Agenda
• Price Adjustment and the Attainment of
General Equilibrium
The IS-LM/AD-AS Model:
A General Framework for
Macroeconomic Analysis,
Part 3
13-1
General equilibrium in the AD-AS model
P
13-2
Disequilibrium in the AD-AS model
LRAS
• Equilibrium in the AD-AS model:
¾ If the economy is NOT in general equilibrium,
economic forces will work to restore general
equilibrium in both the IS-LM and AD-AS models.
P
SRAS
AD
Y*
Y
13-3
13-4
1
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• Price adjustment in the IS-LM and AD-AS
models:
• An increase in government purchases:
¾ In Year 0, the economy is in general equilibrium.
¾ An increase in government purchases,
• Denote the general equilibrium level of output by Y*.
¾ An increase in the real money supply,
¾ A short-run adverse supply shock, and
¾ A long-run adverse supply shock.
13-5
Price Adjustment and General Equilibrium
An increase in government purchases
FE
LRAS
LM0
r
13-6
• An increase in government purchases:
P
¾ In Year 1, government purchases increase.
• Assume Ricardian equivalence does NOT hold.
r0
SRAS0
P0
IS0
Y*0
Y
• An increase in government purchases shifts both the IS
and AD curves to the right.
AD0
Y*0
Y
13-7
13-8
2
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• An increase in government purchases:
• An increase in government purchases:
¾ In Year 1, the increase in government purchases
increases output but leaves the price level
unchanged.
¾ In Year 2, the price level begins to rise.
• In Year 2, the SRAS curve shifts up because of excess
aggregate demand in Year 1, i.e., Y1 > Y*.
• Short-run equilibrium is at:
– The intersection of the IS and LM curves, and
– The intersection of the AD and SRAS curves.
– How far the SRAS curve shifts up depends on the
explicit price adjustment process for the economy.
• The labor market is temporarily out of equilibrium.
– Employment has increased.
– The unemployment rate has declined.
– Generally it is a multiyear process dependent on the
amount of excess aggregate demand.
13-9
13-10
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• An increase in government purchases:
• An increase in government purchases:
¾ In Year 2, the price level begins to rise.
¾ In Year 2, the price level begins to rise.
• A higher price level reduces the real money supply,
Ms/P.
• A higher real interest rate will:
– Reduce interest-sensitive spending,
– Reduce output and employment, and
– Raise the unemployment rate.
– Alternatively, the purchasing power of the nominal
money supply, Ms, has been reduced.
• A lower real money supply shifts the LM curve to the
left, raising the real interest rate.
13-11
13-12
3
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• An increase in government purchases:
• An increase in government purchases:
¾ In Year 3, the price level continues to adjust up.
¾ In Year 4 and beyond, this process continues until
general equilibrium is re-established in both the ISLM and AD-AS models.
• In Year 3, the SRAS curve shifts up because of any
excess aggregate demand in Year 2, i.e., Y2 > Y*.
• Output will be at its full-employment level.
– Employment will be at its full-employment level.
– The unemployment rate will be at its natural level.
– Because excess aggregate demand in Year 2 is less
than in Year 1, the upward shift of the SRAS in Year
3 will be smaller than in Year 2.
• The price level will be permanently higher.
13-13
13-14
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• An increase in government purchases:
• An increase in the real money supply:
¾ Once general equilibrium has been re-established:
¾ In Year 0, the economy is in general equilibrium.
• Output is back at its full-employment level.
• The real money supply is lower.
– Because of the increase in the price level.
• The real interest rate is higher.
• The composition of output has changed.
13-15
13-16
4
Price Adjustment and General Equilibrium
An increase in the money supply
FE
LRAS
LM0
r
• An increase in the real money supply:
P
¾ In Year 1, the nominal money supply increases.
r0
SRAS0
P0
• An increase in the nominal money supply shifts both the
LM and AD curves to the right.
• The increase in the real money supply increases output
but leaves the price level unchanged.
IS0
Y0
Y
AD0
Y0
Y
13-17
13-18
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• An increase in the real money supply:
• An increase in the real money supply:
¾ In Year 2, the price level will begin to rise.
¾ In Year 2, the price level will begin to rise.
• In Year 2, the SRAS curve shifts up because of excess
aggregate demand in Year 1, i.e., Y1 > Y*.
