CHAPTER
7
Putting All Markets
Together: The
AS-AD Model
Prepared by:
Fernando Quijano and Yvonn Quijano
And Modified by Gabriel Martinez
7-1
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.
 Y 
P  P (1  m) F 1  , z 
 L 
e
W  P e F (u, z)
© 2003 Prentice Hall Business Publishing
P  (1  m)W
Macroeconomics, 3/e
Olivier Blanchard
7-1
Aggregate Supply
 Recall the equations for wage and price
determination from chapter 6:
W  P e F (u, z)
P  (1  m)W
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deriving the Aggregate
Supply Relation
 How do we derive the Aggregate Supply
Relation?
 The key is to remember that AS is a …
– … relation between the Price Level and
Production
– And production is related to unemployment.
– So we need an equation with P on the left hand
side and Y on the right hand side.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deriving the Aggregate
Supply Relation
 Step 1: Combine
(by eliminating W from both equations):
W  P e F (u, z) and P  (1  m)W
to get:
P  P (1  m) F (u, z)
e
 This has P on the LHS and u on the RHS.
 The price level depends on the expected price level
and the unemployment rate. We assume that m
and z are constant.
 Here allow P to be different from Pe.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deriving the Aggregate
Supply Relation
 Step 2: Recall that the unemployment rate
can be expressed in terms of output:
U L N
N
Y
u

 1
 1
L
L
L
L
Therefore, for a given labor force, the higher is
output, the lower is the unemployment rate.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deriving the Aggregate
Supply Relation
 Step 3: Replace the unemployment rate (u=1-Y/L)
in the equation obtained in step one:
 Y 
P  P (1  m) F 1  , z 
 L 
In words, the price level depends on the
expected price level, Pe, and the level of
output, Y
e
(and also m, z, and L, but we take those as constant here).
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deriving the Aggregate
Supply Relation
 Y 
P  P (1  m) F 1  , z 
 L 
e
 This is an AS relation. How do we know
that?
– AS is a relation between P and production.
– Here we have a relation between P and Y.
– And Y, here, means output produced.
– How do we know that?
– The “Y” comes in here through a production
relation, that is, through the labor market.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Properties of the AS Relation
 Y 
P  P (1  m) F 1  , z 
 L 
e

The AS relation has two important
properties:
1. An increase in output leads to an increase in
the price level. This is the result of four steps:
1.
2.
3.
4.
Y  N 
N  u 
u  W 
W  P 
© 2003 Prentice Hall Business Publishing
This gives
the slope of
the AS
curve.
Macroeconomics, 3/e
Olivier Blanchard
Properties of the AS Relation
 Y 
P  P (1  m) F 1  , z 
 L 
e
1. Y↑  P↑.
1. If society wants more production, more people
must be hired.
2. This lowers the unemployment rate.
3. Lower unemployment strengthens workers’
bargaining power, leading to higher nominal wages
(at a given expected price level).
4. Higher nominal wages raises firms’ marginal cost,
so prices rise.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Aggregate Supply
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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages and Unemployment
1. Higher output (lower u) strengthens workers,
who demand a higher nominal wage W (at
given P).
W
P
2. Firms raise prices to keep a constant markup,
so P rises above Pe (and W/P falls).
Lower u, higher W
Higher W,
higher P
(Pe constant)
So an
increase in
output
leads to an
increase in
the price
level.
WS
WS
Pe = P
Pe < P
u
© 2003 Prentice Hall Business Publishing
un
Macroeconomics, 3/e
u
Olivier Blanchard
AS Curve
u < un
because
Pe < P
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Properties of the AS Relation
 Y 
P  P (1  m) F 1  , z 
 L 
e
What about SHIFTS of the AS curve?
– 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.
Pe   W 
2. W  P 
If prices are expected to rise, workers demand higher
wages, which raises firms’ marginal cost and prices.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Aggregate Supply
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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages and Unemployment
1. Higher expected prices (Pe) make
workers demand a higher nominal
wage W.
2. Firms raise prices P until P = Pe to
keep a constant m (and W/P). Now
we have a higher W and P at any u,
for the same W/P and un.
W
P
Higher W,
higher P
=higher Pe
W’
P’
So an
increase in
Pe leads to
an increase
in P for any
Y.
WS
Pe = P
Pe’ = P’
u
un
© 2003 Prentice Hall Business Publishing
Pe > P
WS
Macroeconomics, 3/e
Olivier Blanchard
AS Curve
u = un
because
Pe = P
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Properties of the AS curve
 The AS curve will SHIFT upward
– if Pe rises,
– if m rises,
Y 

