AD ASmodel

The AS-AD
model
From the short run to the

medium run
In the short run prices are either sticky (non

moving) or adjusting very slowly. We can say
that their adjustment is sluggish. Output can
be above or below its natural level.
In the medium run prices are flexible. They
adjust over time. Output returns to its natural
level, the level determined by an economys
productive capacity, i.e. the amount of its
factors of production (capital and labor).
2
From the short run to the

medium run
So far, by using the IS-LM model, we
have a picture of the demand side of
the economy.
To get to the medium run we also
need to get a picture of the supply
side of the economy.
The Labor market
To get to the supply side, we need to take

into account the labor market.
In the labor market, we will identify two forces
that determine the equilibrium level of the
real wage and the equilibrium level of
unemployment.
We will call these forces: the wage setting
relation and the price setting relation.
The Labor market (Wage

setting)
Who sets the wages in the labor market?

Who else, the interested parties: employers
and employees.
How do they set the prices?
They bargain, either individually or
collectively through unions.
Why do they do it like that?
Well, there is no other way in a decentralized
economy.
5

setting)
So, as employees, how would decide what

nominal wage offer to float on the
negotiations table?
Wouldnt we take into account the price level
that we would expect to face in the future?
Yes, we would. We would like to be insured
against changes in the price level for the time
that the wage contract would bind us. So our
offer would depend on the expected price
level (Pe).
6

setting)
Our offer would also depend on the

conditions of the labor market. If there is high
unemployment, we would be willing to settle
for a lower wage because the chances of
finding another job are slim. However, if there
is low unemployment, then we can take our
chances and ask for a high wage since we
can find another job easily.
So our wage offer depends negatively on the
rate of unemployment (u).
7

setting)
Finally, our offer depends on other factors

that affect the labor market, like e.g.
unemployment benefits. The higher they are,
the higher wage we will ask. Or another
factor could be the power of the union we
belong in and the solidarity of its members.
We will call these other factors z and we will
assume that our wage offer depends
positively on them. The higher they are, the
more money we ask.
8

setting)
Of course, our employers think in the same

way. The higher they expect the price level to
be, the higher nominal wage they would be
willing to give. The higher they observe the
unemployment rate to be, the lower wage
they are going to offer. The higher the
unemployment benefits and the other factors
are, the higher their offer is going to be.

setting)
Since both parties, employees and employers base their

decisions on the same factors, the wage setting decision
they are going to reach will depend on these factors as
well.
The nominal wage will depend one to one on the
expected price level Pe. It will also depend on the
unemployment rate u and the other factors z. Since we
dont know how exactly it depends on u and z, we will
include those in a function that will call F(u,z).
Therefore, mathematically we write:
W = PeF(u, z)
This is the wage setting relation.
10
The Labor market (Price

setting)
Now, how do the firms determine the price they are going
to sell their goods at?
Well, for starters there is a simple rule: they wouldnt
want to sell at a price that is less than their cost.
But what is their cost?
By assumption, firms only use labor. So, they produce
according to a production function that looks like that:
Y = F(N)
Output is a function of the labor N employed.
What if we make a further assumption: every worker that
firms employ produces only one good. In that case, the
production function becomes even simpler: Y = N
11

setting)
Next step: how much do firms pay their workers?

The answer is easy: they pay them the nominal
wage W.
Now, if we assume that we are in a perfect
competition environment, where firms make zero
profits, then it must be that firms sell each good for a
price P that is equal to the nominal wage W.
Remember each worker produces one good and
firms pay this worker W. Then firms break even if
they sell each good for P = W.
12

setting)
Now, if we assume away perfect competition and

allow firms to make some profits, then the firms may
charge a price that is above the nominal wage that
they pay to the workers.
We call the amount that the price exceeds the
nominal wage, markup and we denote it by .
Mathematically we write: P = (1 + )W
This is the price setting relation and it tells us that P
is greater than W by a factor W. The firms now
make profits and our scenario is more realistic.
13
The Labor market (Wage and

Price setting combined)
We can make an assumption that will simplify things

bit, namely that in the wage setting relation, the
nominal wage depends not on the expected price
level but on the actual price level.
This could be because e.g. workers negotiate
wages very often (say every month). In that case,
they wouldnt need to form expectations about the
price level because since they would renegotiate
their wage very soon.
14

