Introductory Macroeconomics Lecture 11: The AD-AS Model I PDF

Introductory Macroeconomics Lecture 11: The AD-AS Model I Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture The AD-AS Model I (a framework for analysing monetary and fiscal policy) (1) Aggregate Demand...

Introductory Macroeconomics Lecture 11: The AD-AS Model I Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture The AD-AS Model I (a framework for analysing monetary and fiscal policy) (1) Aggregate Demand (a) interest rates and aggregate output (b) monetary policy reaction function (2) Aggregate Supply (a) Phillips Curve and Okun’s Law (b) inflation expectations BOFAH Chapter 11; Review Lectures 3 and 4 2 Overview of AD-AS 3  Microeconomics price S p D q quantity 4  Macroeconomics inflation AS ⇡ AD Y output 5  AD-AS Model Two endogenous variables, inflation π and real output Y AD curve: downward sloping relationship between π and Y – position determined by monetary and fiscal policy, demand shocks AS curve: upward sloping relationship between π and Y – position determined by inflation expectations, supply shocks Intersection of two curves determines equilibrium π and Y 6 Aggregate Demand 7  (1) Aggregate Demand AD curve: downward sloping relationship between π and Y Two components (i) relationship between output Y and real interest rates r (from extended version of Keynesian model) (ii) relationship between inflation π and real interest rates r (from monetary policy reaction function) Short version ↑ π → ↑ r → ↓ Y 8  Reminder Recall the basic Keynesian Model Y = C +I +G with C = C̄ + c(Y − T̄ ) I = I¯ G = Ḡ Gives short-run equilibrium output 1 C̄ − cT̄ + I¯ + Ḡ
Y = 1−c But no role for interest rates at all ! Will now consider an extended Keynesian model that does have a role for interest rates. 9  (1)(a) Consumption and Real Interest Rate Extend consumption function to include real interest rate r C = C̄ + c(Y − T̄ ) − γC r, γc > 0 Higher r reduces consumption and increase saving by changing the inter-temporal trade off between current and future consumption. i.e., borrowing becomes more expensive and the returns to savings rises Parameter γC > 0 measures interest-sensitivity of consumption 10  (1)(a) Investment and Real Interest Rate Extend investment to include real interest rate r I = I¯ − γI r, γI > 0 Higher real interest rate r reduces investment demand as fewer projects are profitable due to – higher cost of borrowing – higher opportunity cost of investment Parameter γI > 0 measures interest-sensitivity of investment 11  Solving the Extended Keynesian Model Combine the following: Y = C +I +G C = C̄ + c(Y − T̄ ) − γC r I = I¯ − γI r G = Ḡ so that: Y = C̄ + c(Y − T̄ ) − γC r + I¯ − γI r + Ḡ And solve for Y : 1 C̄ − cT̄ + I¯ + Ḡ − γC r − γI r
Y = 1−c 12  Output and Real Interest Rate Can highlight the relationship between Y and r by writing: Y = A − γr where A denotes the exogenous aggregate demand components 1 C̄ − cT̄ + I¯ + Ḡ
A = 1−c and where γ is the interest sensitivity of output 1 γ = (γC + γI ) 1−c Output Y is decreasing in real interest rate r 13  Output and Real Interest Rate Gaps Also write natural output Y ∗ in terms of natural real rate r∗ Y ∗ = A∗ − γr∗ Can then write Y − Y ∗ = −γ(r − r∗ ) + εD (1) where εD = A − A∗ represents shocks to aggregate demand Shocks to aggregate demand are anything that shifts components of A away from long run levels A∗ – include fiscal policy shocks, investment demand shocks, consumer sentiment, etc... 14  (1)(b) Monetary Policy Reaction Function Central bank increases interest rates in response to inflation Stylized depiction of monetary policy i = r∗ + π + α(π − π ∗ ) where i = policy interest rate (nominal) ∗ r = natural real rate α = sensitivity of central bank’s policy rate to inflation gap π ∗ = central bank inflation target Write this in terms of real rate r = i − π (see lecture 3) r = r∗ + α(π − π ∗ ) or r − r∗ = α(π − π ∗ ) (2) When inflation at target, π = π ∗ , real rate r = r∗ 15  The AD Curve Plug (2) into (1) to get AD curve Y − Y ∗ = −αγ(π − π ∗ ) + εD (AD) Downward sloping relationship between π and Y , slope αγ Absent shocks, εD = 0, output at natural