AS - AD
AS - AD
• Aggregate Supply
– relates output and price level
– labor market
• Aggregate Demand
– relates output and price level
– IS - LM
Aggregate Supply
As output rises….
P = W(1 + m)
W = PeF(u,z)
P = Pe(1 + m)F(u,z)
For fixed Pe, as Y rises, u falls so P
rises
why?
Hiring pushes up wages.
Note: Pe fixed in the short run.
AS (in detail)
U – number of workers unemployed
N – workforce (constant)
L - workers employed
U=N-L
Unemployment rate
u = (N - L)/N
=1-L/N
Production function
Y=AL
A – productivity
u = 1-Y/(AN)
AS (in detail)
P = Pe(1 + m)F(u,z)
u = 1-Y/(AN)
P = Pe(1 + m)F(1-Y/(AN),z)
AS relation,
as Y ↑ u↓
u ↓ F(u,z) ↑
F(u,z) ↑ P↑
So AS is upward sloping
AS
• Slopes up
• Shifts
– Change in Pe
• Rise in expectations
• Shifts AS up
– Productivity A ↑ AS shifts right/down
– Markup m↑ AS shifts up
– Change in z, labor market
conditions
Aggregate Demand
• How does a price increase
affect equilibrium GDP on an
IS – LM graph.
– LM shifts up (left)
– Y* falls
• AD slopes down
• Shifts – anything else that
affects IS – LM
– Autonomous spending
– Policy (both kinds)
• Exception – supply side tax effects
Problems
• Show how an increase in the
money supply would affect the
equilibrium level of output,
interest rates and prices using
and IS – LM and AS – AD
diagram.
• The 1990s saw an increase
use of IT in business which
improved productivity. Show
the short run effect on an ASAD graph.
Problems
Show how an decrease in
government spending would
affect the equilibrium level of
output, interest rates and prices
using and IS – LM and AS –
AD diagram.
Show the effect of an increase
in oil prices has on an AS-AD
graph.
Medium Run
• Expectations adjust
• P=Pe
• Unemployment at its natural
rate
1 = (1 + m)F(un,z)
• Output at its natural rate
un = 1-Yn/(AL)
AS?
1 = (1 + m)F(1-Yn/(AL),z)
Vertical at the natural rate of
output
Medium run
• What if Y* < Yn ?
– P < Pe (short run)
– medium run, Pe falls to P
– AS shifts down/right
– Y* rises to Yn
• Labor Market interpretation
– u* > u n
– as Pe falls, wages bid down
– lower cost to production
– AS shifts right
• Medium run Y* = Yn
Monetary policy:
short and medium run
• Fed increase Ms
– AD shifts right
– Y* and P* both rise
– short run (P > Pe )
• Medium run
– Pe rises
– AS shifts up/left
– Y* falls back to Yn
– P* rises further
• Money neutrality (med run)
– changes in Ms
• affect nominal variables
• not real variables
Problem
Show how a decrease in the
money supply would affect the
equilibrium output and price
levels on an AS-AD graph in the
short and medium run.
What happens on the IS-LM
graph in the short and medium
run?
Problems AS-AD
Show the short and medium run
effects of an increase in
productivity.
Show the short and medium
effects of a decrease in
consumer confidence.
Show the short and medium run
effects of an increase in oil
prices.
Recessionary Gap
Y* < Yn
Inflationary Gap
Y* > Yn
Show an inflationary gap on an
AS-AD graph, then show how
the government could use tax
policy to close the gap.
Show a recessionary gap on an
AS-AD graphs, then show how
monetary policy could be used to
close the gap.
Gov’t Spending
How does an increase in
government spending affect the
AS-AD graph in the short &
medium run?
Does Gov’t spending affect
productivity?
Show the changes in the graph
for both cases.
Key Equations
P = W(1 + m)
(PS)
W = PeF(u,z)
(WS)
1 = (1 + m)F(un,z)
u = 1-Y/(AL)
P = Pe(1 + m)F(1-Y/(AL),z)
(AS)
Phillip’s Curve
Unemployment &
Inflation
Inverse relation
Can the Fed lower U? Increase
MS
If inflation is caused by AD shift
to the right
output rises, unemployment
falls
Fed can lower U at a cost of
higher p
True? Check the data.
