MACROECONOMICS II

MODEL FOR AN INFLATIONARY ECONOMY:

AD & AS MODEL
 INTRODUCTION
 Keynesian model was developed in response to high and sustained unemployment during the great depression.
 The basic Keynesian theory paid only limited attention to the question of inflation and only in a very circumscribed way
 Below the full employment level of income (Y), the model shows unemployment, but no upward pressure on prices.
 If expenditure is so high that the point of equilibrium is pushed beyond the full employment level of Y—on the 45 degree
diagram, the equilibrium is to the right of the full employment level of income (Y)—then there is no unemployment but
upward pressure on prices (inflation)
 Therefore in the Keynesian model , there can be neither unemployment or inflation –respectively explained by deficient or
excessive aggregate expenditure—but not both.
 Stagflation (1970s)—high or rising inflation occurring simultaneously with high and rising unemployment
 Aggregate Demand (AD)—expenditure models also utilizing the IS-LM Model
 Aggregate Supply (AS)---focuses on the labor market and other supply side policies, together with the aggregate
production function.
 Interaction of AD & AS determine Aggregate level of output and the average level of prices.
 In the SR, the AS curve is flat. In the LR, the AS curve is vertical—it is upward sloping in the medium run (medium term)
 AS curve describes the price adjustment mechanism of the economy.
 Changes in AD, the result of changes in fiscal and monetary policy as well as individual decisions about consumption and
investment, change output in the SR and changes prices in the Long Run.
 Macroeconomics—concerned with the behavior of the economy as a whole—with booms and recessions, the
economy’s total output of goods and services, and the rates of unemployment and inflation
 Aggregate Demand and Aggregate Supply each describe a relation between the overall price level (consumer price
Index/producer price index) and output (GDP).
 The AS Curve describes for each given price level, the quantity of output firms are willing to supply—the Aggregate
Supply curve is upward sloping because firms are willing to supply more output at higher prices.
 The Aggregate Demand (AD) curve shows the combinations of the price level and level of output at which the goods
and money markets are simultaneously in equilibrium.
 The AD curve is downward sloping because higher prices reduce the value of the money supply which reduces
demand for output.
 Equilibrium occurs at the point where the aggregate supply curve intersects the Aggregate Demand Curve
(AS=AD).
 Shifts in either the AS curve or the AD curve causes the price level and the level of output to change.
 Suppose the SARB increases the money supply: What effects will that have on the price level and on output?—In
particular , does an increase in the money supply, cause the price level to rise, thus producing inflation?
 An increase in the money supply shifts the aggregate demand curve to the right , the economy moves towards a new and
higher equilibrium level of income and price level.
WHAT FACTORS MAY CAUSE A SHIFT OF THE AS CURVE?
 DERIVING THE AD CURVE
 The AD relationship shows for each price level, the aggregate quantity of goods and services demanded in the economy.
We derive the aggregate demand curve directly from the 45 degree Keynesian expenditure model
 Along the 45 degree diagram, every level of equilibrium income/output (Y) has a corresponding price level (p)
 A higher price level implies a lower level of aggregate expenditure (C+I+G+X-M)
 The aggregate demand curve shows all combinations of real income Y and the average price level P at which there would
be simultaneous equilibrium in the real and monetary sectors.

WHAT DETERMINES SLOPE OF THE AD CURVE?

𝑀
 Interest rate effect: An increase in the average price level contracts the real money supply 𝑃𝑠 forcing a rise in interest
rates and consequently reduces aggregate expenditure.
 Wealth effect: a higher average price level diminished the real value of assets , people become less affluent and
expenditure is discouraged.
 The foreign trade effect: a higher domestic price level discourages export expenditure (and encourages imports) so that
aggregate expenditure decreases
 The tax effect: when personal income increases in periods of increases in the average price level (ie inflation), taxpayers
are pushed into higher personal income tax brackets : this curbs disposable income and thus expenditure.
 Every level of equilibrium income (Y) has a specific
price level, therefore we plot Price Level (P) on the
vertical axis and Income on the vertical axis (Y).
 The aggregate demand curve therefore shows, for
various average price levels, the corresponding
equilibrium, level of expenditure/income—under the
assumption that supply would respond automatically to
meet changes in expenditure.
 The AD curve can be viewed as a collection of points
of potential equilibrium, each at a different price level,
under the assumption that no supply side constraints are
present.
 Supply side considerations actually limit the choice
between these potential equilibrium points
 The LM curve is always drawn for a particular
(constant) price level
 A higher price level (P) implies a lower real money
supply (MS/P) which shifts the LM curve leftwards
or
 A higher price level implies a higher nominal value
of transactions. This increases the nominal
(transactions) demand for money MD, for a given
nominal money supply—This shifts the LM curve to
the left.
 Suppose the economy is at equilibrium level E1 with
price level (P1) and income (Y1).
 If the price level is at a higher P1, this implies a
lower real money supply (MS/P1), this is the
depicted leftward shift of the LM curve
 The result is a different equilibrium point (E2) with a
higher interest rate and a lower level of real income
(Y1)
 Connecting all the equilibrium points (EK) gives the
Aggregate Demand Curve.
 Wealth, foreign trade and tax reduce expenditure and are reflected as a shift to the level of the IS Curve in
addition to the leftward shift of the LM Curve.
 The combined effect would be a (larger) decline in the equilibrium level of real income Y
 The negative slope of the AD curve is defined by the fact that an increase in the average price level P decreases
the real money supply (MS/PK).
 Factors affecting the potency of monetary policy also influences the slope of the AD Curve.
 Interest sensitivity of money demand,
 the interest sensitivity of investment (capital formation) and
 the size of the expenditure multiplier
 If the interest sensitivity of money demand is low, monetary contraction will have a large effect on the real
economy. In the Ad curve, for a given increase in P (hence a decrease in MS/P), Y will decline a lot—the AD
curve will be relatively flat.
 If the interest sensitivity of investment is high, monetary contraction will have a large impact of the real
economy—therefore given a change in P (thus is real money supply), Y will decline a lot—AD curve will be
relatively flat.
 If the expenditure multiplier is large, the drop in investment (capital formation) caused by the monetary
contraction (via interest rate increase) will have a large impact on the real economy—for a given change in P
(and thus in MS/P) therefore Y will decline a lot—Consequently the AD curve will be relatively flat.