The AS-AD model
Aggregate Demand
Aggregate Supply
Policy analysis
The AS-AD model


Week 6: we examined how monetary and fiscal
policy affect aggregate demand, by using different
combinations of the policy mix
Remember that 2 assumptions were made:



There exists excess production capacity in the economy
(unemployment, under-utilised capital)
The price of goods, services and factors of production are
fixed and do not adjust
These assumptions can be restrictive and create
some problems
The AS-AD model
1. Using the correct policy mix allows
you to increase output and keep
interest rates relatively constant
Interest rate i
To infinity and beyond...
2. But what’s to stop you going on for
ever ??
LM
LM’
LM’’
i2
i1
IS
Y1
Y2
IS’
Income, Output Y
IS’’
The AS-AD model

Intuitively, we know there is a limit to IS-LM:



Why the difference? Where does this inflation come from ?


As we’ve seen, in IS-LM, you can boost GDP forever using the
Policy-mix
In real life, one knows that over-using these policies leads
mainly to inflation.
Bottom line: if demand increases beyond the productive
capacity of the economy, producers have no choice but to
increase prices
The purpose of the AS-AD model is to correct the
predictions of IS-LM in order to account for the fact that
there is not always excess productive capacity.
The AS-AD model

Modelling
strategy
Keynesian
Equilibrium
Money market
equilibrium
IS Curve
LM Curve
Labour market
Equilibrium
IS-LM model
Aggregate supply
curve
Aggregate
demand curve
Model of
macroeconomic
fluctuations
The AS-AD model
The Aggregate Demand curve
The Aggregate Supply curve
The AS-AD equilibrium
The AD curve


The AD curve shows the amount of goods and
services demanded for a given price level.
The AD curve has a negative slope : a lower level of
prices tends to increase the aggregate demand for
goods and services


Prices affect the LM curve through real money balances: a
higher price level leads to higher interest rates in IS-LM,
reducing equilibrium output.
Beware: The negative slope of the AD curve is NOT
linked to the negative slope of micro demand
curves!!
The AD curve
i
This shifts LM left
i
LM’
LM
L2(i)
L2(Y)
Y
L1(Y)
An increase in
prices reduces
real money
balances (M/P)
L1(Y)
L1(Y)
(M/P) = L1(Y) + L2(i)
45°
Y
45°
L2(Y)
The AD curve
2. The AD curve
plots this overall
effect
P
3. However, a
reduction in M at
constant price leads
to a shift in AD
P
P2
P1
P1
AD
i
AD’
Y
Y
M
LM2
P2
M'
LM’
P1
LM1
i2
i1
IS
Y2
Y1
AD
Y
i
M
P1
1. An increase in the
price level from P1
to P2 reduces real
money balances,
which shifts LM
LM1
M
P1
i2
i1
IS
Y2
Y1
Y
The AD curve

P
2. Because prices
are unchanged, this
leads to a shift of
the AD curve
P1

Rules of thumb:
A shift in IS

AD’
Always leads to a
similar shift in AD
AD
Y

i
LM2
i
i2
i1
IS
Y1
Y2
Y
A shift in LM
1. An increase in
government spending
shifts IS to the right,
increasing output and
interest rates

IS’

Leads to a similar shift
in AD only if the shift
is not due to changes
in the price level
Changes in the price
level bring movement
on AD
The AS-AD model
The Aggregate Demand curve
The Aggregate Supply curve
The AS-AD equilibrium
The AS curve


The AS curve shows the amount of goods and
services supplied for a given price level.
Compared to the AD curve, one has to distinguish
between the short run AS (SRAS) and the long run
AS (LRAS):



LRAS : In the long run, the productive capacity of the
economy does not depend on prices
SRAS : A change in prices changes the real cost of labour,
affecting the productive capacity of the economy.
Beware: The positive slope of the SRAS curve is NOT
linked to the slope of micro supply curves !!
The AS curve

The short run AS is derived from the WSPS/Phillips curve framework we examined in
the previous weeks.



The Phillips curve already identifies a negative
trade-off between unemployment and inflation.
But what we need is a trade-off between
prices/inflation and output
So how do we bridge this gap ?

