The AS-AD model
1
From the short run to the medium
run


In the short run prices are either sticky (non
moving) or adjusting very slowly. We can say
that their adjustment is sluggish. Output can
be above or below its natural level.
In the medium run prices are flexible. They
adjust over time. Output returns to its natural
level, the level determined by an economy’s
productive capacity, i.e. the amount of its
factors of production (capital and labor).
2
From the short run to the medium
run
So far, by using the IS-LM model, we
have a picture of the demand side of
the economy.
 To get to the medium run we also
need to get a picture of the supply
side of the economy.

3
The Labor market



To get to the supply side, we need to take
into account the labor market.
In the labor market, we will identify two forces
that determine the equilibrium level of the real
wage and the equilibrium level of
unemployment.
We will call these forces: the wage setting
relation and the price setting relation.
4
The Labor market (Wage setting)






Who sets the wages in the labor market?
Who else, the interested parties: employers
and employees.
How do they set the prices?
They bargain, either individually or
collectively through unions.
Why do they do it like that?
Well, there is no other way in a decentralized
economy.
5
The Labor market (Wage setting)


So, as employees, how would decide what
nominal wage offer to float on the
negotiations table?
Wouldn’t we take into account the price level
that we would expect to face in the future?
Yes, we would. We would like to be insured
against changes in the price level for the time
that the wage contract would bind us. So our
offer would depend on the expected price
level (Pe).
6
The Labor market (Wage setting)


Our offer would also depend on the
conditions of the labor market. If there is high
unemployment, we would be willing to settle
for a lower wage because the chances of
finding another job are slim. However, if there
is low unemployment, then we can take our
chances and ask for a high wage since we
can find another job easily.
So our wage offer depends negatively on the
rate of unemployment (u).
7
The Labor market (Wage setting)


Finally, our offer depends on other factors
that affect the labor market, like e.g.
unemployment benefits. The higher they are,
the higher wage we will ask. Or another
factor could be the power of the union we
belong in and the solidarity of its members.
We will call these other factors z and we will
assume that our wage offer depends
positively on them. The higher they are, the
more money we ask.
8
The Labor market (Wage setting)

Of course, our employers think in the same
way. The higher they expect the price level to
be, the higher nominal wage they would be
willing to give. The higher they observe the
unemployment rate to be, the lower wage
they are going to offer. The higher the
unemployment benefits and the other factors
are, the higher their offer is going to be.
9
The Labor market (Wage setting)




Since both parties, employees and employers base their
decisions on the same factors, the wage setting decision
they are going to reach will depend on these factors as
well.
The nominal wage will depend one to one on the
expected price level Pe. It will also depend on the
unemployment rate u and the other factors z. Since we
don’t know how exactly it depends on u and z, we will
include those in a function that will call F(u,z).
Therefore, mathematically we write:
W = PeF(u, z)
This is the wage setting relation.
10
The Labor market (Price setting)






Now, how do the firms determine the price they are
going to sell their goods at?
Well, for starters there is a simple rule: they wouldn’t
want to sell at a price that is less than their cost.
But what is their cost?
By assumption, firms only use labor. So, they produce
according to a production function that looks like that:
Y = F(N)
Output is a function of the labor N employed.
What if we make a further assumption: every worker that
firms employ produces only one good. In that case, the
production function becomes even simpler: Y = N
11
The Labor market (Price setting)




Next step: how much do firms pay their workers?
The answer is easy: they pay them the nominal
wage W.
Now, if we assume that we are in a perfect
competition environment, where firms make zero
profits, then it must be that firms sell each good for a
price P that is equal to the nominal wage W.
Remember each worker produces one good and
firms pay this worker W. Then firms break even if
they sell each good for P = W.
12
The Labor market (Price setting)




