Lecture 9. The AD–AS Model (Aggregate Supply–Aggregate Demand Model)
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1. (Reference) The IS–LM Model
2. Aggregate Demand
3. Aggregate Supply
4. Equilibrium of Aggregate Demand and Aggregate Supply
1. (Reference) The IS–LM Model
⑴ Limitation 1. A model with a fixed price level
⑵ Limitation 2. No consideration of aggregate supply at all
2. Aggregate Demand (aggregate demand; AD)
⑴ Why the aggregate demand curve slopes downward
① Substitution effect : Not applicable in macroeconomics (#)
② Interest-rate effect : Price level falls → real money supply increases → interest rate falls → private consumption and investment increase → aggregate demand increases
③ Real balance effect : Also called the Pigou effect, wealth effect, or asset effect
○ Definition : The effect in which the value of assets influences consumption
○ Price level falls → the real purchasing power of money increases → real wealth (A/P) increases → consumption increases
④ Current account effect : Price level falls → international competitiveness of domestic goods improves → net exports increase → aggregate demand increases
⑵ The aggregate demand curve
① The slope of the AD curve
○ The larger the interest-rate effect, the flatter the AD curve
○ Higher interest elasticity of investment ↑ → IS curve becomes flatter → AD curve becomes flatter
○ Lower interest elasticity of money demand ↓ → LM curve becomes steeper → AD curve becomes flatter
○ The larger the real balance effect, the flatter the AD curve
○ The larger the current account effect, the flatter the AD curve
② A rightward shift of the IS curve or a rightward shift of the LM curve = a rightward shift of the AD curve
③ However, a fall in the price level does not shift the AD curve : because that is a movement along the curve (a point moves)
3. Aggregate Supply
⑴ The labor market
① Labor demand
○ An increase in the real wage reduces labor demand
○ # An increase in the overall price level means that all output prices rise, so it does not reduce demand
② Labor demand curve : The curve for firms’ labor demand, calculated using the value of marginal product
③ Labor supply curve : The curve describing how much labor workers supply at a given wage
⑵ Theory 1. Money-illusion theory
① Overview
○ Proposed by Keynes
○ An upward-sloping aggregate supply curve can be derived if either of the following two assumptions holds
○ Explains why the AS curve slopes upward by focusing on the labor supply market
② Assumption 1. Money illusion : Because expected price level Pe and actual price level P differ, workers mistake changes in the nominal wage W = P·w for changes in the real wage (i.e., static expectations about the price level)
○ Labor supply : Even if the price level rises, unless the nominal wage changes, the labor supply curve does not change
○ Labor demand : Firms face the real wage; therefore, if prices fall, the labor demand curve shifts left
○ Conclusion 1. Labor supply is a function of the nominal wage. Labor demand is a function of the real wage
○ Conclusion 2. Equilibrium employment is determined entirely by labor demand
③ Assumption 2. Downward rigidity of nominal wages
Figure. 1. Downward rigidity of nominal wages
○ Reason 1. Labor contracts are not made continuously; they are signed for fixed periods
○ Reason 2. In the labor market, workers do not accept nominal wage cuts (downward rigidity in the labor market)
○ Reason 3. When output is low, idle capacity exists, so even if output increases the nominal wage does not increase (to be revised later)
○ Labor supply : Because of downward rigidity of nominal wages, labor supply does not change even if prices fall
○ Labor demand : Firms face the real wage; therefore, if prices fall, the labor demand curve shifts left
○ Conclusion 1. Labor supply is a function of the nominal wage. Labor demand is a function of the real wage
○ Conclusion 2. Equilibrium employment is determined entirely by labor demand
④ The short-run aggregate supply curve
○ Labor supply is an increasing function of the real wage : using money illusion and nominal wage rigidity
○ Short-run aggregate supply curve
Figure. 2. Short-run aggregate supply curve under the money-illusion theory]
○ When the price level falls
○ 1st. Price level falls (P0 → P1), nominal wage unchanged
○ 2nd. Real wage rises (w0 → w1)
○ 3rd. Quantity of labor demanded falls (L0 → L1)
○ 4th. Employment falls (L0 → L1)
○ 5th. Total output falls (Y0 → Y1)
○ When the price level rises
○ 1st. Price level rises
○ 2nd. Nominal wage rises : there is no upward rigidity of nominal wages
○ 3rd. The real wage stays at a constant level
⑤ The long-run aggregate supply curve
Figure. 3. Long-run aggregate supply curve under the money-illusion theory]
○ The money-illusion theory applies only in the short run; in the long run the AS curve is vertical at the full-employment level of output
○ In the long run, imperfect price information diminishes and workers’ expected price level becomes accurate
⑥ Limitations
○ Theoretical foundations for nominal wage rigidity and money illusion are weak
○ An upward-sloping aggregate supply curve can be derived even when price variables are flexible
⑶ Theory 2. Lucas’s rational expectations theory
① Overview
○ Proposed by Lucas (Robert E. Lucas, Jr.)
