Tutorial 4: AS-AD Model Dynamics

Formula’s you should KNOW
• IS: Y = c0 + c1(1-t)Y + I(Y,i) + G + NX
– Goods market equilibrium

• LM: M/P = YL(i)
– Money market: higher interest decreases money demand

• AD: Y = Y(M/P , G, T)
– Equilibria in goods and money market

• AS: P = (1 + μ)PeF(1 – Y/L , z)
– Equilibrium wage market
– WS: W = Pe.F(u, z) u = 1 – N/L ; Y = N & in MR Pe = P
– PS: W/P = 1/(1+μ) real wage W/P is constant

Shifting Dynamics
• The trick to understanding the dynamics in ISLM, AS-AD and Ls-Ld is to know
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The initial situation is believed to be stable: Y = Yn
That SR means a few years
Where movement is initiated
How it affects everything else
That Yn has “magnetic pull” in the MR and LR
Pe adjusts slowly (MR)
Money is neutral in the MR  monetary policy only affects price level
– Fiscal policy is also ineffective in the MR

Exercise
• The wage setting relationship of the workers is W = Pe *
15/100u , where W is wage, Pe is expected price level and u is unemployment rate. A typical firm set prices according to the following price setting relationship P = W/3. Output is produced with the following production function Y = 2N, where N is the number of workers hired. The labour force is
100 000.
• What is natural rate of unemployment?
• What is potential output?
• Is this economy sustainable in the long run?

Solution
In MR, Pe = P 
– W / P (Price Setting) = W / Pe (Wage Setting)
 3 = 15 / 100u
– 100u = 5 and u = 0.05

Given the labour function Y = 2N
• GDP = Y = 2*(100,000 * 0.95) = 190,000
Sustainable?
Markup ~ W/P = 2/(1+mu) = 3
Thus 2/3 = 1 + mu mu = -1/3

What happens?
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Decrease of bank reserves
Higher government expenditure
Rise in bargaining power
Productivity increase (see pdf on the Hub)

Rise in Government Spending
1. IS: Z = C(Y-T) + I(Y, i) + G
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Shift in IS curve to the right
This means increase in Y > Yn and increase in i

2. AD: Y = Y(M/P , G, T)
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AD curve shifts right and follows IS
But moves slightly less due to increase in Prices P

Rise in Government Spending
3. LM: M/P = Md/P =Y.L(i)
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LM responds to changes -> higher Y and higher I => ambiguous effect
Rising prices lead to a small shift left of the LM-curve

4. AS: P = (1 + μ)PeF(1 – Y/L , z)
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Price rise leads to friction between current prices and expected prices => Adaptive expectations
As long as expected price is below actual price AS keeps shifting Rise in Government Spending
5. LM: Shifts back following the AS shifts (higher
P and decreasing Y)
Result: Same equilibrium output Y but higher prices and higher interest rate
- How do investments and consumption evolve over time?

Rise in bargaining power
1. W/Pe = F(u, z): Wage setting curve moves right, while price setting P = W*(1 + μ) is stable –
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This means an increase in natural rate of unemployment and thus a decrease of potential output Yn
Additionally, higher z means higher W and given that μ is a constant, prices P need to rise

Rise in bargaining power

Rise in bargaining power
2. AS: P = (1 + μ)PeF(1 – Y/L , z) shifts left due higher z
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This is accompanied by higher prices P and declining Y as it should be

3. LM follows AS because the higher prices are increasing demand for money, while M is assumed to stay constant => increasing interest rate
4. This cycle continues until new equilibrium Yn’

Increase in Productivity
• Production function: Y = N
• Increase in productivity: Y = AN (A > 1)
– TC = WN = WY/A -> MC = W/A
– PS: P = W/A * (1 + mu) -> P goes down
– W/P = A/(1 + mu)
• Real wage jumps up following the increase in A

– In MR: PS and WS have to be in equilibrium again
• when Pe = P

Price-setting & Wage-setting

What happens in MR?
• PS-WS shows that unemployment will decrease permanently following the productivity increase => Y will move towards a new higher potential output Yn
– Yn = (1 – un)*AL
– Decrease in u and increase in A show that Yn has to increase in MR!

Firms will increase supply at lower costs
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