Macroeconomics 1

The AD-AS Model

Presenter: Ankita Mandal
Date: 21 August, 2024
2 Aggregate Supply

 The aggregate supply relation, depicting the effects of output on the price level, is derived
from labor market.
 Wage-setting relation
𝑊 = 𝑃𝑒 𝐹 𝑢, 𝑧
 Price-setting relation
P= 1+𝑚 𝑊
 From the above two relation we get, the price level P depends on the expected price
level, unemployment, price markup and the catchall variable z.
3 Aggregate Supply

 We have
𝑁 𝑌
𝑢= 1− = 1−
𝐿 𝐿
 Replacing u we get,
𝑌
P=𝑃 1+𝑚𝑒
𝐹 1− ,𝑧
𝐿
+
 The price level P depends on the expected price level Pe and the level of output Y,
along with m, L, and z
4 Aggregate Supply

 Properties of AS:
 Given expected price level, an increase in output -> decrease in unemployment -> increase
in nominal wage rate -> increase in price level
 Given unemployment rate, an increase in the expected price level -> one for one increase in
actual price level.
 The relation between the price level P and output Y, for a given value of the expected
price level Pe, gives the AS curve.
 An increase in the expected price level Pe shifts the aggregate supply curve up.
Conversely: A decrease in the expected price level shifts the aggregate supply curve
down.
5 Aggregate Supply

Fig: The Aggregate Supply Curve Fig: The Effect of an Increase in the Expected Price Level on the
Aggregate Supply Curve
6 Aggregate Demand

 The aggregate demand relation captures the effect of the price level on output.
 The goods market equilibrium
𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑌, 𝑖 + 𝐺
 Financial market equilibrium
𝑀
= 𝑌 𝐿(𝑖)
𝑃
 Using the IS and LM relations, we can derive the relation between the price level and the level of output
giving the goods and financial markets equilibrium.
 This gives a negative relation between output and the price level, which gives the downward–sloping
AD curve
7 Aggregate Demand

Fig: The Derivation of the Aggregate

Demand Curve
8 Aggregate Demand

𝑀
𝑌 = 𝑌( , 𝐺, 𝑇)
𝑃
+, +, −
 Any variable other than the price level that shifts either the IS
curve or the LM curve also shifts the aggregate demand
relation.
 Example1, consider an increase in government spending.
G increases -> At a given price level, the level of output
implied by equilibrium in the goods and the financial markets
is higher -> the aggregate demand curve shifts to the right.
 Example2, consider a decrease in M.
M decreases -> At a given price level, the level of output
implied by equilibrium in the goods and the financial markets
is lower -> the aggregate demand curve shifts to the left. Fig: Shifts of the Aggregate Demand Curve
9 Quiz

Q. Suppose that the interest rate has no effect on investment.

1. What does this imply for the slope of the IS curve?
2. What does this imply for the slope of the LM curve?
3. What does this imply for the slope of the AD curve?
10 Quiz

Q. Suppose that the interest rate has no effect on investment.

1. What does this imply for the slope of the IS curve?
2. What does this imply for the slope of the LM curve?
3. What does this imply for the slope of the AD curve?
Solution:
1. The IS curve is vertical; the interest rate does not affect equilibrium
output.
2. The LM curve is unaffected.
3. The AD curve is vertical; the price level does not affect equilibrium
output.
11 Equilibrium in Short Run, Medium Run and Long
Run

 The short run the AS curve is horizontal (the Keynesian

aggregate supply curve); in the long run the AS curve
is vertical (the classical aggregate supply curve).
 The Keynesian aggregate supply curve is horizontal
due to “short-run price stickiness”. This indicates that
firms will supply whatever amount of goods is Fig: Equilibrium in SR – The Keynesian Case
demanded at the existing price level.
 In the long run, prices are fully flexible and the
classical aggregate supply curve is vertical, indicating
that the same amount of goods will be supplied
whatever the price level.

Fig: Equilibrium in LR – The Classical Case

12 Equilibrium in Short Run, Medium Run and Long
Run
 In the medium run, prices are neither rigid, nor fully
flexible. The AS is upward slopping.
 Transition from medium run to long run AS:
 At point A, output exceeds the natural level of output and
the price level is higher than the expected price level.
 This leads the economic agents to revise upward their Fig: Equilibrium in Medium Run
expectations.
 Next time they set higher nominal wages.
 The AS curve shifts up.
 This adjustment repeats and It ends when the AS curve has
shifted all the way to AS’’, when the equilibrium has moved
all the way to A’’, and the equilibrium level of output is
equal to Yn.

Fig: The Adjustment of Output over Time

13 Effects of monetary expansion
 For a given price level P, M increases -> real money stock
increases -> LM curve down from LM to LM’’ -> The aggregate
demand curve shifts to the right -> price level goes above P -> LM
shifts back to LM’ creating the new equilibrium t A’
 Output increases from Yn to Y, and the price level increases from
P to P’.
 Over time the price level continues to increase, as output is
above its natural level.
 As the price level increases, it further reduces the real money
stock and shifts the LM curve back up to initial level.
 On the other hand, the adjustment of price level expectations
shifts up AS till the equilibrium reaches A’’.
 The Neutrality of Money - 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
output or on the interest rate.

