Macroeconomics

Welcome to ECON2123, HKUST

by LI, Yao
Ch7 Putting All Markets Together:
The AS-AD Model
 Aggregate Supply
 Aggregate Demand
 Equilibrium in the Short Run and in the Medium Run
 The Effects of a Monetary Expansion
 A Decrease in the Budget Deficit
 Changes in the Price of Oil
 Conclusion
2
 QUICK QUESTIONS
1. In the absence of changes in fiscal or monetary policy, the
economy will always remain at the natural level of output. (?)
2. The AS relation implies that an increase in output leads to an
increase in the price level. (?)
3. Changes in any variables that shift the IS or LM curves will
shift the AD curve. (?)
4. In the short run, price cannot change in the AS-AD model. (?)
5. From the short run to the medium run, if price does not equal
expected price, people continue to revise expectations and to
shift the AD curve until the medium run equilibrium.(?)
7-3 EQUILIBRIUM IN THE SHORT RUN
AND IN THE MEDIUM RUN

 Y 
A S R e la tio n P  P (1   ) F  1  , z 
e
 L 

 M 
A D R e la tio n Y  Y  ,G ,T 
 P 

Equilibrium depends on the value of Pe. The value of Pe

determines the position of the aggregate supply curve, and the
position of the AS curve affects the equilibrium.

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7-3 EQUILIBRIUM IN THE SHORT RUN
AND IN THE MEDIUM RUN
Equilibrium in the Short Run
Figure 7 - 5 (taking expected price as given)
The Short-Run
Equilibrium
The equilibrium is given by the
intersection of the aggregate
supply curve and the
aggregate demand curve. At
point A, the labor market, the
goods market, and financial
market are all in equilibrium.
 The aggregate supply curve AS is
drawn for a given value of Pe. The
higher the level of output, the
higher the price level.
 The aggregate demand curve AD
is drawn for given values of M, G,
and T. The higher the price level
is, the lower the level of output.

5
7-3 EQUILIBRIUM IN THE SHORT RUN
AND IN THE MEDIUM RUN
From the Short Run to the Medium Run
At point A,

Y  Yn  P  P e

Wage setters will revise upward

their expectations of the future
price level. This will cause the
AS curve to shift upward. (at a
given level of output, wage
setters expect a higher price
level.)

Expectation of a higher price

level also leads to a higher
nominal wage, which in turn
leads to a higher price level.

6
7-3 EQUILIBRIUM IN THE SHORT RUN
AND IN THE MEDIUM RUN
From the Short Run to the Medium Run
Figure 7 - 6
The Adjustment of
Output over Time
If output is above the natural
level of output, the AS curve
shifts up over time until output
has fallen back to the natural
level of output.

Y  Yn and P  P e

The adjustment ends once wage

setters no longer have a reason to
change their expectations.

In the medium run, output returns to

the natural level of output.

7
7-3 EQUILIBRIUM IN THE SHORT RUN
AND IN THE MEDIUM RUN
From the Short Run to the Medium Run
Let’s summarize:

 In the short run, output can be above or below the natural

level of output. Changes in any of the variables that enter
either the aggregate supply relation or the aggregate demand
relation lead to changes in output and to changes in the price
level. (Y ≠ Yn )

 From the short run to the medium run: adjust expectations;

shift AS curve.

 In the medium run, output eventually returns to the natural

level of output. The adjustment works through changes in
the price level. (Y = Yn )
8
GO TO NEW LECTURE NOTES
PART (II)

9
7-4 THE EFFECTS OF A MONETARY EXPANSION
The Dynamics of Adjustment
 M 
Y  Y  ,G ,T 
 P 

Inthe aggregate demand equation, we can see that an increase in

nominal money, M, leads to an increase in the real money stock,
M/P, leading to an increase in output. The aggregate demand
curve shifts to the right.
7-4 THE EFFECTS OF A MONETARY EXPANSION
The Dynamics of Adjustment
The increase in the
nominal money stock
causes the aggregate
demand curve to shift to
the right.

In the short run, output

and the price level
increase.
7-4 THE EFFECTS OF A MONETARY EXPANSION
The Dynamics of Adjustment
Figure 7 - 7
The Dynamic Effects of
a Monetary Expansion
A monetary expansion leads to
an increase in output in the
short run but has no effect on
output in the medium run.

The difference between Y and Yn

sets in motion the adjustment of
price expectations.

In the medium run, the AS curve

shifts to AS’’ and the economy
returns to equilibrium at Yn.