Inflation versus Unemployment
in the United States, 1948-1969
Inflation versus Unemployment
in the United States since 1970
PC relation to WS
W = PeF(u,z)
P = W(1 + m)
(WS)
(PS)
Let F(u,z) = 1 – au + z
So WS & PS become
P = Pe(1 + m)(1 – au + z)
Do some math….
p = pe + m - au + z
inverse relation does exist
Wage – Price Spiral
Explains inverse relation
• u falls
• wages bid up
• prices rise
• workers demand higher wages
– etc. etc.
• higher p
“Tight labor market” – late 1990s
Shifts in PC
• Expectations
• markup
– input costs
– market power
• labor market condtions
• Anything that shifts AS, shifts
PC
Medium Run
PC equation in the medium run?
expectations equal inflation
un depends only on m, z, a
Monetary Policy and
the PC
The Fed tries to lower u below
the natural rate…..
Show on AS-AD and the PC for
the short and medium run.
Review Problems
Show a Phillips curve graph and an
AS-AD graph starting from an
inflationary gap. Show the medium
run adjustment.
If the Fed acts to close an inflationary
gap, what would they do? Show the
result on an AS-AD graph and a PC
graph.
Story of the Great
Inflation
• Productivity falls
• oil prices rise
– Effect on Yn, un
– Monetary policy reaction
• Fed tried to keep u at the old
level
• expectations rose
Both shifts and a return to the
natural rate
Mr. Burn’s brain
What’s behind the Fed’s
decisions in the 70’s?
• Bad thinking
– Ignoring natural rates
– Expectations
– “old” PC
• Bad data
– Couldn’t see the change in the
natural rates
• Cared more about
unemployment than inflation
Intellectual history & the PC
• “Old” PC (1940-50s)
– Empirical relationship
– Use in Cowles commission
models
• Edmund Phelps / Milton
Friedman (late 60s)
– Argue against the permanent
output/inflation tradeoff
– 70s proved them right
– “Old Keynesian” econometric
models abandoned
Expectations and the PC
pt = pt e + m - aut + z
Static expectations
pt e = pt-1
Rational expectations
pt e = pt + et
et – forecast
error
Policy Effectiveness
Under rational expectations,
what happens when the Fed
increases the money supply?
PC and AS vertical
(with an error term)
P & p rise, not real effect
Money is neutral.
Policy is ineffective. Why?
Problem
Starting from the natural rate of
unemployment, if the Fed acts to
lower inflation, show the SR &
MR effects.
Equations
P=Pe(1+m)F(u,z)
W = PeF(u,z)
p = pe + m - au + z
P = W(1+m)
M/P = L(i,Y)
un = (m + z)/a
Equations
P=Pe(1+m)F(u,z)
AS (sort of)
W = PeF(u,z)
WS
p = pe + m - au + z
SRPC
P = W(1+m)
PS
M/P = L(i,Y)
Money Demand
un = (m + z)/a
MRPC/natural rate
of u
More Review
The government becomes more
aggressive about breaking up
monopolies lowering the pricing
power of firms. Show the impact
on the following graphs.
• real wage / unemployment
• AS – AD
• Phillips curve
• IS – LM
More Review
The recent housing market
decline led to an decrease in
autonomous consumption and
investment. Show that short run
change and the medium run
adjustment, assuming passive
policy on the following graphs:
• IS-LM
• AS-AD
• Phillips Curve
Review problem
Show an inflationary gap on
graphs of AS-AD and IS-LM.
Use the graph to explain how tax
policy could be used to close the
gap..
Review Problem
Show the short run effect of a tax
increase on an expenditure
diagram. Show the short and
medium effects on IS-LM and
AS-AD diagrams.
Review Problem
Keynes once advocated that the
government should bury boxes
of money and let people dig
them up to stimulate to
economy.
Starting from the natural rates or
unemployment and output,
show the short and medium
run effects of an increase in
government spending that
does not change the natural
rates for AS-AD and the
Phillip’s curve.
Review Problem
Currently the Fed is increasing
the money supply and keeping
interest rates low to mitigate
the recession.
Starting from a recessionary gap,
show the effect of an increase
in the money supply on an ASAD graph and the Phillip’s
Curve.
