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Applications of the AD-AS Model Lecture 15 – academic year 2013/14 Introduction to Economics Fabio Landini Where we are… Well, at the end…. •Lectures 1-7: Microeconomics (S&D, regulation, taxes, social efficiency) •Lecture 8-14: Macroeconomics (aggregates, goods mkt, financial mkt, labour mkt, AD-AS) Today: Demand shocks How do we model the transition from the short to the medium period in the AD-AS model? What happens in the medium period when we increase the supply of money? What happens in the medium period when we reduce the public deficit? Which are the effects of demand shocks? Demand shocks • Transitions from short to medium period • Effects of an increase in money supply • Effects of a reduction in public deficit • Effects of a demand shock Transition from the short to the medium period P AS A PA AD YA =Yn Y Point A can be both the short and the medium period equilibrium depending on the assumptions on PE Medium period PE=P -> u=un -> Y=Yn Transition from the short to the medium period P AS A PA AD Yn YA Y In the short period -> PE can be ≠ from P For instance PE<P -> YA>Yn How do we move from the short period equilibrium A to the medium period equilibrium? Transition from the short to the medium period Individuals underestimates prices -> they have wrong expectations concerning prices As times passes workers realize that PE is too low -> price expectations adjust -> PE AS parametrically depends on PE -> If PE the AS curve shifts upward PE -> AS shifts upward AS’ P AS A’ PA’ PA A AD Yn YA’ YA New equilibrium A’ -> Y (YA -> YA’) P (PA -> PA’) PE -> A -> A’; Is A’ the final equilibrium of the system? In A’ -> Y>Yn and P>PE -> PE continues AS’ P AS A’ PA’ PA A AD Yn YA’ YA PE -> A -> A’; Is A’ the final equilibrium of the system? In A’ -> Y>Yn and P>PE -> PE continues AS’’ AS’ AS P A’’ PA’ A’ A PA AD Yn YA’ YA In A’’ -> Y=Yn -> PE=P -> the expectation must not be adjusted -> the adjustment process (i.e. the AS curve) stops Demand shock We use the AD-AS model to examine: •Expansive monetary policy •Reduction of public deficit The two cases are examples of “demand shock” Expansive monetary policy 1) Expansive monetary policy ( MS) Initially, let’s assume Y = Yn Then, the Central Bank increases MS What are the short-period effects on equilibrium prices (P) and quantities (Y)? An what about the medium-period effects? Expansive monetary policy AS -> P= PE (1+m) F( 1 - Y , z) L + MS AD -> Y Y , G, T P + + - MS -> Aggregate demand -> AD shifts rightward AD -> AD’ -> Equilibrium -> A -> A’ -> Y (YA -> YA’) P (PA -> PA’) Short period effects -> Y and P Is it plausible that the economy remains in A’? In A’ Y>Yn -> P>PE -> wrong expectations P AS A’ PA’ PA A AD YA=Yn YA’ AD’ Y Expansive monetary policy Wrong expectations -> adjustment of expectations (described before) -> PE PE -> AS shifts upward The adjustment process continues until Y>Yn -> AS shifts upwards until Y>Yn When Y=Yn -> PE=P -> The adjustment process interrupts -> medium period equilibrium After MS we are in A’; AS shifts upward until Y>Yn AS’’ P AS PA’’ A’ PA’ PA AD YA’’= Yn YA’ AD’ Y During the transition -> Y and P In the medium period -> YA’’ =Yn=YA and PA’’ >PA Expansive monetary policy Total effect of the intervention: •Short period -> Y and P •Transition -> Y and P •Medium period -> Y=, P In the medium period Y does not change. Has the composition of demand changed (Z=C+I+G) ? •Z does not change (in equilibrium Y=Z): •C hasn’t change (Y and T are not changed) •G has not changed (exogenous) •Therefore I hasn’t changed either In the medium period money has no effects on real variables but only on prices -> medium period “neutrality” of money Expansive monetary policy An expansive monetary policy increases production in the short period -> It allows the economy to exit a recession( Y) In the medium period monetary policy in neutral -> It cannot be relied on to generate permanent increases in production Reduction of public deficit 2) Reduction of public deficit ( G , T) Initially, let’s assume Y = Yn Then, government reduces G What are the short-period effects on equilibrium prices (P) and quantities (Y)? An what about the medium-period effects? Expansive monetary policy AS -> P= PE (1+m) F( 1 - Y , z) L + MS AD -> Y Y , G, T P + + - G -> AD shifts leftward Equilibrium A->A’ -> Y (YA -> YA’) P (PA -> PA’) In A’ Y<Yn -> P<PE -> PE -> the transition starts P AS A PA PA’ A’ AD AD’ YA’ Yn Y PE -> AS shifts downward When Y=Yn the adjustment process stops P AS AS’’ A PA PA’ PA’’ A’ A’’ AD AD’ YA’ Yn=YA’’ Y During the transition -> Y and P In the medium period -> YA’’ =Yn=YA and PA’’ <PA P AS AS’’ A PA PA’ PA’’ A’ A’’ AD AD’ YA’ Yn=YA’’ Y Reduction of public deficit Total effects of the intervention: • Short period -> Y P • Transition -> Y P • Medium period -> Y= P Is the composition of demand changed (Z=C+I+G) ? • Z is not changed (in equilibrium Y=Z) • C is not changed (Y and T are not changed) • G is changed (Government has reduced expenditure) • Therefore I has increased Reduction of public deficit In the short period a reduction of public expenditure causes a recession The effect is only temporary -> In the medium period the production comes back to the “natural” level In the short period the reduction of public deficit has an ambiguous effects on investments In the medium period the effect on investment is certainly positive Conclusion The cases that we examined are examples of demand shock Demand shock -> Variations in the values of variables that affect aggregate demand Demand shock: •Variations in public expenditures and taxes •Variations in money supply (and related interests) •Variations in autonomous consumption (tastes, consumers’ expectations) •Variations in investments (firms’ expectations) Conclusion Demand shocks impact the AD curve Positive shocks ( MS, G, C0, I0) -> AD rightward Negative shocks ( MS, G, C0, I0) -> AD leftward P AS AD’ AD Y Conclusion In the short period demand shocks impact on prices and production in the same direction ( P Y or P Y) Moreover, we saw that in the medium period: • In all cases Yn does not change -> Demand shocks do not influence production in the medium period • In all cases P change -> Demand shocks affect prices in the medium period • Demand shock can change the composition of aggregate demand in the medium period