The increase in prices is  M 

Y  Y  ,G ,T 
proportional to the increase in
the nominal money stock.
 P 
( ,  ,  )
7-4 THE EFFECTS OF A MONETARY EXPANSION
Going Behind the Scenes
The impact of a monetary expansion on
the interest rate can be illustrated by the
IS-LM model.

The short-run effect of the monetary

expansion is to shift the LM curve down.
The interest rate is lower, output is
higher.

In the short run, the increase in

price is smaller than the increase
in M.

If the price level did not increase, the

shift in the LM curve would be larger—to
LM’’.
7-4 THE EFFECTS OF A MONETARY EXPANSION
Going Behind the Scenes
Figure 7 - 8
The Dynamic Effects of a
Monetary Expansion on
Output and the Interest
Rate
The increase in nominal money initially shifts
the LM curve down, decreasing the interest
rate and increasing output. Over time, the
price level increases, shifting the LM curve
back up until output is back at the natural
level of output.

In the medium run:

Y returns back to the natural level;
i is also back to its initial value;
P increases.
7-4 THE EFFECTS OF A MONETARY EXPANSION
The Neutrality of Money
 In the short run, a monetary expansion leads to an increase in output, a
decrease in the interest rate, and an increase in the price level.
 How large is the short run effect depends on the slope of the AS curve.
The flatter the AS curve, the larger increase in Y and the smaller
increase in P in this case.

 In the medium run, the increase in nominal money is reflected entirely in a

proportional increase in the price level. The increase in nominal money
has no effect on output or on the interest rate.

Theneutrality of money in the medium run does not mean that monetary policy
cannot or should not be used to affect output.
How Long Lasting Are the Real Effects of Money?

Figure 1
The Effects of an
Expansion in
Nominal Money in
the Taylor Model

Macroeconometric models are larger-scale versions of the

aggregate supply and aggregate demand model in this chapter.
They are used to answer questions such as how long the real
effects of money last.
7-5 A DECREASE IN THE BUDGET DEFICIT
Figure 7 - 9
The Dynamic Effects of a
Decrease in the Budget
Deficit
A decrease in the budget deficit
leads initially to a decrease in
output. Over time, however, output
returns to the natural level of
output.

Towards the medium run:

since Y’ < Yn, P < Pe ;
revise down Pe ,
the AS curve shifts
down.
7-5 A DECREASE IN THE BUDGET DEFICIT
Deficit Reduction, Output,
and the Interest Rate
Since the price level declines in
response to the decrease in output,
the real money stock increases. This
causes a shift of the LM curve to LM’.

Both output and the interest rate are

lower than before the fiscal
contraction.

If the price level didn’t change, the

short run equilibrium would be point
B. Now the short run equilibrium is
point A’, because the price level
declines in response to the decrease
in output, the M/P increases, leading
to a partially offsetting shift of the LM
curve, down to LM’.
7-5 A DECREASE IN THE BUDGET DEFICIT
Deficit Reduction, Output,
and the Interest Rate
Figure 7 - 10
The Dynamic Effects of a
Decrease in the Budget
Deficit on Output and
the Interest Rate
A deficit reduction leads in the short run
to a decrease in output and to a decrease
in the interest rate. In the medium run,
output returns to its natural level, while
the interest rate declines further.
Towards the medium run: since
Y’ < Yn, P < Pe ;
revise down Pe , the price level
continues to decline; a further
increase in M/P;
The LM curve continues to
shift down.
7-5 A DECREASE IN THE BUDGET DEFICIT
Deficit Reduction, Output, and the Interest Rate
The composition of output is different than it was before deficit
reduction.

In the medium IS r e la tio n : Y n  C (Y n  T )  I (Y n ,i )  G

run:
Income and taxes remain unchanged, thus, consumption is the
same as before.
Government spending is lower than before (due to the budget
deficit reduction); therefore, investment must be higher than
before deficit reduction—higher by an amount exactly equal to
the decrease in G.
Hence, in the medium run, a reduction in the budget deficit
unambiguously leads to a decrease in the interest rate and an
increase in investment. But the short run effect on investment is
ambiguous.
7-5 A DECREASE IN THE BUDGET DEFICIT
Budget Deficits, Output, and Investment
Let’s summarize:

 In the short run, a budget deficit reduction, if implemented alone (i.e.,

without policy mix) leads to a decrease in output and may lead to a
decrease in investment. (Y decreases; I ambiguous).

 In the medium run, output returns to the natural level of output, and the
interest rate is lower. A deficit reduction leads unambiguously to an
increase in investment. (Y unchanged; I increases.)

