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B01 ECONOMICS: MACROECONOMICS

Practical Lecture 4: The AS-AD Model


Recap:

Goods Market IS-LM Framework
Money Market Short Run Analysis

So far, we have limited our study to the short run and
taken prices as exogenous.

Goods Market AS-AD Framework
Money Market Medium Run Analysis
Labour Market P
e
= P in equilibrium



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In the medium run, prices are now endogenously
determined. Equilibrium in the medium run occurs
when:

(1) All markets: Goods, Financial and Labour, are
in equilibrium
(2) Expected prices equal actual prices: P
e
= P











3
Derivation of Aggregate Demand Relation

IS Relation (Equilibrium in the Goods Market):

Y = | | G i b b T c c
b c
+ +

2 0 1 0
1 1
1
1


LM relation (Equilibrium in the Money Market):

i d Y d
P
M
2 1
=

Equilibrium in the IS-LM Framework:

Y =
(

+ + +
+
G
P
M
d
b b T c c
d
d
b b c
2
2 0 1 0
2
1
2 1 1
1
1
1



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Aggregate Demand Relation:

|
|
.
|

\
|
=
+
+
G T
P
M
Y Y , ,

The AD curve plots combination of Price and Output
consistent with simultaneous equilibrium in the
Goods and Financial Markets

E.g. Consider the diagram below. At a given price P
0
,
the, the economy is in equilibrium at point A with
equilibrium in both the goods market and the
financial market. Suppose that we get an increase in
prices to P
1
. Then, as prices have increased, real
money supply in the economy falls so that the money
supply curve shifts to the left and so does the LM
curve. New equilibrium is reached at point B.

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i LM
1
i
IS
LM
0

B B
A
A

Y m
1
m
0

P


B
P
1

P
0
A
AD

Y

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Derivation of Aggregate Supply Relation

Wage Setting and Price Setting Relations:

+
=
=
+
1
1
) , (
P
W
z u F P W
e

PS
WS


Aggregate Supply Relation:

|
.
|

\
|
+ = z
L
Y
F P P
e
, 1 ) 1 (

Equilibrium unemployment rate (medium run
concept with P
e
=P) determined by:

( ) z u F P P
n
, ) 1 ( + =

) 1 (
1
,
+
=
|
.
|

\
|
+

z u F
n

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P AS


P
1



P
0





Y
0
Y
1
Y

The AS plots combinations of output and price
consistent with equilibrium in the labour market.

A rise in output from Y
0
to Y
1
implies a lower
unemployment rate. From the WS relation, we know
that a lower u implies higher bargaining power for
workers and therefore higher wages. From the PS
relation, we know that higher wages implies higher
prices. Thus the AS curve is upward sloping.
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Note: AD and AS v/s Demand and Supply Curves

In Microeconomics,

Demand slopes down because a rise in price makes
goods less attractive and thus lead to a decrease in
demand.

Supply slopes up because a rise in price makes
production more profitable and thus firms increase
supply.

In Macroeconomics,

Aggregate Demand slopes down because a rise in
price makes real money supply fall thereby leading to
a rise in the interest rate and a fall in investment and
thus a fall in aggregate demand.

Aggregate Supply slopes up because an increase in
output yields a lower unemployment rate and
therefore higher wages and higher prices.





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Problem 1

Graphically illustrate and explain the effects of an
increase in consumer confidence in the IS-LM and
AS-AD framework. What is the effect on output, the
interest rate and the price level? Assume that before
the increase in consumer confidence, the economy
was at the natural level of output.














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i LM
2


LM
1

LM
0


D
C B
A


IS
1


IS
0

Y


P
AS
1
AS
0



D
C
A B


AD
1


AD
0

Y
n
Y


A: Initial MR Equilibrium
P
e
= P and Y = Y
n


c
0
IS shifts right
AD shifts right

B: SR with price constant

C: Y higher and thus u lower
WS and PS imply P
Real money supply falls
LM shifts left to LM
1

i increases
Investment decreases

D: Price expectations adjust
AS shifts left
Price rises
Real money supply falls
LM shifts left
New equilibrium is reached
P
e
= P and Y = Y
n


Overall effects:
(1) Y is the same
(2) i is higher
(3) P is higher
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Problem 2

Graphically illustrate and explain the effects of an
increase in unemployment benefits in the IS-LM and
AS-AD framework. Then state the effects on output,
in the short run and in the medium run. Assume that
before the increase in unemployment benefits, the
economy was at the natural level of output.

