CHAPTER 7
CHAPTER7
Putting All Markets
Together:
The AS-AD Model
Prepared by:
Fernando Quijano and Yvonn Quijano
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
Chapter 7: Putting All Markets
Together: The AS-AD Model
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.
Recall from chapter 6 the equations for:
wage setting relation: W  P e F (u, z)
price determination :
© 2006 Prentice Hall Business Publishing
P  (1  )W
W = P/1+μ
Macroeconomics, 4/e
Olivier Blanchard
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Aggregate Supply
Chapter 7: Putting All Markets
Together: The AS-AD Model
Step 1: Eliminate the nominal wage from:
W = Pe F(u,z)
and
W = P/1+μ
To get:
P/1+μ = Pe F(u,z)
Or
P = Pe (1+μ) F(u,z)
In words, the
price level depends on the expected
price level and the unemployment rate. We assume
that  and z are constant.
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Supply
Step 2: We know that Y=AN (production
function). If we assume A (output per
worker) to be equal to one, then we can
write Y=N. As a result, we can express
the unemployment rate 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.
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Supply
Step 3: Replace the unemployment rate in the
equation obtained in step one:
Y 

P  P (1   ) F  1  , z

L 
e
In words, the price level depends on:
the expected price level, Pe,
the level of output, Y ,
and also , z, and L, but we take these are
assumed to be constant here.
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
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:
1. 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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Macroeconomics, 4/e
Olivier Blanchard
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Aggregate Supply
 Y 
P  P (1   ) F  1  , z

L 
Chapter 7: Putting All Markets
Together: The AS-AD Model
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
2. 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. P e   W 
2. W   P 
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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Chapter 7: Putting All Markets
Together: The AS-AD Model
Aggregate Supply
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.
© 2006 Prentice Hall Business Publishing
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:
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
(actual output) = Yn (natural level of output=level of output at the
natural rate of unemployment/unemployment) and P ( price level)
= Pe (expected price level). This property has two
implications:
 When P > Pe ,Y > Yn.
 When P < Pe ,Y < Yn .
3. An increase in Pe shifts the AS curve up,
and a decrease in Pe shifts the AS 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
Aggregate SupplyThe 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.
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
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.
© 2006 Prentice Hall Business Publishing
Macroeconomics, 4/e
Olivier Blanchard
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