• A higher price level reduces the real money supply,
Mss/P.
– How far the SRAS curve shifts up depends on the
explicit price adjustment process for the economy.
– Alternatively, the purchasing power of the nominal
money supply, Ms, is reduced.
• A lower real money supply shifts the LM curve to the
left, raising the real interest rate.
– Generally it is a multiyear process dependent on the
amount of excess aggregate demand.
13-19
13-20
5
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• An increase in the real money supply:
• An increase in the real money supply:
¾ In Year 2, the price level will begin to rise.
¾ In Year 3, the price level continues to adjust.
• A higher real interest rate will:
• In Year 3, the SRAS curve shifts up because of any
excess aggregate demand in Year 2, i.e., Y2 > Y*.
– Reduce interest-sensitive spending,
– Reducing output and employment, and
– Raise the unemployment rate.
– Because excess aggregate demand in Year 2 is less
than in Year 1, the upward shift of the SRAS curve
in Year 3 will be smaller than it was in Year 2.
13-21
Price Adjustment and General Equilibrium
13-22
Price Adjustment and General Equilibrium
• An increase in the real money supply:
• An increase in the real money supply:
¾ Once general equilibrium has been re-established:
¾ In Year 4 and beyond, this process continues until
general equilibrium is re-established in both the ISLM and AD-AS models.
• Output is back at its full-employment level.
• The real money supply is back at its original level.
• Output will be back at its full-employment level.
– Employment will be back at its full-employment level.
– The unemployment rate will be back at its natural rate.
• The real interest rate is back at its original level.
• The price level will be permanently higher.
• The composition of output has NOT changed.
13-23
– The price level has increased proportionately with the increase
in the nominal money supply.
13-24
6
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• An increase in the real money supply:
• An increase in the real money supply:
¾ Trend money growth and inflation:
¾ Once general equilibrium has been re-established:
• This analysis can also handle the case in which the
money supply is growing continuously.
• All real variables are unchanged.
• All nominal variables have increased proportionately
with the increase in the money supply.
– If both the money supply and price level grow at the
same rate, then there is no change in the real money
supply, and the LM curve does not shift.
¾ The result is known as the Classical Dichotomy.
– If the money supply grows faster than the price
level, then the LM curve would shift to the right.
• Or the Long-run Neutrality of Money.
13-25
13-26
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• An increase in the real money supply:
• An increase in the real money supply:
¾ Trend money growth and inflation:
¾ Trend money growth and inflation:
• Thus, “an increase in the real money supply” can be
thought of as:
• Similarly, “a decrease in the price level” can be thought
of as:
– An increase in the growth rate of money relative to
its trend, or
– An decrease in the price level or inflation relative to
its trend, or
– An increase in the growth rate of money relative to
the growth rate of inflation.
– An decrease in inflation relative to the growth rate
of money.
13-27
13-28
7
Price Adjustment and General Equilibrium
Price Adjustment and General Equilibrium
• The self-correcting economy:
• The self-correcting economy:
¾ The economy is brought back into general
equilibrium by adjustment of the price level.
¾ Classicals believe that price adjustment is rapid.
• Firms change prices instead of output in response to
changes in demand.
¾ How rapidly does the economy reach general
equilibrium?
• The adjustment process is almost immediate.
– The economy quickly returns to full employment after a shock.
• Classical and Keynesian economists differ significantly
in their answer to this question.
• There is NO appropriate role for monetary and/or fiscal
policy in stabilizing the economy.
13-29
13-30
Price Adjustment and General Equilibrium
Aggregate Demand and Aggregate Supply
• The self-correcting economy:
• A short-run adverse supply shock:
¾ Keynesians believe that price adjustment is slow.
¾ In Year 0, the economy is in general equilibrium.
• It takes years before prices and wages fully adjust to
changes in demand.
• When not in general equilibrium, output is determined
by aggregate demand and the labor market is not in
equilibrium.
• There is an appropriate role for monetary or fiscal
policy in stabilizing the economy.
13-31
13-32
8
A short-run adverse supply shock
FE
LRAS
LM0
r
Aggregate Demand and Aggregate Supply
• A short-run adverse supply shock:
P
¾ In Year 1, imported goods prices increase.
r0
SRAS0
P0
• An increase in imported goods prices immediately
increases the price level and shifts the SRAS curve up.
• A higher price level reduces the real money supply,
Ms/P.
