2003-7-20 1
Chapter 9,Putting All Market
Together,The AS-AD Model
9-1,Aggregate Supply
9-2,Aggregate Demand
9-3,Equilibrium Output in the Short and the
Medium Run
9-4,The Effects of a Monetary Expansion
9-5,A Decrease in the Budget Deficit
9-6,Changes in the Price of Oil
9-7,Conclusions
2003-7-20 2
9-1,Aggregate Supply
Recall our characterization of wage and price
determination in chapter 8
W = Pe F(u,z)
P = (1+ μ)W
Combining these two equation
P= Pe (1+ μ) F(u,z)
∵ u≡ U/L = (L-N)/L = 1- N/L = 1- Y/L
∴ P= Pe (1+ μ) F[(1-Y/L),z] (9.1)
to continue
2003-7-20 3
The Derivation of the Aggregate Supply
Relation
Note two things about equation (9.1):
1,A higher expected price level leads,one for one,to a higher
actual price level
2,An increase in output leads to an increase in the price
level.This is the result of four underlying steps:
? An increase in output to an increase in employment
? The increase in employment leads to a decrease in
unemployment rate.
? The lower unemployment rate leads to an increase in
nominal wages
? The increase in nominal wages leads to an increase in costs,
which leads firms to increase prices.
to continue
2003-7-20 4
The characteristics of the aggregate
supply curve in figure 9-1
It is upward sloping
When output is above its natural level,the price level is
higher than expected,P> Pe,Conversely,when output is
below its natural level,the price level is lower than expected,
P< Pe,
It goes through point A,where Y= Yn and P= Pe,That is,if
output is equal to its natural level Yn,then the price level is
equal to the expected price level,P= Pe,
An increase in the expected price level shifts the aggregate
supply curve up,Conversely,a decrease in the expected
price level shifts the aggregate supply curve down,
Figure 9-1:The Aggregate Supply Curve
P r i c e l e v e l,P A S
(a ) P
e
A
Y
n
O u t p u t Y
P r i c e l e v e l,P A S 1 (for P
e
1 > P
e
)
A S (fo r P
e
)
P
e
1 A 1
(b )
P
e
A
Y
n
O u t p u t Y
2003-7-20 6
9-2,Aggregate Demand
(goods market) IS,Y = C(Y-T) + I(Y,i) + G
(Financial market) LM,M/P = YL(i)
We represent the aggregate demand relation by
Y=Y(M/P,G,T) (9.2)
( +,+,- )
Output is an increasing function of the real money
stock,an increasing function of government spending,
and a decreasing function of taxes,Given M,G,T,an
increase in price level P leads to a decrease in real
money stock,M/P,which leads to a decrease in output,
This is the relation capture by the AD curve in Figure
In t e r e st r a t e i L M 1
( f o r P 1 > P )
i 1 L M ( f o r P )
i
IS
Y 1 Y O u t p u t Y
P r ic e l e v e l p
P 1 A 1
P A A D
Y 1 Y O u t p u t Y
2003-7-20 8
9-3,Equilibrium Output in the Short and
the Medium Run
AS relation P= Pe (1+ μ) F[(1-Y/L),z]
AD relation Y= Y ( M/P,G,T )
The equilibrium is given by the intersection of the two
curves at point A,By construction,at point A,the
goods,financial,and the labor market are all in
equilibrium,The fact that the labor market is in
equilibrium comes from the fact that point A is on the
aggregate supply curve,The fact that goods and
financial markets are in equilibrium comes from the
fact that point A is also on the aggregate demand
curve,The equilibrium level of output and price level
are given by Y and P,
Figure 9-3,Equilibrium output and
price level
P r i c e l e v e l P
A S
P A
P
e
B A D
Y
n
Y
O u t p u t Y
2003-7-20 10
The Dynamics of output and the price level
As we look at the evolution of output and other variable over
time,the other thing we need to do is to introduce time indices,
So,Pt will refer to the price level in year t,Pt-1 to the price level
in year t-1,Pt+1 to the price level in year t+1,and so on.