Fig: The Dynamic Effects of a Monetary Expansion on

Output and the Interest Rate
14 A Decrease in the Budget Deficit
 Suppose the government wants to decrease its budget
deficit by reducing its spending while leaving taxes T
unchanged.
 As a result, the IS curve shifts to the left.
 The price level declines in response to the decrease in
output.
 This leads to to a partially offsetting shift of the LM curve,
down to LM’.
 So long as output remains below the natural level of
output, the price level continues to decline and the LM
curve continues to shift down.
 The economy moves down from point A’ along IS’, till it
reaches A’’, where output is back at the natural level of
output.
 Because income Yn and taxes T are unchanged,
consumption remains same, while investment increases
exactly equal to the decrease in G.
Fig: The Dynamic Effects of a Decrease in the Budget
Deficit on Output and the Interest Rate
15 Quiz

Q. Continue to assume that the interest rate has no effect on investment.

Assume that the economy starts at the natural level of output. Suppose there is
a shock to the variable z, so that the AS curve shifts up.
1. What is the short-run effect on output and the price level?
2. What happens to output and the price level over time?
16 Quiz

Q. Continue to assume that the interest rate has no effect on investment. Assume that the
economy starts at the natural level of output. Suppose there is a shock to the variable z, so that
the AS curve shifts up.
1. What is the short-run effect on output and the price level?
2. What happens to output and the price level over time?
Solution:
1. The increase in z reduces the natural level of output and shifts the AS curve
up. Since the AD curve is vertical, equilibrium output does not change, but
the price level increases. Note that output is above its natural level.
2. Since Y>Yn and P>Pe. Therefore, Pe rises and the AS curve shifts up. In fact,
the AS curve shifts up forever, and the price level increases forever.
Output does not change; it remains above its natural level forever.
17 Quiz

Q. What are the effects of a reduction in income taxes on the position of the AD,
AS, IS, and LM curves in the long run?
18 Quiz

Q. What are the effects of a reduction in income taxes on the position of the AD,
AS, IS, and LM curves in the long run?

Solution: IS shifts right -> AD shifts right -> P increases, Y increases

over natural level -> M/P falls -> LM shifts left -> AS shifts up.
19 An Increase in the Price of Oil

Fig: The Nominal and the Real Price of Oil, 1970–2010

20 An Increase in the Price of Oil
 As a result of increase in oil price, the cost of
production went up, given the nominal wage
rate -> mark up increases -> real wage falls by
price-setting rule -> natural rate of
unemployment goes up.
 As shifts up to AS’. The output goes down to Y’.
 The output is above the new natural rate of Fig: The Effects of an Increase in the Price of Oil on the Natural Rate of
output Yn’. Unemployment

 The AS curve continues to shift up till A’’ where

Yn’ is reached.
 At new equilibrium, output goes down to a lower
natural level of output and the price level is
higher than before the oil shock.

Fig: The Dynamic Effects of an Increase in the Price of Oil

21 Problem

Q. Suppose the price-setting equation is given by

P = 1 + 𝑚 𝑊 𝑎 𝑃𝐸1−𝑎
where 𝑃𝐸 is the price of energy resources and 0 < 𝑎 < 1.
Ignoring a multiplicative constant, 𝑊 𝑎 𝑃𝐸1−𝑎 is the marginal cost function that would
result from the production technology
Y = 𝑁 𝑎 𝐸1−𝑎
The wage-setting relation is given by
𝑊 = 𝑃(1 − 𝑢)
Assuming the labor force L, obtain the aggregate supply relation.
Hint: Substitute the wage-setting relation into the price-setting relation.
22 Problem

Q. Suppose the price-setting equation is given by

P = 1 + 𝑚 𝑊 𝑎 𝑃𝐸1−𝑎
where 𝑃𝐸 is the price of energy resources and 0 < 𝑎 < 1.
Ignoring a multiplicative constant, 𝑊 𝑎 𝑃𝐸1−𝑎 is the marginal cost function that would result from the
production technology
Y = 𝑁 𝑎 𝐸1−𝑎
The wage-setting relation is given by
𝑊 = 𝑃(1 − 𝑢)
Assuming the labor force L, obtain the aggregate supply relation.
Hint: Substitute the wage-setting relation into the price-setting relation.
1
𝑃𝐸 (1+𝑚)1/(1−𝑎)
Solution: P = 𝑌 1−𝑎
𝐿𝑎/(1−𝑎) 𝐸
 Reading: Olivier Blanchard, David R. Johnson. (2012). Macroeconomics (6th Edition). : Pearson.
23
For queries, reach out to me at ankitam@igidr.ac.in