Now, if we assume away perfect competition and
allow firms to make some profits, then the firms may
charge a price that is above the nominal wage that
they pay to the workers.
We call the amount that the price exceeds the
nominal wage, markup and we denote it by μ.
Mathematically we write: P = (1 + μ)W
This is the price setting relation and it tells us that P
is greater than W by a factor μW. The firms now
make profits and our scenario is more realistic.
13
The Labor market (Wage and Price setting
combined)


We can make an assumption that will simplify things
bit, namely that in the wage setting relation, the
nominal wage depends not on the expected price
level but on the actual price level.
This could be because e.g. workers negotiate
wages very often (say every month). In that case,
they wouldn’t need to form expectations about the
price level because since they would renegotiate
their wage very soon.
14
The Labor market (Wage and Price setting
combined)

So, if Pe = P, the wage setting relation
becomes: W = PF(u, z)

Solving for the real wage W/P, we obtain:
W/P = F(u, z)
This expression tells us that the real wage W/P
is negatively related to unemployment u and
positively related to the other factors z.

15
The Labor market (Wage and Price setting
combined)


Also solving the price setting relation for the
real wage we obtain:
P = (1 + μ)W =>
P/W = (1 + μ) =>
W/P = 1/(1 + μ)
This expression tells us that the real wage
W/P does not depend on unemployment but
only on the markup μ.
16
The Labor market (Wage and Price setting
combined)


If we equate the two expressions for the real
wage that we obtained from the wage and the
price setting relations we obtain:
F(un, z) = 1/(1 + μ)
When the real wage is in equilibrium, we say
that unemployment is at its natural rate,
which we denote by un.
17
The Labor market in equilibrium
Here we combine the wage
setting relation, which tells us that
the real wage is a negative
function of the unemployment
rate, and the price setting relation,
which tells us that the real wage
does not depend on
unemployment. When the labor
market clears we obtain the
equilibrium level of real wage and
the equilibrium rate of
unemployment, which we call the
natural rate of unemployment.
W/P
1/(1 +μ)
PS
WS
un
u
18
Deriving the AS curve


Now that we have described the labor
market, we can combine the wage setting
and the price setting relation to get an
expression between prices and output.
Let’s start from the price setting equation
P = (1 + μ)W and let’s substitute the wage
with its equal from the wage setting equation
W = PeF(u,z)

We obtain P = Pe(1 + μ)F(u, z).
19
Deriving the AS curve

Furthermore:
u = U/L =>
u = (L – N)/L =>
u = L/L – N/L =>
u = 1 – N/L
But according to our production function Y=N.
Therefore: u = 1 – Y/L
20
Deriving the AS curve



Substituting this expression for u into the
expression that we obtained before, we get:
P = Pe(1 + μ)F(1 – Y/L, z), which is the AS
relation.
This expression shows a positive relationship
between output and prices.
We will now explain why.
21
Deriving the AS curve




If output goes up then unemployment goes down.
If unemployment goes down, workers are in a better
bargaining position and can ask for higher nominal
wages (remember the wage setting equation).
If nominal wages go up, this means that the firms have
to charge higher prices to cover their increased costs
(remember the price setting equation).
Therefore higher output leads to higher prices and we
have established the positive relationship between the
two variables.
22
Deriving the AS curve
P
Starting from the labor market
we have managed to establish a
positive relationship between
output and prices. The AS curve
depicts this relationship.
AS
Y
23
Deriving the AD curve


Let’s return to the IS-LM model and let’s see
what happens if we assume an increase in
prices.
The increase in prices means that the supply
of real money balances decreases shifting
the LM curve to the left (up). This results in a
lower level of output.
24
Deriving the AD curve