Using the notation,the assumption that the expected price level
equals the price level last year is written as
Pte = Pt-1
And the aggregate supply and demand relation must now be:
AS relation Pt = Pt-1 (1+μ) F [(1-Yt / L),z] (9.3)
AD relation Yt = Y[ (M/ Pt),G,T ] (9.4)
Note that the parameters (μ,z) and the exogenous variables L,
M,G,T do not have a time subscript,This is because we shall
assume they remain constant,so there is no need for a time
2003-7-20 11
To summarize
IN the short run,output can be above or below its
natural level,Changes in any of the variables that
enter either the aggregate supply or aggregate
demand relation lead to changes in output and prices,
In the medium run,however,output eventually returns
to its natural level,The adjustment process works
through prices,When output is above its natural level,
prices increase,Higher prices decrease demand and
output,When output is below its natural level,prices
decrease,increasing demand and output,
2003-7-20 12
9-4,The Effects of a Monetary
Expansion
The Dynamics of Adjustment
Looking Behind the Scene
The Neutrality
2003-7-20 13
The Dynamics of Adjustment
Yt = Y [ (M/ Pt),G,T ) ] (9.4)
For a given price level Pt,the increase in money leads to an
increase in M/ Pt,Leading to an increase in output,The
aggregate demand curve shifts to the right,from AD to AD',
Output is higher,and so is the price level.
Over time,the adjustment of price expectations comes into play,
Seeing higher prices,wage setters ask for higher nominal
wages,which lead to higher prices,Prices keep rising,As long
as output exceeds its natural level,the aggregate supply curve
shifts up,The adjustment process stops when output has
returned to its natural level,In the medium run,the aggregate
supply curve is given by AS",and the economy is at point A",
Output is back to its natural level,and the price level is higher.
Figure 9-5,The Dynamic effects
of a Monetary Expansion
P r i c e Le v e l,P A S "
A S
A "
A 1
A A D ( fo r M 1 > M )
A D
Y
n
Y
O u t p u t,Y
2003-7-20 15
Looking Behind the scene
The increase in nominal money shifts the LM curve
down to LM",If the price level did not change,the
economy would move to point B.
But even in the short run,the price level increase with
output as the economy shifts along the aggregate
supply curve,So this increase in the price level shifts
the LM curve upward from LM" to LM',partially
offsetting the effect of the increase in nominal money.
To clear it,to see the figure 9-6:The dynamic effects of
a monetary expansion on output and the interest rate
P r i c e l e ve l,P
A "
( a) A S
A 1
A A D 1 ( f or M 1 > M )
A D
Y
n
Y
t
O u t p u t,Y
i n t e r e s t r at e,i L M
i A ( a n d A " ) L M 1
( b ) L M "
i
t
A 1
B I S
Y
n
Y
t
O u t p u t,Y
2003-7-20 17
The neutrality of money
In the short run,a monetary expansion leads to an
increase in output,a decrease in the interest rate,and
an increase in the price level,How much of the initial
effect falls on output and how much falls on prices
depends on the slope of the aggregate supply curve.
Over time,prices increase,and the effects of the
monetary expansion on output and the interest rate
disappear,In the medium run,the increase in nominal
money is reflected entirely in a proportional increase in
the price level; it has no effect on output or the interest
rate,Economists refer to the absence of medium-run
effects of money on output and the interest rate by
saying that money is neutral in the medium run.
2003-7-20 18
9-5,A Decrease in the Budget
Deficit
The Budget Deficit,Output,and the
Interest Rate
Budget Deficit,Output,and Investment
2003-7-20 19
A Outline
The decrease in government spending shifts the
aggregate demand curve to the left,The economy
therefore moves from A to A',leading to lower output
and lower prices,The initial effect of deficit reduction
is thus to trigger a recession.
Over time,as long as output is below its natural level,
the aggregate supply curve keeps shifting down,The
economy moves down along the aggregate demand
curve AD' until the aggregate supply curve is given by
AS" and the economy reaches point A",By then,the
initial recession is over,and output is back at Yn.