So, if Pe = P, the wage setting relation

becomes: W = PF(u, z)
Solving for the real wage W/P, we obtain:

W/P = F(u, z)
This expression tells us that the real wage W/P
is negatively related to unemployment u and
positively related to the other factors z.
15

Also solving the price setting relation for the

real wage we obtain:
P = (1 + )W =>
P/W = (1 + ) =>
W/P = 1/(1 + )
This expression tells us that the real wage
W/P does not depend on unemployment but
only on the markup .
16

If we equate the two expressions for the real

wage that we obtained from the wage and the
price setting relations we obtain:
F(un, z) = 1/(1 + )
When the real wage is in equilibrium, we say

that unemployment is at its natural rate,
which we denote by un.
17
The Labor market in

equilibrium
Here we combine the wage
setting relation, which tells us that
the real wage is a negative
function of the unemployment
rate, and the price setting relation,
which tells us that the real wage
does not depend on
unemployment. When the labor
market clears we obtain the
equilibrium level of real wage and
the equilibrium rate of
unemployment, which we call the
natural rate of unemployment.
W/P
1/(1 +)
PS
WS
un
18
Deriving the AS curve
Now that we have described the labor

market, we can combine the wage setting
and the price setting relation to get an
expression between prices and output.
Lets start from the price setting equation
P = (1 + )W and lets substitute the wage
with its equal from the wage setting equation
W = PeF(u,z)
We obtain P = Pe(1 + )F(u, z).

19
Furthermore:
u = U/L =>
u = (L N)/L =>
u = L/L N/L =>
u = 1 N/L
But according to our production function Y=N.
Therefore: u = 1 Y/L
20
Substituting this expression for u into the

expression that we obtained before, we get:
P = Pe(1 + )F(1 Y/L, z), which is the AS
relation.
This expression shows a positive relationship
between output and prices.
We will now explain why.
21
If output goes up then unemployment goes down.

If unemployment goes down, workers are in a better
bargaining position and can ask for higher nominal
wages (remember the wage setting equation).
If nominal wages go up, this means that the firms have
to charge higher prices to cover their increased costs
(remember the price setting equation).
Therefore higher output leads to higher prices and we
have established the positive relationship between the
two variables.
22

P
Starting from the labor market

we have managed to establish a
positive relationship between
output and prices. The AS curve
depicts this relationship.
AS
23
Deriving the AD curve
Lets return to the IS-LM model and lets see

what happens if we assume an increase in
prices.
The increase in prices means that the supply
of real money balances decreases shifting
the LM curve to the left (up). This results in a
lower level of output.
24
Therefore a higher level of prices, through the IS-LM

model, leads to a lower level of output.
We call this negative relationship between prices
and output AD relation and mathematically we
express it as:
Y = Y(G, T, M/P)
This means that output depends on G, T and M/P.
In particular any change of these factors that shifts
the IS or the LM to the right (or to the left), also
shifts the AD curve to the right (or to the left).
25

P
P2
Panel B
P1
AD
Y2
Y1
Y
LM2
Panel A
i2
LM1
i1
Starting from an increase in

prices in Panel A, the supply of
real money balances M/P goes
down. This shifts the LM curve
to the left (up) leading to a lower
level of output. Therefore, we
have established that a higher
level of output, through the ISLM model translates to a lower
level of output. The AD curve in
Panel B sums up this negative
relationship between prices and
output.
IS
Y2
Y1
Y
26
Combining the AS and AD

curves
P
Combining the AS and AD

curves we may find the
equilibrium level of prices and
output in an economy.
AS
P*
AD
Y*
27
Fiscal expansion
As we already know, a fiscal expansion is a situation

where the government increases government
expenditures (G). This is synonymous to an
increase in the government deficit (G - T).
As we have mentioned, this corresponds to a shift of
the IS curve to the right.
If we assume that we start at the natural level of
output (Yn), the result of the shift is a level of output
higher than the natural level and a higher level of
interest rate.
28
Fiscal expansion
Turning to the AS-AD model, the shift of the

