**Unformatted text preview: **The AS-AD Model
(cont.)
Lecture 14
October 31, 2016 Announcements Assigned Reading:
Textbook, Chapter 7 Tutorial this week for midterm checking: Tutorial in Week 9 (31/10 - 4/11)
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to check your paper AFTER week 9. NO checking will be entertained other
than tutorial sessions in the coming week.
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T1B, Fri, 4/11, 11:00 - 11:50AM, Rm 1007, LSK (Regular tutorial Rm)
T2A, Mon, 31/10, 4:30 - 5:20PM, G012, LSK (Regular tutorial Rm)
T2B, Thur, 3/11, 6:00 - 6:50PM, Rm 1014, LSK (Regular tutorial Rm)
ECON2123 - AS-AD Model (cont.) 2 Application – Monetary Expansion
Ms ↑ , so Y ↑ (detail: LM shifts down) Therefore, AD shifts right to AD’ Y’ > Yn and P’ > Pe (1st round) Expectation on P will be revised upward as
P’>Pe (2nd round) AS shifts up b/c upward revision of Pe
In the medium run, monetary expansion does not affect output but it effectively affects
(2) FALSE
D. All of the above
ECON2123 - AS-AD Model (cont.) 3 Application – Monetary Expansion
Figure 7-7 The Dynamic Effects of a Monetary Expansion (first round) short run eq. -> immediate change to AD
curve output at natural level
both SR and MR eq.
P=Pe, Y=Yn
monetary expansion-> increase Y-> AD curve shifts-> price increases
P'>Pe
ECON2123 - AS-AD Model (cont.) 4 Application – Monetary Expansion
Figure 7-7 The Dynamic Effects of a Monetary Expansion =Pe
MR and SR eq. after adjusting expectations ECON2123 - AS-AD Model (cont.) 5 Application – Monetary Expansion
Short Run ASAD: price is endogenous If P does not increase, shift
in LM curve would be larger If price does not change, B
would be the equilibrium in ASAD model (increase in
price) offsets interest decrease
IS-LM
in ISLM model (price doesn't Two effects work behind the change):
LM curve increases as price
shift from LM to LM’
increases and money demand
price: exogenous variable in ISLM model P increases (from P to P’) increases-> interest increases
shifts the LM upward from
LM’’ to LM’ How about interest rate (i)? Increase
ECON2123 - AS-AD Model (cont.) 6 Application – Monetary Expansion
Medium Run P increases and shifts LM’
back to LM Y back to Yn i back to original level Upward adjustment in Pe,
AS shift up to AS’’ (not
shown here) LM’ shifts (back) LM
MR: output level has to remain at Yn
price increases
LM curve shifts back to LM position
M/P real money supply decreases-> money demand increases
interest increases ECON2123 - AS-AD Model (cont.) 7 Neutrality of Money The above shown Monetary expansion leads
to an increases in Y, but in short run ONLY
i decreases and P increases as well How large is the SR effect depends on the
slope of the AS
Flatter the AS, larger increase in Y and smaller
increase in P, vice versa
Meaning of a flatter AS? In medium run, increase in nominal money
has no effect on Y and i
Proportional increase in price level: M/P remains
the same increase in nominal money supply-> proportional increase in actual price 8level ECON2123 - AS-AD Model (cont.) Neutrality of Money - Facts
Figure 1 The Effects of an Expansion in Nominal Money in the
Taylor Model
medium run short run ECON2123 - AS-AD Model (cont.) 9 Application – Decrease in budget deficit Budget deficit: G – T > 0
↓G or/and ↑T can reduce the deficit
Here ↓G In real world, why budget deficit happen for
some countries? ↑G or/and ↓T affect AD and/or AS?
↓G only affect AD
Shift down
How IS shifts in IS-LM framework? Short Run effect:
↓Y, ↓P (below Yn and Pe)
ECON2123 - AS-AD Model (cont.) Medium Run? 10 Application – Decrease in budget deficit
Figure 7-9 The Dynamic Effects of a Decrease in the Budget Deficit
short run:
if AD is shifted
AS does not move
expected price is fixed AD shifts to AD'
Eq. shifts to A' (which is not at Yn)
so AS shifts to AS" to reach Yn actual price<Pe
A' short run eq.
after policy shock(?) ECON2123 - AS-AD Model (cont.) Pe=P
new medium run eq.
after policy shock 11 Application – Decrease in budget deficit
Short Run If price does not change, B
would be the equilibrium in
IS-LM P decreases (from P to P’)
shifts the LM downward
from LM to LM’ How about interest rate (i)? Decrease
graph b)
reduction in govt spending (IS curve shifts to the left)
A->B (expected price doesn't change?-> no, the AS curve is general)
reduction of price level (LM curve shifts down)
intersection of new ISLM: A'-> new eq. output Y'<Yn
interest rate decreases ECON2123 - AS-AD Model (cont.) 12 Application – Decrease in budget deficit
Medium Run P decreases and shifts LM’
to LM’’
money supply increases, Y back to Yn real
LM shifts down i decreases to i’’ (decrease
further) Downward adjustment in Pe,
AS shift down to AS’’ (not
shown here, see Fig7-9)
monetary policy in MR LM’ shifts to LM’’ using
doesn't affect investment at natural output, P=Pe From SR to MR: 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.
ECON2123 - AS-AD Model (cont.) 13 Deficit reduction, Y, and i
IS r e la tio n : Y n C ( Y n T ) I ( Y n , i ) G Short Run: Deficit reduction only ↓ Y , C(Y-T)
reduces, however I (Y, i) is uncertain Medium Run: Y unchanged (back to Yn) and
T the same, so C(Y-T) back to original; I (Y,i)
increases due to lower i; G decreases Composition of Y changes in medium run
after a reduction in G
I “substitutes” G
Bigger I means larger capital stock and increase
in productivity (Long Run)
ECON2123 - AS-AD Model (cont.) 14 Thank you very much! (1) true (2) False (3) uncertain
1. Fiscal policy cannot affect investment in the medium run because output always returns to the natural level
Ans: (2) output and interest return to original level for monetary policy
fiscal policy: interest rate go to new eq. level See you next time ! 2. In the aggregrate demand relation, an increase in the price-level causes output to decrease because of it effect on
A) government spending
B) the money market and subsequently, investment
C) the nominal wage
D) firms' markup over labour costs
E) the expected price level
Ans: B. *AD curve* downward sloping (output decreasing function of price level in AD)
affect LM eq.(M/P real money supply) ; affect money market-> eq. interest rate level (outcome variable) -> investment in
goods market affected -> part of demand in goods market (Y=C+I+G)
higher price level -> lower output level
AD curve: output Y function of P; AS curve: P function of Y
see which one is the outcome variable ...

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- Macroeconomics, budget deficit