To clear it,see figure 9-7
Figure 9-7:The Dynamic Effects of a
Decrease in the Budget Deficit
P r i c e l e v e l,P A S
A S "
A
A 1
A " A D
A D 1 ( fo r G 1 <G )
Y
t
Y
n
O u t p u t,Y
2003-7-20 21
The Budget Deficit,Output,and
the Interest Rate
As the government reduces the budget deficit,the IS curve
shifts to the left,to IS',If the price level did not change,the
economy would move from Point A to point B,But,because
prices decline in response to the decrease in output,the real
money stock increases,leading to a partly offsetting shift of the
LM curve downward,to LM',The initial effect of deficit reduction
is thus to move the economy from A to A'.
Over time,output below the natural level leads to a further
decrease in prices,As long as output is below its natural level,
prices decrease,and the LM curve shifts down,Eventually,
output will be back at its natural level,But the interest rate is
lower than it was before deficit reduction.
To clear it,see the figure 9-8,The dynamic effects of a
decrease in the budget deficit on output and the interest rate.
P r i c e l e v e l,P A S
A
(a ) A 1
A " A D
AD 1 ( fo r G 1 <G )
Y
t
Y
n
O u t p u t,Y
I n te r e s t r a te,i
L M
i A LM 1
B
(b ) i 1 A 1 LM "
I S
i " A "
IS 1
Y
t
Y
n
O u t p u t,Y
2003-7-20 23
Budget Deficit,Output,and
Investment
1,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.
2.In the medium run,output returns to its natural level,
and the interest rate is lower,In the medium run,
deficit reduction leads to an increase in investment,So
far,we have not taken into account the effects of
investment on capital accumulation,and the effects of
capital on production,But it is easy to see how our
conclusions would be modified if we did,In the long
run,a lower budget deficit leads to higher investment,
Higher investment leads to a higher capital stock,
which leads to higher output.
2003-7-20 24
9-6:Changes in the price of oil
In thinking about the macroeconomic effects of an
increase in the price of oil,we face an obvious
problem,The price of oil appears neither in our
aggregate supply relation nor in our aggregate
demand relation,The reason is that we have assumed
thus far that output was produced using only labor.
In order to consider the effect of changes in the price
of oil,we shall use a shortcut and capture the increase
in the price of oil by an increase in μ,the markup of
prices over wages,This justification is straightforward,
given wages,an increase in the price of oil increase
the cost of production,forcing firms to increase prices
2003-7-20 25
Effect on the Natural Rate of
Unemployment
An increase in the markup leads to a downward shift
of the price-setting line,from PS to PS',The
equilibrium moves from A to A',The real wage is lower,
The natural unemployment rate is higher.
The increase in the natural rate of unemployment
implies a decrease in the natural level of employment,
If we assume the relation between employment and
output is unchanged,then the decrease in the natural
level of employment leads to an identical decrease in
the natural level of output.
To clear it,see the figure 9-10.
Figure 9-10:The effects of increase in
the price of oil on the natural rate of
unemployment
R e a l w a g e,W / P
1 / ( 1 + μ ) A P S
1 / (1 + μ 1 ) A 1 P S 1
( f o r μ 1 > μ )
W S
u
n
u
n
1
U n e m p l o y m e n t r a t e,u
2003-7-20 27
The dynamic of adjustment
Recall that the aggregate supply relation is given by:
Pt = Pt-1 (1+μ) F [(1-Yt / L),z]
An increase in the markup leads to an increase in the
price level (Pt ) at a given level of output (Yt),Thus,in
the short run,the aggregate supply curve shifts up.
Over time,although output has decreased,the natural
level of output has decreased even more,The
economy therefore moves over time from A' to A",
Shifts in aggregate supply affect output not only in the
short run but in the medium run as well.
Figure 9-11:The Dynamic Effects of
an Increase in the Price of oil
To clear it,see figure 9-11.