We use Okun’s law, the empirical relation
between output and unemployment
The AS curve
Reminder of the Phillips curve
inflation
rate π
   e   u  u n 
β
1
Πe
un
Unemployment rate u
The AS curve
Percentage change in real GDP
5
4
3
2
1
0
-15
-10
-5
0
5
Change in the -1
rate of unemployment
10
15
20
The AS curve
Percentage change in real GDP
5
4
3
2
1
Δy = -0,070 Δu + 2,345
R² = 0,239
0
-15
-10
-5
0
5
10
15
Change in the-1rate of unemployment

Okun’s Law:
Y  Yn   u  un 
20
The AS curve

The Phillips curve is the negative empirical relation between
inflation and unemployment (It can be obtained with the WS –
PS model) :
     u  u  v
e

Negative Relations
n
Okun’s law is a similar negative empirical relation :


Y  Y n   u  u n  

Disregarding the random shocks, one can combine these two
to obtain a short run aggregate supply (SRAS) equation:

Y Y    
n
e




Positive Relation
The AS curve
inflation
rate π
   e   u  u n 
inflation
rate π
   e   Y  Y n 
β
γ
1
1
Πe
un
Unemployment rate u
Yn
Output Y
The AS curve
π
LRAS
In the long run, π* = π e, and the
economy is at its potential output Yn,
which corresponds to the natural rate
of unemployment un.
SRAS
If a shock increases prices, then the
real cost of labour W/P will drop,
pushing output Y above potential
output and unemployment u below the
natural rate.
π’
π*
Workers will adjust their expectations
π e and negotiate higher nominal
wages. This increases the real labour
costs and shifts the SRAS to the left,
until the long run equilibrium is
reached again
Yn
Y
Y
The AS curve
π
LRAS
The long run aggregate supply is
vertical at Yn.
This means that the Y=Yn
condition is equivalent to u=un
and π = π e
Fall in
LRAS
Increase in
LRAS
This does NOT mean that the
potential level of output Yn is fixed
in time
It means that Yn is a function
of other variables than price
Yn
Y
The AS-AD model
The Aggregate Demand curve
The Aggregate Supply curve
The AS-AD equilibrium
The AS-AD equilibrium
π
LRAS
SRAS
In the long run macroeconomic
equilibrium, price expectations are
fulfilled (π* = π e), and demand in the
economy is equal to the long run
productive capacity (Y =Yn).
π*
AD
Yn
Y
The AS-AD equilibrium


Shocks to demand and supply lead to fluctuations at the
macroeconomic level.
By “shocks” economists mean exogenous variations to
supply and demand



A demand shock modifies aggregate demand: increase in G
or T, change in M, etc.
A supply shock modifies aggregate supply: increase in oil
prices, change in technology, etc.
Stabilisation policies are policies that attempt to keep
output, inflation and employment around their long run
equilibrium levels
 The aim is to minimise the fluctuations around equilibrium
The AS-AD equilibrium
π
A negative demand shock shifts
the AD curve to the left, which
reduces output and prices
LRAS
SRAS
SRAS2
How can we return to the long
run equilibrium ?
Supply-side policy:
A
Stimulate the SRAS by reducing
the effective cost of factors
(wages) and get to C
π*
π1
B
π2
Demand-side policy :
C
Stimulate AD with an IS-LM
policy-mix to return to point A.
AD2
Y1
Yn
AD
Y
Preferred solution as it
stimulates a depressed
demand. Consistent with the
IS-LM framework
The AS-AD equilibrium
π
LRAS
SRAS2
SRAS
A negative supply shock (increase in
production costs) causes an increase
in prices and a fall in output in the
short run: This is called stagflation
π2
Demand-side policy :
π1
A demand-side policy can avoid the
recession, but at the cost of high
inflation: this is what happened in the
late 70’s
π*
AD2
Supply-side policy:
It is preferable to carry out a supplyside policy aiming to increase the
SRAS, through a reduction of inflation
expectations and a policy of wage
moderation.
AD
Y1
Yn
Y
The AS-AD equilibrium

The AS-AD model allows a better
understanding of how to coordinate
stabilisation policies
 The best response to a demand shock is a
demand policy (such as a fiscal stimulus
policy)
 The best response to a supply shock is a
supply side policy (such as wage
moderation and reduction of inflation
expectations)