The AD-AS model

Lecture 24 – academic year 2014/15Introduction to Economics

Fabio Landini

Questions of the day…

• How do we describe the functioning of the economy in the medium period?

• Which are the features of the equilibrium in the medium period?

• What differentiates the medium period equilibrium from the short period one?

What do we do today?

• Premise: short vs. medium period

• Construction of the AS curve

• Construction of the AD curve

• Equilibrium in the short and medium period

Premise: short vs. medium period

In Lecture 17 we distinguished three different time horizons: short, medium and long period

What differentiates short and medium period?

1)Degree of price flexibility•Short period -> prices are partially flexible•Medium (and long) period -> prices are fully flexible

Flexible prices -> Price adjustment mechanism

Premise: short vs. medium period

2) Accuracy of expectations

In deriving the equilibrium of the labour market using the WS – PS model we assumed P=PE.

P=PE is correct in the medium period because workers have time to adjust expectations.

If P=PE then u=un e Y = YN

Premise: short vs. medium period

In the short period, however, workers can have wrong expectations : P can differ from PE.

The real wage that workers seek on the basis of wrong expectation can differ from the real wage that is set by firms while fixing the prices.

When this happens:•P differ from PE

•u differ from un

•Y differ from Yn

In the short-period this is possible… in the medium period, however, the economy tends to go back to its natural valuesThe AD-AS model will explain us why…

Premise: short vs. medium period

WS W/PE = F(u,z)

PS W/P= 1/ 1+

If P differ from PE -> W/P differ from da W/PE

-> F(u,z) differ from 1/1+ -> u differ from da un

In the short-period, the unemployment rate, the employment level and the level of production can differ from the natural values

Premise: short vs. medium period

The AS/AD model

Our aim is to build a model to determine production in the medium period.

In this model prices are flexible.

To achieve the economic equilibrium we need to have: equilibrium of good market + equilibrium of financial market + equilibrium of labour market where prices are formed

To build this model we start by constructing the AS curve, which reflects the equilibrium in the labour market (this curve captures the effect of production on prices).

Then, we will build the AD curve, which reflects the equilibrium of both the good market and the financial market (this curve captures the effect of prices on production).

The AS/AD model

Construction of the AS curveAS curve -> equilibrium in the labour market

Labour market•WS -> W = PE F(u,z)•PS -> P = W(1+) -> = W

Labour market equilibrium -> WS and PS simultaneously verified

By substituting PS in WS -> = PE F(u,z)from which we get P= PE (1+ ) F(u,z)

Construction of the AS curve

In the model of the labour market (WS – PS) we assumed P=PE

Under this Hp., u=un where un is the natural rate of unemployment

The Hp. P=PE is correct in the medium period -> un is the rate of unemployment in the medium period

From the definition of unemployment:

Construction of the AS curve

We know that, Unemployed = Labour Forces – Employed U = L – N

Therefore,

Finally, the assumption Y=N implies

When P=PE we have u=un and where Yn is the natural level of production

PE=P -> u=un -> Y=Yn

LY

1u

LN

1L

NLLU

u

L

Y1u n

n

Construction of the AS curve

By substituting in P = PE (1+m) F(u,z) we get

P= PE (1+m) F( , z)

+

which is called equation of aggregate supply (AS)

The equation shows a positive relationship between P and Y

Y -> -> F( , z) -> P

LY

1u

Costruzione della curva AS

Economic intuition (labour market):

• Y ->

• Employment N ->

• u ->

• Workers’ bargaining power ->

• W (via mark up) ->

• P

The relationship between P and Y is increasing -> the AS equation is an increasing curve in a (Y,P) diagram

AS curve -> Equilibrium in the labour marketImportant: the curve is not necessarily a straight line

ASP

Y

ASP

Y

What happens if the expected prices vary?

AS -> P = PE (1+m) F( , z)

PE -> P -> AS curve shifts upward AS’

The AS curve, expected and effective level of prices

The aggregate supply (AS) curve passes through a specific point in which the level of expected prices is equal to the level of effective prices and the level of production is equal to the natural level of production.

ASP

Y

P=PE

YN

A

In A and only in A P=PE and Y=YN

To the right of A P>PE and Y>YN

To the left of A P<PE and Y<YN

The curve represent the equilibrium on both the good market and the financial market with flexible prices.

It allows one to examine the effects of the level of prices on production.

The AD curve is built starting from the IS-LM curves

Construction of the AD curve

Let’s consider now the goods market and the financial markets togetherIS-LM model : IS -> Y= C(YT) + I(Y,i) + G;

LM -> MS/P = YL(i)

i

Y

LM

IS

Construction of the AD curve

Pair (i,Y) for which both markets are in equilibrium

E

So far we considered a model with fixed PWhat happens if P varies (medium period)?P affects the position of the LM curve P -> MS/P -> same as MS -> LM shifts leftwardEffects: E-> E’ and YE-> YE’ -> YIn equilibrium: P -> Y

i

Y

IS

LM

LM’

YEYE’

E

E’

Decreasing relationship between Y and P -> AD curve

AD curve -> Equilibrium in goods market and financial marketsImportant: The curve is not necessarily a straight line

P

Y

AD

What happens when we vary Ms/P, G e T ?

a) Ms/P (expansionary monetary policy) -> LM shifts rightward -> Y

Y occurs for any level of P -> AD shifts rightward

AD

P

Y

AD’

A similar effect occurs if Gb) G -> IS shifts rightward -> Y Y occurs for any level of P -> AD shifts

rightward

AD

P

Y

AD’

c) T -> IS shifts leftward -> Y given P

Y occurs for any level of P -> AD shifts leftward

AD’

P

Y

AD

The preceding results suggest when the goods market and the financial markets are in equilibrium, Y is:

•An increasing function of

•An increasing function of G

•A decreasing function of T

Therefore we have, AD curve: Y=Y( , G, T)

+ + -

PMS

PMS

Construction of the AD curve

Determination of the equilibriumIn the equilibrium point AS and AD are simultaneously verified

Graphically -> Intersection of AD and AS

Equilibrium of the system -> Point A -> Y=YA e P=PAP

Y

AS

AD

APA

YA

In point A:

• Along the AS -> labour market in equilibrium

• Along the AD -> goods market and financial market in equilibrium

P

Y

AS

AD

APA

YA

Determination of the equilibrium

Determination of the equilibriumPoint A can represent the equilibrium both in the short and in the medium period, depending on the assumption on PE

The position of A, indeed, depends on the position of the AS curve and thus on PE

In particular :

•Medium period, PE=P -> u=un -> Y=Yn

In the medium period equilibrium Y is always equal to Yn

•Short period, PE can be ≠ P -> Y ≠ Yn

Three cases:

PE=P -> Y=Yn ; PE>P -> Y<Yn ; PE<P -> Y>Yn

Let’s consider the case PE<P -> YA>Yn

In the medium period the equilibrium is always along Yn

AS

AD

P

Y

A

YAYn

How do we move from the short period eq. A to the medium period equilibrium?

Next class….

AS

AD

P

Y

A

YAYn