Putting All Markets Together: The AS-AD

Model

Chapter 7: Putting All Markets Together: The ASAD Model

Chapter 7
Q :How are output, the unemployment rate, and the interest rate
determined in the short run and the medium run?
A: Output, the unemployment rate, and the interest rate are
determined by simultaneous equilibrium in the goods,
financial, and labor markets.

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7-1 Aggregate Supply

Chapter 7: Putting All Markets Together: The ASAD Model

The aggregate supply relation captures the effects of

output (Y) on the price level (P). It is derived from the
behavior of wages and prices.
Recall the equations for wage and price determination
from Chapter 6:

W P e F (u ,z)

P (1 m)W

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7-1 Aggregate Supply

Chapter 7: Putting All Markets Together: The ASAD Model

Step 1: Eliminate the nominal wage W from:

W P eF(u, z)

P (1 m)W

P P e (1 m) F (u, z )
In words, the price level (P) depends on the
expected price level (Pe) and the
unemployment rate (u). We assume that m
and z are constant.

Step 2: Replace the unemployment rate u in terms of output Y:

U
L N
N
Y
u

1
1
L
L
L
L
Therefore, for a given labor force, the higher is output,
the lower is the unemployment rate. (Y u)
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7-1 Aggregate Supply

Chapter 7: Putting All Markets Together: The ASAD Model

Step 3: Replace the unemployment rate in the equation obtained in

step one gives us the aggregate supply relation:

Y
P P (1 m)F(1 , z)
L
e

In words, the price level, P, depends on the expected

price level, Pe, and the level of output, Y (and also m, z,
and L, but we take those as constant here).

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7-1 Aggregate Supply

The AS relation has two important properties:

Chapter 7: Putting All Markets Together: The ASAD Model

Y P :

An increase in output (Y) leads to an increase in the price

level (P). This is the result of four steps:

Y N u W P
1.An increase in output leads to an increase in employment.

(Y N)

2.The increase in employment leads to a decrease in unemployment and

N
therefore to a decrease in the unemployment rate.
(u 1 )

3.The lower unemployment rate leads to an increase in the nominal wage.

(W P eF(u, z))

The increase in the nominal wage leads to an increase in the prices set by
(P (1 m)W)
firms and therefore to an increase in the price level.

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7-1 Aggregate Supply

The second property of the AS relation is that:

Chapter 7: Putting All Markets Together: The ASAD Model

P e P : An increase in the expected price level leads, one for one,

to an increase in the actual price level. This effect works through
wages:

P e W P
1.

If wage setters expect the price level to be higher, they set a higher nominal
e
wage. (W P F(u, z))

2.

The increase in the nominal wage leads to an increase in costs, which leads
to an increase in the prices set by firms and a higher price level.

(P (1 m)W)

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7-1 Aggregate Supply

AS relation: Y vs. P

Y
P P (1 m)F(1 , z)
L

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 1
The Aggregate Supply
Curve
Given the expected price level,
an increase in output leads to
an increase in the price level.
If output is equal to the natural
level of output, the price level is
equal to the expected price
level.

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7-1 Aggregate Supply

Y
P P (1 m)F(1 , z)
L

Chapter 7: Putting All Markets Together: The ASAD Model

The AS curve has three properties that will prove useful in

what follows:
The aggregate supply curve is upward sloping.(Y and P
are endogenous variables)

Y P
The aggregate supply curve goes through point A, where
Y = Yn and P = Pe.
An increase in the expected price level, Pe, shifts the
aggregate supply curve up. Conversely, a decrease in the
expected price level, Pe, shifts the aggregate supply curve
down. (Pe is an exogenous variable)
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Chapter 7: Putting All Markets Together: The ASAD Model

7-1 Aggregate Supply

Figure 7 - 2
The Effect of an Increase
in the Expected Price
Level on the Aggregate
Supply Curve

(P e )

An increase in the expected

price level shifts the aggregate
supply curve up.

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7-1 Aggregate Supply

Chapter 7: Putting All Markets Together: The ASAD Model

What causes AS curve to shift?