IS curve to the right means that the AD curve
also shifts to the right. This leads to a higher
level of prices. Prices now exceed the
expected level of prices. Remember that by
definition, when output is at the natural level,
actual prices are equal to expected prices.
Now, we are at our new short run equilibrium
(point B). Output and prices are higher
compared to the initial level.
29
Fiscal expansion
Moving from the short to the medium run, since prices rose,
wage setters, who are not idiotic, will increase their price
expectations. In turn, this increase in expected prices will shift
the AS curve upward, so actual prices will rise again.
The process starts again: wages setters adjust their price
expectations shifting the AS curve up and increasing actual
prices.
The process comes to an end, when output, moving along the
new AD curve returns to its natural level. When output reaches
again its natural level, wage setters have no reason to adjust
their expectations and the spiral price increase ends. Now, we
are at our new medium run equilibrium (point C). Output is the
same compared to the initial level but prices are higher.
30
Fiscal expansion
We have to take one final step to complete our

experiment: turn back to the IS-LM model.
The rise in prices that occurred from the short run to
the medium run means that the supply of real
money balances (M/P) decreased. This means that
the LM curve will shift to the left (up). It will keep
shifting left (up) until output reaches its previous
natural level (point C). The interest rate now is even
higher.
31
Fiscal expansion
P
AS2
Panel B
Pe = P3
AS1
P2
Pe = P1
AD2
AD1
Yn
Y1
Y
LM2
Panel A
i3
LM1
i2
i1
IS2
IS1
Yn
Y1
Starting at the natural level of output, an

initial increase in G shifts the IS to the
right in Panel A. This results in a level of
output higher than the natural level and a
higher interest rate. In Panel B the AD
curve shifts to the right leading to higher
output and actual prices higher than the
expected level. The short run equilibrium
is at point B in both panels. Over time, the
higher prices induce wage setters to
increase their price expectations shifting
up the AS curve in Panel B. Shifting stops
at the new medium run equilibrium at
point C along the new AD curve, where
output is back to its initial natural level
and prices are higher. Back to Panel A,
the increase in prices reduces the supply
of real money balances shifting the LM
curve to the left (up). In the medium run
we end up at point C, back to the natural
level of output but with a higher interest
rate.
Y
32
Fiscal expansion in the short

run
a)
b)
c)
d)
e)
f)
g)
So now, we have a clear picture of how all our variables moved in

the short run compared to their initial level:
Y: output is positively affected. It rises above its natural level.
C: consumption is positively affected since our disposable income
increases.
i: the interest rate increases.
I: the movement of investment is ambiguous because on the one
hand output went up and we know that this boosts I, but on the
other hand the interest rate increased and we also know that this
shrinks investment. So the net effect is ambiguous.
P: prices increase.
u: unemployment rate goes down, below its natural level, since
output goes up and we need more people employed to produce
that.
G: government expenditures go up by assumption.
33
Aggregate effects of a fiscal

expansion in the short run
Y
34
Fiscal expansion in the

medium run
a)
b)
c)
d)
e)
f)
g)
We also have a clear picture of how all our variables moved in the
medium run compared to their initial level:
Y: output goes back to its natural level. It is unchanged compared
to the initial level.
C: consumption is also unchanged since output is unchanged.
I: investment unambiguously decreases because the interest rate
increased, while output is unchanged. So only the negative effect
of the interest rate increase is at work.
P: prices increase.
u: unemployment rate is unchanged since we are back to the
previous level of output.
G: government expenditures go up by assumption. Notice that
investment goes down by as much as G goes up in order for
output to be unchanged. This is the well known crowding out
effect.
35

expansion in the medium run
Y
36
Fiscal contraction
A fiscal contraction is a situation where the

government decreases government
expenditures (G). This is synonymous to a
decrease in the government deficit (G - T).
As we have mentioned, this corresponds to a
shift of the IS curve to the left.
If we assume that we start at the natural level
of output (Yn), the result of the shift is a level
of output lower than the natural level and a
lower level of interest rate.
37
Fiscal contraction

