The AD-AS Model : Policy Analysis

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2 AD-AS analysis is a powerful tool for studying short-run fluctuations in the macroeconomy. We can analyze how aggregate output and inflation rate are determined in the short-run.

3 1 Aggregate Demand Aggregate Expenditures Monetary Policy and Aggregate Demand AD Curve 2 Curve and Phillips Curve 3 Short-Run Changes in 4 The Objectives of Macroeconomic Policy Analyzing Policy Effects

4 Aggregate Demand Aggregate Expenditures Monetary Policy and Aggregate Demand AD Curve Aggregate Demand : The total amount of output demanded in the economy. Keynes proposed that low aggregate demand is responsible for low income and high employment. In the short-run, economy s total income was determined largely by the spending of plans of households, firms, and the government. Planned expenditure (PE): the amount households, firms and the government would like to spend on goods and services. Planned Expenditure = Aggregate Demand Y pe = C + I + G + NX

5 Goods Market Aggregate Expenditures Monetary Policy and Aggregate Demand AD Curve Y = Y pe Y = C + I + G + NX Y = C + (mpc Y D ) cr + Ī dr + Ḡ + NX xr Y = C + Ī + Ḡ + NX + (mpc Y ) (mpc T ) (c + d + x)r subtracting mpc Y from both dies of equation Y (mpc Y ) = Y (1 mpc) = C + Ī + Ḡ + NX (mpc T ) (c + d + x)r dividing both sides of equation (1 mpc) Y = [ C + Ī + Ḡ + NX (mpc T )] 1 1 mpc c+d+x 1 mpc r

6 Aggregate Expenditures Monetary Policy and Aggregate Demand AD Curve Y = [ C + Ī + Ḡ + NX (mpc T 1 )] c + d + x 1 mpc 1 mpc r }{{}}{{} The equation shows how to determine aggregate output when goods market is in equilibrium. It shows the relationship between aggregate output and the real interest rate when the goods market is in equilibrium. First component of the equation explains shifts in IS curve (given interest rate) Second component of the equation explains movements on IS curve (changes in real interest rate)

7 Monetary Policy Aggregate Demand Aggregate Expenditures Monetary Policy and Aggregate Demand AD Curve We need real interest rate : r = i π e - changes in nominal interest rate changes in real interest rate (only if actual and expected inflation remain unchanged in the short-run) - We know prices are sticky in the short-run. Central bank can determine the real interest rate in the short-run. not long run, because prices are flexible in the long-run. In the long-run, real interest rate is determined by the interaction of saving and investment.

8 MP Curve Aggregate Demand Aggregate Expenditures Monetary Policy and Aggregate Demand AD Curve MP curve indicates the relationship between the real interest rate which central bank sets and the inflation rate. r = r + λπ MP has an upward slope : - Policy makers follow Taylor principle to stabilise inflation. - Interest rate is raised more than any rise in expected inflation. - Real interest rate rise if there is a rise in inflation.

9 AD Curve Aggregate Demand Aggregate Expenditures Monetary Policy and Aggregate Demand AD Curve MP curve shows how central bank respond to changes in inflation with setting interest rate IS curve shows how changes in interest rate affects equilibrium output. AD curve shows the relationship between the quantity of aggregate output and inflation rate(given inflation expectations and stance of monetary policy) π r I, C, NX Y

10 Shifts in AD Curve Aggregate Demand Aggregate Expenditures Monetary Policy and Aggregate Demand AD Curve

11 Aggregate Demand Curve and Phillips Curve Aggregate supply behaves differently in the short-run than in the long-run. In the long-run, prices are flexible, and the aggregate supply curve is vertical. shifts in aggregate demand curve affect the price level and output remains its natural level. In the short-run, prices are sticky, and the aggregate supply curve is not vertical. shifts in aggregate demand curve affect the output and do cause fluctuations in output. Some prices are sticky and others not. This is the better reflection of the real world.

12 Curve Curve and Phillips Curve We get the inflation equation : π = π e + γ(y Y p ) + ρ where π e = π 1 γ : how inflation respond to the output gap higher γ more flexible wages (ω ) steeper PC steeper AS

13 Shifts in AD Curve Aggregate Demand Curve and Phillips Curve π = π e + γ(y Y p ) + ρ

14 Short-Run Short-Run Changes in

15 Short-Run Changes in Adjustment to Long-Run

16 Short-Run Changes in Adjustment to Long-Run

17 Short-Run Changes in Changes in : Aggregate Demand Shocks Positive demand shock

18 Short-Run Changes in Changes in : Aggregate Demand Shocks Negative demand shock

19 Short-Run Changes in Changes in : Shocks Negative supply shock

20 Short-Run Changes in Changes in : Shocks Negative permanent supply shock

21 Short-Run Changes in Changes in : Aggregate Demand and Supply Shocks Negative demand and supply shock: Economic Crisis

22 Short-Run Changes in Changes in : Aggregate Demand and Supply Shocks

23 The Policy Objectives The Objectives of Macroeconomic Policy Analyzing Policy Effects There are two primary objectives: Stabilizing economic activity Achieving natural rate of unemployment is equivalent to stabilizing the economy. At the natural level of unemployment, the economy moves to its natural level of output, which we refer to more commonly as potential output. Minimizing output gap: Y Y p Stabilizing inflation around a low level Price stability Maintanig inflation (π) close to a target level (π T ) Minimizing inflation gap: π π T

24 Hierarchical Versus Dual Mandates The Objectives of Macroeconomic Policy Analyzing Policy Effects Hierarchical mandates require stable inflation as a condition of pursuing other goals. Dual mandates are referred as price stability and maximum sustainable employment Loss Function: L = α(π π T ) 2 + (1 α)(y Y p ) 2

25 The Framework Aggregate Demand The Objectives of Macroeconomic Policy Analyzing Policy Effects

26 Aggregate Demand Shock The Objectives of Macroeconomic Policy Analyzing Policy Effects Aggregate demand shock: no policy response

27 Aggregate Demand Shock The Objectives of Macroeconomic Policy Analyzing Policy Effects Aggregate demand shock: policy stabilize output in the short-run

28 Shock The Objectives of Macroeconomic Policy Analyzing Policy Effects Aggregate supply shock: no policy response

29 Shock The Objectives of Macroeconomic Policy Analyzing Policy Effects Aggregate supply shock: policy stabilize inflation in the short-run

30 Shock The Objectives of Macroeconomic Policy Analyzing Policy Effects Aggregate supply shock: policy stabilize output in the short-run

31 Policy Results Aggregate Demand The Objectives of Macroeconomic Policy Analyzing Policy Effects For demand shocks, policy that stabilizes inflation will also stabilize economic activity. The Divine Coincidence : stabilizing inflation also stabilize output. For supply shocks, central bank must choose between the two objectives. There is trade-off for the supply shocks

32 References Aggregate Demand The Objectives of Macroeconomic Policy Analyzing Policy Effects Mishkin, Macroeconomics: Policy and Practice, Chapter 12 and 13