Review
Chapter 7: Putting All Markets
Together: The AS-AD Model
Review of
IS-LM AS-AD Model
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Jenny Xu
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
From Chapter 5 and 6
Chapter 5 talks about the determination of
output and interest rate in the short-run.
Chapter 6 tells us the determination of output
in the medium run – by the natural rate of
unemployment.
This chapter we look at the output
determination in both the short-run and
medium run –the AS-AD model;
AS- from the labor market;
AD- from the IS-LM analysis;
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Olivier Blanchard
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IS Curve
Chapter 7: Putting All Markets
Together: The AS-AD Model
IS relation: Y  C ( Y  T )  I ( Y , i )  G
IS Curve is derived from the Goods Market
Clearing condition:
Supply of goods: Y
equals to
Demands of Goods coming from:
Consumption demand: C;
Investment demand: I;
Government Expenditure: G
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Olivier Blanchard
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IS Curve
Chapter 7: Putting All Markets
Together: The AS-AD Model
IS relation: Y  C ( Y  T )  I ( Y , i )  G
IS Curve captures the effect of nominal interest
rate i on output Y, for given values of T and G.
(tax and government purchase).
Investment demand depends negative on interest
rate. Hence, when i increase, the investment and
then the total demand will fall. So will the total
output Y.
Therefore, IS curve is downward sloping.
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Macroeconomics, 4/e
Olivier Blanchard
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LM Curve
Chapter 7: Putting All Markets
Together: The AS-AD Model
LM relation:
M
P
 YL ( i )
LM Curve is derived from the financial market
clearing condition.
Supply of nominal money: M
equals to
Demands of nominal money coming from the
transaction demand, which in turn depends
positively on the price level P, and the total output
Y, and negatively on the nominal interest rate.
(Why? Because higher i implies a higher OC of
holding money).
So nominal money demand is given by PYL(i)
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Olivier Blanchard
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LM Curve
Chapter 7: Putting All Markets
Together: The AS-AD Model
LM relation:
M
 YL ( i )
P
LM Curve captures the effect of output Y on
nominal interest rate i, for given values of M
(nominal money supply) and P (in short run
price is assumed to be fixed).
Higher total output implies higher transaction
demand. So for given level of nominal money
supply, high demand implies the interest rate
that clear the money market has to increase. So
when Y increases, the nominal interest rate i
increases.
Therefore, LM curve is upward sloping.
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Olivier Blanchard
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Aggregate Demand
Chapter 7: Putting All Markets
Together: The AS-AD Model
When we derive the AD and AS curve, we no
longer assume that price level is fixed.
The AD curve indicates that, for given levels of M,
T, and G, when the price level change, how does
the output level change.
The aggregate demand relation captures the
effect of the price level on output. It is derived
from the equilibrium conditions in the goods and
financial markets.
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Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Demand
Recall the equilibrium conditions for the goods
and financial markets described in chapter 5:
IS relation: Y  C ( Y  T )  I ( Y , i )  G
LM relation:
M
P
 YL ( i )
When P increases, then real money supply will
decrease, so the nominal interest rate will
increase, investment and output will fall.
So the AD curve is downward sloping.
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Macroeconomics, 4/e
Olivier Blanchard
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Aggregate Demand
Chapter 7: Putting All Markets
Together: The AS-AD Model
Figure 7 - 3
The Derivation of the
Aggregate Demand
Curve
An increase in the price
level leads to a decrease
in output.
 P  
M
P
 i    dem and   Y
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Shift of Aggregate Demand
AD curve describes the relationship between
price level and the output. So changes in
monetary or fiscal policy—or more generally in
any variable, other than the price level, that
shift the IS or the LM curves—shift the
aggregate demand curve.
 M

Y  Y
,G,T
 P

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( ,  ,  )
Macroeconomics, 4/e
Olivier Blanchard
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Aggregate Demand
Chapter 7: Putting All Markets
Together: The AS-AD Model
Figure 7 - 4
Shifts of the Aggregate
Demand Curve
An increase in
government spending
increases output at a
given price level, shifting
the aggregate demand
curve to the right. A
decrease in nominal
money decreases output
at a given price level,
shifting the aggregate
demand curve to the left.
© 2006 Prentice Hall Business Publishing
 M

Y  Y
,G,T
 P

( ,  ,  )
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Demand
Let’s summarize:
 Starting from the equilibrium conditions for the
goods and financial markets, we have derived
the aggregate demand relation.
 This relation implies that the level of output is
a decreasing function of the price level. It is
represented by a downward-sloping curve,
called the aggregate demand curve.
 Changes in monetary or fiscal policy – or more
generally in any variable, other than the price
level, that shifts the IS or the LM curves – shift
the aggregate demand curve.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Supply
The aggregate supply relation captures the
effects of output on the price level. It is derived
from the behavior of wages and prices.
Recall the equations for wage and price
determination from chapter 6:
W  P F (u, z)
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e
P  (1   )W
Macroeconomics, 4/e
Olivier Blanchard
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Aggregate Supply
Step 1: Eliminate the nominal wage W  P F ( u , z )
e
Chapter 7: Putting All Markets
Together: The AS-AD Model
from: P  (1   )W
, then
P  P (1   ) F ( u , z )
e
Step 2: Express the unemployment rate in terms of
output:
u 
U
L

