The AD-AS Model
Lecture 14 – academic year 2013/14
Introduction to Economics
Fabio Landini
Where we are…
• Lectures 1-7: Microeconomics
• Lecture 8-9: GDP, Inflation and unemployment
• Lecture 11: Goods market
• Lecture 13: Financial market
• Lecture 14: Labour market
Questions of the day…
• How do we describe the functioning of the
economy in the medium period?
• Which are the features of the equilibrium in the
medium period?
• What differentiates the medium period
equilibrium from the short period one?
What do we do today?
• Premise: short vs. medium period
• Construction of the AS curve
• Construction of the AD curve
• Equilibrium in the short and medium period
Premise: short vs. medium period
In Lecture 9 we distinguished three different time
horizons: short, medium and long period
What differentiates short and medium period?
1) Degree of price flexibility
• Short period -> prices are partially flexible
• Medium (and long) period -> prices are fully flexible
Flexible prices -> Price adjustment mechanism
Premise: short vs. medium period
2) Accuracy of expectations
In lecture 14 we introduced the workers’ price
expectations (WS curve)
In which context are expectations accurate?
It is plausible to assume that :
• In the short period workers can make errors in
forecasting prices (PE can differ from P)
• As time passes workers can realize the error and
adjust their expectations
• In the medium period expectations are assumed to be
correct (PE = P)
Premise: short vs. medium period
Passage from short to the medium period:
Equilibrium in the goods market + Equilibrium in the
financial markets + Equilibrium in the labour market
AD-AS Model:
• Aggregate Supply -> AS
• Aggregate Demand -> AD
Construction of the AS curve
AS curve -> equilibrium in the labour market
Labour market
• WS -> W = PE F(u,z)
• PS -> P = W(1+m) ->
P
=W
1+ m
Labour market equilibrium -> WS and PS simultaneously
verified
P
By substituting PS in WS ->
= PE F(u,z)
1+ m
from which we get
P= PE (1+ m) F(u,z)
Construction of the AS curve
In the model of the labour market (WS – PS) we
assumed P=PE
Under this Hp., u=un where un is the natural rate of
unemployment
The Hp. P=PE is correct in the medium period -> un is
the rate of unemployment in the medium period
From the definition of unemployment:
Disoccupati
U
u

Forze di Lavoro L
Construction of the AS curve
We know that, Unemployed = Labour Forces - Employed
U =L-N
U L-N
N
 1Therefore, u  
L
L
L
Y
Finally, the assumption Y=N implies u  1 L
Yn
E
When P=P we have u=un and u n  1 where Yn is
L
the natural level of production
PE=P -> u=un -> Y=Yn
Construction of the AS curve
Y
By substituting u  1 in P = PE (1+m) F(u,z) we get
L
P= PE (1+m) F( 1 - Y , z)
L
+
which is called equation of aggregate supply (AS)
The equation shows a positive relationship between P
and Y
Y ->
Y
1 - ->
L
F( 1 - Y , z) ->
L
P
Costruzione della curva AS
Economic intuition (labour market):
• Y ->
• Employment N ->
• u ->
• Workers’ bargaining power ->
• W (via mark up) ->
• P
The relationship between P and Y is increasing -> the AS
equation is an increasing curve in a (Y,P) diagram
P
AS
Y
AS curve -> Equilibrium in the labour market
Important: the curve is not necessarily a straight line
What happens if the expected prices vary?
AS -> P = PE (1+m) F( 1 - Y , z)
L
PE ->
P
P -> AS curve shifts upward
AS’
AS
Y
Construction of the AD curve
In constructing the AD curve let’s first consider the goods
market and the financial markets in isolation
While deriving the aggregate demand (goods market Lecture 11) we assumed that investments were exogenous
(I=I0). Let’s now try to make investments endogenous
What do firms consider when they have to decide how much
to invest?
Mainly two things:
1) Sales. If I sell more I need to produce more -> I need more
capital -> Investments (I) depend positively on sales
Construction of the AD curve
2) The cost of investment -> interest rate i
•
If the firm borrows money to finance investments ->
the cost of the borrowing depends positively on the
interest that is paid
•
If the firm uses her own funds -> Investments in
capital are the more convenient the lower the return
offered by the best alternative financial instruments
Example: If the return on bonds increases it is convenient
to use funds to buy bonds rather than capital ->
capital’s opportunity cost increases
Construction of the AD curve
In both cases: i -> financial cost (or opportunity
cost) of investments -> I
We can thus conclude that investment depends
positively on production and negatively on interest rate
I=I(Y,i)
+-
Construction of the AD curve
Let’s go back to the equilibrium in the goods market
Aggregate demand -> Z = C + I + G
Consumption (C) depends on disposable income YD
C = C (YD) where YD=Y-T
+
Investments (I) depend positively on production (Y) and
negatively on interest rate
I = I(Y,i)
+Government expenditure (G) and taxation are chosen by the
government and are exogenous
G = G0 and T = T0
Construction of the AD curve
By substituting the components of Z ->
Z = C(Y-T0) + I(Y,i) + G0
Equilibrium condition in the good markets -> Z=Y
Let’s consider the two equations together ->
Y = C(Y-T0) + I(Y,i) + G0
In this equation we have two variables (Y and i) -> Let’s
consider their relationship in the goods market
Construction of the AD curve