 It is easy to see how our conclusions would be modified if we did take

into account the effects on capital accumulation. In the long run, the
level of output depends on the capital stock in the economy. We will
learn this in the long run model. (the long run: Y and I both increase).
 QUICK QUESTIONS
1. Expansionary monetary policy has no effect on the level of output
in the medium run. (?)
2. Fiscal policy cannot affect investment in the medium run because
output always returns to its natural level. (?)
3. The neutrality of money means in the short run monetary policy
does not affect output. (?)
4. In the medium run, monetary expansion does not affect output but it
effectively affects interest rate and price level. (?)
IN-CLASS QUESTION
Q2. (Textbook) Spending shocks and the medium run
Suppose the economy begins with output equal to its natural level.
Then, there is a reduction in income taxes.
(a) Using the AS-AD model developed in this chapter, show the
effects of a reduction in income taxes on the position of the AD,
AS, IS, and LM curves in the medium run.
Answer: (1) in the AS-AD:
T↓ (similar to G↑), AD shifts right; P↑, P> Pe
increase Pe ;AS shifts up.
(2) In the IS-LM:
T↓demand ↑IS shifts right;
Since P ↑ in the AS-AD, (M/P)↓,  LM shifts up.
Q2.
(b) What happens to output, the interest rate, and the price
level in the medium run? What happens to consumption
and investment in the medium run?

Answer: from part (a), you know that Y returns to Yn, P↑

(from the AS-AD), and i↑ (from the IS-LM)
IS r e la tio n : Y n  C (Y n  T )  I (Y n ,i )  G

T↓, (Yn-T)↑, C↑, G is unchanged, Investment I ↓

25
7-6 CHANGES IN THE PRICE OF OIL
Figure 7 - 11
The Real Price of Oil
Since 1970
There were two sharp
increases in the relative price
of oil in the 1970s, followed by
a decrease until the 1990s, and
a large increase since then.

Each of the two large price increases of the 1970s was associated with
a sharp recession and a large increase in inflation—a combination
macroeconomists call stagflation, to capture the combination of
stagnation and inflation that characterized these episodes.
7-6 CHANGES IN THE PRICE OF OIL
Effects on the Natural Rate of Unemployment
Figure 7 - 12
The Effects of an
Increase in the Price of
Oil 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.

 Yn ↓ to Yn’
7-6 CHANGES IN THE PRICE OF OIL
The Dynamics of Adjustment

 Y 
P  P (1   ) F  1  , z 
e
 L 
An increase in the markup, , caused by an increase in the price of oil,
results in an increase in the price level, at any level of output, Y. The
aggregate supply curve shifts up.
7-6 CHANGES IN THE PRICE OF OIL
The Dynamics of Adjustment
After the increase in the price of
oil, the new AS curve goes
through point B, where output
equals the new lower natural level
of output, Y’n, and the price level
equals Pe.

The economy moves along the

AD curve, from A to A’. Output
decreases from Yn to Y’.

A’: equilibrium in the short run

7-6 CHANGES IN THE PRICE OF OIL
The Dynamics of Adjustment
Figure 7 - 13
The Dynamic Effects of
an Increase in the Price
of Oil
An increase in the price of oil leads, in
the short run, to a decrease in output
and an increase in the price level.
Over time, output decreases further,
and the price level increases further.

A’’: equilibrium in the medium run

This supply shock affects Y in both the

short run and the medium run.

Assume no effect on AD.

7-6 CHANGES IN THE PRICE OF OIL
Effects on the Natural Rate of Unemployment
Figure 7 - 14
Oil Price Increases and
Inflation in the United
States Since 1970
The oil price increases of the
1970s were associated with
large increases in inflation. But
this has not been the case for
the recent oil price increases.
7-6 CHANGES IN THE PRICE OF OIL
Effects on the Natural Rate of Unemployment
Figure 7 - 15
Oil Price Increases and
Unemployment in the
United States Since 1970
The oil price increases of the
1970s were associated with
large increases in
unemployment. But this has not
been the case for the recent oil
price increases.
Oil Price Increases: Why Are the 2000s So
Different from the 1970s?
The effects of an increase in the price of oil on output and the price
Figure 1 level are much smaller than they used to be.
The Effects of a Two hypothesis: (1) decrease in works’ bargaining power, catchall
100% Increase in variable z↓; AS shifts down; offset some effects of upward shift in
the Price of Oil on the AS; (2) monetary policy is different. It seems nowadays people
the CPI and on GDP tend to believe that monetary policy is more useful, and the Fed will
not let the increase in the price of oil lead to a higher price level.
7-7 CONCLUSIONS
The Short Run Versus the Medium Run