L N
L
 1
N
L
 1
Y
L
Step 3. Substitute u,
Y 

P  P (1   ) F  1 
, z

L 
e
In words, the price level depends on the expected
price level, Pe, and the level of output, Y (and also ,
z, and L, but we take those as constant).
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Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Supply
Y 

P  P (1   ) F  1 
, z

L 
e
The AS relation has two important properties:
 First, How does the change in Y affect P?
An increase in output leads to an increase in
the price level. This is the result of four steps:
1. Y   N 
2. N   u 
3. u   W 
4. W   P 
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Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Supply
Y 

P  P (1   ) F  1 
, z

L 
e
The second important property ask the
relationship between expected price level
and P :
 An increase in the expected price level leads,
one for one, to an increase in the actual price
level. This effect works through wages:
1. W   P 
2. P e   W 
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Macroeconomics, 4/e
Olivier Blanchard
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Aggregate Supply
Chapter 7: Putting All Markets
Together: The AS-AD Model
Figure 7 - 1
The Aggregate Supply
Curve
Given the expected
price level, an increase
in output leads to an
increase in the price
level. If output is equal
to the natural level of
output, the price level is
equal to the expected
price level.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Supply
The AS curve has three properties that will prove
to be useful in what follows:
 The AS curve is upward sloping. As
explained earlier, an increase in output leads
to an increase in the price level.
 The AS curve goes through point A, where Y
= Yn and P = Pe. This property has two
implications:
 When Y > Yn, P > Pe.
 When Y < Yn, P < Pe.
 An increase in Pe shifts the AS curve up, and
a decrease in Pe shifts the AS curve down.
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Olivier Blanchard
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Aggregate Supply
Chapter 7: Putting All Markets
Together: The AS-AD Model
Figure 7 - 2
The Effect of an
Increase in the
Expected Price Level
on the Aggregate
Supply Curve
An increase in the
expected price level
shifts the aggregate
supply curve up.
Meanwhile, changes
of , z, also lead to
shift of the AS curve.
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Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Supply
Let’s summarize:
 Starting from wage determination and price
determination in the labor market, we have
derived the aggregate supply relation.
 This means that for a given expected price
level, the price level is an increasing function
of the level of output. It is represented by an
upward-sloping curve, called the aggregate
supply curve.
 Increases in the expected price level shift the
aggregate supply curve up; decreases in the
expected price level shift the aggregate supply
curve down.
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Macroeconomics, 4/e
Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Equilibrium in the Short
Run and in the Medium Run
Y 

AS Relatio n P  P (1   ) F  1 
, z

L 
e
 M

A D R elatio n Y  Y 
,G,T
 P

Equilibrium depends on the value of Pe. The
value of Pe determines the position of the
aggregate supply curve, and the position of the
AS curve affects the equilibrium.
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Olivier Blanchard
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Equilibrium in the Short Run
Chapter 7: Putting All Markets
Together: The AS-AD Model
Figure 7 - 5
The Short Run
Equilibrium
The equilibrium is given by
the intersection of the
aggregate supply curve
and the aggregate demand
curve. At point A, the labor
market, the goods market,
and financial markets are
all in equilibrium.
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Olivier Blanchard
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Equilibrium in the Short Run
Chapter 7: Putting All Markets
Together: The AS-AD Model
From the above figure, we can see that
Y  Yn
In the equilibrium point A.
Why is that?
This is because the equilibrium depends on both the
AS and the AD curve. And position of AS curve
depends on expected price level P e , while the
position of the AD curve depends on M , G , T , so
in the short-run, output might not equal to natural
level of output.
So what will happen over time?
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Olivier Blanchard
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From the Short Run
to the Medium Run
Chapter 7: Putting All Markets
Together: The AS-AD Model
At point A,
Y  Yn  P  P
e
 Wage setters will revise
upward their expectations
of the future price level.
This will cause the AS curve
to shift upward.
 Expectation of a higher
price level also leads to a
higher nominal wage, which
in turn leads to a higher
price level.
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Olivier Blanchard
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From the Short Run
to the Medium Run
Chapter 7: Putting All Markets
Together: The AS-AD Model
Will the adjustment stop at A’? No, since at A’ we still have Y  Yn  P  P e
The adjustment ends
once
Y  Yn and P  P
e
and wage setters no
longer have a reason to
change their
expectations.
In the medium run,
output returns to the
natural level of output.
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Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
From the Short Run
to the Medium Run
Let’s summarize:
 In the short run, output can be above or below
the natural level of output. Changes in any of
the variables that enter either the aggregate
supply relation or the aggregate demand
relation lead to changes in output and to
changes in the price level.
 In the medium run, output eventually returns to
the natural level of output. The adjustment
works through changes in the price level.
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Macroeconomics, 4/e
Olivier Blanchard
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