Macroeconomics II Class 4 THE AD-AS MODEL Class 8 A Road Map THE AD-AS MODEL: MICROFOUNDATIONS 1. Aggregae Supply 1.1 The Long-Run AS Curve 1.2 rice and Wage Sickiness 2.1 Aggregae Demand 2.2 Equilibrium in he Shor and Long Run 1
1.1 The Long Run AS Curve 1/2 1. Aggregae Supply Full employmen oupu,, is he amoun of oupu produced when employmen is a is fullemploymen level. The full employmen level of employmen corresponds o he naural level of employmen. Algebraically AF K, L 1 u n where u n is he naural rae of unemploymen 1.1 The Long Run AS Curve 2/2 1. Aggregae Supply LRAS In he long run, he increase in he price level (as a resul of a rise in nominal money) has no effec on oupu. The aggregae amoun of oupu supplied is he fullemploymen level, regardless of he price level. 2
1.2 rice and Wage Sickiness 1/2 1. Aggregae Supply The fracion (1 s) of firms have flexible prices and se heir prices according o p The fracion s of firms have sicky prices. They announce heir prices in advance on he basis of expeced economic condiions a p 1.2 rice and Wage Sickiness 2/2 1. Aggregae Supply The pricing rules of he wo groups of firms combined give he overall price level 1 s a s Rearranging yields he AGGREGATE SUL curve s 1 s a 3
Conclusion The shor run and long run aggregae supply curves 1. Aggregae Supply 2.1 Aggregae Demand 1/2 = C, A + I MK, uc + G AD Slope of he AD curve Higher prices erode he purchasing power of consumer wealh (nonindexed asses). Higher prices lead o less spending a any given level of real income. 4
2.1 Aggregae Demand 2/2 0 1 Facors ha shif he AD curve o he righ Households consume more and firms inves more a each level of wealh. Expansionary fiscal or moneary policy. 2.2 Equilibrium in he Shor and Long Run 1/6 Equilibrium in he AD AS model Adverse supply shock LRAS SRAS Beneficial demand shock AF K, L 1 u n AD 5
2.2 Equilibrium in he Shor and Long Run 2/6 The Neuraliy of Money In he shor run, a moneary expansion leads o an increase in oupu. Over ime, he price level increases, and he effecs of he moneary expansion on oupu disappear. In he long run, moneary losening is refleced enirely in an increase in he price level; i has no effec on oupu. 2.2 Equilibrium in he Shor and Long Run 3/6 Moneary nonneuraliy 1. Ineres rae falls 6
2.2 Equilibrium in he Shor and Long Run 4/6 An increase in governmen purchases A fiscal expansion raises boh he price level and real GD in he shor run. 2.2 Equilibrium in he Shor and Long Run 5/6 Effec of a Decline in lanned Spending When he rice Level Is erfecly Flexible. 7
2.2 Equilibrium in he Shor and Long Run 6/6 The economy is brough ino general equilibrium by adjusmen of he price level: Under he classical assumpion ha prices are flexible, he adjusmen process is rapid. Firms respond o increased demand by raising prices raher han by emporarily producing more. According o he opposing Keynesian view, sluggish adjusmen of prices (and of wages) migh preven general equilibrium from being aained for a much longer period, perhaps even several years. roblem 1 Suppose people have raional expecaions and he AD and AS curves ake he following forms: 200 AD: 400 AS: 50 1. Full employmen level of oupu is equal o 550 and fiscal and moneary policy mulipliers are equal o 1 and ½, respecively. In period =0 he acual price level 1 and i was NOT equal o he expeced price level. 0 a) Is he economy in he long-run equilibrium? Calculae (i) he level of oupu and (ii) he expeced price level. Graph he AD and AS curves. b) Calculae a rise in governmen spending necessary o increase income o full employmen level in period =0. Show he impac of governmen policy on he AD AS diagram. c) Taking accoun of he expecaions formaion mechanism, do you hink ha he governmen policy described above should be announced in advance o achieve is goals? 8
roblem 2 400 The economiss esimaed he following aggregae demand AD1 equaion: 500, where sands for income and is he general price level. The economy is iniially in he long run equilibrium. Following a fiscal expansion he aggregae demand curve swiches o AD 2 in 400 he following form: 600. A rise in aggregae demand ranslaes ino a rise in he firms individual demand. The firms may respond eiher by increasing producion or prices or boh. a) A ypical firm faces he following dilemma. The iniial price level (and he general price level) is equal o 2 and he corresponding value of profis is 100. If he firm raises is price o new opimal level equal o 4, is profis afer he fiscal expansion would be equal o 140. If he firm keeps he price a 2, is profis would increase o 130. The menu coss are equal o 12. Compue he level of prices and oupu in he shor and long run following a change in he aggregae demand assuming ha all firms behave like he ypical firm. b) Illusrae you calculaions in (a) by means of an AS-AD graph. Explain he slope and shifs of all curves. c) Now assume ha menu coss are equal o zero bu nominal wages are rigid. Use he AS- AD diagram o explain he shor and long run evoluion of prices and oupu resuling from a fiscal expansion. Assume ha price expecaions are raional and he change in governmen expendiures was unexpeced. Macroeconomics II THE DNAMIC AD-AS MODEL 9
