Download AS & AD - Vincent Hogan

AS & AD
Account for price movements
AGGREGATE DEMAND AND SUPPLY
• So far, we have assumed for simplicity that in the short-run, general Price
and Wage levels are fixed.
• This means that changes in Demand lead to changes in real GDP, and not
prices.
• However, it is clear that prices and wages adjust over time, and that we
have to relax the fixed-price assumption.
• One way of looking at this is to derive Aggregate Supply and Demand
curves, where real demand and supply (GDP) are related to the general
price level
• We can then see how changes to demand (from fiscal and monetary
policy actions, etc) interact to produce changes in Real GDP and the price
level.
• This will be a first step towards looking at Inflation.
CHANGING P AND MS/P
• Suppose the general price level changes (and nothing else changes – i.e.
ceteris paribus)
• The immediate effect is that the Real Money Supply changes:
• ms  Ms/P so as P increases, real money supply (ms) decreases, assuming
nominal money supply is (Ms) unchanged
• A lower ms immediately implies an excess of md over ms , and thus a
higher interest rate (r)
• In turn this leads to a lower level of total demand for output (i.e.
aggregate demand) because: Ip = Ia + b.r (b <0)
• A graphical version: (note P2 > P1 > P0)
CHANGES IN P AND AGGREGATE DEMAND
• Effect of P on AD
r
LM2
LM1
LM0
r2
r1
r0
As P increases, real
ms falls, r increases,
AD falls
0
IS
Y2
Y1
Y0
Y
P
P2
P1
P0
0
AD
Y2 Y1
Y0
Y
SLOPE OF IS-CURVE AND AD-CURVE
r
LM2
LM1
The IS-Curve shows how Y
Responds to changes in r
ISB is steeper than ISA
Result: steeper ADB
ISB
0
LM0
ISA
Y
P
ADB
0
ADA
Y
AGGREGATE DEMAND SHIFTS
• Monetary Policy: An expansion of Ms, leading to a real expansion of
(Ms/P) will boost Aggregate Demand, via lower interest rates. This is
depicted as a shift in the AD curve.
• Later we will see that if there is an inflationary result, this will further
lower the real interest rate (= nominal int rate minus inflation)
• Fiscal Policy: an increase in G or a reduction in T (fiscal stimulus) will
increase AD at any given interest rate and price level: again a shift in the
AD curve.
• We can illustrate these diagrammatically:
MONETARY EXPANSION AND AD-SHIFT
• Effect of Ms on AD
r
As Ms increases, real
ms increases, r falls,
AD increases (shifts up)
LM1
LM2
r0
r1
r2
0
P assumed constant, but
the exact outcome will
depend on AS as well (later)
LM0
IS
Y0
Y1
Y
Y2
P
P0
0
AD2
AD1
AD0
Y0 Y1
Y2
Y
A FISCAL STIMULUS AND AD-SHIFT
• Effect of (G – T) on AD
r
LM
r1
As (G – T) increases,
IS shifts, AD increases
(shifts out)
r0
0
P assumed constant, but
the exact outcome will
depend on AS as well (later)
IS0
Y0
IS1
Y
Y1
P
P0
0
AD1
AD0
Y0
Y1
Y
LABOUR MARKET AND AGG. SUPPLY (1)
•
•
•
•
•
•
•
How does the Supply of Output respond to changes in the Price level?
Output (Y): Y = f(N, K)
MPN :
dY/dN > 0 and d2Y/dN2 < 0
Firms employ labour (N) such that wage (W) = P. MPN
or:
W/P = MPN
Next, some assumptions about price and wage flexibility.
In the short run we can assume that most prices respond to supply and
demand shocks
• However wage rates are an exception: typically wages are viewed as
being inflexible in the short-run: wage contracts are negotiated for
periods of 1 to 3 years, for a variety of reasons
• Initially Nd = f(W/P); dNd /dw < 0
Ns = g(W/P); dNs /dw > 0
• Where
w  W/P
LABOUR MARKET AND AGG. SUPPLY (2)
• Initial equilibrium at W/P0, etc
If P increases,
W/P1 falls , and
Nd increases to N1
W/P1 is not a full
Equilibrium: not
on Ns curve. Upward
pressure on W
Long-run adjustment
Increases W, restores
W/P, and N  N0
W/P
Ns
W/P0
W/P1
Nd
0
N0
N1
N
SHORT-RUN AGGREGATE SUPPLY (1)
• If W is relatively inflexible (compared with P), then the short-run
response is that Output tends to increase when P rises, because real w
falls, and tends to fall when P falls (because real w increases).