Therefore a higher level of prices, through the IS-LM
model, leads to a lower level of output.
We call this negative relationship between prices
and output AD relation and mathematically we
express it as:
Y = Y(G, T, M/P)
This means that output depends on G, T and M/P.
In particular any change of these factors that shifts
the IS or the LM to the right (or to the left), also
shifts the AD curve to the right (or to the left).
25
Deriving the AD curve
P
P2
Panel B
P1
AD
Y2
i
Y1
Y
LM2
LM1
Panel A
i2
B
i1
A
Starting from an increase in
prices in Panel A, the supply of
real money balances M/P goes
down. This shifts the LM curve
to the left (up) leading to a lower
level of output. Therefore, we
have established that a higher
level of output, through the ISLM model translates to a lower
level of output. The AD curve in
Panel B sums up this negative
relationship between prices and
output.
IS
Y2
Y1
Y
26
Combining the AS and AD curves
P
Combining the AS and AD
curves we may find the
equilibrium level of prices and
output in an economy.
AS
P*
AD
Y*
Y
27
Fiscal expansion



As we already know, a fiscal expansion is a situation
where the government increases government
expenditures (G). This is synonymous to an
increase in the government deficit (G - T).
As we have mentioned, this corresponds to a shift of
the IS curve to the right.
If we assume that we start at the natural level of
output (Yn), the result of the shift is a level of output
higher than the natural level and a higher level of
interest rate.
28
Fiscal expansion

Turning to the AS-AD model, the shift of the
IS curve to the right means that the AD curve
also shifts to the right. This leads to a higher
level of prices. Prices now exceed the
expected level of prices. Remember that by
definition, when output is at the natural level,
actual prices are equal to expected prices.
Now, we are at our new short run equilibrium
(point B). Output and prices are higher
compared to the initial level.
29
Fiscal expansion



Moving from the short to the medium run, since prices rose,
wage setters, who are not idiotic, will increase their price
expectations. In turn, this increase in expected prices will shift
the AS curve upward, so actual prices will rise again.
The process starts again: wages setters adjust their price
expectations shifting the AS curve up and increasing actual
prices.
The process comes to an end, when output, moving along the
new AD curve returns to its natural level. When output reaches
again its natural level, wage setters have no reason to adjust
their expectations and the spiral price increase ends. Now, we
are at our new medium run equilibrium (point C). Output is the
same compared to the initial level but prices are higher.
30
Fiscal expansion


We have to take one final step to complete our
experiment: turn back to the IS-LM model.
The rise in prices that occurred from the short run to
the medium run means that the supply of real
money balances (M/P) decreased. This means that
the LM curve will shift to the left (up). It will keep
shifting left (up) until output reaches its previous
natural level (point C). The interest rate now is even
higher.
31
Fiscal expansion
P
AS2
Panel B
P’e = P3
C
AS1
P2
B
Pe = P1
A
AD2
AD1
Yn
i
Y1
Y
LM2
Panel A
i3
C
LM1
i2
B
i1
A
IS2
IS1
Yn
Y1
Starting at the natural level of output, an
initial increase in G shifts the IS to the
right in Panel A. This results in a level of
output higher than the natural level and a
higher interest rate. In Panel B the AD
curve shifts to the right leading to higher
output and actual prices higher than the
expected level. The short run equilibrium
is at point B in both panels. Over time, the
higher prices induce wage setters to
increase their price expectations shifting
up the AS curve in Panel B. Shifting stops
at the new medium run equilibrium at
point C along the new AD curve, where
output is back to its initial natural level and
prices are higher. Back to Panel A, the
increase in prices reduces the supply of
real money balances shifting the LM curve
to the left (up). In the medium run we end
up at point C, back to the natural level of
output but with a higher interest rate.
Y
32
Fiscal expansion in the short run

a)
b)
c)
d)
e)
f)
g)
So now, we have a clear picture of how all our variables moved in
the short run compared to their initial level:
Y: output is positively affected. It rises above its natural level.
C: consumption is positively affected since our disposable income
increases.
i: the interest rate increases.
I: the movement of investment is ambiguous because on the one
hand output went up and we know that this boosts I, but on the
other hand the interest rate increased and we also know that this
shrinks investment. So the net effect is ambiguous.
P: prices increase.
u: unemployment rate goes down, below its natural level, since
output goes up and we need more people employed to produce
that.
G: government expenditures go up by assumption.
33
Aggregate effects of a fiscal expansion in
the short run
Y
i
C
I
P
u
G
↑
↑
↑
?
↑
↓
↑
34
Fiscal expansion in the medium run