P r i c e Le v e l,P A S "
A S 1
A " A S
A 1
P
t - 1
B A
A D
Y
n
1 Y
n
O u t p u t,Y
2003-7-20 29
Table 9-1,The effects of increase
in the price of oil,1973-1975
1973 1974 1975
Rate of change of petroleum
price (%)
10.4 51.8 15.1
Rate of change of GDP
deflator (%)
5.6 9.0 9.4
Rate of GDP growth (%) 5.8 -0.6 -0.4
Unemployment rate (%) 4.9 5.6 8.5
2003-7-20 30
9-7,Conclusions
The short run versus the medium run
Shocks and Propagation Mechanisms
Output,Unemployment,and Inflation
2003-7-20 31
The short run versus the medium run
This difference between the short-and medium-run
effects of policies is one of the main reasons
economists disagree in their policy
recommendations,Some economists believe that
the economy adjusts quickly to its medium-run
equilibrium,and so they emphasize medium-run
implications of policy.
Others believe that the adjustment mechanism
through which output returns to its natural level is a
slow one at best,so they put more emphasis on the
short-run effects of policy.
2003-7-20 32
Short-and medium-run effects of all sorts of
policies
Short Run
Output level Interest rate Price level
Monetary expansion Increase Decrease Increase
Deficit reduction Decrease Decrease Decrease
Increase in oil price Decrease Increase Increase
Medium Run
Output level Interest rate Price level
Monetary expansion No change No change increase
Deficit reduction No change Decrease decrease
Increase in oil price decrease increase increase
2003-7-20 33
Shocks and Propagation Mechanisms
There are all sorts of shocks in our economy,Each
shock has dynamic effects on output and its
components,These dynamic effects are called the
propagation mechanism of the shock,Propagation
mechanism are different for different shocks,The
effects on activity may be largest at the beginning
and then they may decrease over time,Or the
effects may build up for while,and then decrease
and eventually disappear,
2003-7-20 34
Output,Unemployment,and Inflation
So far,we did not allow for sustained nominal money
growth,One implication of that assumption was that
the price level was constant in the medium run,that
there was no inflation,We must now relax this
assumption and allow for nominal money growth,
Only by doing so can we explain why inflation is
typically positive and think about the relation
between economic activity and inflation,Movements
in unemployment,output,and inflation are the topics
of the next two chapters.
Chapter 9,Putting All Market
Together,The AS-AD Model
9-1,Aggregate Supply
9-2,Aggregate Demand
9-3,Equilibrium Output in the Short and the
Medium Run
9-4,The Effects of a Monetary Expansion
9-5,A Decrease in the Budget Deficit
9-6,Changes in the Price of Oil
9-7,Conclusions
2003-7-20 2
9-1,Aggregate Supply
Recall our characterization of wage and price
determination in chapter 8
W = Pe F(u,z)
P = (1+ μ)W
Combining these two equation
P= Pe (1+ μ) F(u,z)
∵ u≡ U/L = (L-N)/L = 1- N/L = 1- Y/L
∴ P= Pe (1+ μ) F[(1-Y/L),z] (9.1)
to continue
2003-7-20 3
The Derivation of the Aggregate Supply
Relation
Note two things about equation (9.1):
1,A higher expected price level leads,one for one,to a higher
actual price level
2,An increase in output leads to an increase in the price
level.This is the result of four underlying steps:
? An increase in output to an increase in employment
? The increase in employment leads to a decrease in
unemployment rate.
? The lower unemployment rate leads to an increase in
nominal wages
? The increase in nominal wages leads to an increase in costs,
which leads firms to increase prices.