In equilibrium
i ->
Y
Explanation:
•
i ->
cost of funding ->
• + multiplier effect ->
equil.) Y
I ->
Z -> (in equil.) Y
Y -> C and
I ->
Z -> (in
In the equilibrium of the goods market the relationship
between Y and i is decreasing
This relationship can be represented by a decreasing curve
in a (Y,i) diagram
i
IS
Y
The IS curve represent all the pair (Y,i) for which the
goods market is in equilibrium
Construction of the AD curve
Let’s now consider the equilibrium in the financial
markets
The demand of money depends positively on income
and negatively on rate of interest
MD = €YL(i)
The supply of money is fixed by the Central Bank
Ms exogenous
Construction of the AD curve
Equilibrium condition in the financial markets
MS = €YL(i)
Equilibrium condition in financial markets -> nominal income (€Y)
Equilibrium condition in goods market -> real income(Y)
To make variables homogeneous we divide both sides of the
condition MS = €YL(i) by the level of prices P (measured by the
GDP deflator)
In this way we obtain
MS
where
P
MS
 YL(i)
P
is the real money supply
Construction of the AD curve
Equilibrium condition in financial markets ->
MS
 YL(i)
P
In the equation there are two variables (Y and i) -> we
can represent the equilibrium condition in financial
markets in a (Y,i) diagram
Such curve is called LM because it equalizes money
demand (“liquidity”- “L”) and money supply (“M”)
Construction of the AD curve
To construct the LM curve we consider the effects of
an Y in financial markets
In Lecture 12 we saw that Y -> i in equilibrium
In equilibrium there is a positive relationship
between Y and i -> The LM curve is upward sloping
€Y -> Y (P is fixed) -> shift of the MD curve rightward
€Y -> E ->E’ ->
MD
i
MD ’
i in equilibrium
MS
E’
iE’
iE
E
MD
i
LM
Y
The LM curve represents all the pairs (Y,i) for which
the financial markets are in equilibrium
Construction of the AD curve
Let’s now consider the goods market and the financial
markets together
IS-LM model : IS -> Y= C(Y-T) + I(Y,i) + G;
LM -> MS/P = YL(i)
i
Pair (i,Y) for which both
markets are in equilibrium
LM
E
IS
Y
So far we considered a model with fixed P
What happens if P varies (medium period)?
P affects the position of the LM curve
P -> MS/P -> same as MS -> LM shifts leftward
Effects: E-> E’ and YE-> YE’ -> Y
In equilibrium: P -> Y
i
LM’
LM
E’
E
IS
YE’
YE
Y
Decreasing relationship between Y and P -> AD curve
P
AD
Y
AD curve -> Equilibrium in goods market and financial markets
Important: The curve is not necessarily a straight line
What happens when we vary Ms/P, G e T ?
a) Ms/P (expansionary monetary policy) -> LM shifts
rightward -> Y
Y occurs for any level of P -> AD shifts rightward
P
AD’
AD
Y
A similar effect occurs if G
b) G -> IS shifts rightward -> Y
Y occurs for any level of P -> AD shifts rightward
P
AD’
AD
Y
c) T -> IS shifts leftward -> Y given P
Y occurs for any level of P -> AD shifts leftward
P
AD
AD’
Y
Construction of the AD curve
The preceding results suggest when the goods market and
the financial markets are in equilibrium, Y is:
S
• An increasing function of M
P
• An increasing function of G
• A decreasing function of T
Therefore we have, AD curve:
S
M
Y=Y(
, G, T)
P
+ + -
Determination of the equilibrium
In the equilibrium point AS and AD are simultaneously verified
Graphically -> Intersection of AD and AS
Equilibrium of the system -> Point A -> Y=YA e P=PA
P
PA
AS
A
AD
YA
Y
Determination of the equilibrium
In point A:
• Along the AS -> labour market in equilibrium
• Along the AD -> goods market and financial market in
equilibrium
P
PA
AS
A
AD
YA
Y
Determination of the equilibrium
Point A can represent the equilibrium both in the short and in
the medium period, depending on the assumption on PE
The position of A, indeed, depends on the position of the AS
curve and thus on PE
In particular :
•Medium period, PE=P -> u=un -> Y=Yn
In the medium period equilibrium Y is always equal to Yn
•Short period, PE can be ≠ P -> Y ≠ Yn
Three cases:
PE=P -> Y=Yn ; PE>P -> Y<Yn ; PE<P -> Y>Yn
Let’s consider the case PE<P -> YA>Yn
In the medium period the equilibrium is always
along Yn
P
AS
A
AD
Yn
YA
Y
How do we move from the short period eq. A to the medium
period equilibrium?
With the passage of time expectations are corrected ( PE) and
the curve AS shifts until Y =Yn
AS’
P
AS
A
AD
Yn
YA
Y
How do we move from the short period eq. A to the medium
period equilibrium?
With the passage of time expectations are corrected ( PE) and
the curve AS shifts until Y =Yn
AS’
P
AS
A
AD
Yn
YA
Y
How do we move from the short period eq. A to the medium
period equilibrium?
With the passage of time expectations are corrected ( PE) and
the curve AS shifts until Y =Yn
AS’
P
AS
A
AD
Yn
YA
Y
How do we move from the short period eq. A to the medium
period equilibrium?
With the passage of time expectations are corrected ( PE) and
the curve AS shifts until Y =Yn
AS’
P
AS
A
AD
Yn
YA
Y
Conclusion
Combining goods market, financial market
and labour market we studied the
determination of equilibrium in the medium
period .
The main difference with the short period is
that now price can vary (+ investment are
endogenous).
The AD-AS model is the main macroeconomic
model that is used to investigate the effect of
policy interventions.
Next
AD-AS exercises and applications