P  P (1  ) F  1  , z

L 
 m includes monopoly power, costs of inputs
other than labor, etc.
e
– if L falls,
 (which would raise unemployment, given the
same level of output)
– if z and the function F change in ways that
make the same natural unemployment rate
consistent with higher wage demands.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Properties of the AS curve
1. The AS curve is upward sloping. An increase in
output leads to an increase in the price level.
2. The AS curve goes through point A, where
Y = Yn and P = Pe. This property has two
implications:
1. When Y > Yn, P > Pe.
If output is above the natural level, prices will rise above
expected prices.
2. When Y < Yn, P < Pe.
3. An increase in Pe shifts the AS curve up, and a
decrease in Pe shifts the AS curve down.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Wages and Unemployment
When P= Pe, u = un.
W
Lower output (higher u) weakens
workers, who accept a lower nominal
wage W.
Firms lower prices to keep a
constant markup, so P falls below Pe.
P
When P < Pe,
u > un,
so Y< Yn.
Lower W,
lower P
WS
Higher u, Lower W
(Pe constant)
Pe > P
WS
When P >
u < un,
so Y> Yn.
Pe = P
P e,
un
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
u
u
Olivier Blanchard
Aggregate Supply
The Aggregate Supply
Curve
1. The AS curve is
upward sloping.
2. The AS curve goes
through point A,
where
Y = Yn and P = Pe.
1. When
Y > Yn, P > Pe.
3. An increase in Pe
shifts the AS curve
up.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
7-2
Aggregate Demand
 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.
 Recall the equilibrium conditions for the
goods and financial markets described in
chapter 5:
IS relation: Y  C(Y  T )  I (Y , i )  G
M
LM relation:
 YL(i )
P
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Aggregate Demand
IS relation: Y  C(Y  T )  I (Y , i )  G
M
LM relation:
 YL(i )
P
 Now, what will happen if P rises?
 At given M, M/P will contract.
i
Ms/P’ Ms/P
Lower M/P, at the same level of
income, raises interest rates 
lower Investment.
Md/P
M/P
© 2003 Prentice Hall Business Publishing
(Sure, the fall in I lowers Y, and
Md falls, which moderates the
rise in i. But Y still falls and i
rises, for most normal
parameter values.)
Macroeconomics, 3/e
Olivier Blanchard
Aggregate Demand
IS relation: Y  C(Y  T )  I (Y , i )  G
M
LM relation:
 YL(i )
P
 P   M/P  i  (LM shifts)
 spending falls (movement along IS)
LM’
i
LM
IS’
– LM curves shifts up,
raising interest rates and
lowering equilibrium
output.
IS
Y
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Aggregate Demand
The Derivation of the Aggregate
Demand Curve
An increase in the price level leads
to a decrease in output.
P 
M
 i  quantity of GDP demanded  Y 
P
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Aggregate Demand
 Summarizing:
– A rise in P reduces real money supply MS/P,
increasing interest rates.
– The LM curve shifts up, for any Y.
– The economy moves along the IS curve to a
lower equilibrium level of Y.
– Therefore, higher P means lower Y demanded:
– The AD curve is downward sloping.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Aggregate Demand
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

( ,  ,  )
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Aggregate Demand and Monetary
Policy
i
Ms/P Ms’/P
i
LM
LM’
Md(Y’)/P
Md(Y)/P
IS
M/P
P
 Expansionary Monetary Policy
lowers interest rates and
raises output at any given
level of prices, so the AD
curve shifts right.
– Higher Y raises
bit, which
moderates the rise in i.
Md a
© 2003 Prentice Hall Business Publishing
Y
Y Y’
AD’
AD
Y
Macroeconomics, 3/e
Olivier Blanchard
Aggregate
Demand and
Fiscal Policy
Z
Y
Z(T,i)
Z’(T’,i’)
Z’(T’,i)
Y
i
 Contractionary Fiscal
Policy lowers demand
for goods and lowers
output at any given level
of prices, so the AD
curve shifts right.
– Lower Y lowers Md,
which reduces i. This
causes I to increase
(“crowding out” in
reverse), which
moderates the fall in Y.
LM
i
i’
IS’
IS
Y
P
AD’ AD
Y
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Aggregate Demand
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.
© 2003 Prentice Hall Business Publishing
M

