Four Different Framework for Analysing
Aggregate Demand and Aggregate Supply
AS-AD Diagrams with Natural Rate of Output
One Sector Closed Economy Business Cycle Model
One Sector Open Economy Small Economy Model
Multiple Sector Dynamic General Equilibrium Model
Macroeconomic Theme:16
1
Sources of Demand Shocks
Positive demand shocks include
factors such as increase in public spending,
increase in external demand due to increase in output in
trading partners,
rise in consumer and investor confidence;
A negative demand shock arise due to
lower volume of spending due to a loss of investor and
consumer confidence, decrease in external demand,
reduction in public deficit.
Macroeconomic Theme:16
2
Sources of Supply Shock
Positive supply shock includes
increase in productivity due to technical innovation such as
the internet,
good weather condition in case of agriculture and
harmony among workers and owners in the industrial
sector.
Adverse supply shock include
natural calamities such as floods, earthquake, global
warming and environmental pollution,
strikes and dispute between management and workers in
the industrial sector,
spread of diseases such as the foot and mouth,
bad weather,
hike in oil prices or other energy inputs,
increase in prices of imported goods.
Macroeconomic Theme:16
3
Impact of Negative and Positive Supply
Shocks in the Short and Long Run
Dynamic adjustment process toward equilibrium
Positive demand shock and negative supply shock
AD2
LAS
AD1
D
SAS
P
c
b
Dynamic adjustment process after a positive
supply shock
P  (1   ) P e N s ( 1 
Y
; z)
L
a
P
b
C
AS1
a
Y  F(
M
, G, T )
P
AS2
AD
AS3
Yn
Y
Aggregate demand and aggregate supply
Yn
Y
Aggregate demand and aggregate supply in the
short and the long run
Output returns to the natural level in the medium run.
Macroeconomic Theme:16
4
Dynamic Adjustment Process After a
Negative Demand and Supply Shocks
Output returns to the natural level in the medium run.
Dynamic adjustment process of contractionary
Dynamic adjustment process after a negative
monetary and fiscal policy
supply shocks (increase in oil prices)
AD1
SAS
AD1
LAS
AS1
AD
AS2
P1
a
P
P
c
b
P2
P3
B
AS3
a
C
Yn
Y
Aggregate demand and aggregate supply
Yn
Y
Aggregate demand and aggregate supply in the
short and the long
Macroeconomic Theme:16
5
Impact of Shocks to Aggregate Demand and
Aggregate Supply on Output and Inflation
Aggregate demand depends on real growth rate of money


    , its own lagged value y
t
 t
t 1 and the demand


shock dt ~ N  0, 2  .


yt  a y  a  t  t   dt (1)
1 t 1 2
The supply function is given by
 t    b  yt  y   st (2)
1
Core inflation depends upon the current and past
inflation
   t  1  
t 1
(3)
Macroeconomic Theme:16
6
Demand and Supply Shocks in AD-AS Model
Iterate back (1) and subtract the resulting equation from (1)
y  a y  a      d
t 1 1 t 2 2  t 1 t 1 t 1
(4)
yt  y  a  y  y  a  t   a t   dt d
t1 1 t1 t2  2
t1 2
t1
t1
Substitute (3) in (2)
 t   t  1  
 b  yt  y   st
t 1 1
b 
1  y  y   st




 t
t 1 1   t  1  (5)
Substituting (5) in (4)
s 
 b
y t  y t 1  a1  y t 1  y t  2   a 2  t   t 1   a 2  1  y t  y   t   d t  d t 1
1  
1 
yt 
a 2 b1
y t  1  a1  y t 1  a1 y t  2  a 2  t  a 4 d t  a 5 y  a 6 s t
1 
Macroeconomic Theme:16
7
Impact of shock on the Time Path of Output




 b
st 
1

yt  y
a y y
 a t  
a
y y 
 dt  d

t 1 1 t 1 t 2
2
t 1
2 1  t
t 1
1








a b
yt  2 1 yt  1  a y  a y
 a  t  a d t  a y  a st
5
1 t 1 1 t 2
2
4
6
1 
yt   y
 y
   t   d t   y   st
5
1 t 1
2 t 2
3
4
6
 