Increase in unemployment benefits (z)
Increase in bargaining power of workers
Higher wages in Wage Setting relation due to
increase in z [WS shifts up]
Higher prices in Price Setting relation due to
increase in W
AS curve shifts up
Y
n
decreases


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i LM
2


LM
1

LM
0


C
B
A




IS
0

Y


P AS
2
AS
1
AS
0



C
B
A




AD
0

Y
n
Y
n
Y



A: Initial MR Equilibrium
P
e
= P and Y = Y
n


B: Increase in UN Benefits
AS shifts up
Price increases
Real money supply falls
LM shifts left

C: Price expectations adjust
AS shifts left
Price rises
Real money supply falls
LM shifts left
New equilibrium is reached
P
e
= P and Y = Y
n


Overall effects:

WS PS AS AD LM
SR





MR

IS Y i P Y
n
SR

MR

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Problem 3

Assume that the economy starts at the natural level of
output. Now suppose there is an increase in the price
of oil.

(a) In an AS-AD diagram, show what happens to
output and the price level in the short run and the
medium run.
(b) What happens to the unemployment rate in the
short run? In the medium run?

Increase in price of oil ()
Mark up increases
Price in Price Setting Relation increases [PS shifts
up]
AS shifts up
Y
n
shifts down
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i LM
2


LM
1

LM
0


C
B
A




IS
0

Y


P AS
2
AS
1
AS
0



C
B
A




AD
0

Y
n
Y
n
Y



A: Initial MR Equilibrium
P
e
= P and Y = Y
n


B: Increase in Price of oil
AS shifts up
Price increases
Real money supply falls
LM shifts left

C: Price expectations adjust
AS shifts left
Price rises
Real money supply falls
LM shifts left
New equilibrium is reached
P
e
= P and Y = Y
n


Overall effects:

WS PS AS AD LM
SR



MR

IS Y i P u
n

SR

MR

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Suppose that the Federal Reserve decides to respond
immediately to the increase in the price of oil. In
particular, suppose that the Fed wants to prevent the
unemployment rate from changing in the short run,
after the increase in the price of oil. Assume that the
Fed changes the money supply once immediately
after the increase in price of oil and then does not
change the money supply again.

(c) What should the Fed do to prevent the
unemployment rate from changing in the short run?
Show how the Feds action combined with the
decline in business confidence affects the AD-AS
diagram in the short and medium run.




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i LM
3


LM
1

LM
0
=LM
2


D
B
A=C




IS
0

Y

AS
2

P

D AS
1
AS
0


C

B
A


AD
1


AD
0

Y
n
Y
n
Y



A: Initial MR Equilibrium
P
e
= P and Y = Y
n


B: Increase in Price of oil
AS shifts up
Price increases
Real money supply falls
LM shifts left to LM
1


C: Increase in Money supply
LM shifts right to LM
2

AD shifts up
Y same but P has increased

D: Price expectations adjust
AS shifts left to AS
2

Price rises even more
Real money supply falls
LM shifts left to LM
3

New equilibrium is reached
P
e
= P and Y = Y
n


Overall effects:

WS PS AS AD LM
SR

MR


IS Y i P u
n

SR

MR

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(d) How do output and the price level in the short run
and the medium run compare to your answers from
part (a)?

In the short run, output and the price level are higher
in part (c) than in part (a)

In the medium run, output is the same in both part (c)
and part (a) but price level is higher in part (c) than in
part (a)

(e) How do the short run and medium run
unemployment rates compare to your answers from
part (b)?

In the short run, unemployment rate is lower in part
(c) than in part (a) but in the medium run,
unemployment rate is the same in part (c) and (a)