Topic 5

The Medium Run: The AS-AD Model
Aggregate Demand Relationship

The aggregate demand relation captures the effect of the price level on output. It is derived from the equilibrium in the market for goods and services and in the market for money (IS-LM model) for different levels of prices.

  • M: nominal amount of money

  • M/P: real amount of money (consumption capability of M, units of product that can be bought with M monetary units). Example:

    • M = 1,000,000 \text{ €}

    • P = 2
      When the price level (p) decreases, the real amount of money (M/p) increases. This leads to an increase in the consumption capability of families, causing them to consume more, which in turn increases the aggregate demand.

Also, when (M/p) increases, the interest rate (i) goes down, leading to an increase in firm investment (I), which is also a component of aggregate demand. This is a shift along the AD line, making AD a decreasing function.

Derivation of the Aggregate Demand

As the price level changes (e.g., p0 > p1 > p2), the real money supply changes accordingly (M/p0 < M/p1 < M/p2). This leads to a shift of the LM curve. At each level of prices, we will have a different level of output. These are pairs of (P, Y ) that maintain the equilibrium in the goods and money markets.

AD = AD(G, TR, t, M/p)

Expansionary Fiscal Policy

Increase of G, TR, and decrease of t shifts the AD curve to the right.

Expansionary Monetary Policy

Increase of M shifts the AD curve to the right.

Aggregate Supply
Aggregate Supply in the Long Run

In the long run, aggregate production depends on the availability of inputs (capital and labor) and technology. It does not depend on the level of prices.

Y = A F(K, L)

  • Y: Aggregate Output

  • A: Production Technology

  • K: Amount of Capital

  • L: Amount of Labor

The long run aggregate supply (LRAS) curve is a vertical line at the natural level of output (Y_n), also known as “full employment.” The unemployment rate corresponding to Yn is the natural level of unemployment (un), which varies across countries. The natural level of unemployment includes frictional and structural unemployment.

  • Frictional Unemployment: occurs when workers are “in-between jobs.”

  • Structural Unemployment: caused by a mismatch between the skills that a worker offers and those that employers demand.

  • Cyclical unemployment: labor forces are reduced as a result of business cycles or fluctuations in the economy, such as recessions (periods of economic decline).

Shifts in Aggregate Supply (Long Run)

Caused by measures that increase the productivity of the economy:

  • Increasing the Stock of Capital (K).

  • Improving education (increasing the quality of labor).

  • Technological innovation.

  • Better organization in production.

  • Improving the quality of some institutions.

Technological innovation shifts the LRAS curve to the right.

Aggregate Supply in the Short Run

Prices are fixed, and firms sell whatever amount they produce at the existing level of prices. Therefore, the short-run aggregate supply (SRAS) curve is horizontal.

Aggregate Supply in the Medium Run

Prices are “sticky” (some firms can change them, others cannot). Some firms can increase prices, so, at the aggregate level, these firms will be willing to increase their production if they can get a higher price. Therefore, the SRAS is upward sloping.

Shift in Aggregate Supply (Medium Run)

Technological Innovation shifts the SRAS curve to the right.

Aggregate Supply and Aggregate Demand Equilibrium

Equilibrium occurs where AD, SRAS, and LRAS intersect.

Demand Side Policies: The Effects of a Monetary Expansion

Initial effect of a monetary expansion shifts the AD curve to the right, increasing both output and price level.

Expectations about prices are crucial. When firms make decisions, they have expectations of the level of prices at which the product will be sold. Workers do the same when negotiating their salary.

When EP = P (expectations on the level of prices are right), the production is at the natural level. Only when P’ > EP, Y > Yn

An increase in EP, the expected level of prices, shifts SRAS upwards because firms believe work and other inputs will be more expensive.

Effects of Expansionary Monetary Policy: The Transition to the Long-Run Equilibrium

The difference between Y1 and Yn Y_n. The increase in prices is proportional to the increase in the nominal money stock (money is neutral in the long-run).

In the long run, production goes back to the natural level (Y_N). This is why the LRAS is vertical. Only prices have increased. The short run expansion of the aggregate production vanishes in the long run.

Demand Side Policies: The Effects of a Fiscal Expansion

Expansionary fiscal policy shifts the AD curve to the right, increasing both output and price level in the short run.

In the long run, production goes back to the natural level (Y_n$$). This is why the LRAS is vertical. Only prices have increased. The short run expansion of the aggregate production vanishes in the long run.

Supply Side Policies

In the long run, only supply side policies can increase (permanently) the aggregate production. These policies imply increasing the productivity of the economy.

Increase in Productivity

Shifts both LRAS and SRAS to the right, leading to a higher natural level of output.

Historical Examples
The Great Recession (2008-2010)
Reduction of Public Deficit in the Euro Zone in (2010-2012)
Oil Price Crisis (1973-1980)