Y  Y
, G, T 
 P

( ,  ,  )
Macroeconomics, 3/e
Olivier Blanchard
AS, AD, and Causality
 In the Aggregate Supply relation, causality
runs from Y to P
– Higher Y lowers u which raises W/P. This
causes firms to raise P.
 In the Aggregate Demand relation, causality
runs from P to Y.
– Higher P lowers M/P which lowers expenditure,
lowering Y.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
AS, AD, and Causality
 In the Aggregate Supply relation, causality
runs from Y to P
– An exogenous change in costs causes prices to
change for any output level, causing the AS
curve to shift vertically.
 In the Aggregate Demand relation, causality
runs from P to Y.
– An exogenous change in expenditure causes
output to change for any price level, causing the
AD curve to shift horizontally.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in the Short
Run and in the Medium Run
7-3
Y 

AS Relation P  P (1  ) F  1  , z

L 
e
M

AD Relation 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.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in the Short Run
The Short Run
Equilibrium
The equilibrium
is given by the
intersection of
the aggregate
supply curve
and the
aggregate
demand curve.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in the Short Run
The Short Run
Equilibrium
At point A,
the labor
market,
the goods
market, and
financial
markets are all
in equilibrium.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Equilibrium in the Short Run
The Short Run
Equilibrium
Notice that at
point A, P > Pe.
What will
happen over
time?
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
From the Short Run
to the Medium Run
 At point A, Y  Yn 
P  Pe
 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.
© 2003 Prentice Hall Business Publishing
P’
=Pe’
Pe
B
P > Pe leads to higher Pe, which
raises W. This raises P above Pe,
which eventually leads to higher
Pe, which …
Macroeconomics, 3/e
Olivier Blanchard
From the Short Run
to the Medium Run
 The adjustment ends
e
Y

Y
and
P

P
once
.
n
Wage setters no
longer have a reason
to change their
expectations.
 In the medium run,
output returns to the
natural level of
output.
© 2003 Prentice Hall Business Publishing
B’’=
B’
Notice that as AS shifts and P rises, we
move along the AD curve.
(Higher P reduces M/P and lowers Y.)
Macroeconomics, 3/e
Olivier Blanchard
From the Short Run
to the Medium Run
The Adjustment of Output over
Time
If output is above the natural
level of output, the AS curve
shifts up over time, until
output has decreased back to
the natural level of output.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
From the Short Run
to the Medium Run
 To Summarize:
– In the short run , output can be below or above
the natural level of output.
 The reason is that in the short run, price expectations
are sticky and therefore wages are sticky.
– In the medium run, output returns to its natural
level.
 The reason is that prices adjust:
 Prices P fall if Y<Yn, lowering wages (shift AS down)
and raising M/P (move along AD).
 Prices P rise if Y>Yn, raising wages (shift AS up) and
lowering M/P (move along AD).
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Effects of a
7-4
Monetary Expansion
M

Y  Y
, G, T 
 P

 In the aggregate demand equation, we can
see that an increase in nominal money, M,
leads to an increase in the real money
stock, M/P, leading to an increase in output.
The aggregate demand curve shifts to the
right.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Dynamics of Adjustment
 The increase in the
nominal money stock
causes the aggregate
demand curve to shift
to the right.
 In the short run, output
and the price level
increase.
 The difference between
Y and Yn sets in motion
the adjustment of price
expectations.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Dynamics of Adjustment
 Stop for a second.
 Assume an economy where dollar bills are
used only once a year (velocity = 1); and
where annual real GDP = 10 million houses.
 Suppose Ms=$10bn. What will P be?
 MV = PY
 $10bn x 1 = P x 10 million houses
 P = $1 thousand / house
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Dynamics of Adjustment