a)
b)
c)
d)
e)
f)
g)
We also have a clear picture of how all our variables moved in the
medium run compared to their initial level:
Y: output goes back to its natural level. It is unchanged compared
to the initial level.
C: consumption is also unchanged since output is unchanged.
i: the interest rate increases.
I: investment unambiguously decreases because the interest rate
increased, while output is unchanged. So only the negative effect
of the interest rate increase is at work.
P: prices increase.
u: unemployment rate is unchanged since we are back to the
previous level of output.
G: government expenditures go up by assumption. Notice that
investment goes down by as much as G goes up in order for
output to be unchanged. This is the well known crowding out
effect.
35
Aggregate effects of a fiscal expansion in
the medium run
Y
i
C
I
P
u
G
0
↑
0
↓
↑
0
↑
36
Fiscal contraction



A fiscal contraction is a situation where the
government decreases government
expenditures (G). This is synonymous to a
decrease in the government deficit (G - T).
As we have mentioned, this corresponds to a
shift of the IS curve to the left.
If we assume that we start at the natural level
of output (Yn), the result of the shift is a level
of output lower than the natural level and a
lower level of interest rate.
37
Fiscal contraction

Turning to the AS-AD model, the shift of the
IS curve to the left means that the AD curve
also shifts to the left. This leads to a lower
level of prices. Prices now are below the
expected level of prices. Now, we are at our
new short run equilibrium (point B). Output
and prices are lower compared to the initial
level.
38
Fiscal contraction



Moving from the short to the medium run, since prices fell, wage
setters will decrease their price expectations. In turn, this
decrease in expected prices will shift the AS curve downward, so
actual prices will fall again.
The process starts again: wages setters adjust their price
expectations shifting the AS curve down and decreasing actual
prices.
The process comes to an end, when output, moving along the
new AD curve returns to its natural level. When output reaches
again its natural level, wage setters have no reason to adjust
their expectations and the spiral price decrease ends. Now, we
are at our new medium run equilibrium (point C). Output is the
same compared to the initial level but prices are lower.
39
Fiscal contraction

Going back to the IS-LM model, the fall in
prices that occurred from the short run to the
medium run means that the supply of real
money balances (M/P) increased. This
means that the LM curve will shift to the right
(down). It will keep shifting right (down) until
output reaches its previous natural level
(point C). The interest rate now is even lower.
40
Fiscal contraction
P
AS1
Panel B
Pe = P1
A
P2
AS2
B
P’e = P3
C
AD1
AD2
Y1
i
Yn
Y
LM1
Panel A
i1
i2
A
LM2
B
i3
C
IS1
IS2
Y1
Yn
Starting at the natural level of output, an
initial decrease in G shifts the IS to the left
in Panel A. This results in a level of output
lower than the natural level and a lower
interest rate. In Panel B the AD curve
shifts to the left leading to lower output
and actual prices lower than the expected
level. The short run equilibrium is at point
B in both panels. Over time, the lower
prices induce wage setters to decrease
their price expectations shifting down the
AS curve in Panel B. Shifting stops at the
new medium run equilibrium at point C
along the new AD curve, where output is
back to its initial natural level and prices
are lower. Back to Panel A, the decrease
in prices increases the supply of real
money balances shifting the LM curve to
the right (down). In the medium run we
end up at point C, back to the natural level
of output but with a lower interest rate.
Y
41
Fiscal contraction in the short run

a)
b)
c)
d)
e)
f)
g)
So now, we have a clear picture of how all our variables moved in
the short run compared to their initial level:
Y: output is negatively affected. It falls below its natural level.
C: consumption is negatively affected since our disposable
income decreases.
i: the interest rate decreases.
I: the movement of investment is ambiguous because on the one
hand output went down and we know that this lowers I, but on the
other hand the interest rate decreased and we also know that this
boosts investment. So the net effect is ambiguous.
P: prices decrease.
u: unemployment rate goes up, above its natural level, since
output goes down and we need less people employed to produce
that.
G: government expenditures go down by assumption.
42
Aggregate effects of a fiscal contraction in
the short run
Y
i
C
I
P
u
G
↓
↓
↓
?
↓
↑
↓
43
Fiscal contraction in the medium run