○ Lucas received the Nobel Prize in Economics in 1995 for his work on rational expectations
○ Explains why the AS curve slopes upward by focusing on the labor demand curve
○ As a new classical economist, Lucas assumes the long-run AS curve is vertical at the natural level of output : it can slope upward in the short run
② Assumption : Under rational expectations, output can change due to imperfect information about the price level
○ (Reference) Perfect expectation : expectations that always match actual outcomes; an assumption of classical economists
○ (Reference) Static expectation : expecting the future to continue like the past○ Money illusion occurs
○ Under static expectations (or money illusion), expected and unexpected price changes are not distinguished
○ (Reference) Adaptive expectation : forecasting current/future prices based on past experience
○ No ex-ante adjustment ×, ex-post adjustment ○
○ Rational expectation : forming expectations about future prices rationally using all currently available information
○ Ex-ante adjustment ○, ex-post adjustment ○
○ Rational expectations do not mean perfect foresight
○ Under rational expectations, expected and unexpected price changes are not distinguished
③ Idea
○ If the overall price level rises, individual firms have no reason to increase output
○ If only the price of the good a firm produces rises, the firm should increase output
○ Each firm cannot know whether the rise in its product price reflects general inflation or a relative-price change
○ Lucas’s contribution : Even with rational expectations, imperfect information in the goods market makes the AS curve slope upward
④ Formalization : If a firm’s product price is high relative to the general price level, it increases output to maximize profit
○ Yi : output of firm i
○ Yi* : normal output level of firm i
○ Pi : price of firm i’s good
○ P : general price level of the overall economy
○ γ : sensitivity of firm i’s output to changes in the relative price
○ Individual firms cannot perfectly distinguish relative-price changes from changes in the general price level
⑤ Meaning of γ
○ If γ is close to 0 : the AS curve is very steep; aggregate output does not change much
○ If γ is very large : the AS curve is very flat; aggregate output changes a lot
○ Countries where governments frequently used unanticipated monetary/financial policies in the past : γ is small
○ Economies with pervasive uncertainty about the future : γ is small (∵ firms respond conservatively)
⑥ Government policy
○ Both fiscal and monetary policies can temporarily raise output in the short run and raise prices
○ Neither fiscal nor monetary policy has effects in the long run
⑦ Policy ineffectiveness proposition
○ Anticipated monetary policy and expansionary fiscal policy raise the price level but cannot increase income even in the short run
○ Unlike anticipated monetary policy, anticipated expansionary fiscal policy affects the composition of aggregate-demand spending
⑷ Theory 3. The New Keynesian aggregate supply curve : also called the price-rigidity model
① Overview : Explains why the AS curve slopes upward by focusing on the labor demand curve
② Formalization
○ Firms under monopolistic competition set prices, so there are two groups of firms
○ Group 1. Flexible-price firms : adjust prices flexibly as economic conditions change
○ Group 2. Sticky-price firms : form rational expectations about the price level; when conditions change, they keep prices unchanged and respond via changes in output○ If the cost of adjusting prices is sufficiently large (menu costs), income becomes an increasing function of the price level
○ The menu-cost concept was proposed by Mankiw
○ Derivation of the AS curve
○ s : share of sticky-price firms; in new classical approaches (e.g., Lucas), s = 0
○ α : responsiveness of flexible-price firms
③ Significance : Even if policy is anticipated, the existence of firms that keep prices sticky allows macroeconomic policies to have effects in the short run
Figure. 4. Significance of the New Keynesian aggregate supply curve
⑸ Applications
① Short run vs. long run
○ Short run : price variables are sticky; a short period in which expectations do not fully adjust
○ Short-run AS curve : upward sloping○ Case 1. Productivity improves → AS curve shifts right
○ Case 2. Labor supply decreases due to labor unions → AS curve shifts left
○ Long run : a sufficiently long period for expectations to fully adjust
○ Long-run AS curve : vertical at the natural level of output
② Positions by school
○ A general AS curve
○ Keynes model : horizontal supply curve, implying the existence of idle capacity
○ Keynesians : relatively flat slope