IS curve to the left means that the AD curve
also shifts to the left. This leads to a lower
level of prices. Prices now are below the
expected level of prices. Now, we are at our
new short run equilibrium (point B). Output
and prices are lower compared to the initial
level.
38
Fiscal contraction
Moving from the short to the medium run, since prices fell, wage
setters will decrease their price expectations. In turn, this
decrease in expected prices will shift the AS curve downward, so
actual prices will fall again.
expectations shifting the AS curve down and decreasing actual
prices.
their expectations and the spiral price decrease ends. Now, we
same compared to the initial level but prices are lower.
39
Fiscal contraction
Going back to the IS-LM model, the fall in

prices that occurred from the short run to the
medium run means that the supply of real
money balances (M/P) increased. This
means that the LM curve will shift to the right
(down). It will keep shifting right (down) until
output reaches its previous natural level
(point C). The interest rate now is even lower.
40
Fiscal contraction
P
AS1
Panel B
Pe = P1
P2
AS2
Pe = P3
AD1
AD2
Y1
Yn
Y
LM1
Panel A
i1
i2
LM2
i3
IS1
IS2
Y1
Yn

initial decrease in G shifts the IS to the
left in Panel A. This results in a level of
output lower than the natural level and a
lower interest rate. In Panel B the AD
curve shifts to the left leading to lower
output and actual prices lower than the
expected level. The short run equilibrium
is at point B in both panels. Over time, the
lower prices induce wage setters to
decrease their price expectations shifting
down the AS curve in Panel B. Shifting
stops at the new medium run equilibrium
at point C along the new AD curve, where
and prices are lower. Back to Panel A, the
decrease in prices increases the supply
curve to the right (down). In the medium
run we end up at point C, back to the
natural level of output but with a lower
interest rate.
Y
41
Fiscal contraction in the

short run
a)
b)
c)
d)
e)
f)
g)

Y: output is negatively affected. It falls below its natural level.
C: consumption is negatively affected since our disposable
income decreases.
i: the interest rate decreases.
I: the movement of investment is ambiguous because on the one
hand output went down and we know that this lowers I, but on the
other hand the interest rate decreased and we also know that this
boosts investment. So the net effect is ambiguous.
P: prices decrease.
u: unemployment rate goes up, above its natural level, since
output goes down and we need less people employed to produce
that.
G: government expenditures go down by assumption.
42

contraction in the short run
Y
43
Fiscal contraction in the

medium run
a)
b)
c)
d)
e)
f)
g)
I: investment unambiguously increases because the interest rate
decreased, while output is unchanged. So only the positive effect
of the interest rate decrease is at work.
P: prices decrease.
G: government expenditures go down by assumption. Notice that
investment goes up by as much as G goes down in order for
output to be unchanged.
44

contraction in the medium run
Y
45
Monetary expansion
We already know that a monetary expansion

is a situation where the central bank
increases the money supply.
We also know that this shifts the LM curve to
the right (down).
The result is a higher a level of output and a
lower level of interest rate.
46
Monetary expansion

LM curve to the right means that the AD
curve also shifts to the right. This leads to a
higher level of prices. Prices now exceed the
and prices are higher compared to the initial
level.
47
Monetary expansion
Moving from the short to the medium run, since prices rose,
wage setters will increase their price expectations. In turn, this
increase in expected prices will shift the AS curve upward, so
actual prices will rise again.
expectations shifting the AS curve up and increasing actual
prices.
their expectations and the spiral price increase ends. Now, we
same compared to the initial level but prices are higher.
48
Monetary expansion
Going back to the IS-LM model, the rise in

money balances (M/P) decreased. This
means that the LM curve will shift to the left
(up). It will keep shifting left (up) until output
reaches its previous natural level, back to
point A. The interest rate returns to its
previous level.
49
Monetary expansion
P
AS2
Panel B
Pe = P3
AS1
P2
Pe = P1
AD2
AD1
Yn
Y1
Y
LM1
Panel A
i1
LM2
i2
B
IS
Yn
Y1

initial increase in money supply shifts the
LM to the right (down) in Panel A. This
results in a level of output higher than the
natural level and a lower interest rate. In
Panel B the AD curve shifts to the right
leading to higher output and actual prices
higher than the expected level. The short
run equilibrium is at point B in both
panels. Over time, the higher prices
induce wage setters to increase their
price expectations shifting up the AS
curve in Panel B. Shifting stops at the
new medium run equilibrium at point C in
Panel B along the new AD curve, where
and prices are higher. Back to Panel A,
the increase in prices reduces the supply
curve back to the left (up). In the medium
run in Panel A, we end up back at point A,
back to the natural level of output but with
the same interest rate compared to the
initial level.
50
Monetary expansion in the

short run
a)
b)
c)
d)
e)
f)