Now suppose Ms=$20bn. What will P be?
MV = PY
$20bn x 1 = P x 10 million houses
P = $2 thousand / house
If M doubles, P doubles. M/P doesn’t
change.
 Why doesn’t this happen in the short
run?
 Because M affects P through the goods, money, and labor
market, over time, esp. through changes in Pe.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Dynamic Effects of
a Monetary Expansion
 In the medium run, the
AS curve shifts to AS’’
and the economy
returns to equilibrium at
Yn.
 The increase in prices
is proportional to the
increase in the nominal
money stock.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Dynamics of Adjustment
The Dynamic Effects of
a Monetary Expansion
A monetary expansion leads
to an increase in output in the
short run, but has no effect
on output in the medium run.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Going Behinds the Scenes
 The impact of a
monetary expansion on
the interest rate can be
illustrated by the IS-LM
model.
 The short-run effect of
the monetary
expansion is to shift the
LM curve down. The
interest rate is lower,
output is higher.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Going Behinds the Scenes
 Notice that, even in the
short run, prices
change slightly.
 If the price level had
not increased at all, the
shift in the LM curve
would have been
larger—to LM’’.
© 2003 Prentice Hall Business Publishing
LM’’
Macroeconomics, 3/e
Olivier Blanchard
Going Behinds the Scenes
 Over time, the price level
increases, the real money
stock decreases and the
LM curve returns to where
it was before the increase
in nominal money.
 In the medium run, the
real money stock and the
interest rate remain
unchanged.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Going Behinds the Scenes
The Dynamic Effects of a
Monetary Expansion on Output
and the Interest Rate
The increase in nominal
money initially shifts the LM
curve down, decreasing the
interest rate and increasing
output. Over time, the price
level increases, shifting the
LM curve back up until output
is back at the natural level of
output.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy is Neutral in the
long run
 In other words, monetary policy is
– Effective in the short run
 In the short run, a monetary expansion increases
M/P and output, moving the economy along the AS
curve.
 A monetary contraction would reduce M/P and
reduce output along the AS curve.
– Neutral in the medium run
 In the medium run, DP = DM, so output returns to Yn
 In the medium run, Yn is consistent with any level of
P.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Monetary Policy is Neutral in the
long run
P
AS’’
AS’
AS
AD
AD’
AD’’
Y
Yn
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Anticipated versus Unanticipated
Policies
 We have assumed that workers do not
anticipate monetary expansions, so Pe
remains constant for a long time.
– Output takes a lot time to return to Yn.
– The conclusion is that monetary surprises can
affect output, but not predicted monetary
expansions.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Anticipated versus Unanticipated
Policies
 But what if workers do anticipate the monetary
expansion? Pe will rise very soon after, so this
whole process will take little time.
– In most economies, the Central Bank increases the
money supply constantly. The public watches the
Central Bank because it is used to predictable rates of
monetary expansion, and price expectations increase all
the time.
 But the public can still be surprised.
– In some economies, expectations catch up so quickly
that monetary policy is ineffective even in the short run,
leading to high rates of inflation.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
7-5
A Decrease in
the Budget Deficit
The Dynamic
Effects of a
Decrease in the
Budget Deficit
A decrease in the
budget deficit leads
initially to a decrease
in output. Over time,
output returns to the
natural level of output.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deficit Reduction, Output,
and the Interest Rate
 Since the price level
declines in response to
the decrease in output,
the real money stock
increases. This causes
a shift of the LM curve
to LM’.
 Both output and the
interest rate are lower
than before the fiscal
contraction.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deficit Reduction, Output,
and the Interest Rate
 AS the AS curve shifts
down, P falls and M/P
rises.
 The LM curve
continues to shift down
until output is back to to
the natural level of
output.
 The interest rate is
lower than it was
before deficit reduction.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deficit Reduction, Output,
and the Interest Rate
The Dynamic Effects of a
Decrease in the Budget Deficit
on Output and the Interest Rate
Deficit reduction leads in the
short run to a decrease in
output and to a decrease in
the interest rate. In the
medium run, output returns
to its natural level, while the
interest rate declines further.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Deficit Reduction, Output,
and the Interest Rate
 The composition of output is different than it
was before deficit reduction.
IS relation: Yn  C(Yn  T )  I (Yn , i )  G
 Income and taxes remain unchanged, thus, consumption is the
same as before.
 Government spending is lower than before, but Y is the same
 Therefore, investment must be higher than before deficit
reduction—higher by an amount exactly equal to the decrease
in G. This can only happen if
 Interest rates fall in the SR, and even more in the medium run.
 In the medium run, budget deficit reduction leads to a
decrease in the interest rate and an increase in
investment.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
7-6
Changes in the Price of
Oil
The Price of Crude