IS0
Y0
Y
AD0
Y0
Y
• A lower real money supply shifts the LM curve shifts to
the left, raising the real interest rate.
13-33
13-34
Aggregate Demand and Aggregate Supply
Aggregate Demand and Aggregate Supply
• A short-run adverse supply shock:
• A short-run adverse supply shock:
¾ In Year 2, the price level will begin to fall.
¾ In Year 1, the increase in imported goods prices
raises the price level and decreases output.
• In Year 2, the SRAS curve shifts down because of the
insufficient aggregate demand in Year 1, i.e., Y1 < Y*.
• A higher real interest rate will:
– As the SRAS curve shifts down, the price level falls.
– Reduce interest-sensitive spending,
– Reduce output and employment, and
– Raise the unemployment rate.
– A lower price level increases the real money supply.
– A higher real money supply shifts the LM curve to
the right, reducing the real interest rate.
13-35
13-36
9
Aggregate Demand and Aggregate Supply
Aggregate Demand and Aggregate Supply
• A short-run adverse supply shock:
• A short-run adverse supply shock:
¾ In Year 2, the price level will begin to fall.
¾ In Year 3 and beyond, the price level continues to
fall until general equilibrium is re-established in
both the IS-LM and AD-AS models.
• A lower real interest rate stimulates:
– Increases interest-sensitive spending,
– Increases output and employment, and
– Decreases the unemployment rate.
• Output will be back at its full-employment level.
– Employment will be back at its full-employment level.
– The unemployment rate will be back at its natural rate.
• The price level will be back at its original level.
13-37
13-38
Aggregate Demand and Aggregate Supply
A long-run adverse supply shock
FE
• A long-run adverse supply shock:
LRAS
LM0
r
P
¾ In Year 0, the economy is in general equilibrium.
r0
SRAS0
P0
IS0
Y0
13-39
Y
AD0
Y0
Y
13-40
10
Aggregate Demand and Aggregate Supply
Aggregate Demand and Aggregate Supply
• A long-run adverse supply shock:
• A long-run adverse supply shock:
¾ In Year 1, there is a decrease in productivity.
¾ In Year 1, the upward shift of the SRAS curve:
• A decrease in productivity shifts BOTH the SRAS curve
up and the LRAS curve (and the FE line) to the left.
– The short-run effects could be:
» Greater than,
» Equal to, or
» Less than the long-run effects.
•
•
•
•
•
•
Increases the price level,
Reduces the real money supply,
Shifts the LM curve to the left,
Raises the real interest rate,
Reduces interest-sensitive spending, and
Reduces output and employment.
13-41
13-42
Aggregate Demand and Aggregate Supply
Aggregate Demand and Aggregate Supply
• A long-run adverse supply shock:
• A long-run adverse supply shock:
¾ In Year 2, if the short-run effects are less than the
long-run effects, then:
¾ In Year 1, the leftward shift of the LRAS curve
reduces the economy’s full-employment level of
output.
• Output in Year 1 is greater than the new, lower fullemployment level of output, i.e., Y1 > Y*1.
• Which reduces general equilibrium output.
• So there is excess aggregate demand and the SRAS
curve will shift up and the price level will rise.
¾ This process continues until general equilibrium is
re-established.
13-43
13-44
11
A long-run adverse supply shock
FE
LRAS
LM0
r
Aggregate Demand and Aggregate Supply
• A long-run adverse supply shock:
P
¾ In Year 2, if the short-run effects are greater than
the long-run effects, then:
r0
SRAS0
P0
• Output in Year 1 is less than the new, lower fullemployment level of output, i.e., Y1 < Y*1.
• So there is insufficient aggregate demand and the SRAS
curve will shift down and the price level will fall.
IS0
AD0
Y
Y0
Y0
Y
¾ This process continues until general equilibrium is
re-established.
13-45
A long-run adverse supply shock
FE
Aggregate Demand and Aggregate Supply
LRAS
LM0
r
13-46
• A long-run adverse supply shock:
P
¾ Once general equilibrium has been re-established:
• Output is at its new, lower full-employment level.
r0
SRAS0
P0
• The price level will be permanently higher.
• The real money supply will be lower.
IS0
Y0
Y
AD0
Y0
Y
13-47
• The real interest rate will be higher.
• The composition of output has changed.
13-48
12