Table 7-1 Short-Run Effects and Medium-Run Effects of a Monetary Expansion, a

Budget Deficit Reduction, and an Increase in the Price of Oil on Output,
the Interest Rate, and the Price Level
Short Run Medium Run
Output Interest Price Output Interest Price
Level Rate Level Level Rate Level
Monetary Increase
expansion Increase Decrease (small) No change No change Increase
Deficit Decrease
reduction Decrease Decrease (small) No change Decrease Decrease
Increase
in oil price Decrease Increase Increase Decrease Increase Increase
(1) MONETARY EXPANSION
Short run:
 The AS-AD diagram: AD shifts right;  Y↑, P

↑;
 The IS-LM diagram: LM shifts down: Y ↑ , i↓

Medium run:
 The AS-AD: Since Y’>Yn, P> Pe ; Revise up

Pe, AS shifts up Y return back; P ↑ further

 The IS-LM: since P ↑, (M/P) ↓; LM shifts up

back to its initial level  i unchanged, Y

unchanged
(2) BUDGET DEFICIT REDUCTION
Short run vs. Medium run (work through it!)
(3) INCREASE IN THE PRICE OF OIL
 The AS-AD: follow textbook!
 The IS-LM: effect on interest rate
 Short run: P↑, (M/P)↓ LM shifts up, i↑
 Medium run: P ↑ further, (M/P)↓ further  LM shifts
up further, i↑ further
7-7 CONCLUSIONS
Shocks and Propagation Mechanisms
Output fluctuations (sometimes called business
cycles) are movements in output around its
trend.

The economy is constantly hit by shocks to

aggregate supply, or to aggregate demand, or to
both.

Each shock has dynamic effects on output and

its components. These dynamic effects are
called the propagation mechanism of the
shock.
KEY TERMS
 aggregate supply relation  stagflation
 aggregate demand relation  output fluctuations, business
 neutrality of money cycles
 macroeconometric models  shocks
 propagation mechanism
 QUICK QUESTIONS
1. The natural level of output can be determined by looking at the
aggregate supply relation alone. (?)
2. if there is an increase in the price of oil, it will decrease firms’
profit, so it will decrease the markup firms will charge. (?)
3. The increase in price of oil will decrease output in the short run
but the output in the medium run is unchanged since it will
return to its initial natural level of output. (?)
4. The AS curve slopes up, i.e., positive relation between output
and price. Hence, the increase in price of oil will decrease both
output and the price level. (?)
IN-CLASS QUESTION
Q2. (Textbook) Spending shocks and the medium run
Suppose the economy begins with output equal to its natural level.
Then, there is a reduction in income taxes.
(a) Using the AS-AD model developed in this chapter, show the
effects of a reduction in income taxes on the position of the AD,
AS, IS, and LM curves in the medium run.
Answer: (1) in the AS-AD:
T↓ (similar to G↑), AD shifts right; P↑, P> Pe
increase Pe ;AS shifts up.
(2) In the IS-LM:
T↓demand ↑IS shifts right;
Since P ↑ in the AS-AD, (M/P)↓,  LM shifts up.
Q2.
(b) What happens to output, the interest rate, and the price
level in the medium run? What happens to consumption
and investment in the medium run?

Answer: from part (a), you know that Y returns to Yn, P↑

(from the AS-AD), and i↑ (from the IS-LM)
IS r e la tio n : Y n  C (Y n  T )  I (Y n ,i )  G

T↓, (Yn-T)↑, C↑, G is unchanged, Investment I ↓

IN-CLASS QUESTION:
Q3.(TEXTBOOK) SUPPLY SHOCKS AND THE MEDIUM RUN

Consider an economy with output equal to the

natural level of output. Now suppose there is an
increase in unemployment benefits.
a. Using the model developed in this chapter, show the effects
of an increase in unemployment benefits on the position of
the AD and AS curves in the short run and in the medium
run.
a. Using the model developed in this chapter, show the effects
of an increase in unemployment benefits on the position of
the AD and AS curves in the short run and in the medium
run.
SR: short run WS: wage-setting curve
MR: medium run PS: price-setting curve
b. How will the increase in unemployment benefits affect
output and the price level in the short run and in the medium
run?
b. How will the increase in unemployment benefits affect
output and the price level in the short run and in the medium
run?