a)
b)
c)
d)
e)
f)
g)
We also have a clear picture of how all our variables moved in the
medium run compared to their initial level:
Y: output goes back to its natural level. It is unchanged compared
to the initial level.
C: consumption is also unchanged since output is unchanged.
i: the interest rate decreases.
I: investment unambiguously increases because the interest rate
decreased, while output is unchanged. So only the positive effect
of the interest rate decrease is at work.
P: prices decrease.
u: unemployment rate is unchanged since we are back to the
previous level of output.
G: government expenditures go down by assumption. Notice that
investment goes up by as much as G goes down in order for
output to be unchanged.
44
Aggregate effects of a fiscal contraction in
the medium run
Y
i
C
I
P
u
G
0
↓
0
↑
↓
0
↓
45
Monetary expansion



We already know that a monetary expansion
is a situation where the central bank
increases the money supply.
We also know that this shifts the LM curve to
the right (down).
The result is a higher a level of output and a
lower level of interest rate.
46
Monetary expansion

Turning to the AS-AD model, the shift of the
LM curve to the right means that the AD
curve also shifts to the right. This leads to a
higher level of prices. Prices now exceed the
expected level of prices. Now, we are at our
new short run equilibrium (point B). Output
and prices are higher compared to the initial
level.
47
Monetary expansion



Moving from the short to the medium run, since prices rose,
wage setters will increase their price expectations. In turn, this
increase in expected prices will shift the AS curve upward, so
actual prices will rise again.
The process starts again: wages setters adjust their price
expectations shifting the AS curve up and increasing actual
prices.
The process comes to an end, when output, moving along the
new AD curve returns to its natural level. When output reaches
again its natural level, wage setters have no reason to adjust
their expectations and the spiral price increase ends. Now, we
are at our new medium run equilibrium (point C). Output is the
same compared to the initial level but prices are higher.
48
Monetary expansion

Going back to the IS-LM model, the rise in
prices that occurred from the short run to the
medium run means that the supply of real
money balances (M/P) decreased. This
means that the LM curve will shift to the left
(up). It will keep shifting left (up) until output
reaches its previous natural level, back to
point A. The interest rate returns to its
previous level.
49
Monetary expansion
P
AS2
Panel B
P’e = P3
C
AS1
P2
B
Pe = P1
A
AD2
AD1
Yn
i
Y1
Y
LM1
Panel A
i1
A
LM2
i2
B
IS
Yn
Y1
Y
Starting at the natural level of output, an
initial increase in money supply shifts the
LM to the right (down) in Panel A. This
results in a level of output higher than the
natural level and a lower interest rate. In
Panel B the AD curve shifts to the right
leading to higher output and actual prices
higher than the expected level. The short
run equilibrium is at point B in both
panels. Over time, the higher prices
induce wage setters to increase their price
expectations shifting up the AS curve in
Panel B. Shifting stops at the new
medium run equilibrium at point C in
Panel B along the new AD curve, where
output is back to its initial natural level and
prices are higher. Back to Panel A, the
increase in prices reduces the supply of
real money balances shifting the LM curve
back to the left (up). In the medium run in
Panel A, we end up back at point A, back
to the natural level of output but with the
same interest rate compared to the initial
level.
50
Monetary expansion in the short run

a)
b)
c)
d)
e)
f)
So now, we have a clear picture of how all our variables moved in
the short run compared to their initial level:
Y: output is positively affected. It rises above its natural level.
C: consumption is positively affected since our disposable income
increases.
i: the interest rate decreases.
I: investment unambiguously increases because we saw that the
interest rate went down (this increases investment) and also
income went up (this also increases investment). So a monetary
expansion gives a twofold boost to investment (compare that to
the fiscal expansion which had an ambiguous effect on
investment).
P: prices increase.
u: unemployment rate goes down, below its natural level, since
output goes up and we need more people employed to produce
that.
51
Aggregate effects of a monetary
expansion in the short run
Y
i
C
I
P
u
↑
↓
↑
↑
↑
↓
52
Monetary expansion in the medium run

a)
b)
c)
d)
e)
f)