Class 9 A Road Map THE DNAMIC AD-AS MODEL 1. Componens of he Model 2. Shor and Long-Run Equilibriums 1. Componens of he Model The dynamic aggregae supply curve (DAS). 1 DAS The upward slope of he DAS curve reflecs wage and price rigidiy. The curve shifs up when an adverse supply shock his he economy (v >0), poenial GD decreases or he previous period inflaion is higher. 10
1. Componens of he Model The dynamic aggregae demand curve (DAD). * r r r i 1 1 i r h 1. Componens of he Model The dynamic aggregae demand curve (DAD). DAD h * When inflaion rises, he cenral bank follows is rule and responds by increasing he nominal and real ineres raes. The increase in he real ineres rae reduces he quaniy of goods demanded. 11
1. Componens of he Model The DAD shifs in response o changes in fiscal policy and oher aggregae demand shocks, as well as changes in moneary policy. Any change in fiscal policy or consumers and invesors behavior ha increase he demand for goods means a shif of he DAD curve o he righ. An increase in he arge rae of inflaion (expansionary moneary policy) raises he quaniy of oupu demanded and shifs he DAD curve o he righ. When he cenral bank raises is arge for inflaion, i reduces he nominal and real ineres raes. Lower real ineres rae simulaes spending. 2. Shor and Long- Run Equilibriums An increase in he naural level of oupu. 12
2. Shor and Long- Run Equilibriums The naural level of oupu increases because of populaion growh, capial accumulaion or echnological progress. Boh he DAD and DAS curves shif o he righ by exacly he amoun ha he naural level of oupu has increased. eople are richer and spend more (consumpion depends on lifeime human and nonhuman wealh!), firms can produce more wihou raising prices. The simulaneous shifs in supply and demand increase he economy s oupu wihou puing (eiher upward or downward) pressure on inflaion. 2. Shor and Long- Run Equilibriums An adverse supply shock. 13
2. Shor and Long- Run Equilibriums A supply shock capures any even ha influences inflaion beyond expeced inflaion and he sae of business cycle. When and adverse supply shock his he economy, he DAS curve shifs upward, v >0. The cenral bank raises he ineres rae and he economy moves along he DAD curve. Even hough he shock variable reurns o is normal value v +1 =0, he DAS curve does no immediaely reurn o is iniial posiion. I slowly shifs back as a lower level of economic aciviy reduces inflaion and inflaion expecaions. 2. Shor and Long- Run Equilibriums A persisen demand shock, =1 for five periods. 14
2. Shor and Long- Run Equilibriums When he demand shock occurs he DAD curve shifs o he righ. The cenral bank raises he ineres rae and parly offses he expansionary effecs of he demand shock. Inflaion increases and expeced inflaion in he periods afer he shock is higher. The DAS curve shifs up. When he demand shock disappears, he economy does no immediaely reurns o is iniial equilibrium. High expeced inflaion causes recession when demand falls off. The economy hen gradually recovers. 2. Shor and Long- Run Equilibriums The cenral bank lowers is arge for inflaion. 15
2. Shor and Long- Run Equilibriums When he inflaion arge falls, he DAD curve shifs o he lef. The cenral bank raises he real and nominal ineres raes. Oupu and inflaion boh fall. Lower inflaion reduces expeced inflaion and shifs he DAS curve downward, furher reducing inflaion. As expeced inflaion falls, he DAS curve repeaedly shifs downward and he economy approaches he new equilibrium. Oupu reurns o is naural level and inflaion ends a is lower arge. Reducing he arge inflaion rae causes recession for a while. roblem 1 The dynamic aggregae demand curve is given by: 1 * 2 The dynamic aggregae supply curve is given by (inflaion expecaions are backward looking): 1 2 a) The economy was in equilibrium. The rae of inflaion was equal o 10%. The cenral bank reduces inflaion arge o 2%. Calculae oupu loss (fall in oupu) arising from his disinflaion policy during he firs year of is implemenaion. Calculae he rae of inflaion during he firs year of he disinflaion policy implemenaion. b) Use a graph of he dynamic AD-AS curves o show he shor and long-run consequences of a reducion in inflaion arge described in (a). Briefly explain he shifs of he curves. 16
roblem 2 We know he following abou an economy. The (log of) full employmen oupu equals 1000. The aggregae spending falls by 12 in response o a rise in he real ineres rae by one percenage poin above he naural rae. The DAS curve is given by he following equaion: 1 1 2. The economy is in he long run equilibrium when a supply shock occurs, v+1=6,5. Calculae he shor run level (in period +1) of oupu gap and inflaion if he cenral bank arges inflaion rae of 2% and responds o a one percenage poin increase in he level of inflaion above he arge by raising is ineres rae by 2 percenage poins. 17