Aggreg
gg gate Demand
Aggregate Supply
15 012 Applied Macro and International Economics
15.012
Alberto Cavallo
February 2011
Class Outline
• The Business‐Cycle: Potential and Actual GDP
• Aggregate Demand (AD)
– The interest‐rate effect and slope
• Aggregate Supply (AS)
– Long
Long‐run
run  potential output, vertical AS
– Short‐run  sticky prices, positive slope AS
• Effects of Policies in AS‐AD
AS AD
Alberto Cavallo ‐ 15.012 © MIT Sloan School of Management
Potential and Actual GDP
Y = C + G + I + NX
• Potential GDP  estimate of GDP when all factors of
production (capital
(capital, labor,
labor and technology) are used at
“normal” rates
– Long‐run  Growth theory Y = Af(K,L)  not in 15.012
• Actual GDP  can be different because of booms and
recessions
– These
Th
are sh
hort‐run
t
flucttuati
fl
tions, allso calllled
d the
th “b
“busiiness
cycle”
– We will use the AS‐AD model to analyze it
Alberto Cavallo ‐ 15.012 © MIT Sloan School of Management
Potential and Actual GDP
Output
Boom
A t l GDP
Actual
Potential
GDP
Recession
Time
Alberto Cavallo ‐ 15.012 © MIT Sloan School of Management
IS‐LM and AS‐AD
IS Curve
Goods market
Y‐C‐G = I(i
( ,,bc))
P
AS
Aggregate
Demand
LM Curve
LM
C
Money Market
Ms = Md(PY,i)
i
IS
Aggregate
Supply
(sticky prices)
AD
Y
LM
Prices and Output
Y
IS‐LM and AS‐AD
• AS‐AD prices can change
‐ +
• In the money market… Ms = Md(i,PY)
Money Market
i
Ms
‐ +
Md(I, PY)
M
Aggregate Demand
Why is the AD curve downward sloping? (not micro…)
• Wealth effect
↓P  wealthier  ↑C  ↑Y
P
• Interest rate eff
ffect (LM)
↓P  less money needed to buy
↓ Md  put money in bank
↓ i  ↑I  ↑Y
AD
• Exchangge rate effect
↓P ↓ i  ↑Capital Ou lows
 Sell dollars  Dollar Depreciates
 ↑ net exports X  ↑Y
↑Y
Y
The interest rate effect
Money Market
i
IS‐LM
IS
‐LM
Ms
i
AD
P
LM
LM’ with
lower P
Md((PY,,i))
Md((PY,i)’
Md
PY,i)’
M
IS
AD
Y
↓P  less cash needed to buy things↓ Md  ↓ i  ↑I  ↑Y
Alberto Cavallo
15.012 © MIT
Sloan School of Management
Y
Aggregate Demand
Y = C + I + G + NX
P
Increases in C, I, G or NX will make
the AD curve shift to the right
AD
Y
Monetary Policy and AD
A
• Expansionary monetary polic
policy
↑ money supply  ↓ interest rates  ↑investment  ↑ Y and AD
Money Market
i
Ms
IS‐LM
Ms
Ms’
i
AD
LM
LM’
IS
AD
Md(PY,i)
M
P
Y
AD’
Y
Fiscal Policy and AD
• Expansionary fiscal policy
↑ G  ↑ AD
Or ↓ T  ↑C  ↑ AD
AD
IS‐LM
i
AD
P
LM
IS’
IS
AD
Y
AD’
Y
Demand and Supply
• Monetary and fiscal policies move aggregate
aggregate
demand (AD)
• But final impact on Y and P depends on….
on
• Aggregate Supply (AS)
–Long run
–Short run
AS curve in Long Run
• Long‐run (LRAS)  capacity to produce by an
economy given by Y=Af(K,L)
P
LRAS = Potential Output
K is the capital stock, which
depends on savings and
investments
L is the labor force, affected by
workers and average number of
hours worked
AD
Y
A is the technology, skills, quality
of management.