Changes in Available Resources and Technology

Changes in the Expected Price Level

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7-1 Aggregate Supply

Chapter 7: Putting All Markets Together: The ASAD Model

Lets summarize:
Starting from wage determination and price determination
in the labor market, we have derived the aggregate supply
relation.
This means that for a given expected price level, the price
level is an increasing function of the level of output. It is
represented by an upward-sloping curve, called the
aggregate supply curve.
Increases in the expected price level shift the aggregate
supply curve up; decreases in the expected price level shift
the aggregate supply curve down.

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Chapter 7: Putting All Markets Together: The ASAD Model

7-2 Aggregate Demand

The aggregate demand relation captures the effect of the
price level (P) on output (Y). It is derived from the
equilibrium conditions in the goods and financial markets
described in Chapter 5:

IS r e la tio n : Y C (Y T ) I (Y ,i ) G

M
L M r e la tio n :
Y L (i)
P

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7-2 Aggregate Demand

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 3
The Derivation of the
Aggregate Demand
Curve
An increase in the price level
leads to a decrease in output.

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7-2 Aggregate Demand

AD relation: P vs. Y

Chapter 7: Putting All Markets Together: The ASAD Model

Y Y
,G ,T
P

(, , )

Endogenous variables: P and Y;

Exogenous variables: M, G, T, etc.
Changes in monetary (M) or fiscal policy (T/G)or more generally in
any variable, other than the price level (P), that shift the IS or the LM
curvesshift the AD curve.
The negative relation between output and the price level is drawn
as the downward-sloping curve AD.

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7-2 Aggregate Demand

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 4
Shifts of the Aggregate
Demand Curve
At a given price level, an
increase in government
spending increases output,
shifting the aggregate demand
curve to the right. At a given
price level, a decrease in
nominal money decreases
output, shifting the aggregate
demand curve to the left.

Y Y
,G ,T
P

( , , )

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7-2 Aggregate Demand

Chapter 7: Putting All Markets Together: The ASAD Model

What Factors Shift the AD Curve?

Demand Shocks

Consumer Confidence (+)

Business Confidence (+)
Willingness of foreigners to purchase domestic goods (+)
Etc.

Stabilization Policy:
Fiscal Policy
Monetary Policy

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7-2 Aggregate Demand

Chapter 7: Putting All Markets Together: The ASAD Model

Lets summarize:
Starting from the equilibrium conditions for the goods and financial
markets, we have derived the aggregate demand relation.
This relation implies that the level of output is a decreasing function
of the price level. It is represented by a downward-sloping curve,
called the aggregate demand curve.
Changes in monetary or fiscal policy or more generally in any
variable, other than the price level, that shifts the IS or the LM
curves shift the aggregate demand curve.

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7-3 Equilibrium in the Short Run

and in the Medium Run

Chapter 7: Putting All Markets Together: The ASAD Model

AS relation:
AD relation:

Y
P P (1 m)F(1 , z)
L
M
Y Y( , G,T)
P
e

Equilibrium depends on the value of Pe. The value of Pe

determines the position of the aggregate supply curve,
and the position of the AS curve affects the equilibrium.

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7-3 Equilibrium in the Short Run

and in the Medium Run

Equilibrium in the Short Run

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 5
The Short-Run
Equilibrium
The equilibrium is given by the
intersection of the aggregate
supply curve and the
aggregate demand curve. At
point A, the labor market, the
goods market, and financial
market are all in equilibrium.
The aggregate supply curve AS is
drawn for a given value of Pe.

The aggregate demand curve AD

is drawn for given values of M, G,
and T.

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7-3 Equilibrium in the Short Run

and in the Medium Run

From the Short Run to the Medium Run

Chapter 7: Putting All Markets Together: The ASAD Model

At point A,

Y Yn P P

Wage setters will revise upward

their expectations of the future
price level (Pe>Pe). This will
cause the AS curve to shift
upward.
Expectation of a higher price
level also leads to a higher
nominal wage, which in turn
leads to a higher price level.

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7-3 Equilibrium in the Short Run

and in the Medium Run

From the Short Run to the Medium Run

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 6
The Adjustment of
Output over Time
If output is above the natural
level of output, the AS curve
shifts up over time until output
has fallen back to the natural
level of output.

Y Yn and P P

The adjustment ends once wage

setters no longer have a reason to
change their expectations.
In the medium run, output returns to
the natural level of output.

