary policy) -> LM shifts
rightward -> Y
Y occurs for any level of P -> AD shifts rightward
P
AD’
AD
Y
A similar effect occurs if G
b) G -> IS shifts rightward -> Y
Y occurs for any level of P -> AD shifts rightward
P
AD’
AD
Y
c)
T -> IS shifts leftward ->
Y given P
Y occurs for any level of P -> AD shifts leftward
P
AD
AD’
Y
Construction of the AD curve
The preceding results suggest when the goods
market and the financial markets are in equilibrium,
Y is:
• An increasing function of
M
S
P
• An increasing function of G
• A decreasing function of T
Therefore we have, AD curve:
Y=Y(
M
S
P
+
, G, T)
+ -
Determination of the equilibrium
In the equilibrium point AS and AD are simultaneously verified
Graphically -> Intersection of AD and AS
Equilibrium of the system -> Point A -> Y=YA e P=PA
P
PA
AS
A
AD
YA
Y
Determination of the equilibrium
In point A:
• Along the AS -> labour market in equilibrium
• Along the AD -> goods market and financial market in
equilibrium
P
PA
AS
A
AD
YA
Y
Determination of the equilibrium
Point A can represent the equilibrium both in the short
and in the medium period, depending on the assumption
on PE
The position of A, indeed, depends on the position of the
AS curve and thus on PE
In particular :
•Medium period, PE=P -> u=un -> Y=Yn
Yn
In the medium period equilibrium Y is always equal to
•Short period, PE can be ≠ P -> Y ≠ Yn
Three cases:
PE=P -> Y=Yn ; PE>P -> Y<Yn
;
PE<P -> Y>Yn
Let’s consider the case PE<P -> YA>Yn
In the medium period the equilibrium is always along Yn
P
AS
A
AD
Yn
YA
Y
How do we move from the short period eq. A to the
medium period equilibrium?
Next class….
P
AS
A
AD
Yn
YA
Y