We also have a clear picture of how all our variables moved in the
medium run compared to their initial level:
Y: output goes back to its natural level. It is unchanged compared
to the initial level.
C: consumption is also unchanged since output is unchanged.
i: the interest rate is unchanged.
I: investment is unchanged since output is unchanged and the
interest rate is unchanged.
P: prices increase.
u: unemployment rate is unchanged since we are back to the
previous level of output.
Notice that the only variable that changed in the medium run is the
level of prices. This phenomenon is the so called money neutrality.
Money in the long run (medium run) does not affect real variables
but only nominal ones.
53
Aggregate effects of a monetary
expansion in the medium run
Y
i
C
I
P
u
0
0
0
0
↑
0
54
Monetary contraction



We already know that a monetary contraction
is a situation where the central bank
decreases the money supply.
We also know that this shifts the LM curve to
the left (up).
The result is a lower a level of output and a
higher level of interest rate.
55
Monetary contraction

Turning to the AS-AD model, the shift of the
LM curve to the left means that the AD curve
also shifts to the left. This leads to a lower
level of prices. Prices now are below the
expected level of prices. Now, we are at our
new short run equilibrium (point B). Output
and prices are lower compared to the initial
level.
56
Monetary contraction



Moving from the short to the medium run, since prices fell, wage
setters will decrease their price expectations. In turn, this
decrease in expected prices will shift the AS curve downward, so
actual prices will fall again.
The process starts again: wages setters adjust their price
expectations shifting the AS curve down and decreasing actual
prices.
The process comes to an end, when output, moving along the
new AD curve returns to its natural level. When output reaches
again its natural level, wage setters have no reason to adjust
their expectations and the spiral price decrease ends. Now, we
are at our new medium run equilibrium (point C). Output is the
same compared to the initial level but prices are lower.
57
Monetary contraction

Going back to the IS-LM model, the fall in
prices that occurred from the short run to the
medium run means that the supply of real
money balances (M/P) increased. This
means that the LM curve will shift to the right
(down). It will keep shifting right (down) until
output reaches its previous natural level,
back to point A. The interest rate returns to its
previous level.
58
Monetary contraction
P
AS1
Panel B
Pe = P1
A
P2
AS2
B
P’e = P3
C
AD1
AD2
Y1
i
Yn
Y
LM2
Panel A
LM1
i2
B
i1
A
IS
Y1
Yn
Y
Starting at the natural level of output, an
initial decrease in money supply shifts the
LM to the left (up) in Panel A. This results
in a level of output lower than the natural
level and a higher interest rate. In Panel B
the AD curve shifts to the left leading to
lower output and actual prices lower than
the expected level. The short run
equilibrium is at point B in both panels.
Over time, the lower prices induce wage
setters to decrease their price
expectations shifting down the AS curve
in Panel B. Shifting stops at the new
medium run equilibrium at point C in
Panel B along the new AD curve, where
output is back to its initial natural level and
prices are lower. Back to Panel A, the
decrease in prices increases the supply of
real money balances shifting the LM curve
back to the right (down). In the medium
run in Panel A, we end up back at point A,
back to the natural level of output but with
the same interest rate compared to the
initial level.
59
Monetary contraction in the short run

a)
b)
c)
d)
e)
f)
So now, we have a clear picture of how all our variables moved in
the short run compared to their initial level:
Y: output is negatively affected. It falls below its natural level.
C: consumption is negatively affected since our disposable
income decreases.
i: the interest rate increases.
I: investment unambiguously falls because we saw that the
interest rate went up (this decreases investment) and also income
went down (this also decreases investment). So a monetary
expansion gives a twofold blow to investment.
P: prices decrease.
u: unemployment rate goes up, above its natural level, since
output goes down and we need less people employed to produce
that.
60
Aggregate effects of a monetary
contraction in the short run
Y
i
C
I
P
u
↓
↑
↓
↓
↓
↑
61
Monetary contraction in the medium run

a)
b)
c)
d)
e)
f)