to continue
2003-7-20 4
The characteristics of the aggregate
supply curve in figure 9-1
It is upward sloping
When output is above its natural level,the price level is
higher than expected,P> Pe,Conversely,when output is
below its natural level,the price level is lower than expected,
P< Pe,
It goes through point A,where Y= Yn and P= Pe,That is,if
output is equal to its natural level Yn,then the price level is
equal to the expected price level,P= Pe,
An increase in the expected price level shifts the aggregate
supply curve up,Conversely,a decrease in the expected
price level shifts the aggregate supply curve down,
Figure 9-1:The Aggregate Supply Curve
P r i c e l e v e l,P A S
(a ) P
e
A
Y
n
O u t p u t Y
P r i c e l e v e l,P A S 1 (for P
e
1 > P
e
)
A S (fo r P
e
)
P
e
1 A 1
(b )
P
e
A
Y
n
O u t p u t Y
2003-7-20 6
9-2,Aggregate Demand
(goods market) IS,Y = C(Y-T) + I(Y,i) + G
(Financial market) LM,M/P = YL(i)
We represent the aggregate demand relation by
Y=Y(M/P,G,T) (9.2)
( +,+,- )
Output is an increasing function of the real money
stock,an increasing function of government spending,
and a decreasing function of taxes,Given M,G,T,an
increase in price level P leads to a decrease in real
money stock,M/P,which leads to a decrease in output,
This is the relation capture by the AD curve in Figure
In t e r e st r a t e i L M 1
( f o r P 1 > P )
i 1 L M ( f o r P )
i
IS
Y 1 Y O u t p u t Y
P r ic e l e v e l p
P 1 A 1
P A A D
Y 1 Y O u t p u t Y
2003-7-20 8
9-3,Equilibrium Output in the Short and
the Medium Run
AS relation P= Pe (1+ μ) F[(1-Y/L),z]
AD relation Y= Y ( M/P,G,T )
The equilibrium is given by the intersection of the two
curves at point A,By construction,at point A,the
goods,financial,and the labor market are all in
equilibrium,The fact that the labor market is in
equilibrium comes from the fact that point A is on the
aggregate supply curve,The fact that goods and
financial markets are in equilibrium comes from the
fact that point A is also on the aggregate demand
curve,The equilibrium level of output and price level
are given by Y and P,
Figure 9-3,Equilibrium output and
price level
P r i c e l e v e l P
A S
P A
P
e
B A D
Y
n
Y
O u t p u t Y
2003-7-20 10
The Dynamics of output and the price level
As we look at the evolution of output and other variable over
time,the other thing we need to do is to introduce time indices,
So,Pt will refer to the price level in year t,Pt-1 to the price level
in year t-1,Pt+1 to the price level in year t+1,and so on.
Using the notation,the assumption that the expected price level
equals the price level last year is written as
Pte = Pt-1
And the aggregate supply and demand relation must now be:
AS relation Pt = Pt-1 (1+μ) F [(1-Yt / L),z] (9.3)
AD relation Yt = Y[ (M/ Pt),G,T ] (9.4)
Note that the parameters (μ,z) and the exogenous variables L,
M,G,T do not have a time subscript,This is because we shall
assume they remain constant,so there is no need for a time
2003-7-20 11
To summarize
IN the short run,output can be above or below its
natural level,Changes in any of the variables that
enter either the aggregate supply or aggregate
demand relation lead to changes in output and prices,
In the medium run,however,output eventually returns
to its natural level,The adjustment process works
through prices,When output is above its natural level,
prices increase,Higher prices decrease demand and
output,When output is below its natural level,prices
decrease,increasing demand and output,
2003-7-20 12
9-4,The Effects of a Monetary
Expansion
The Dynamics of Adjustment
Looking Behind the Scene
The Neutrality
2003-7-20 13
The Dynamics of Adjustment
Yt = Y [ (M/ Pt),G,T ) ] (9.4)
For a given price level Pt,the increase in money leads to an
increase in M/ Pt,Leading to an increase in output,The
aggregate demand curve shifts to the right,from AD to AD',
Output is higher,and so is the price level.
Over time,the adjustment of price expectations comes into play,
Seeing higher prices,wage setters ask for higher nominal
wages,which lead to higher prices,Prices keep rising,As long
as output exceeds its natural level,the aggregate supply curve
shifts up,The adjustment process stops when output has
returned to its natural level,In the medium run,the aggregate
supply curve is given by AS",and the economy is at point A",
Output is back to its natural level,and the price level is higher.
Figure 9-5,The Dynamic effects
of a Monetary Expansion
P r i c e Le v e l,P A S "
A S
A "
A 1
A A D ( fo r M 1 > M )
A D
Y
n
Y
O u t p u t,Y
2003-7-20 15
Looking Behind the scene
The increase in nominal money shifts the LM curve
down to LM",If the price level did not change,the
economy would move to point B.