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7-3 Equilibrium in the Short Run

and in the Medium Run

From the Short Run to the Medium Run

Chapter 7: Putting All Markets Together: The ASAD Model

Lets summarize:
In the short run, output can be above or below the
natural level of output. Changes in any of the variables
that enter either the aggregate supply relation or the
aggregate demand relation lead to changes in output
and to changes in the price level.
In the medium run, output eventually returns to the
natural level of output. The adjustment works through
changes in the price level.

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7-4 The Effects of a Monetary Expansion

The Dynamics of Adjustment

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 7
The Dynamic Effects of
a Monetary Expansion
A monetary expansion leads to
an increase in output in the
short run but has no effect on
output in the medium run.
In the short run, AD AD

In the medium run, AS AS

The increase in prices is

proportional to the increase in
the nominal money stock.

Y
P P e(1 m)F(1 , z)
L
M

,G ,T
P

Y Y

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7-4 The Effects of a Monetary Expansion

Going Behind the Scenes

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 8
The Dynamic Effects of a
Monetary Expansion on Output
and the Interest Rate
The increase in nominal money initially shifts
the LM curve down, decreasing the interest
rate and increasing output. Over time, the
price level increases, shifting the LM curve
back up until output is back at the natural
level of output.

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7-4 The Effects of a Monetary Expansion

Chapter 7: Putting All Markets Together: The ASAD Model

The Neutrality of Money

In the short run, a monetary expansion leads to an
increase in Y, a decrease in the i, and an increase in the
P.
In the medium run, the increase in nominal money is
reflected entirely in a proportional increase in the price
level. The increase in nominal money has no effect on
Y or on i.
The absence of a medium-run effect of money on Y and
i is referred as money is neutral in the medium run.
The neutrality of money in the medium run does not mean
that monetary policy cannot or should not be used to affect
output.
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Chapter 7: Putting All Markets Together: The ASAD Model

How Long Lasting Are the Real Effects of Money?

Figure 1
The Effects of an
Expansion in
Nominal Money in
the Taylor Model

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7-5 A Decrease in the Budget Deficit

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 9
The Dynamic Effects of a
Decrease in the Budget
Deficit
A decrease in the budget deficit
leads initially to a decrease in
output. Over time, however, output
returns to the natural level of
output.
In the short run, AD AD

In the medium run, AS AS

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7-5 A Decrease in the Budget Deficit

Chapter 7: Putting All Markets Together: The ASAD Model

Deficit Reduction, Output,

and the Interest Rate
Figure 7 - 10
The Dynamic Effects of a
Decrease in the Budget
Deficit on Output and
the Interest Rate
A deficit reduction leads in the
short run to a decrease in
output and to a decrease in the
interest rate. In the medium
run, output returns to its natural
level, while the interest rate
declines further.

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7-5 A Decrease in the Budget Deficit

Chapter 7: Putting All Markets Together: The ASAD Model

Deficit Reduction, Output, and the Interest Rate

The composition of output is different than it was before deficit
reduction.

IS r e la tio n : Y n C (Y n T ) I (Y n ,i ) G
Y and T remain unchanged, thus, C is the same as
before.

G I
Investment is higher by an amount exactly equal to the
decrease in G.

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7-5 A Decrease in the Budget Deficit

Budget Deficits, Output, and Investment

Chapter 7: Putting All Markets Together: The ASAD Model

Lets summarize:

In the short run, a budget deficit reduction, if

implemented alone leads to a decrease in output and
may lead to a decrease in investment.

In the medium run, output returns to the natural level of

output, and the interest rate is lower. A deficit reduction
leads unambiguously to an increase in investment.

It is easy to see how our conclusions would be modified if

we did take into account the effects on capital
accumulation. In the long run, the level of output
depends on the capital stock in the economy.

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7-6 Changes in the Price of Oil

Figure 7 - 11

Chapter 7: Putting All Markets Together: The ASAD Model

The Nominal and the Real

Price of Oil, 19702010

Over the last 40 years, there

have been three sharp
increases in the real price of
the oil. The first two increases
took place in the 1970s. The
more recent one took place in
the 2000s, until the crisis hits.

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7-6 Changes in the Price of Oil

Effects on the Natural Rate of Unemployment

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 12
The Effects of an
Increase in the Price of
Oil on the Natural Rate
of Unemployment
An increase in the price of oil
leads to a lower real wage and
a higher natural rate of
unemployment.

