The AD-AS model Lecture 24 – academic year 2014/15 Introduction 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=P E. P=P E is correct in the medium period because workers have time to adjust expectations. If P=P E then u=u n e Y = Y N

Premise: short vs. medium period In the short period, however, workers can have wrong expectations : P can differ from P E. 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 P E u differ from u n Y differ from Y n In the short-period this is possible… in the medium period, however, the economy tends to go back to its natural values The AD-AS model will explain us why… Premise: short vs. medium period

WSW/P E = F(u,z) PS W/P= 1/ 1+  If P differ from P E -> W/P differ from da W/P E -> F(u,z) differ from 1/1+  -> u differ from da u n 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 curve AS curve -> equilibrium in the labour market Labour market WS -> W = P E F(u,z) PS -> P = W(1+  ) -> = W Labour market equilibrium -> WS and PS simultaneously verified By substituting PS in WS -> = P E F(u,z) from which we get P= P E (1+  ) F(u,z)

Construction of the AS curve In the model of the labour market ( WS – PS) we assumed P=P E Under this Hp., u=u n where u n is the natural rate of unemployment The Hp. P=P E is correct in the medium period -> u n 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=P E we have u=u n and where Y n is the natural level of production P E =P -> u=u n -> Y=Y n

Construction of the AS curve By substituting in P = P E (1+m) F(u,z) we get P= P E (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

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 market Important: the curve is not necessarily a straight line AS P Y

P Y What happens if the expected prices vary? AS -> P = P E (1+m) F(, z) P E -> 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.

AS P Y P=P E YNYN A In A and only in A P=P E and Y=Y N To the right of A P>P E and Y>Y N To the left of A P<P E and Y<Y N

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 together IS-LM model : IS -> Y= C(Y  T) + I(Y,i) + G; LM -> M S /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 P What happens if P varies (medium period)? P affects the position of the LM curve P -> M S /P -> same as M S -> LM shifts leftward Effects: E-> E’ and Y E -> Y E ’ -> Y In equilibrium: P -> Y i Y IS LM LM’ YEYE YE’YE’ E E’E’

Decreasing relationship between Y and P -> AD curve AD curve -> Equilibrium in goods market and financial markets Important: The curve is not necessarily a straight line P Y AD

What happens when we vary M s /P, G e T ? a) M s /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 G b) 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) Construction of the AD curve

Determination of the equilibrium In the equilibrium point AS and AD are simultaneously verified Graphically -> Intersection of AD and AS Equilibrium of the system -> Point A -> Y=Y A e P=P A P Y AS AD A PAPA YAYA

In point A: Along the AS -> labour market in equilibrium Along the AD -> goods market and financial market in equilibrium P Y AS AD A PAPA YAYA Determination of the equilibrium

Point A can represent the equilibrium both in the short and in the medium period, depending on the assumption on P E The position of A, indeed, depends on the position of the AS curve and thus on P E In particular : Medium period, P E =P -> u=u n -> Y=Y n In the medium period equilibrium Y is always equal to Y n Short period, P E can be ≠ P -> Y ≠ Y n Three cases: P E =P -> Y=Y n ; P E >P -> Y Y>Y n

Let’s consider the case P E Y A >Y n In the medium period the equilibrium is always along Y n AS AD P Y A YAYA YnYn

How do we move from the short period eq. A to the medium period equilibrium? Next class…. AS AD P Y A YAYA YnYn