Transcript AS & AD part 1

Monetary Theory:
The AD/AS Model – Pt. I
ECO 473 – Money & Banking – Dr. D. Foster
Warning .. Warning .. Warning
• Aggregate Supply and Aggregate Demand are not
like market supply & demand !!!!!
• The “static” analysis only hints at dynamic
interpretation.
• Ceteris Paribus assumption problematic to the point
of being wholly inappropriate.
Contrasting views:
Classical/Monetarist vs. Keynesian
Friedman vs. Keynes
Non-activist vs. Activist
The Aggregate Demand Schedule
P
P = Price Level;
CPI or GDP deflator
Q = Y = Real GDP;
(real output)
A
P2
B
P1
AD = Agg. Demand;
From 4 sectors –
HH, Bus, G, Foreign
AD1
Q1
Q2
Q or R-GDP
Aggregate Demand
• The price level and real output demanded are
inversely related.
• A fall in the price level will increase quantity
demanded.
• Why? -- the Real Balances Effect
•
•
•
•
All prices and wages change.
But, our fixed money holdings are … well, still fixed!
So, with lower prices we feel wealthier. Woo Hoo!
And, so we want to buy more stuff.
Aggregate Demand
• What about:
 Interest effect
 Foreign trade effect
 Exchange rate effect
Can’t do “all else equal.”
e.g. Price of apples - QD for apples
... and the QD for oranges.
But, Price of everything and their isn’t
anything else to hold constant!
• AD can shift to the left or right.
 Increase AD – shift to the right.
 Decrease AD – shift to the left.
 Whenever C, I, G, net X increase/decrease.
 Why? Due to changes in the money supply!
The Aggregate Demand Schedule
P
Increases in
C, I, G, net X
Decreases in
C, I, G, net X
AD3
AD2
AD1
Q or R-GDP
Money and Aggregate Demand
• Equation of exchange:
MS * V = P * Y
 An accounting identity:
• Quantity theory of money:
MD = k * P * Y
 People hold money for transactions purposes.
 Velocity (V) is constant, or, at least, stable (=1/k).
 Real output (Y) is constant w.r.t. labor supply.
 Therefore, changes in MS will only change P.
• Aggregate Demand for output (AD)
- derived from the demand for money, or
- derived from the real balance effect.
QTM & The Aggregate Demand Schedule
P
MD = MS
Increases
in MS
MS = k * P * Y
MS/(k * P) = Y
AD = MS/(k * P)
Decreases
in MS
AD2
AD1
AD3
MS/(k*P)
MS/(k*P)
Q or R-GDP
The Money Supply and the Long Run Equilibrium
between Aggregate Demand and Aggregate Supply
P
ASLR
P1
There is a “long run”
Aggregate Supply,
which is perfectly vertical
at the “full employment”
level of Real GDP.
It is unaffected by changes in
the price level, but is affected
by a host of real variables…
AD1
Classical Model
of the Economy
Q or R-GDP
The Money Supply and the Long Run Equilibrium
between Aggregate Demand and Aggregate Supply
P
AS1
MS and that increases AD.
MS and that decreases AD.
Shifts in AD can only change
the price level and not real
output (nor employment).
P1
“Inflation is always, and
everywhere, a monetary
phenomenon.”
-Milton Friedman
AD1
Q or R-GDP
What affects the Aggregate Supply?
• Labor force participation.
• Labor productivity.
• Marginal tax rates on wages.
• Provision of government benefits that affect
household incentives w.r.t. supply labor.
• State of technology.
• Capital stock.
A change in these factors
can AS (shift right)
or AS (shift left)
Short Run Aggregate Supply – Wage Inflexibility
• Nominal wages are sluggish upwards:
 A rise in prices has delayed effect on wages.
• Nominal wages are inflexible downwards:
 A fall in prices will result in employment and y.
• Workers have money illusion:
 Higher nominal wages are viewed as real wage.
 So, more workers available even though real wage
has not risen.

e.g. if prices rise 5% and wages rise 3%…
Short Run Aggregate Supply
• What about:
 Sticky prices
 Misperception
 Intertemporal substitution
Unnecessary complications
to explain the SR AS.
Inflexible wages is all we need.
What happens if there is a AD?
• The Short Run will adjust to the Long Run:
 An AD will P and Q, but only in the SR.
 Prices rise but wages lag. Firms employment and
output.
 Eventually, workers realize their real wages (W/P) are
falling, get comparable wage, AS.

The temporary profit motive has been eliminated.
Monetary Theory:
The AD/AS Model – Pt. I
ECO 473 – Money & Banking – Dr. D. Foster