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7-6 Changes in the Price of Oil

Chapter 7: Putting All Markets Together: The ASAD Model

The Dynamics of Adjustment

Y
P P (1 m)F(1 , z)
L
e

An increase in the markup, m, caused by an increase in the

price of oil, results in an increase in the price level, at any level
of output, Y. The aggregate supply curve shifts up.
m(The price of oil ) P AS shifts up

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7-6 Changes in the Price of Oil

The Dynamics of Adjustment

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 13
The Dynamic Effects of
an Increase in the Price
of Oil
An increase in the price of oil
leads, in the short run, to a
decrease in output and an
increase in the price level.
Over time, output decreases
further, and the price level
increases further.

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7-6 Changes in the Price of Oil

Chapter 7: Putting All Markets Together: The ASAD Model

The Dynamics of Adjustment

In the short run, the economy
moves along the AD curve,
from A to A. Output
decreases from Yn to Y.

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7-6 Changes in the Price of Oil

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 14
Oil Price Increases and
Inflation in the United
States Since 1970
The oil price increases of the
1970s were associated with
large increases in inflation. This
was however the case in the
2000s.

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7-6 Changes in the Price of Oil

Chapter 7: Putting All Markets Together: The ASAD Model

Figure 7 - 15
Oil Price Increases and
Unemployment in the
United States Since 1970
The oil price increases of the
1970s were associated with
large increases in inflation. This
was however the case in the
2000s.

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Chapter 7: Putting All Markets Together: The ASAD Model

Focus: Oil Price Increases: Why Were the 2000s so Different

from the 1970s?
Figure 1 The Effects of a 100% Permanent Increase in the Price of Oil on the
CPI and on GDP. The effects of an increase in the price of oil on output and the
price level are smaller than they used to be

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7-7 Conclusions

Chapter 7: Putting All Markets Together: The ASAD Model

Table 7-1 Short-Run Effects and Medium-Run Effects of a Monetary Expansion

and a Budget Deficit Reduction on Output, the Interest Rate, and the Price
Level

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7-7 Conclusions

Chapter 7: Putting All Markets Together: The ASAD Model

Shocks and Propagation Mechanisms

Output fluctuations (sometimes called business cycles)
are movements in output around its trend.
The economy is constantly hit by shocks to aggregate
supply, or to aggregate demand, or to both.
Each shock has dynamic effects on output and its
components. These dynamic effects are called the
propagation mechanism of the shock.

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Chapter 7: Putting All Markets Together: The ASAD Model

Key Terms

aggregate supply relation

aggregate demand relation
neutrality of money
macroeconometric models

stagflation
output fluctuations, business
cycles
shocks
propagation mechanism

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Chapter 7: Putting All Markets Together: The ASAD Model

Sample Questions
1. Based on the aggregate supply relation, an increase in current output will cause
A) a shift of the aggregate supply curve.
B) an increase in the current price level.
C) a change in the expected price level this year.
D) an increase in the expected price level and an upward shift of the AS curve.
E) an increase in the markup over labor costs.
2. Which of the following will cause the aggregate supply curve to shift down?
A) an increase in firms' markup over labor costs
B) an increase in the expected price level
C) an increase in unemployment benefits
D) all of the above
E) none of the above

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Chapter 7: Putting All Markets Together: The ASAD Model

Sample Questions
3. When the current price level is equal to the expected price level, we know that
A) the unemployment rate is zero.
B) the goods market and financial markets are in equilibrium.
C) the output is equal to the natural level of output.
D) the money market is in equilibrium.
E) none of the above
4. When the economy is operating at a point where output is greater than the natural level
of output, which of the following occurs?
A) the unemployment rate is less than the natural unemployment rate.
B) the price level is greater than the expected price level.
C) the price level will be higher next period than it is this period.
D) all of the above
E) none of the above

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Sample Questions

Chapter 7: Putting All Markets Together: The ASAD Model

Essay Questions:
1.Explain how a reduction in each of the following variables affects the aggregate price
level (P): (1) the expected price level; (2) employment; (3) the markup; and (4)
unemployment benefits.
2.Explain what is meant by the neutrality of money.

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