○ Monetarists : relatively steep slope
○ Classical economists : AS curve is vertical in both the long run and the short run
4. Equilibrium of Aggregate Demand and Aggregate Supply
⑴ Shifts of the aggregate supply curve
① Changes in climate conditions such as droughts in an agrarian society : marginal product of labor falls → labor demand falls → AS curve shifts left
② International oil price increases : firms reduce energy usage → marginal product of labor (a complementary input) falls → labor demand falls → AS curve shifts left
③ Wage-increase demands by labor unions : labor supply falls → AS curve shifts left
⑵ Examples of equilibrium analysis
① Increase (decrease) in the price level
○ Goods market : real exchange rate falls (rises) → net exports fall (rise) → IS curve shifts left (right)
○ Money market : real money supply falls (rises) → LM curve shifts left (right)
○ Labor market : labor supply increases (decreases) due to money illusion → labor supply curve shifts right (left)
○ In the AD–AS diagram, this appears as a movement along the curves : not a shift of the curves
② Increase in autonomous investment
○ 1st. IS curve shifts right
○ 2nd. AD curve shifts right
○ 3rd. As prices rise, the real money supply decreases
○ 4th. LM curve shifts left
○ 5th. Due to money illusion, Ls shifts right
○ Conclusion 1. Income rises, prices rise, investment rises
○ Conclusion 2. As the interest rate rises, investment partially falls
○ Conclusion 3. From Y = C + I + G, we can see that I ultimately increases
③ Increase in total factor productivity
○ 1st. Ld shifts right
○ 2nd. AS curve shifts right
○ 3rd. As prices fall, the real money supply increases
○ 4th. LM curve shifts right
○ 5th. Due to money illusion, Ls shifts left
○ Conclusion 1. Income rises, employment rises, prices fall
○ Conclusion 2. Real wages rise, interest rates fall
○ Conclusion 3. Consumption and investment rise
○ Conclusion 4. Government spending is unchanged
⑶ Empirical analysis
Table. 1. Predictions of the AD–AS model and the data
① Aggregate demand shocks : based on changes in autonomous investment
○ Procyclical prices are due to increased autonomous investment
○ Countercyclical real wages are due to workers’ money illusion
② Aggregate supply shocks : based on changes in total factor productivity
○ Except for procyclical money supply, the comovements of major macro indicators are well explained
○ Real business cycle theory : a business-cycle theory that views changes in total factor productivity as a main cause of short-run fluctuations
⑷ The IMF financial crisis
① Macroeconomic policies required by the IMF : tight monetary policy (high interest rates) and fiscal austerity
② Tight monetary policy (high interest rate policy)
○ Maintaining high interest rates via tight policy brings in foreign capital : by eliminating currency speculation, the exchange rate stabilizes
○ Reduces consumption and investment, contributing to an improved current account
○ Prevents wasteful and duplicative overinvestment by large firms
○ Functions as an effective restructuring tool by forcing marginal firms into bankruptcy
③ Fiscal austerity
○ Improves the current account and stabilizes the exchange rate by reducing aggregate demand
④ Disadvantages
○ Excessively high interest rates can cause otherwise healthy firms to fail despite profitability (black insolvency)
○ High interest rates worsen corporate financial structure, making financial normalization difficult
○ Even if interest rates are raised, large capital inflows cannot be expected unless macro fundamentals improve
○ Reducing aggregate demand may improve the current account in the short run, but increases unemployment and further depresses the economy
⑸ Credit crunch
① Definition : a phenomenon in which liquidity is not properly supplied to the market
② Example 1. During the Great Depression of the 1930s
○ Investment does not respond sensitively to interest rates, so the IS curve is relatively steep
③ Example 2. When a socialist economy transitions to a market economy
○ 1st. After the transition, the economy grows rapidly
○ 2nd. Demand for funds needed for real investment increases greatly
○ 3rd. In a transition economy, capital markets such as stock and bond markets are underdeveloped, so the supply of funds falls short of demand
○ 4th. Liquidity is not properly supplied to the market
④ Countermeasures
○ Fundamentally, domestic financial institutions and markets must develop to match the scale of the economy
○ In the short run, foreign capital should be actively utilized (e.g., attracting foreign investment capital, introducing foreign loans)
Entered: 2020.11.02 00:17