But even in the short run,the price level increase with
output as the economy shifts along the aggregate
supply curve,So this increase in the price level shifts
the LM curve upward from LM" to LM',partially
offsetting the effect of the increase in nominal money.
To clear it,to see the figure 9-6:The dynamic effects of
a monetary expansion on output and the interest rate
P r i c e l e ve l,P
A "
( a) A S
A 1
A A D 1 ( f or M 1 > M )
A D
Y
n
Y
t
O u t p u t,Y
i n t e r e s t r at e,i L M
i A ( a n d A " ) L M 1
( b ) L M "
i
t
A 1
B I S
Y
n
Y
t
O u t p u t,Y
2003-7-20 17
The neutrality of money
In the short run,a monetary expansion leads to an
increase in output,a decrease in the interest rate,and
an increase in the price level,How much of the initial
effect falls on output and how much falls on prices
depends on the slope of the aggregate supply curve.
Over time,prices increase,and the effects of the
monetary expansion on output and the interest rate
disappear,In the medium run,the increase in nominal
money is reflected entirely in a proportional increase in
the price level; it has no effect on output or the interest
rate,Economists refer to the absence of medium-run
effects of money on output and the interest rate by
saying that money is neutral in the medium run.
2003-7-20 18
9-5,A Decrease in the Budget
Deficit
The Budget Deficit,Output,and the
Interest Rate
Budget Deficit,Output,and Investment
2003-7-20 19
A Outline
The decrease in government spending shifts the
aggregate demand curve to the left,The economy
therefore moves from A to A',leading to lower output
and lower prices,The initial effect of deficit reduction
is thus to trigger a recession.
Over time,as long as output is below its natural level,
the aggregate supply curve keeps shifting down,The
economy moves down along the aggregate demand
curve AD' until the aggregate supply curve is given by
AS" and the economy reaches point A",By then,the
initial recession is over,and output is back at Yn.
To clear it,see figure 9-7
Figure 9-7:The Dynamic Effects of a
Decrease in the Budget Deficit
P r i c e l e v e l,P A S
A S "
A
A 1
A " A D
A D 1 ( fo r G 1 <G )
Y
t
Y
n
O u t p u t,Y
2003-7-20 21
The Budget Deficit,Output,and
the Interest Rate
As the government reduces the budget deficit,the IS curve
shifts to the left,to IS',If the price level did not change,the
economy would move from Point A to point B,But,because
prices decline in response to the decrease in output,the real
money stock increases,leading to a partly offsetting shift of the
LM curve downward,to LM',The initial effect of deficit reduction
is thus to move the economy from A to A'.
Over time,output below the natural level leads to a further
decrease in prices,As long as output is below its natural level,
prices decrease,and the LM curve shifts down,Eventually,
output will be back at its natural level,But the interest rate is
lower than it was before deficit reduction.
To clear it,see the figure 9-8,The dynamic effects of a
decrease in the budget deficit on output and the interest rate.
P r i c e l e v e l,P A S
A
(a ) A 1
A " A D
AD 1 ( fo r G 1 <G )
Y
t
Y
n
O u t p u t,Y
I n te r e s t r a te,i
L M
i A LM 1
B
(b ) i 1 A 1 LM "
I S
i " A "
IS 1
Y
t
Y
n
O u t p u t,Y
2003-7-20 23
Budget Deficit,Output,and
Investment
1,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.
2.In the medium run,output returns to its natural level,
and the interest rate is lower,In the medium run,
deficit reduction leads to an increase in investment,So
far,we have not taken into account the effects of
investment on capital accumulation,and the effects of
capital on production,But it is easy to see how our
conclusions would be modified if we did,In the long
run,a lower budget deficit leads to higher investment,
Higher investment leads to a higher capital stock,
which leads to higher output.
2003-7-20 24
9-6:Changes in the price of oil
In thinking about the macroeconomic effects of an
increase in the price of oil,we face an obvious
problem,The price of oil appears neither in our
aggregate supply relation nor in our aggregate
demand relation,The reason is that we have assumed
thus far that output was produced using only labor.