Petroleum, 19602001
There was two sharp
increases in the
relative price of oil in
the 1970s, followed by
a decrease in the
1980s and the 1990s.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Changes in the Price of Oil
 Recall that, for Price Setting, P=(1+m)W
 In Chapter 6 we assumed firms had no costs
besides wages, and that m was entirely due to
monopoly power.
 Here we have to add another input (oil). We could
re-derive the entire AS curve.
 Or we could say that (1+m) captures any reason
for a difference between P and W, reflecting:
– Monopoly power,
– Marginal Cost of other inputs besides labor,
 (Such as oil)
– Taxes on business profits, labor regulation,
– Etc.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Effects on the Natural
Rate of Unemployment
The Effects of an
Increase in the Price
of Oil on the Natural
Rate of
Unemployment
We can model the
higher price of oil
as an increase in
the markup (of
prices over wages)
and a downward
shift of the pricesetting line.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Dynamics of Adjustment
 Y 
P  P (1  m) F 1  , z 
 L 
e
 An increase in the markup, m, caused by an
increase in the price of oil, results in an
increase in the natural unemployment rate,
which reduces Yn for any P. The AS curve
shifts left.
– Alternatively, we can think of a higher m causing
an increase in the price level, at any level of
output, Y, shifting the AS curve up.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
The Dynamics of Adjustment
 After the increase in the
price of oil, the new AS
curve goes through point B,
where output equals the
new lower natural level of
output, Y’n, and the price
level equals Pe.
 The economy moves along
the AD curve, from A to A’.
Output decreases from Yn
to Y’.
 But now P>Pe, so Pe will
rise over time, and the AS
curve will shift upwards
even more.
© 2003 Prentice Hall Business Publishing
B
Macroeconomics, 3/e
Olivier Blanchard
The Dynamics of Adjustment
 Over time, the
economy moves along
the AD curve, from A’
to A”.
 At point A”, the
economy has reached
the new lower natural
level of output, Y’n, and
the price level is higher
than before the oil
shock.
© 2003 Prentice Hall Business Publishing
B’’=
Macroeconomics, 3/e
Olivier Blanchard
The Dynamics of Adjustment
The Dynamic Effects of an
Increase in the Price of Oil
An increase in the price of oil
leads, in the short run, to a
decrease in output and an
increase in the price level.
Over time, output decreases
further and the price level
increases further.
© 2003 Prentice Hall Business Publishing
B’’=
Macroeconomics, 3/e
Olivier Blanchard
The Dynamics of Adjustment
Table 7-1
The Effects of the Increase in the Price of Oil,
1973-1975
1973
1974
1975
10.4
51.8
15.1
Rate of change of GDP deflator (%)
5.6
9.0
9.4
Rate of GDP growth (%)
5.8
0.6
 0.4
Unemployment rate (%)
4.9
5.6
8.5
Rate of change of petroleum price (%)
 The combination of negative growth and high
inflation, or stagnation accompanied by inflation, is
called stagflation.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Conclusions
7-6
The Short Run Versus the Medium Run
Table 7-2 Short-Run Effects and Medium-Run Effects of a Monetary
Expansion, a Budget Deficit Reduction, and an Increase in the Price
of Oil on Output, the Interest Rate, and the Price Level
Short Run
Medium Run
Output
Level
Interest
Rate
Price Level
Output Level
Interest Rate
Price Level
Monetary
expansion
increase
decrease
increase
(small)
no change
no change
increase
Deficit
reduction
decrease
decrease
decrease
(small)
no change
decrease
decrease
Increase in
oil price
decrease
increase
increase
larger
decrease
larger
increase
larger
Increase
i increases because M/P falls as
P increases
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Conclusions
 If policy does not change output in the
medium run, should we bother?
 This depends on
– How fast price expectations adjust,
 And this depends on whether the shock is
anticipated/unanticipated, on whether it is well
understood or not, on whether it affects relatively
sophisticated agents or uneducated ones, etc.
– The shapes of the IS, LM, and labor market
curves,
– How quickly policy can be carried out and how
quickly it affects output.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Conclusions
 “Activists”, typically associated with the
Keynesian school, believe Pe adjusts very
slowly and policy affects output relatively
quickly and accurately.
– If the economy takes a long time to move back
to Yn and if government policy can make the
right decisions,
– a lot of pain can be avoided by activist policy.
– Policy can improve welfare.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Conclusions
 “Non-activists”, typically New Classicals,
believe Pe adjusts quickly, and policy is
often wrongheaded or tardy.
– If the economy goes back to Yn quickly and if
government policy is often wrongheaded,
– Policy will typically overreact or react to events
too late,
– Leading to more instability and less welfare.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Shocks and Propagation
Mechanisms
 Output fluctuations (sometimes called business
cycles) are movements in output around its trend.
 The economy is constantly hit by shocks to
aggregate supply, or to aggregate demand, or to
both.
 Each shock has dynamic effects on output and its
components. These dynamic effects are called
the propagation mechanism of the shock.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard
Where we go from here
 In the next chapters, we’ll introduce
sustained nominal money growth,
 Which explains sustained inflation.
 Inflation, its level and its change, affects
(and is affected by) output and
unemployment.
© 2003 Prentice Hall Business Publishing
Macroeconomics, 3/e
Olivier Blanchard