Where 1
5 
1   1  a1 
 a1 1   


2
1     a 2 b1 ;
1     a 2 b1 ;
3 
1   
 a 2 1   
4 
1     a 2 b1
1     a 2 b1
 1   a 2
 1   a 2
6 
1     a 2 b1 ;
1     a 2 b1
Current output in a non-linear function of past level of
output, money supply and demand shock and the supply
shocks.
Macroeconomic Theme:16
8
Impact of Demand and Supply Shocks on
Inflation
 t    b1  y t  y   s t and  t    b1  y t  y   s t
and
y t  a1 y t 1  a 2  t   t   d t
 t   t  1    t 1  b1 a1 y t 1  a 2  t   t   d t   b1 y  s t
 t   t  b1 a 2 t  1    t 1  b1 a1 y t 1  a 2 b1  t  b1 d t  b1 y  s t
t 
1   
1    a 2 b1
 t 1 
a1b1
a 2 b1
b1
b1
1
y t 1 
t 
dt 
y  a6
st
1    a 2 b1
1    a 2 b1
1    a 2 b1
1    a 2 b1
1    a 2 b1
 t   1 t 1   2 y t 1   3  t   4 d t   5 y   6 s t
Thus current inflation is determined by past inflation,
output, money growth rate, demand and supply shocks.
Macroeconomic Theme:16
9
A Simple AS-AD Model in an Open Economy
Aggregate demand


 
Yt  Y  FPt   (t   t )   ( i   t )  s
(1)
1t
 >0,  <0, and  <0

FPt is a fiscal policy variable (budget deficit),   t
t
 
represents the exchange rate policy, and i  t represents
monetary policy. Finally the last term in (1)
s represents shocks in aggregate demand.
1t
Aggregate Supply


 t  t b (Yt  Y )  s
1
2t
(2)
where  t = core inflation rate in t,
level of output
Y
= trend (equilibrium)
s
2,t = one-off supply shock
Macroeconomic Theme:16
10
A Simple AS-AD Model in an Open Economy:
Inflation and Unemployment
Autoregressive process for aggregate prices
Pt  P (1   t )
t 1
This implies that the real exchange rate ,to be
Et Pt 
(1   t )(1   t )
t 
, t 
Pt
1  t
where  is the (expected and actual)
rate of change of the exchange rate and * is the foreign rate of inflation
assumed to be constant. Inflation rates depend on money supplies.
Backward-Looking and Forward-Looking Inflation

 t  
t 1
 (1 )
t 1
(3)
Inflation and unemployment
.

Ut
  (Yt  Y t )   ( t   t)  s
2
3t
Ut 1
Macroeconomic Theme:16
11
Econometric Estimation of AS-AD and
Inflation
and
Unemployemnt
The results for the aggregate demand is
YYt  0.01  0.06 DEF t  0.09 RR t  0.03 RIR  1.00YYt 1
t-ratio
-0.31
-1.22
2.01**
39.65***
R2 = 0.94; F (4,113) = 463.1***; DW-stat. = 1.81
The results for the aggregate supply is
RPI t  0.05  1.00 CINF t  0.07YYt
t-ratio
82.43***
2.97***
R2 = 0.98; F (2,116) = 3398.0***; DW-stat. = 1.06
The results for unemployment is
URATE t  7.98  0 .87YYt  0.15 DINF t
t-ratio
-11.4*** -2.57***
R2 = 0.53; F (2,116) = 65.24***; DW-stat. = 1.05
Macroeconomic Theme:16
12
Impulse Response Analysis for Demand and
Supply Shocks
GeneralisedImpulseResponsestoone SEshockintheequationfor RPI
2.0
1.5
1.0
RPI
0.5
0.0
-0.5
0
5
10
15
20
25
30
35
40
45
5050
Horizon
GeneralisedImpulseResponsestooneSEshockintheequationfor
URATE
2.5
2.0
1.5
URATE
1.0
0.5
0.0
-0.5
0
5
10
15
20
25
30
35
40
45
5050
Horizon
Macroeconomic Theme:16
13
Definition of Dynamic General Equilibrium
A dynamic competitive equilibrium is a of sequences of prices and
quantities such that
1. households maximise intertemporal utility subject to their
wealth constraint;
2. investors maximise intertemporal profits subject to arbitrage
conditions in capital markets;
3. producers minimise costs subject to technology constraints;
4. unit profits are zero in all production sectors;
5. markets for goods and services clear;
6. the government account constraint is satisfied;
7. the balance of payments condition is fulfilled
the economy grows at a constant rate beyond a certain terminal
period T.
Macroeconomic Theme:16
14
Questions That Require a Dynamic GE Model
1. How does the entire economy evolve over time?
How demand and supply grow for various sectors
of the economy?
2. How does the economy respond to demand, supply
or policy shocks?
 What are the dynamic efficiency effects of tax
reform over the model horizon?
 How do unanticipated tax changes affect sectoral
output, employment and capital formation in the
economy?
 How do anticipated tax changes affect sectoral
output, employment and capital formation?
Does the international openness of capital markets
alter the dynamic effects of tax changes?
Macroeconomic Theme:16
15
Demand in A Dynamic General Equilibrium Model
Consumers’ optimization
Max