In order to consider the effect of changes in the price
of oil,we shall use a shortcut and capture the increase
in the price of oil by an increase in μ,the markup of
prices over wages,This justification is straightforward,
given wages,an increase in the price of oil increase
the cost of production,forcing firms to increase prices
2003-7-20 25
Effect on the Natural Rate of
Unemployment
An increase in the markup leads to a downward shift
of the price-setting line,from PS to PS',The
equilibrium moves from A to A',The real wage is lower,
The natural unemployment rate is higher.
The increase in the natural rate of unemployment
implies a decrease in the natural level of employment,
If we assume the relation between employment and
output is unchanged,then the decrease in the natural
level of employment leads to an identical decrease in
the natural level of output.
To clear it,see the figure 9-10.
Figure 9-10:The effects of increase in
the price of oil on the natural rate of
unemployment
R e a l w a g e,W / P
1 / ( 1 + μ ) A P S
1 / (1 + μ 1 ) A 1 P S 1
( f o r μ 1 > μ )
W S
u
n
u
n
1
U n e m p l o y m e n t r a t e,u
2003-7-20 27
The dynamic of adjustment
Recall that the aggregate supply relation is given by:
Pt = Pt-1 (1+μ) F [(1-Yt / L),z]
An increase in the markup leads to an increase in the
price level (Pt ) at a given level of output (Yt),Thus,in
the short run,the aggregate supply curve shifts up.
Over time,although output has decreased,the natural
level of output has decreased even more,The
economy therefore moves over time from A' to A",
Shifts in aggregate supply affect output not only in the
short run but in the medium run as well.
Figure 9-11:The Dynamic Effects of
an Increase in the Price of oil
To clear it,see figure 9-11.
P r i c e Le v e l,P A S "
A S 1
A " A S
A 1
P
t - 1
B A
A D
Y
n
1 Y
n
O u t p u t,Y
2003-7-20 29
Table 9-1,The effects of increase
in the price of oil,1973-1975
1973 1974 1975
Rate of change of petroleum
price (%)
10.4 51.8 15.1
Rate of change of GDP
deflator (%)
5.6 9.0 9.4
Rate of GDP growth (%) 5.8 -0.6 -0.4
Unemployment rate (%) 4.9 5.6 8.5
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9-7,Conclusions
The short run versus the medium run
Shocks and Propagation Mechanisms
Output,Unemployment,and Inflation
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The short run versus the medium run
This difference between the short-and medium-run
effects of policies is one of the main reasons
economists disagree in their policy
recommendations,Some economists believe that
the economy adjusts quickly to its medium-run
equilibrium,and so they emphasize medium-run
implications of policy.
Others believe that the adjustment mechanism
through which output returns to its natural level is a
slow one at best,so they put more emphasis on the
short-run effects of policy.
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Short-and medium-run effects of all sorts of
policies
Short Run
Output level Interest rate Price level
Monetary expansion Increase Decrease Increase
Deficit reduction Decrease Decrease Decrease
Increase in oil price Decrease Increase Increase
Medium Run
Output level Interest rate Price level
Monetary expansion No change No change increase
Deficit reduction No change Decrease decrease
Increase in oil price decrease increase increase
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Shocks and Propagation Mechanisms
There are all sorts of shocks in our economy,Each
shock has dynamic effects on output and its
components,These dynamic effects are called the
propagation mechanism of the shock,Propagation
mechanism are different for different shocks,The
effects on activity may be largest at the beginning
and then they may decrease over time,Or the
effects may build up for while,and then decrease
and eventually disappear,
2003-7-20 34
Output,Unemployment,and Inflation
So far,we did not allow for sustained nominal money
growth,One implication of that assumption was that
the price level was constant in the medium run,that
there was no inflation,We must now relax this
assumption and allow for nominal money growth,
Only by doing so can we explain why inflation is
typically positive and think about the relation
between economic activity and inflation,Movements
in unemployment,output,and inflation are the topics
of the next two chapters.
