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Chapter 7: Putting All Markets Together: The AS-AD Model 7-6 The Price of Crude Petroleum since 1960 There were two sharp increases in the relative price of oil in the 1970s, followed by a decrease in the 1980s and the 1990s. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 1 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment The higher price of oil causes an increase in the markup and a downward shift of the price-setting line. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 2 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment Y P P (1 ) F 1 , z 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. © 2006 Prentice Hall Business Publishing e Macroeconomics, 4/e Olivier Blanchard 3 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment 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’. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 4 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment Over time, the economy moves along the AD curve, from A’ to A”. At point A”, the economy has reached the new lower natural level of output, Y’n, and the price level is higher than before the oil shock. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 5 of 49 Chapter 7: Putting All Markets Together: The AS-AD Model The Effects of an Increase in the Price of Oil on the Natural Rate of Unemployment 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 6 of 49 The Dynamics of Adjustment Chapter 7: Putting All Markets Together: The AS-AD Model Table 7-1 The Effects of the Increase in the Price of Oil, 1973-1975 1973 1974 1975 10.4 51.8 15.1 Rate of change of GDP deflator (%) 5.6 9.0 9.4 Rate of GDP growth (%) 5.8 0.6 0.4 Unemployment rate (%) 4.9 5.6 8.5 Rate of change of petroleum price (%) The combination of negative growth and high inflation, or stagnation accompanied by inflation, is called stagflation. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 7 of 49 Conclusions 7-7 Chapter 7: Putting All Markets Together: The AS-AD Model The Short Run Versus the Medium Run Table 7-2 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 Output Level Monetary expansion increase Medium Run Interest Rate Price Level Output Level Interest Rate Price Level decrease increase (small) no change no change increase no change decrease decrease decrease increase increase Deficit reduction decrease decrease decrease (small) Increase in oil price decrease increase increase © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 8 of 49 Conclusions Chapter 7: Putting All Markets Together: The AS-AD Model 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. © 2006 Prentice Hall Business Publishing Macroeconomics, 4/e Olivier Blanchard 9 of 49