Aggreg

gg gate Demand

Aggregate Supply

15 012 Applied Macro and International Economics

15.012

Alberto Cavallo

February 2011

 Class Outline

• The Business‐Cycle: Potential and Actual GDP

• Aggregate Demand (AD)

– The interest‐rate effect and slope
• Aggregate Supply (AS)
– Long run  potential output, vertical AS
Long‐run
– Short‐run  sticky prices, positive slope AS
• Effects of Policies in AS‐AD
AS AD

Alberto Cavallo ‐ 15.012 © MIT Sloan School of Management

 Potential and Actual GDP

Y = C + G + I + NX

• Potential GDP  estimate of GDP when all factors of

production (capital
(capital, labor,
labor and technology) are used at
“normal” rates
– Long‐run  Growth theory Y = Af(K,L)  not in 15.012

• Actual GDP  can be different because of booms and

recessions
– These
Th are sh
hort‐run
t flucttuati
fl tions, allso calllled
d the
th “b
“busiiness
cycle”
– We will use the AS‐AD model to analyze it

Alberto Cavallo ‐ 15.012 © MIT Sloan School of Management

 Potential and Actual GDP

Output
A t l GDP
Actual Potential
Boom GDP

Recession

Time

Alberto Cavallo ‐ 15.012 © MIT Sloan School of Management

 IS‐LM and AS‐AD

IS Curve
Goods market
Y‐C‐G = I(i
( ,,bc))
P
AS
Aggregate
Demand
LM Curve
LM C
Money Market
Ms = Md(PY,i)
Aggregate
Supply AD
i
(sticky prices)
IS LM Y

Prices and Output

Y
 IS‐LM and AS‐AD
• AS‐AD prices can change
‐ +
• In the money market… Ms = Md(i,PY)

Money Market
Ms
i

‐ +
Md(I, PY)

 Aggregate Demand
Why is the AD curve downward sloping? (not micro…)

• Wealth effect
P
↓P  wealthier  ↑C  ↑Y

• Interest rate eff

ffect (LM)
↓P  less money needed to buy

↓ Md  put money in bank

↓ i  ↑I  ↑Y

AD
• Exchangge rate effect
Y
↓P ↓ i  ↑Capital Ou lows

 Sell dollars  Dollar Depreciates

 ↑ net exports X  ↑Y↑Y

 The interest rate effect

Money Market IS‐LM

IS ‐LM AD
Ms
i i P
LM
LM’ with
lower P

Md((PY,,i))
IS
AD

M Y Y
Md((PY,i)’
Md PY,i)’

↓P  less cash needed to buy things↓ Md  ↓ i  ↑I  ↑Y

Alberto Cavallo
15.012 © MIT
Sloan School of Management
 Aggregate Demand

Y = C + I + G + NX
P

Increases in C, I, G or NX will make

the AD curve shift to the right

AD

 Monetary Policy and AD

• Expansionary monetary polic

policy
↑ money supply  ↓ interest rates  ↑investment  ↑ Y and AD

Money Market IS‐LM AD

Ms Ms
Ms’
i i P
LM
LM’

IS AD’
Md(PY,i) AD
M Y Y
 Fiscal Policy and AD
• Expansionary fiscal policy
↑ G  ↑ AD

Or ↓ T  ↑C  ↑ AD
AD

IS‐LM AD

i P
LM

IS’
IS AD’
AD
Y Y
 Demand and Supply

• Monetary and fiscal policies move aggregate

aggregate

demand (AD)
• But final impact on Y and P depends on….

on
• Aggregate Supply (AS)
– Long run
– Short run
 AS curve in Long Run

• Long‐run (LRAS)  capacity to produce by an

economy given by Y=Af(K,L)

P K is the capital stock, which

LRAS = Potential Output
depends on savings and
investments

L is the labor force, affected by

workers and average number of
hours worked

A is the technology, skills, quality

AD
of management.
Y

 AS Curve in Short Run

• Completely Flexible prices (classical view)
– Output is given
i by potential
i l output
– Increase in AD lead only to increases in price
• AS curve is a vertical line
• Monetary and fiscal policy have no effect on output

P
AS = Potential Output

Flexible Prices
Actual Y= Potential Y

AD

 AS Curve in Short Run

• Completely fixed prices (Keynesian view)

– Increases in AD can be met by increases in output

• AS curve is a horizontal line
• Mone
Monetary
tary and fisc
fiscal
al policy can affect
affect output

AS Fixed Prices

AD

 AS Curve in Short Run

• New “consensus” view:

– Upward‐sloping AS curve due to “sticky” prices

P Sticky Prices  firms adjust

AS prices slowly

Why?
•Menu Costs
•Contracts
•Contracts
•Staggered price setting
•Coordination failure
•Customer relations

AD

Y
 AS Curve in Short Run

• New “consensus” view:

– Upward‐sloping AS curve due to “sticky” prices

P Sticky Prices  firms adjust

AS prices slowly

Why?
•Menu Costs
•Contracts
•Contracts
•Staggered price setting
•Coordination failure
•Customer relations
AD
Curved depends on the
Y degree of slack in the economy
(more Keynesiani to th he lleft,
f
classical to the right)
 AS‐AD
AS AD in equilibrium

P LRAS

AS

AD

Y
 Policy example: Expansionary MP

Short ‐ Run

P
LRAS Short‐run effects:
AS
↑P and ↑Y

Y actual > Y Pot  boom

b or
over‐employment

AD’

AD

Y
YPot Y actual

inflationary gap
 Examp
ple: Exp
pansionaryy MP

Transition to Long ‐ Run

AS final

P
LRAS With time, AS moves up as more
AS
and more firms adjust their
prices

In the LR, Y actual = Y Pot

Longg‐run effects:
↑  P
no change in Y
AD’

AD

Y
YPot Y actual
 AS‐AD
AS AD and policy analysis
• What is your starting position?
• Equilibrium
• Boom
• Recession

• What is the main shock?

• Demand d or supply?
l ?

• Different policies can achieve different things

• Monetary and Fiscal Policy target the AD
• Supply‐side policies  target the AS
 Demand‐shock
Demand shock Recession

P
LRAS AS
Fall in AD  ↓ Y, ↓ P

‐Policy Response?

Expansionary Monetary and/or

Fiscal Policy  ↑ Y, ↑ P 
restore the eqquilibrium

AD

AD’

Y actual YPot
 Supply‐shock
Supply shock Recession
Recession

LRAS
P AS
If there is an oil price shock that
shifts AS in  ↓ Y, ↑ P (stagflation)
Policyy options?
p
1
Option 1:

B
Shift AD out to stabilize Y

2
3 Option 2:

A
Shift AD In to stabilize P

AD
Option 3:
Y “Supply Side” Economics
production incentives to get
closer to potential Y
try to push LRAS as well
US in the 80
80’s:
s: Reagan

Courtesy of Trading Economics, www.tradingeconomics.com. Used with permission.

 Remember

• Th
The AS‐AD
AS AD model
d l and
d transition
i i back
b k to potential
i l

output

• Monetary and fiscal policy in the AS‐AD model

• Use it for shock and policy analysis:

– St
Starting
ti position?
iti ?
– Type of shock?
– Effects of policies? Short‐run
Short run vs Long
Long‐run
run
 Next Class

• So far we have talked about stabilization

•
policies in an closed economy

• Next two classes we will talk more about how

the Central Bank operates, introduce
exchange rates and discuss financial crises
MIT OpenCourseWare
http://ocw.mit.edu

15.012 Applied Macro- and International Economics

Spring 2011

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