Lecture7_ASADModel

# Lecture7_ASADModel - EC3024 Managerial Macroeconomics The...

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EC3024 Managerial Macroeconomics The AS-AD Model

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The aggregate supply relation captures the short-term equilibrium in the labor market. Recall the equations for wage and price determination: Aggregate Supply 2 and Step 1: Eliminate the nominal wage, then: Step 2: Express the unemployment rate in terms of output: Therefore, for a given labor force, the higher is output, the lower is the unemployment rate. W P F u z e ( , ) P W ( ) 1 P P F u z e ( ) ( , ) 1 u U L L N L N L Y L 1 1
Step 3: Replace the unemployment rate in the equation obtained in Step 1 gives us the aggregate supply relation : In words, the price level depends on the expected price level, P e , and the level of output, Y (and also , z , and L , but we take those as constant here). Aggregate Supply 3 P P F Y L z e ( ) , 1 1

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The AS relation has three important properties: An increase in output leads to an increase in the price level . This is the result of four steps: 1. An increase in output leads to an increase in employment. 2. The increase in employment leads to a decrease in unemployment and therefore to a decrease in the unemployment rate. 3. The lower unemployment rate leads to an increase in the nominal wage. 4. The increase in the nominal wage leads to an increase in the prices set by firms and therefore to an increase in the price level. Aggregate Supply 4 Y N N u u W W P
The second property of the AS relation is that: When the expected price level equal to the actual price level, P = P e , the output is equal to the natural level of output, Y = Y n . This is because: 1. If P = P e , the AS relation reduces to 2. This expression is exactly the one for the natural level of output. 3. Notice that the natural level of output is the medium run equilibrium in the labor market. 4. In other words, the medium run equilibrium in the labor market is a special case of the short run equilibrium where P = P e . Aggregate Supply 5

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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. The Aggregate Supply Curve Figure 7 - 1 6
The third property of the AS relation is that: 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. If wage setters expect the price level to be higher, they set a higher nominal wage. 2. The increase in the nominal wage leads to an increase in costs, which leads to an increase in the prices set by firms and a higher price level. Aggregate Supply 7 P W e W P

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Aggregate Supply An increase in the expected price level shifts the aggregate supply curve up.
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