Flashcards in L10 - The AD-AS Model Deck (19):

1

## What does the AD-AS Model look like?

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- With Price Level (P) on the y-axis and Income/GDP (Y) on the x-axis

- With the AD curve on a negative linear line with the main shift variables -->G, I, (P^*E)

- With the SRAS curve on a positive gradient curve with the shift variables --> μ, z, Φ, P^e

- they intercept at P(0) and Y(0)

- Only at the combination of GDP and price level given by the intersection of the SRAS and AD curves are desired spending (Aggregate demand) and desired production (aggregate supply) activities consistent

2

## What are some key things to remember about the AD-AS model?

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- The variables beside the curves are shift variables – changes in these exogenous variables shift the curves

- The main policy instruments affect only the demands curve

3

## What are the two types of Potential Shocks?

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- Demand Shocks

- Supply Shocks

4

## What happens with a Demand Shock?

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- For example an increase investment with shift the AD curve right - with Y(0) being original output, Y(1) equilibrium output and Y(2) it output on the new AD at the same price Level P(0)

- Aggregate demand shocks cause the price level and real GDP to change in the same direction, both rise with an increase in AD, and both fall with a decrease in AD

- Note also that the multiplier is smaller now that prices can change; i.e. it is ΔY = (Y(1) - Y(0)) < (Y(2) – Y(0)). As the price level rises net exports fall so there is a movement up along the new AD curve to the new equilibrium above Y(1)

- On the supply side the rise in Y raises P along the SRAS curve. The real wage rate (W/P) falls (because P rises whilst P^e is constant) making it profitable for firms to employ more workers. Thus at Y(1) there is higher employment and output

5

## What happens with a Supply Shock?

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- This could be a mark-up change, cut in unemployment benefits, increase in productivity etc --> With P(0) and Y(0) being the original equilibrium and P(1) and Y(1) being the new equilibrium after the shock

- A supply shock causes the price level and output to move in opposite directions --> if there is an increase in supply (SRAS shifts right and down) P will fall and Y will rise --> and with a decrease in Supply (SRAS shifts left and up) P will rise and Y will fall

- Note that the expected price level (P^e) is again assumed not to change, even though actual prices have fallen. This is due to the short-run nature of the model.

6

## What is the Long-Run Aggregate Supply (LRAS)?

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- In the long run the LRAS curve is vertical. In this case the unique level of output Y* is known (alternatively) as: the natural level of output; the full employment level of output; or the potential level of output

- This means there will be a different SRAS curve for every level of P^e

- The equation for the LRAS is

P = P^e (1+μ)f(Y/Φ, z)

- If P = P^e then this equation becomes

1 = (1+μ)f(Y/Φ, z) or 1/(1+μ) = f(Y/Φ, z)

- Which is independent of P (and P^e)

Rearranging in terms of Y* - the full employment (or potential) level of output is given as

Y*= F(Φ, μ, z)

7

## Why would the LRAS curve shift to the right?

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- if LRAS at the potential level of output is given as Y*= F(Φ, μ, z)

- the LRAS shifts to right as:

- Φ rises; μ falls; and z falls

8

## What does the AD-AS Model look like with the LRAS curve?

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- With Price Level (P) on the y-axis and Income/GDP (Y) on the x-axis

- there is the AD curve with a negative gradient and the SRAS curve with a positive gradient

- And a vertical line or LRAS (Φ, μ, z)

- equilibrium occurs when all these lines cross which is also the point P=P^e

- Above equilibrium point the difference between AD and SRAS is excess supply

- Below equilibrium point the difference between AD and SRAS is excess demand

9

## What can we interpret from the AD-AS model?

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- It is now time to put both the AD-AS curves together to give the equilibrium level of output (Y*) and price level - only at point a are desired spending (AE) and desired production (supply) activities consistent

- If P < P(0) (say at P(2)) then desired spending is consistent with a level of GDP that is less than the desired output of firms as at b

- If P > P{0} (say at P{1} then desired spending is consistent with a level of GDP that is less than the desired output of firms as at b

- If P > P^e then P is rising (as at P{1}); if P < P^e the P is falling (as at P{2})

10

## How does the AD-AS model with LRAS recover from a shock?

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- If the model is away from full employment equilibrium (Y*) the model will automatically self-adjust back to equilibrium.

- This may take too long in calendar time, prompting the authorities to take remedial policy action to restore the model to equilibrium

11

## How does the AD-AS Model Automatically Adjust to Equilibrium?

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In this case automatic adjustment comes about because of a disequilibrium between P and P^e.

If P>P^e, then P^e will be rising so that in equilibrium, P = P^e --> Inflationary Gap

If P < P^e then P^e will be falling so that in equilibrium P=P^e Deflationary Gap

- however we dont often see negative inflation --> hard to get automatic adjustment at P < P^e deflationary gaps can be a problem and get stuck at P < P^e

12

## What is the Asymmetric Adjustment in the AD-AS model?

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- The automatic adjustment mechanism implied in the previous slide is not a symmetric process. Prices are in general slower to fall than they are to rise.

- Thus whereas an inflationary gap may be eliminated quickly by rising prices and unit labour costs, a recessionary (or deflationary) gap may never be eliminated by wage and price adjustment – justifies policy interventions

13

## How do you eliminate a Recessionary Gap?

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- Start with Y(1) < Y* - a recessionary (output) gap.

-There are then 2 options:

- Increase AD by a rise in G or P*E

- or cut in r (which is assumed to increase I)

14

## How can Increasing AD to eliminated a Recessionary Gap be interpreted?

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- An AD shift will help to raise GDP, in the short-run, but if the policy is ‘misjudged’ then excess demand maybe created and inflation result. The final position must be where AD intersects the LRAS curve.

- A permanent increase in GDP can only happen if it is caused by a rise in productivity (Φ), or a permanent cut in unemployment benefit (z) or the mark-up (µ). In these cases both SRAS and LRAS shift to the right

15

## What were the three Big Policy dilemmas that have faced the UK authorities in recent times?

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- The oil price shocks 1973-4 & 1979-80

- ERM Membership 1990-92

- The Global financial crash 2008-09

16

## What is Stagflation?

### rising prices, falling output (falling employment)

17

## What was the Policy response the The Oil Price Shocks 197-4 & 1979-80?

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Oil price rise shifts SRAS(0) to SRAS(1) - shifts up and left – giving higher price at P(1) and lower output at Y(1)

- Option 1: Do nothing wait until unemployment puts downward pressure on money wages and price expectations so SRAS(1) moves back to SRAS(0)

- Option 2: Increase AD to AD(1) to protect employment but take a hit on inflation (Labour Party policy 1974-78)

- Option 3: Cut demand to AD(2) to keep inflation low at all costs and take an even bigger hit on unemployment (Conservative Party policy 1979-83)

18

## What was the Policy response to the ERM Membership Shock 1990-92?

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- UK joining the EMS at an overvalued exchange rate made UK exports uncompetitive – a large negative demand shock – shifting AD(0) back to AD(1) shift down and left

- Option 1: Take a hit on unemployment and wait until in the long run wage and price expectations adjust downwards – restoring output back to its equilibrium level (Conservative Party policy 1990-92)

- Option 2: Admit policy mistake and devalue £ against other EMS currencies

- Option 3: Wait for a speculative attack to destroy the credibility of the fixed rate policy, forcing the £ out of the system and bring about a 14% devaluation of the £ and shift AD curve back to the right (What happened in September 1992)

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