level Y = Y ∗ when inflation at target π = π ∗ 16  AD Curve inflation Y Y⇤ = ↵ (⇡ ⇡ ⇤ ) + "D ⇡ AD Y output 17  Shocks to AD Curve inflation Y Y⇤ = ↵ (⇡ ⇡ ⇤ ) + "D ⇡ AD Y output 18 Aggregate Supply 19  (2) Aggregate Supply AS curve: upward sloping relationship between π and Y holding inflation expectations fixed Two components (i) relationship between unemployment u and inflation π (from Phillips Curve, natural rate hypothesis) (ii) relationship between unemployment u and real output Y (from Okun’s Law) Short version, holding inflation expectations fixed ↑ Y → ↓ u → ↑ π 20  (2)(a) Phillips Curve Short run tradeoff between inflation and unemployment π = π e − ϕ(u − u∗ ) + εS (PC) where π e = inflation expectations (taken as exogenous for now) ϕ = inflation sensitivity to labour market tightness εS = supply shocks Holding inflation expectations fixed, a decrease in unemployment u increases inflation π As labour market gets tighter, wages rise, business costs rise, and hence prices rise 21  (2)(a) Phillips Curve inflation ⇡ = ⇡e (u u⇤ ) + "S ⇡ PC u unemployment 22  (2)(a) Natural Rate Hypothesis In long run π e = π and εS = 0 Long run Phillips’ Curve is then π = π − ϕ(u − u∗ ) Long run unemployment u = u∗ Long run inflation indeterminate No long run tradeoff between inflation and unemployment 23  (2)(a) Natural Rate Hypothesis inflation long run Phillips Curve vertical at u = u⇤ ⇡ u⇤ unemployment 24  (2)(b) Okun’s Law Inverse relationship between output gap and cyclical unemployment This can be expressed as u − u∗ = −β(Y − Y ∗ ) (OL) Unemployment u = u∗ when output Y = Y ∗ 25  The AS Curve Plugging (OL) into (PC) gives π = π e + ϕβ(Y − Y ∗ ) + εS (AS) More precisely, this is the Short Run AS (SRAS) curve, takes inflation expectations as exogenous – Upward sloping relationship between Y and π, slope ϕβ Long Run AS (LRAS) curve when π = π e and εS = 0 – Vertical at Y = Y ∗ 26  SRAS Curve inflation ⇡ = ⇡e + (Y Y ⇤ ) + "S SRAS ⇡ Y output 27  SRAS Curve inflation ⇡ = ⇡e + (Y Y ⇤ ) + "S SRAS ⇡ Y output 28  LRAS Curve inflation LRAS Y⇤ output 29 AD-AS Equilibrium 30  LRAS Curve inflation LRAS Y⇤ output 31  Long Run Equilibrium Long run equilibrium where – demand and supply shocks equal zero εD = εS = 0 – inflation expectations consistent π e = π AD-AS equations in the long run Y − Y ∗ = −αγ(π − π ∗ ) + 0 (LRAD) π = π + ϕβ(Y − Y ∗ ) + 0 (LRAS) Solves for Y = Y ∗ and hence π = π ∗ 32  Long Run Equilibrium inflation LRAS ⇡⇤ LRAD Y⇤ output 33  Short Run Equilibrium Short run equilibrium where – demand and supply shocks εD , εS – inflation expectations π e treated as exogenous AD-AS equations in the short run Y − Y ∗ = −αγ(π − π ∗ ) + εD (SRAD) π = π e + ϕβ(Y − Y ∗ ) + εS (SRAS) Solves for Y and π in terms of exogenous π e , εD , εS and parameters ϕ, β, α, γ 34  Example: Negative AD Shock inflation LRAS SRAS ⇡⇤ ⇡ LRAD SRAD Y Y⇤ output 35  Learning Outcomes 1 Understand and explain the determinants of the AD Curve, including behavioral responses to changes in real interest and the relationships captured in the monetary policy reaction function. 2 Understand and explain the determinants of the AS Curve, including relationships captured in Phillips Curve and Okun’s Law. 3 Understand and explain why the AS curve is different in the short run and the long run with a focus on the role of inflation expectations and the natural rate hypothesis. 4 Mathematically derive the AD and AS curves. 5 Be familiar with equilibrium diagrams in the long run and short run for the AD-AS model. 36  New Formula(s) and Notation i = r∗ + π + α (π − π ∗ ) (Monetary Policy Rule) Y − Y ∗ = −αγ (π − π ∗ ) + εD (Aggregate Demand) π = π e + ϕβ (Y − Y ∗ ) + εS (Aggregate Supply) r∗ natural real rate α sensitivity of policy rate to inflation gap γ sensitivity of expenditure to interest ε εD demand shock, εS supply shock ϕ sensitivity of inflation to output gap e π inflation expectations ∗ π central bank inflation target 37  Next Lecture Working with the AD-AS model – Temporary shock * investment boom * confidence slump * energy price hike – Permanent shocks * increase in natural output * decrease in inflation target BOFAH Chapter 11 38