• Hence an upward-sloping S.R Aggregate Supply curve:
P
SAS
0
Y
SHORT-RUN AGGREGATE SUPPLY (2)
•
P increases to P2, W1 constant: w decreases, N increases, Y increases
P
W1
SAS
P2
P1
w
w1 w2
Y1
Y2
Y
ND
N1
N2
Y=f(N, K)
N
LONG-RUN AGGREGATE SUPPLY
•
P increases to P2, W2 eventually adjusts: SAS shifts; LAS vertical
P
W2
LAS
W1
SAS1
SAS2
P2
P1
w
w1
Y1
Y
ND
N1
Y=f(N, K)
N
RESPONSE TO AD SHOCKS (SR)
• SAS  vertical as Y  Y*
• AD1  AD2: small Pa, large Ya
• AD3  AD4: larger Pb, smaller Yb
P
SAS
Pb
Pa
AD1
0
Ya
AD2
Yb
AD3
AD4
Y
RESPONSE TO AD SHOCKS (LR)
•
•
Initially AD-shift increases Y  Y2
In LR, AS  SAS2 and LAS  P3, Y1
P
LAS
SAS2
SAS1
P3
P2
P1
AD1
0
Y1
Y2
AD2
Y
KEYNESIAN VERSUS CLASSICAL VIEWS
• Prior to the great Depression of the 1930s the prevailing (“Classical”)
view was that the Macroeconomy tended to full-employment
equilibrium
• Deviations were viewed as short-lived, and the key to adjustment was
flexibility of prices and wages
• The experience of the 1930s shattered this view, and the Keynesian
perspective became dominant
• Much later, in the late 60s and the 70s, the Keynesian orthodoxy was
obviously deficient in dealing with inflation.
• Also with “fine-tuning” to counter relatively mild recessions was seen to
be problematic: hence a revival of classical and monetarist views
• Recently, the emergence of a very serious recession, with echoes of the
1930s prompts a renewed emphasis on Keynes
THE KEYNESIAN PERSPECTIVE (1)
• What Keynes demonstrated was that an economy could get trapped in a
high-unemployment equilibrium: this necessitated government policy
intervention, primarily in the form of a fiscal stimulus.
• The experience of the 1930s stemmed from a rapid expansion of credit in
the 1920s, overinvestment in housing and other assets, followed by a
financial collapse. The result of this was a drastic fall in Aggregate
Demand. (sounds familiar?)
• Fiscal expansion was the only way to counter this Aggregate Demand
deficiency: Monetary policy alone would not work
• What we need to understand is why the economy might be stuck in an
under-employment equilibrium and why decisive fiscal policy measures
might be necessary to solve the problem
THE KEYNESIAN PERSPECTIVE (2)
• Keynes argued that Nominal Wages are relatively inflexible, even when
there is high unemployment and perhaps price deflation
• However what matters is the real wage (W/P), and if there is a need to
reduce real wages (W/P), then perhaps increasing P rather than reducing
W may be more effective.
• This may be because of Money Illusion (an idea which we sometimes find
troublesome): however if W is reduced, do people perceive that it may
apply to them only? (i.e. relative as well as absolute W)
• Falling P may increase (Ms/P). Result:
– falling r boosts AD (Keynes effect)
– increase in (Ms/P) increases real wealth and thus AD (Pigou effect)
• But real value of Debt also increases in a Deflation
• Also expectations of further deflation may depress AD
THE KEYNESIAN PERSPECTIVE (3)
• Keynes also argued that Md may become practically infinitely elastic at
low interest rates (liquidity preference theory)
• This effectively limits the scope for reductions in interest rates as a
stimulant to AD
• Note that even if the nominal interest rate should go to zero, deflation
implies a higher real interest rate, and so monetary policy may inevitably
be quite restrictive in a deflation
r = i – e
• So if
e = – 4% and i = 1%, then r = +5%
• However there are problems:
– information and timing of fiscal interventions financing
– public debt accumulation
Summary of AS
• We have a distinction between short run and long
run
• The Short run is for fixed expectations
– AS(Pe)
– SRAS
– Quite flat: Explains why ISLM works as approx
• LR is how long it takes for real wages to adjust
– Expectations adjust
– Workers to act on exp
– ISLM wont work in LR
• In LR Y is unaffected by P
LRAS
P
AS(Pe)
Y*
Y
• Note the Notation AS(Pe)
– Alternative to SAS
– Makes explicit that the SR is for fixed price
expectations
– When price expectations change workers (and
others) will demand higher wages
– SAS will shift up
• What determines Y*?
