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Applications of the AD-AS Model Lecture 25 – academic year 2014/15 Introduction to Economics Fabio Landini

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Demand shocks How do we model the transition from the short to the medium period in the AD-AS model? What happens in the medium period when we increase the supply of money? What happens in the medium period when we reduce the public deficit? Which are the effects of demand shocks?

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Transitions from short to medium period Effects of an increase in money supply Effects of a reduction in public deficit Effects of a demand shock Demand shocks

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Transition from the short to the medium period Point A can be both the short and the medium period equilibrium depending on the assumptions on P E Medium period P E =P -> u=u n -> Y=Y n P AS AD Y PAPA YAYA A =Y n

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In the short period -> P E can be ≠ from P For instance P E Y A >Y n How do we move from the short period equilibrium A to the medium period equilibrium? P AS AD Y PAPA YAYA A YnYn Transition from the short to the medium period

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Is it plausible that the economy remains in equilibrium A? In A (short period equilibrium) -> Y>Y n and P>P E -> individuals underestimate prices P AS AD Y PAPA YAYA A YnYn Transition from the short to the medium period

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Individuals underestimates prices -> they have wrong expectations concerning prices As times passes workers realize that P E is too low -> price expectations adjust -> P E AS parametrically depends on P E -> If P E the AS curve shifts upward Transition from the short to the medium period

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P PAPA PA’PA’ A’A’ A YnYn YA’YA’ YAYA AD AS AS’ P E -> AS shifts upward New equilibrium A’ -> Y (Y A -> Y A ’) P (P A -> P A ’)

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P PAPA PA’PA’ A’A’ A YnYn YA’YA’ YAYA AD AS AS’ P E -> A -> A’; Is A’ the final equilibrium of the system? In A’ -> Y>Y n and P>P E -> P E continues

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P PAPA PA’PA’ A’A’ A YnYn YA’YA’ YAYA AD AS AS’ P E -> AS shifts again upward Y is still > Y n -> new P E … the process continues until Y=Y n -> P E = P In A’’ -> Y=Y n -> P E =P -> the expectation must not be adjusted -> the adjustment process (i.e. the AS curve) stops AS’’ A’’

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When Y=Y n (point A’’) the adjustment stops In the medium period the intersection between the AS and AD curves is always along the line Y = Y n Conclusion: Until P>P E -> agents adjust their expectations: P E -> P and Y The adjustment process stops when Y = Y n and P = P E Point A’’ -> Medium period equilibrium of the system The dynamics is the opposite if in the short period equilibrium we have Y < Y n Transition from the short to the medium period

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We use the AD-AS model to examine: Expansive monetary policy Reduction of public deficit The two cases are examples of “demand shock” Demand shock

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1) Expansive monetary policy ( M S ) Let’s assume Y = Y n The Central Bank increases M S M S is a component of AD: M S -> Aggregate demand -> AD shifts rightward Expansive monetary policy

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M S -> Aggregate demand -> AD shifts rightward AD -> AD’ -> Equilibrium -> A -> A’ -> Y (Y A -> Y A ’) P (P A -> P A ’) Short period effects -> Y and P Is it plausible that the economy remains in A’? In A’ Y>Y n -> P>P E -> wrong expectations P Y Y A =Y n YA’YA’ PA’PA’ AS AD AD’ A A’A’ P E =P A

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Wrong expectations -> adjustment of expectations (described before) -> P E P E -> AS shifts upward The adjustment process continues until Y=Y n -> AS shifts upwards until Y=Y n When Y=Y n -> P E =P -> The adjustment process interrupts -> medium period equilibrium Expansive monetary policy

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P PA’PA’ A’A’ YnYn YA’YA’ AD’ AS After M S we are in A’; AS shifts upward until Y=Y n AS’’ AD Y PAPA During the transition -> Y and P In the medium period -> Y A ’’ =Y n =Y A and P A ’’ >P A P A ’’ Y A ’’=

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Total effect of the intervention: Short period -> Y and P Transition -> Y and P Medium period -> Y=, P In the medium period Y does not change. Has the composition of demand changed (Z=C+I+G) ? Z does not change (in equilibrium Y=Z): C hasn’t change (Y and T are not changed) G has not changed (exogenous) Therefore I hasn’t changed either In the medium period money has no effects on real variables but only on prices -> medium period “neutrality” of money Expansive monetary policy

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An expansive monetary policy increases production in the short period -> It allows the economy to exit a recession( Y) In the medium period monetary policy is neutral -> It cannot be relied on to generate permanent increases in production Expansive monetary policy

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2) Reduction of public deficit ( G, T) Let’s assume Y = Y n Government reduces G G is a component of AD: G -> Aggregate demand -> AD shifts leftward Reduction of public deficit

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AS AD P Y A YnYn AD’ A’A’ YA’YA’ PA’PA’ G -> AD shifts leftward Equilibrium A->A’ -> Y (Y A -> Y A ’) P (P A -> P A ’) In A’ Y P P E -> the transition starts P E = P A

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AS AD P Y A YnYn PAPA AD’ A’A’ YA’YA’ AS’’ A’’ P A ’’ PA’PA’ P E -> AS shifts downward When Y=Y n the adjustment process stops =Y A ’’

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Total effects of the intervention: Short period -> Y P Transition -> Y P Medium period -> Y= P Is the composition of demand changed (Z=C+I+G) ? Z is not changed (in equilibrium Y=Z) C is not changed (Y and T are not changed) G is changed (Government has reduced expenditure) Therefore I has increased Reduction of public deficit

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In the short period a reduction of public expenditure causes a recession The effect is only temporary -> In the medium period the production comes back to the “natural” level In the short period the reduction of public deficit has an ambiguous effects on investments In the medium period the effect on investment is certainly positive Reduction of public deficit

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The cases that we examined are examples of demand shock Demand shock -> Variations in the values of variables that affect aggregate demand Demand shock: Variations in public expenditures and taxes Variations in money supply (and related interests) Variations in autonomous consumption (tastes, consumers’ expectations) Variations in investments (firms’ expectations) Effects of demand shocks

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Demand shocks impact the AD curve Positive shocks ( M S, G, C 0, I 0 ) -> AD rightward Negative shocks ( M S, G, C 0, I 0 ) -> AD leftward AS AD Y P AD’ Effects of demand shocks

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In the short period demand shocks impact on prices and production in the same direction ( P Y or P Y) Moreover, we saw that in the medium period: In all cases Y n does not change -> Demand shocks do not influence production in the medium period In all cases P change -> Demand shocks affect prices in the medium period Demand shock can change the composition of aggregate demand in the medium period Effects of demand shocks

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