AS-AD Model: Monetary Policy, Fiscal Policy, and Supply Shocks Part B

Equilibrium and the AS-AD Model

Equilibrium in the Short Run and Medium Run

• Equilibrium is where aggregate demand (AD) equals aggregate supply (AS).

• Equilibrium depends on the expected price level (P^e).

• P^e determines the position of the AS curve, which affects the equilibrium.

• AS relation: Y = Y(P - P^e, F, z), where:

  • Y = Output
  • P = Price level
  • P^e = Expected price level
  • F = Factors
  • z = Other variables
  • µ = markup
  • L = Labor

• AD relation: Y = Y(M/P, G, T), where:

  • M = Nominal money supply
  • P = Price level
  • G = Government spending
  • T = Taxes

Monetary Expansion

• An increase in nominal money (M) leads to an increase in the real money stock (M/P), which increases output.
• The aggregate demand curve shifts to the right.

Dynamics of Adjustment

• The increase in the nominal money stock shifts the AD curve to the right.
• In the short run, both output and the price level increase.
• The difference between actual output (Y') and the natural level of output (Y_n) causes an adjustment of price expectations.

Medium Run Effects

• In the medium run, the AS curve shifts to AS’’, and the economy returns to equilibrium at Y_n.
• The increase in prices is proportional to the increase in the nominal money stock.
• A monetary expansion increases output in the short run but has no effect on output in the medium run.

IS-LM Model and Monetary Expansion

• The impact of a monetary expansion on the interest rate can be illustrated using the IS-LM model.
• The short-run effect of the monetary expansion is a downward shift of the LM curve, leading to a lower interest rate and higher output.
• If the price level did not increase, the shift in the LM curve would be larger (to LM’’).
• Over time, as the price level increases, the real money stock decreases, and the LM curve shifts back to its original position.
• In the medium run, the real money stock and the interest rate remain unchanged.

Neutrality of Money

• In the short run, a monetary expansion leads to increased output, a decreased interest rate, and an increased price level.
• In the medium run, the increase in nominal money is fully reflected in a proportional increase in the price level.
• The increase in nominal money has no effect on output or the interest rate in the medium run.
• The neutrality of money in the medium run does not imply that monetary policy should not be used to affect output.

How Long Lasting are the Real Effects of Money?

• Macroeconometric models, such as the Taylor model, are larger-scale versions of the AS-AD model.
• In the Taylor model, money is increased gradually over four quarters by 3%.
• The maximum effect on output (Y) is 1.8%, reached after three quarters, declining to 0 by year 8.
• Over time, the price level increases, and output returns to the natural level.
• In year 4, the price level is up by 2.5%.

Decrease in the Budget Deficit

Dynamic Effects

• A decrease in the budget deficit leads to a leftward shift in the AD curve.
• Output and the price level fall.
• The decrease in output leads to a decline in inflation, increasing the real money stock, and shifting the LM curve to LM’.
• Both output and the interest rate are lower than before the fiscal contraction.

Medium Run Effects

• The LM curve continues to shift down until output returns to the natural level if wages and prices adjust downwards due to higher unemployment.
• The interest rate is lower than before deficit reduction.
• In the short run, a deficit reduction decreases output and the interest rate.
• In the medium run, output may return to its natural level, while the interest rate declines further.

Composition of Output

• The composition of output changes after deficit reduction.
• IS relation: Yn = C(Yn - Tn) + I(Yn, i) + G, where:
  • Y_n = Natural level of output
  • C = Consumption
  • T_n = Taxes at the natural level of output
  • I = Investment
  • i = Interest rate
  • G = Government spending
• Income and taxes remain unchanged, so consumption is the same as before.
• Government spending is lower; therefore, investment must be higher by an amount equal to the decrease in G.

Budget Deficits, Output, and Investment

• In the short run, a budget deficit reduction implemented alone decreases output and may decrease investment.
• In the medium run, output may return to the natural level if the price level or inflation falls sufficiently, and the interest rate is lower.
• A deficit reduction unambiguously leads to an increase in investment, which stimulates economic growth.
• In the long run, the level of output depends on the capital stock in the economy.

Changes in the Price of Oil

Stagflation

• The two large oil price increases of the 1970s were associated with a sharp recession and a large increase in inflation, known as stagflation.
• There were two sharp increases in the relative price of oil in the 1970s, followed by a decrease until the 1990s, a large increase between 1998 and 2006, a significant fall during the pandemic, and a rise due to the Russia-Ukraine war.

Effects on the Natural Rate of Unemployment

• An increase in the price of oil leads to a lower real wage and a higher natural rate of unemployment.

Dynamics of Adjustment

• An increase in the markup (µ) due to an increase in the price of oil increases the price level at any level of output (Y).
• The aggregate supply curve shifts up: P = P^e(1 + µ)F(Y, z)
• In the short run, an increase in the price of oil decreases output and increases the price level.
• Over time, output decreases further, and the price level increases further.

Oil Price Increases and Economic Indicators

• The oil price increases of the 1970s were associated with large increases in inflation and unemployment in the UK.
• However, the oil price increases between 2002 and 2006 did not have the same effect on inflation and unemployment.

Policies to Counteract Supply Side Shocks

Types of Policies

• There are three main types of supply-side policies designed to combat a supply-side shock:
  • Policies to counteract the original upward shift of the AS curve.
  • Policies to prevent the AS curve from shifting up further.
  • Policies to counteract the fall in the natural rate of output.

Counteracting the Initial AS Shift

• Governments may reduce non-labor costs to businesses by reducing payroll tax, sales tax, or business taxes.
• The intention is to offset the original upward shift in the AS curve, preventing a drastic increase in operating costs for businesses.

Preventing Further AS Shifts

• Policies are designed to prevent the AS curve from shifting up further following the initial supply-side shock.
• Governments may grant personal tax exemptions in exchange for lower cost-of-living adjustments in wages, impose a wage freeze, or adopt some form of incomes policy.

Counteracting the Fall in Natural Rate of Output

• Policies are designed to counteract the fall in the natural rate of output.
• Following a supply-side shock, the economy may become less efficient, producing a lower level of output at full employment (Yn falls).
• Inefficiency may arise due to technical reasons, such as industry being geared towards high energy-consuming machinery.
• The economy's natural level of output declines, reducing the size of the national cake available for distribution.
  *Policies
  *The government could reduce business taxes so as to encourage investment and thus improve long term economic growth.
  *Government granting investment tax credits, deregulating industries and increasing expenditure on ports, roads etc.,
  *Improve the infrastructure, thereby lowering the operational costs of industry and the economy in general.

Improving Long-Term Efficiency

• Policies are designed to improve the long-term efficiency of the economy.
• The government could reduce business taxes to encourage investment and improve long-term economic growth.
• Other examples include granting investment tax credits, deregulating industries, and increasing expenditure on infrastructure (ports, roads, etc.).
• These measures aim to improve infrastructure, lowering operational costs for industry and the economy.

Common Factor

• The common factor behind all these policies is to increase output without increasing prices.
• This is what classifies them as supply-side policies.

Demand-Side Implications

• Some supply-side policies have demand-side implications.
• Personal income tax reductions can also have demand-side effects, potentially outweighing supply-side effects, leading to increased prices as output increases.

Complications

• The AD curve may shift relatively more to the right than the AS curve shifts downwards as a result of personal income tax cuts.
• The end result is more output but at higher prices, complicating the situation if the primary aim is to increase output without increasing prices.

Summary