Y: output is positively affected. It rises above its natural level.
C: consumption is positively affected since our disposable income
increases.
I: investment unambiguously increases because we saw that the
interest rate went down (this increases investment) and also
income went up (this also increases investment). So a monetary
expansion gives a twofold boost to investment (compare that to
the fiscal expansion which had an ambiguous effect on
investment).
P: prices increase.
u: unemployment rate goes down, below its natural level, since
output goes up and we need more people employed to produce
that.
51
Aggregate effects of a monetary

expansion in the short run
Y
52
Monetary expansion in the

medium run
a)
b)
c)
d)
e)
f)
i: the interest rate is unchanged.
I: investment is unchanged since output is unchanged and the
interest rate is unchanged.
P: prices increase.
Notice that the only variable that changed in the medium run is the
level of prices. This phenomenon is the so called money neutrality.
Money in the long run (medium run) does not affect real variables
but only nominal ones.
53

expansion in the medium run
Y
54
Monetary contraction
We already know that a monetary contraction

is a situation where the central bank
decreases the money supply.
We also know that this shifts the LM curve to
the left (up).
The result is a lower a level of output and a
higher level of interest rate.
55

LM curve to the left means that the AD curve
also shifts to the left. This leads to a lower
level of prices. Prices now are below the
and prices are lower compared to the initial
level.
56
Moving from the short to the medium run, since prices fell, wage
setters will decrease their price expectations. In turn, this
decrease in expected prices will shift the AS curve downward, so
actual prices will fall again.
expectations shifting the AS curve down and decreasing actual
prices.
their expectations and the spiral price decrease ends. Now, we
same compared to the initial level but prices are lower.
57
Going back to the IS-LM model, the fall in

money balances (M/P) increased. This
means that the LM curve will shift to the right
(down). It will keep shifting right (down) until
output reaches its previous natural level,
back to point A. The interest rate returns to its
previous level.
58
P
AS1
Panel B
Pe = P1
P2
AS2
Pe = P3
AD1
AD2
Y1
Yn
Y
LM2
Panel A
i2
LM1
i1
A
IS
Y1
Yn

initial decrease in money supply shifts the
LM to the left (up) in Panel A. This results
in a level of output lower than the natural
level and a higher interest rate. In Panel
B the AD curve shifts to the left leading to
lower output and actual prices lower than
the expected level. The short run
equilibrium is at point B in both panels.
Over time, the lower prices induce wage
setters to decrease their price
expectations shifting down the AS curve
in Panel B. Shifting stops at the new
medium run equilibrium at point C in
Panel B along the new AD curve, where
and prices are lower. Back to Panel A, the
decrease in prices increases the supply
curve back to the right (down). In the
medium run in Panel A, we end up back
at point A, back to the natural level of
output but with the same interest rate
compared to the initial level.
59
Monetary contraction in the

short run
a)
b)
c)
d)
e)
f)

Y: output is negatively affected. It falls below its natural level.
C: consumption is negatively affected since our disposable
income decreases.
I: investment unambiguously falls because we saw that the
interest rate went up (this decreases investment) and also income
went down (this also decreases investment). So a monetary
expansion gives a twofold blow to investment.
P: prices decrease.
u: unemployment rate goes up, above its natural level, since
output goes down and we need less people employed to produce
that.
60

contraction in the short run
Y
61
Monetary contraction in the

medium run
a)
b)
c)
d)
e)
f)
i: the interest rate is unchanged.
I: investment is unchanged since output is unchanged and the
interest rate is unchanged.
P: prices decrease.
Money neutrality reaffirms itself.
62

contraction in the medium run
Y
63
Price Shock
When we face an exogenous price shock that

affects the production process, our approach
to the problem changes a bit.
We have to start our analysis from the labor
market and observe how this market reacts to
this shock.
64
Price Shock
Lets assume that energy prices go up. This affects the cost of
our production.
The problem is that according to our production function, we
only use labor to produce our goods.
So, the only way to incorporate the effect of the price increase
on the cost of production is to make use of the markup .
Remember that the markup is a percentage that tells us how
much over our marginal cost, we charge for our goods.
In our case, marginal cost is the nominal wage, so the markup
tells us how much over the nominal wage we charge. Since
the cost of production went up, this means that will charge
more over the nominal wage, i.e. the markup will increase.
65
Price Shock
The increase in the markup affects the price