–
–
–
–
–
Natural rate
Incentives
Technology
“growth”
Not anything that just affects price
THE KEYNESIAN PERSPECTIVE (4)
• Here: flat LM: fiscal policy effective; monetary policy ineffective
r
LM1
LM2
E1
E2
IS2
IS1
0
Y1
Y2
y
THE KEYNESIAN PERSPECTIVE (5)
• Here: inelastic IS curve: monetary policy ineffective; fiscal policy
effective
r
IS1
IS2
LM1
LM2
E2
E1
0
Y1
Y2
y
THE KEYNESIAN PERSPECTIVE (6)
• The problem may also be shown in terms of AS and AD
• Shock to AD; SAS may be slow to change
P
LAS
SAS0
AD 1931, 2009
AD 1929, 2007
0
Y0
Y*
Y
SR IMPACT OF AD AND AS SHOCKS (1)
• AD: positive shock  inflationary pressure
• Implies positive correlation between inflation and output, etc
AS
P
AD1
0
AD2
Y
SR IMPACT OF AD AND AS SHOCKS (2)
• AS: negative shock  inflationary pressure
• Implies negative correlation between inflation and output, etc
P
AS2
AS1
AD
0
Y
INFLATION AND TREND OUTPUT:
USA 1960-2005
Policy in AS-AD Model
• Suppose there is an increase in G
• AD shifts right
– For all P, there is higher AD, because govt component has
risen
– Could derive this from IS-LM
– Same for MP
• For fixed expectations i.e. SR
–
–
–
–
Move along AS
New (temp) eqm at B
Y increases
P increases (but not by much)
• P rising implies real wage falling
– P>Pe
• Pe will adjust upwards
– W increase
– SRAS shifts up
• Keep going until output returns to “natural
level”
• How long does transition take?
– Theory: depends. Instantaneous?
– Empirics: about 2 years – see diagram
LRAS
AS(Pce)
P
C
AS(PAe)
B
A
AD1
AD0
Y*
Y
• Be clear on the reasons why there is no
long run effect
– In order to get more output need to pay more
people higher wages
– Higher wages imply firms need to charge
higher prices
– Higher prices negate the higher wages as far as
workers are concerned
– We go back to original values of real variables
– Only affect nominal variables
• Policy is ineffective!
• We can only get an increase in Y in long run
i.e. increase in Y*
– If induce people to work more
– Need increase in real wage
– Technology
– Efficiency
– Lower taxes?
• Reganomics
• Supply side economics
• Voodoo economics
Reagan Style Tax Cut
• Cut personal taxes
–
–
–
–
–
Idea is that this will improve incentives
People will work more
Shift the LRAS to the right
Increase Y* and reduce P
Note that SRAS shifts also as expectations adjust to the
new lower level
• But cutting taxes will shift the AD curve to right
– SR boom
– LR return to Y* with higher P
• Which happened?
– Both
– Demand effect larger
LRAS0
LRAS0
P
AS(Pe)
AS(Pe)
AD0
Y*
Y1*
Y
Dealing With Shocks
• The AS-AD diagram shows how an economy
will automatically adjust to a shock
• Start from LR eqm
– Y=Y*
– Pe=P
• Suppose there is a fall in AD
– Eqm moves from A to B
– Y<Y*
• This can only be a temporary eqm
• At B, P<Pe
– Real wages are higher than expected
• Prices fall, but by more than nominal wages
• See labour market diagram
– Workers are expensive
– Explains the decline in output
– Over time workers will
• Reduce price expectations
• Reduce wage demands
• SRAS shifts down
• Process continues until LR eqm is restored at C
– Real wage returns to original level
– Y=Y*
– Pe=P but at new lower level
LRAS
P
SRAS(P0e)
SRAS(P1e)
A
B
C
AD0
AD1
Y*
Y
• So the economy will automatically work itself out
of recession
• Mechanism depends on wage adjustment
– Mirror image of previous discussions
– Workers respond to lower prices by demanding lower
wages
– Reasonable?
• Yes real wages return to normal
• No long term decline in real wages
– Realistic?
• No! see data
• Nominal wages are rigid
• Have to wait for productivity
– Have lower wage increases than otherwise
• All this takes time
– 3+ years
• Alternative is for Government to expand AD
– Shift AD back
– Return to long run equilibrium A
• Rationale for stabilization policy
– After WTC, cut interest rates
– Enough? Or too much?
• Debate over which is best
– Policy: “long and variable lags”
– Automatic: “long run we are all dead”
– Calls for “flexibility” after EMU