Practice Problem
The financial crisis has led to a
decrease in lending and
therefore an fall in the money
supply.
Starting from the natural rates of
output and unemployment,
show the resulting change on
AS-AD and Phillips curve
graphs in the short run.
A small macro model
Goals
• Connect output, unemployment
and inflation
• Use equations
• Explain both short and medium
runs
y, u and p
Actually,
we’ll use gy – growth rate
The U.S.
unemployment
rate, 1890–2002
Okun’s law in the U.S.:
1951–2002
Okun’s Law
Connects u and y
ut – ut-1 = - b(gy,t – gn)
gn - “normal” or natural growth
rate of output
- growth rate of potential GDP
Phillips Curve
Connects p and u
p = pe + m - au + z
or pt - pet = a(un - ut)
Related to AS
p and Y
Focus on AD and monetary policy
M/P rises, LM & AD shift right
Y rises
Let Y = g(M/P)
Assumes fiscal policy and
autonomous expenditures are fixed.
Log differencing the equation:
gy,t = gm,t - pt
small macro model
ut – ut-1 = - b(gy,t – gn)
pt - pet = a(un - ut)
gy,t = gm,t – pt
MR implications:
p = pe ; u = un ; gy,t = gn
pt = gm,t – gn
Problem
Let gn = 3%, un = 6%, gm,t = 8%
a = 1.0, b = 0.5
Find the medium run values of
gy,t , ut and pt
Using those as starting values, find
the short run (one period) values if
gm,t rises to 9%.
Find the new medium run values
after expectations adjust to the
new gm,t.
Problem
Let gn = 3%, un = 6%, gm,t = 7%
a = 1.0, b = 0.5
Find the medium run values of gy,t , ut
and pt
Using those as starting values, if the Fed
wants to lower inflation to 2% in the
medium run, to what level should they
set gm,t ? Find the short run (after one
period) values if they make this
change.
Show these changes including the
medium run adjustment on a graph of
AS-AD and a PC graph.
Sacrifice Ratio
• Lowering pt in the MR has a
cost of higher ut in the SR.
• To measure this cost
Sacrifice Ratio = -Du/Dp
=excess unemployment/
decrease in inflation
For the previous problem….
Credibility
Problem
Let gn = 3%, un = 5%, gm,t = 5%
a = 1.0, b = 0.5
Find the medium run values of gy,t , ut
and pt
Using those as starting values, the Fed
increases gm,t to 8%. Find the new SR
values (one period).
Find the new medium run values.
Show these changes on a graph of ASAD and a PC graph.
Time Consistency
TC problem: conflict between long
term plan/policy and short term
incentive
- grading
- dieting
- shutting down failed banks
- monetary policy
Long term goal: maintain inflation
target
Short term incentive: lower
unemployment
Reason for an independent Fed.
Expectations and the PC
pt - pet = a(un - ut)
Static expectations
pt e = pt-1
Rational expectations
pt e = pt + et
et – forecast
error
Policy Ineffectiveness
Policy does not have real effects
if
• Expectations are rational.
• Wages and prices adjust
immediately.
– MR is short
– Contracts?
• Sacrifice ratio?
– Credibility
– Evidence?
Problem
Let gn = 2%, un = 7%, gm,t = 8%
a = 1.0, b = 0.5
Find the medium run values of gy,t , ut
and pt
The Fed wants to reduce inflation to 2%
in the medium run. What value should
they choose for gm,t ? Find the new SR
values (one period) if they do this.
Find the new medium run values.
Show these changes on a PC graph.
What is the sacrifice ratio?
Review Questions
• The strong growth in the 1990s is often
attributed to technology use by firms.
Show the short and medium run changes
on an AS-AD graph.
• One story explaining the Great
Depression is the stock market crash
reduced consumer spending. The
government then tried to boost the
economy with increased spending. Show
both changes on an AS-AD graph
explaining changes in equilibrium prices
and output.
• Show how a change in the markup would
affect the graph of the Phillip’s curve in
the short and medium run.