AS Curve in Short Run
• Completely Flexible prices (classical view)
– Output is given
i
by potential
i l output
– Increase in AD lead only to increases in price
• AS curve is a vertical line
• Monetary and fiscal policy have no effect on output
P
AS = Potential Output
Flexible Prices
Actual Y= Potential Y
AD
Y
AS Curve in Short Run
• Completely fixed prices (Keynesian view)
– Increases in AD can be met by increases in output
• AS curve is a horizontal line
• Mone
Monetary
tary and fisc
fiscal
al policy can affect
affect output
P
AS
AD
Y
Fixed Prices
AS Curve in Short Run
• New “consensus” view:
– Upward‐sloping AS curve due to “sticky” prices
Sticky Prices  firms adjust
prices slowly
P
AS
Why?
•Menu Costs
•Contracts
•Contracts
•Staggered price setting
•Coordination failure
•Customer relations
AD
Y
AS Curve in Short Run
• New “consensus” view:
– Upward‐sloping AS curve due to “sticky” prices
Sticky Prices  firms adjust
prices slowly
P
AS
Why?
•Menu Costs
•Contracts
•Contracts
•Staggered price setting
•Coordination failure
•Customer relations
AD
Y
Curved depends on the
degree of slack in the economy
(more Keynesian
i to th
he lleft,
f
classical to the right)
AS‐AD
AS
AD in equilibrium
P
LRAS
AS
AD
Y
Policy example: Expansionary MP
Short ‐ Run
P
Short‐run effects:
↑P and ↑Y
LRAS
AS
Y actual > Y Pot  boom
b
or
over‐employment
AD’
AD
Y
YPot
Y
actual
inflationary gap
Examp
ple: Exp
pansionaryy MP
Transition to Long ‐ Run
AS final
P
With time, AS moves up as more
and more firms adjust their
prices
LRAS
AS
In the LR, Y actual = Y Pot
Longg‐run effects:
↑ P
no change in Y
AD’
AD
Y
YPot
Y
actual
AS‐AD
AS
AD and policy analysis
• What is your starting position?
• Equilibrium
• Boom
• Recession
• What is the main shock?
• Demand
d or supply?
l ?
• Different policies can achieve different things
• Monetary and Fiscal Policy target the AD
• Supply‐side policies  target the AS
Demand‐shock
Demand
shock Recession
LRAS
P
Fall in AD  ↓ Y, ↓ P
AS
‐Policy Response?
Expansionary Monetary and/or
Fiscal Policy  ↑ Y, ↑ P 
restore the eq
quilibrium
AD
AD’
Y
Y
actual
YPot
Supply‐shock
Supply
shock Recession
Recession
LRAS
P
If there is an oil price shock that
shifts AS in  ↓ Y, ↑ P (stagflation)
AS
Policyy options?
p
1
Option 1:
Shift AD out to stabilize Y
B
2
A
3
Option 2:
Shift AD In to stabilize P
AD
Y
Option 3:
“Supply Side” Economics
production incentives to get
closer to potential Y
try to push LRAS as well
US in the 80
80’s:
s: Reagan
Courtesy of Trading Economics, www.tradingeconomics.com. Used with permission.
Remember
• Th
The AS‐AD
AS AD model
d l and
d transition
i i back
b k to potential
i l output
• Monetary and fiscal policy in the AS‐AD model
• Use it for shock and policy analysis:
– St
Starting
ti position?
iti ?
– Type of shock?
– Effects of policies? Short‐run
Short run vs Long
Long‐run
run
Next Class
• So far we have talked about stabilization
•
policies in an closed economy
• Next two classes we will talk more about how
the Central Bank operates, introduce
exchange rates and discuss financial crises
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http://ocw.mit.edu
15.012 Applied Macro- and International Economics
Spring 2011
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