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The AS-AD model .

Consider the AS-AD model discussed in the course. Assume that the real interest rate only affects investment, not net exports. a. Write down the expressions for the AS and AD curves and illustrate the equilibrium in a diagram.

b. Interpret the expressions: what is the intuition behind the two curves? What must be true of the model parameters and variables in the long-run equilibrium, i.e. in the steady state?

c. Analyze the effects of a supply shock that causes a temporary increase in inflation, using a diagram. Assume that the shock lasts for one period and then assumes the value zero. Describe how the economy reaches the long-run equilibrium.

d. Use the AS-curve and Okun’s law to derive an expression for the Phillips curve in terms of cyclical unemployment.

Answer 1

a.) he expressions for Aggregate Demand and Aggregate Supply are:

AS = Y = C + S, where C = Consumption Expenditure, Y = National Income, and S = Savings

or

, whereY = aggregate output, Y(bar) = natural rate output, P = actual price level, Pe = expected price level, alpha = positive parameter.

SRAS = Y = y + a(P - Pe)

AD = C + I + G + NX, where C = Consumption, I = Investment, G = Governnment Expenditure, and NX = Net Exports

ASLR Price Level Pli AD Real GDP

In the diagram above we can see that the short-run AS supply intersects with AD at a point on the long-run AS curve. This intersection of the AD-AS curve determines the price level and the output in the economy. If the AD-AS curve intersect before the long-run AS curve we witness a recessionary gap or a negative output gap, and the economy should aim to place itself at the long-run AS curve, however, if the AD-AS curve intersect after the long-run equilibrium we witness an inflationary gap, at this point the economy should employ contractionary measures to bring the economy back to long-run equilibrium, or shift the long-run AS curve to the right by increase the economies productive potential.

b.)  

Interpretation of the AS (Aggregate Supply) curve:

AS = Y = C + S

It is theorized that the monetary value of final outputs is distributed among factor incomes profits, wages, rent, interest among the components that produce the goods and services in a national economy, or namely the factors of production. the incomes generated by factors of production are known as factor incomes, and the cumulation of these factor incomes on a national level is recognised as national income (Y). The national income, after taxes,  is then spent on consumption expenditure (C) and the balance (Y-C) is the savings (S).

SRAS = Y = y + a(P - Pe)

For steady-state equilibrium, the components actual price and expected price are needed to be the same, or $\alpha$ needs to be equal to zero and not a positive parameter. At this point, aggregate output will be equal to output at the natural rate.

For

Interpretation of the AD (Aggregate Demand) curve:

AD = C + I + G + XN

Also referred to as the domestic final demand, has 4 components. The C represents consumption and is the total consumption demand in an economy. The I represents investment the holistic intended investment in the economy, which could result in an increase in employment. The G represents the government spending, this is the gross government consumption expenditure and investment made by the government in the economy, which could result in an increase in employment through investments in public services or projects. The NX component represents the net exports or exports minus the imports (X-N). All the components share a linear relationship with to form the AD curve in the expression above and are positively correlated, thus an increase in any one of the components will result in the AD increasing.

c.)If the economy experiences a supply shock, the aggregate supply will shift to the left, causing the prices to increase from Pe to Ps and the output to drop from Qe to Qs (This point assumes value zero after the shock dissipates). In order to counter that autonomous easing of the monetary policy pushes the aggregate demand curve outwards to E2, which is the new equilibrium on the long-run AS curve. The economy is once again at long-run equilibrium output Qe but at a higher to price level. Pe2.

Price Level LRAS (PL) AS2 - LEA ADZ 1 - CADI 1 output (Y)

d.) Deviating from the plain illustration of the aggregate supply illustration of AS = C + S, in order to derive the Phillips curve from the short-run aggregate supply curve we need to use the formula:

SRAS = Y = y + a(P - Pe)

Y = aggregate output

Y(bar) = natural rate of output

P = actual price

Pe = expected price

We can then derive an expression for the Phillips curve as:

Phillips curre Y = y + @ CP-pe) pepe + (Ya)(y-Y) P= Pet('/a)(y-7)+v (P-P-) = (Re-7-1)+( -) T-te+(1/a)(y-7)+r. (la)(y-7)= - B(4-un) T=Te B (4-Un)tre tr y = aggregate output - Y = natural rate output IP actual price. Pe=expected price B - exogenous constant > 0 Ir supply shock Te = expected inflation t = actual inflation. entration supply shoeks. BUY

Adhering to the Okuns Law which establishes a relationship between unemployment and loss in gross output. This can be substantiated as inflation is a signal of economic growth, and growth in production, therefore as unemployment is low, the demand for goods and services is higher, and gross output is high, and the same applies vice Versa, low employment, low inflation and low output.