A small macro model
Goals
• Connect output, unemployment
and inflation
• Use equations
• Explain both short and medium
runs
y, u and p
Actually,
we’ll use gy – growth rate
The U.S.
unemployment
rate, 1890–2002
Okun’s law in the U.S.:
1951–2002
Okun’s Law
Connects u and y
ut – ut-1 = - b(gy,t – gn)
gn - “normal” or natural growth
rate of output
- growth rate of potential GDP
Phillips Curve
Connects p and u
p = pe + m - au + z
or pt - pet = a(un - ut)
Related to AS
p and Y
Focus on AD and monetary policy
M/P rises, LM & AD shift right
Y rises
Let Y = g(M/P)
Assumes fiscal policy and
autonomous expenditures are fixed.
Log differencing the equation:
gy,t = gm,t - pt
small macro model
ut – ut-1 = - b(gy,t – gn)
pt - pet = a(un - ut)
gy,t = gm,t – pt
MR implications:
p = pe ; u = un ; gy,t = gn
pt = gm,t – gn
Problem
Let gn = 3%, un = 6%, gm,t = 8%
a = 1.0, b = 0.5
Find the medium run values of
gy,t , ut and pt
Using those as starting values, find
the short run (one period) values if
gm,t rises to 9%.
Find the new medium run values
after expectations adjust to the
new gm,t.
Problem
Let gn = 3%, un = 6%, gm,t = 7%
a = 1.0, b = 0.5
Find the medium run values of gy,t , ut
and pt
Using those as starting values, if the Fed
wants to lower inflation to 2% in the
medium run, to what level should they
set gm,t ? Find the short run (after one
period) values if they make this
change.
Show these changes including the
medium run adjustment on a graph of
AS-AD and a PC graph.
Sacrifice Ratio
• Lowering pt in the MR has a
cost of higher ut in the SR.
• To measure this cost
Sacrifice Ratio = -Du/Dp
=excess unemployment/
decrease in inflation
For the previous problem….
Credibility
Problem
Let gn = 3%, un = 5%, gm,t = 5%
a = 1.0, b = 0.5
Find the medium run values of gy,t , ut
and pt
Using those as starting values, the Fed
increases gm,t to 8%. Find the new SR
values (one period).
Find the new medium run values.
Show these changes on a graph of ASAD and a PC graph.
Time Consistency
TC problem: conflict between long
term plan/policy and short term
incentive
- grading
- dieting
- shutting down failed banks
- monetary policy
Long term goal: maintain inflation
target
Short term incentive: lower
unemployment
Reason for an independent Fed.
Expectations and the PC
pt - pet = a(un - ut)
Static expectations
pt e = pt-1
Rational expectations
pt e = pt + et
et – forecast
error
Policy Ineffectiveness
Policy does not have real effects
if
• Expectations are rational.
• Wages and prices adjust
immediately.
– MR is short
– Contracts?
• Sacrifice ratio?
– Credibility
– Evidence?
Problem
Let gn = 2%, un = 7%, gm,t = 8%
a = 1.0, b = 0.5
Find the medium run values of gy,t , ut
and pt
The Fed wants to reduce inflation to 2%
in the medium run. What value should
they choose for gm,t ? Find the new SR
values (one period) if they do this.
Find the new medium run values.
Show these changes on a PC graph.
What is the sacrifice ratio?
Review Questions
• The strong growth in the 1990s is often
attributed to technology use by firms.
Show the short and medium run changes
on an AS-AD graph.
• One story explaining the Great
Depression is the stock market crash
reduced consumer spending. The
government then tried to boost the
economy with increased spending. Show
both changes on an AS-AD graph
explaining changes in equilibrium prices
and output.
• Show how a change in the markup would
affect the graph of the Phillip’s curve in
the short and medium run.
Problem
Starting from the natural rate of
output, show the short and
medium run effects of a tax cut
that leads to increased
productivity. Is it possible that
the equilibrium price level rises?
Do tax cuts pay for themselves?
Taxes & Revenue
Laffer Curve
• Tax revenue vs. tax rates
– Tax rate = 0%?
– Tax rate = 100%?
• Laffer curve peaks somewhere
in between.
Cross country analysis says
~50%
Tax Cuts
• Can pay for themselves if rates
are very high
• Can improve productivity
– Labor incentives
• Less effective as short run
stimulus than spending
increases
– Some is saved