 







 1

cCt

U   ( 1 )t
t 0 1 
 1
 1  1
  
 (1c)Lt




1 





1
(6)
Subject to
 1
 Rt (PtCt  wt Lt )  Wt
t 0 Macroeconomic Theme:16
16
Supply in A Dynamic General Equilibrium Model
Max
 y 1
y
 y 1 1

 1
  e PE y )] y (7)
 y  [((1  e )PD
j,t
i
i,t
i i,t
 v PY v  d  ad P  m  am PM
j j,t j i i, j i,t j i i, j
j,t
subject to




Y   (1  )(K )
i,t
i
i i,t
i
1
 i 
i
  (LS )
i i,t
(8)


PY Y  wt LS  rt K
i,t i,t
i,t
i,t






















(9)












DI
MI
i
,
j
,
t
i, j,t
GY  min Y ,
,
i,t
i,t ad
am
i, j i j
i, j i j
K
 K (1  )  I
i,t
i
i,t
i,t 1
I  K (g   )
i
i,T
i,T
(12)
LSt  Lt  Lt
Macroeconomic Theme:16








(10)
(11)
17
Fiscal Policy in A Dynamic GE Model
Government Budget
The value of government consumption is given by
G   PA GD   PA GM
i
i i i i i
(27)
Tax revenue
REVt  t k rt K  t vc P CC
i,t i i i,t i,t
i i
 t vg P G  t vk P I  t wLSt
i i i,t i,t i i i,t i,t i l
 t m PM M  t p P GY
i,t i,t i i i,t i,t
i i
(28)
Use of revenue
REVt  Gt  TR Macroeconomic Theme:16
t
(29)
18
Steps for Constructing and Dynamic General Equilibrium
Model
Figure 1
Steps for Implementing a General Equilibrium Model
Raw Data (National
Accounts, IO, tax, trade,
household survey)
Adjustments to yield
benchmark
(micro consistent) data set
Model Structure
Functional forms
Adjustments to yield
benchmark
(micro
consistent)
data set
Calibration
check
Replication
check
Parameters and
Adjustments to yield
Elasticities
benchmark
(micro consistent) data set
Policy change
(tax) specified
Compute New
Equilibrium
Compare to benchmark
Equilibrium
data
Macroeconomic
Theme:16
19
An Example of Policy Application of A
Dynamic GE Analysis
Impact of Tax Reform in the Capital Accumulation Accross Sectors
25.000
20.000
FOODD
OTHMA
POWER
CONST
DISTR
TRANS
FINAN
PUBAD
EDUCA
HOUSE
10.000
5.000
20
29
20
27
20
25
20
23
20
21
20
19
20
17
20
15
20
13
20
11
20
09
20
07
20
05
20
03
20
01
19
99
19
97
0.000
19
95
Relative to the Reference Path
15.000
-5.000
-10.000
-15.000
-20.000
Macroeconomic Theme:16
20
An Example of Policy Application of A
Dynamic GE Analysis
Impact of Tax Reform in Accumulation of Capital Stock Across Sectors
15.000
5.000
AGRIC
EXTRA
MININ
CHEMI
METAL
ENGIN
20
29
20
27
20
25
20
23
20
21
20
19
20
17
20
15
20
13
20
11
20
09
20
07
20
05
20
03
20
01
19
99
19
97
0.000
19
95
Relative to the reference path
10.000
-5.000
-10.000
Macroeconomic Theme:16
21
References
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Burda and Wyplosz (2002) Macroeconomics: An European Text, Chapter 14.
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David Colander (1995) The Stories We Tell: A Reconsideration of AS/AD Analysis
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Prescott, E.C. (1986), “Theory Ahead of Business Cycle Measurement,” Federal Reserve Bank of
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Quah, D.T., (1995), “Business Cycle Empirics: Calibration and Estimation,” The Economic Journal 105
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Sidney Weintraub (1957) The Micro-Foundations of Aggregate Demand and Supply
The Economic Journal, Vol. 67, No. 267. Sep., pp. 455-470.
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Theme:16
22