1. CHAPTER 7 © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard Putting All Markets Together: The AS-AD Model Prepared by: Fernando Quijano and Yvonn Quijano

2. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard2 of 49 Aggregate Supply The aggregate supply relation captures the effects of output on the price level. It is derived from the behavior of wages and prices. Recall from chapter 6 the equations for: wage setting relation: price determination : W = P/1+μ 7-1

3. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard3 of 49 Aggregate Supply Step 1: Eliminate the nominal wage from: W = P e F(u,z) and W = P/1+μ To get: P/1+μ = P e F(u,z) Or P = P e (1+μ) F(u,z) In words, the price level depends on the expected price level and the unemployment rate. We assume that  and z are constant.

4. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard4 of 49 Aggregate Supply Step 2: We know that Y=AN (production function). If we assume A (output per worker) to be equal to one, then we can write Y=N. As a result, we can express the unemployment rate in terms of output: Therefore, for a given labor force, the higher is output, the lower is the unemployment rate.

5. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard5 of 49 Aggregate Supply Step 3: Replace the unemployment rate in the equation obtained in step one: In words, the price level depends on:  the expected price level, P e,  the level of output, Y,  and also , z, and L, but we take these are assumed to be constant here.

6. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard6 of 49 Aggregate Supply The AS relation has two important properties: 1.An increase in output leads to an increase in the price level. This is the result of four steps: 1. 2. 3. 4.

7. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard7 of 49 1. An increase in output leads to an increase in the price level. This is the result of four steps 2. An increase in the expected price level leads, one for one, to an increase in the actual price level. This effect works through wages: 1. 2. 2. Aggregate Supply The AS relation has two important properties:

8. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard8 of 49 Aggregate Supply Given the expected price level, an increase in output leads to an increase in the price level. If output is equal to the natural level of output, the price level is equal to the expected price level.

9. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard9 of 49 Aggregate Supply The AS curve has three properties that will prove to be useful in what follows: 1.The AS curve is upward sloping. An increase in output leads to an increase in the price level. 2.The AS curve goes through point A, where Y (actual output) = Y n ( natural level of output=level of output at the natural rate of unemployment/unemployment ) and P ( price level) = P e (expected price level). This property has two implications:  When P > P e,Y > Y n.  When P < P e,Y < Y n. 3. An increase in P e shifts the AS curve up, and a decrease in P e shifts the AS curve down.

10. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard10 of 49 Aggregate SupplyThe Effect of an Increase in the Expected Price Level on the Aggregate Supply Curve An increase in the expected price level shifts the aggregate supply curve up.

11. Chapter 7: Putting All Markets Together: The AS-AD Model © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard11 of 49 Aggregate Supply Let’s summarize:  Starting from wage determination and price determination in the labor market, we have derived the aggregate supply relation.  This means that for a given expected price level, the price level is an increasing function of the level of output. It is represented by an upward-sloping curve, called the aggregate supply curve.  Increases in the expected price level shift the aggregate supply curve up; decreases in the expected price level shift the aggregate supply curve down.