setting equation: W/P = 1/(1 + )
The increase in means that the real wage
must go down.
Lets graph this result.
66
Price Shock
W/P
1/(1 +1)
PS1
1/(1 +2)
PS2
The rise in the markup causes a

drop in the real wage and an
increase in the natural rate of
unemployment. A higher natural
rate of unemployment translates
to a lower natural level of output.
WS
un
un
67
Price Shock
Since the natural rate of unemployment

increased, this means that the natural level of
output must have decreased.
Our next task is to find out what happens with
the AS-AD model.
We are not interested in the IS-LM model
because the energy price increase is a
supply side shock and has nothing to do with
aggregate demand, which is described by the
IS-LM model.
68
Price Shock
Lets go back to our equation for aggregate

supply: P = Pe (1 + ) F(1 (Y/L), z)
We observe that the markup is positively
related with the level of prices P. This means
that for a given level of output, if the markup
goes up, the AS curve will shift up.
The AD curve does not move.
The new short run equilibrium will be at point
B with lower output and higher prices.
69
Price Shock
Moving from the short to the medium run, since

prices rose, wage setters will increase their price
expectations. In turn, this increase in expected
prices will shift the AS curve upward, so actual
prices will rise again.
The process comes to an end, when output, moving
along the AD curve reaches its new lower natural
level. Now, we are at our new medium run
equilibrium (point C). Output is even lower
compared to the initial level and prices are higher.
70
Price Shock
P
AS3
AS2
P3
AS1
P2
Pe = P1
A
AD
Yn
Y1
Yn
The energy prices shock increases the

natural rate of unemployment and lowers
the medium run natural level of output. In
the short run the rise in the markup shifts
the AS curve up. The new short run
equilibrium is at point B where the actual
level of prices exceeds the expected level
of prices for the initial natural level of
output. Over time, the higher prices induce
wage setters to increase their price
expectations shifting the AS curve further
up. Shifting stops at the new medium run
equilibrium at point C along the AD curve,
where output reaches its new natural level
and prices are higher.
71

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AD ASmodel

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The AS-AD

From the short run to the

In the short run prices are either sticky (non

From the short run to the

The Labor market

To get to the supply side, we need to take

The Labor market (Wage

Who sets the wages in the labor market?

The Labor market (Wage

So, as employees, how would decide what

The Labor market (Wage

Our offer would also depend on the

The Labor market (Wage

Finally, our offer depends on other factors

The Labor market (Wage

Of course, our employers think in the same

The Labor market (Wage

Since both parties, employees and employers base their

The Labor market (Price

The Labor market (Price

Next step: how much do firms pay their workers?

The Labor market (Price

Now, if we assume away perfect competition and

The Labor market (Wage and

We can make an assumption that will simplify things

The Labor market (Wage and

So, if Pe = P, the wage setting relation

Solving for the real wage W/P, we obtain:

The Labor market (Wage and

Also solving the price setting relation for the

The Labor market (Wage and

If we equate the two expressions for the real

When the real wage is in equilibrium, we say

The Labor market in

Deriving the AS curve

Now that we have described the labor

We obtain P = Pe(1 + )F(u, z).

Deriving the AS curve

Deriving the AS curve

Substituting this expression for u into the

Deriving the AS curve

If output goes up then unemployment goes down.

Deriving the AS curve

Starting from the labor market

Deriving the AD curve

Lets return to the IS-LM model and lets see

Deriving the AD curve

Therefore a higher level of prices, through the IS-LM

Deriving the AD curve

Starting from an increase in

Combining the AS and AD

Combining the AS and AD

As we already know, a fiscal expansion is a situation

Turning to the AS-AD model, the shift of the

We have to take one final step to complete our

Starting at the natural level of output, an

Fiscal expansion in the short

So now, we have a clear picture of how all our variables moved in

Aggregate effects of a fiscal

Fiscal expansion in the

Aggregate effects of a fiscal

A fiscal contraction is a situation where the

Turning to the AS-AD model, the shift of the

Going back to the IS-LM model, the fall in