We also have a clear picture of how all our variables moved in the
medium run compared to their initial level:
Y: output goes back to its natural level. It is unchanged compared
to the initial level.
C: consumption is also unchanged since output is unchanged.
i: the interest rate is unchanged.
I: investment is unchanged since output is unchanged and the
interest rate is unchanged.
P: prices decrease.
u: unemployment rate is unchanged since we are back to the
previous level of output.
Money neutrality reaffirms itself.
62
Aggregate effects of a monetary
contraction in the medium run
Y
i
C
I
P
u
0
0
0
0
↓
0
63
Price Shock


When we face an exogenous price shock that
affects the production process, our approach
to the problem changes a bit.
We have to start our analysis from the labor
market and observe how this market reacts to
this shock.
64
Price Shock




Let’s assume that energy prices go up. This affects the cost of
our production.
The problem is that according to our production function, we
only use labor to produce our goods.
So, the only way to incorporate the effect of the price increase
on the cost of production is to make use of the markup μ.
Remember that the markup is a percentage that tells us how
much over our marginal cost, we charge for our goods.
In our case, marginal cost is the nominal wage, so the markup
tells us how much over the nominal wage we charge. Since
the cost of production went up, this means that will charge
more over the nominal wage, i.e. the markup will increase.
65
Price Shock



The increase in the markup affects the price
setting equation: W/P = 1/(1 + μ)
The increase in μ means that the real wage
must go down.
Let’s graph this result.
66
Price Shock
W/P
1/(1 +μ1)
A
PS1
B
1/(1 +μ2)
PS2
The rise in the markup causes a
drop in the real wage and an
increase in the natural rate of
unemployment. A higher natural
rate of unemployment translates
to a lower natural level of output.
WS
un
u’n
u
67
Price Shock



Since the natural rate of unemployment
increased, this means that the natural level of
output must have decreased.
Our next task is to find out what happens with
the AS-AD model.
We are not interested in the IS-LM model
because the energy price increase is a
supply side shock and has nothing to do with
aggregate demand, which is described by the
IS-LM model.
68
Price Shock




Let’s go back to our equation for aggregate
supply: P = Pe (1 + μ) F(1 – (Y/L), z)
We observe that the markup μ is positively
related with the level of prices P. This means
that for a given level of output, if the markup
goes up, the AS curve will shift up.
The AD curve does not move.
The new short run equilibrium will be at point
B with lower output and higher prices.
69
Price Shock


Moving from the short to the medium run, since
prices rose, wage setters will increase their price
expectations. In turn, this increase in expected
prices will shift the AS curve upward, so actual
prices will rise again.
The process comes to an end, when output, moving
along the AD curve reaches its new lower natural
level. Now, we are at our new medium run
equilibrium (point C). Output is even lower
compared to the initial level and prices are higher.
70
Price Shock
P
AS3
AS2
AS1
P3
C
P2
B
Pe = P1
A
AD
Y’n
Y1
Yn
The energy prices shock increases the
natural rate of unemployment and lowers
the medium run natural level of output. In
the short run the rise in the markup shifts
the AS curve up. The new short run
equilibrium is at point B where the actual
level of prices exceeds the expected level of
prices for the initial natural level of output.
Over time, the higher prices induce wage
setters to increase their price expectations
shifting the AS curve further up. Shifting
stops at the new medium run equilibrium at
point C along the AD curve, where output
reaches its new natural level and prices are
higher.
Y
71