Prof.

Fei DING
The Hong Kong University of Science and Technology

MORE ON
THE AS-AD MODEL
(Supplementary notes for Chapter 7)

PURPOSE

This set of notes aims to clarify and enhance

your understanding of the medium run
analysis.

Your TAs will answer any questions you may

have and go over some exercises during
tutorials (Nov. 2 6).

Please feel free to ask any additional

questions.
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SHORT RUN VS. MEDIUM RUN EFFECTS

Table 7-1 Short-Run Effects and Medium-Run Effects of a Monetary Expansion, a
Budget Deficit Reduction, and an Increase in the Price of Oil on Output, the
Interest Rate, and the Price Level
Short Run
Output
Level
Monetary
expansion

Increase

Medium Run

Interest
Rate

Price
Level

Output
Level

Interest
Rate

Price
Level

Decrease

Increase
(small)

No change

No change

Increase

No change

Decrease

Decrease

Decrease

Increase

Increase

Deficit
reduction

Decrease

Decrease

Decrease
(small)

Increase
in oil price

Decrease

Increase

Increase

(1) MONETARY EXPANSION

Short run:

The AS-AD diagram: AD shifts right Y , P

The IS-LM diagram: LM shifts down Y , i here the LM curve after shifitn

Medium run:

down will shift up abit as a re

of the increase in price level
arrows along the line from the old AS to the new AS.

The AS-AD: since Y>Yn and P>Pe Revise up Pe P

exp price level will
rises AS shifts up Y returns; P further cause
revise

and then as AS rises as a result of the increase in price, it will result in decrease in M/P and affect LM.

The IS-LM: since P , (M/P) LM shifts up back to

its initial level i and Y unchanged
need arrows for the LM moving back
"prices increased further, clearer than sr situation"

to the original position also.

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(2) BUDGET DEFICIT REDUCTION

Short run vs. Medium run (work through it!)

ad ad, the AD will just decrease and of the ISLM, the IS will decrease and the LM will increase slightly because of the decrease
in prices.
we can do the LR and SR to be in the same diagram, from the shock to the MR situation and do not need to draw the 2 diag
and need to draw all the related curves
shift of AS is always because of Pe and this will result in the shifts.
the LM is because of the price level and hence, will shif down even further
increase in COP will result in an increase in mark up this will affect the natural rate of unemployment; unemployment increase,
natural level of output will hence decrease and the new level of nat. output is determined.

(3) INCREASE IN OIL PRICE

The AS-AD: follow slides or textbook.

The IS-LM: effect on interest rate?

Short run: P (M/P) LM shifts up i

Medium run: P further (M/P) further LM

shifts up further i further

Overall: C , I , Y

need to have the intermediate LM and then, the final

LM curve at the natural level of output. the initial increase
is because of the price increase and the final LM is price level

new Yn is already determined in the SR and hence, theres no further changes.

THE AD CURVE VS. DEMAND CURVES

The AD curve plots the combinations of P and Y

consistent with simultaneous equilibrium in the goods
and financial markets.

It slopes down because of the effect of P on the real

money supply, and hence on the interest rate,
investment, and output.

The AD curve sloping down is NOT because a lower

price level makes goods more attractive to people.

THE AS CURVE VS. SUPPLY CURVES

The AS curve plots the combinations of P and Y

consistent with the equilibrium in the labor market,
conditional on the expected price level.

It slopes up because higher output implies a lower

unemployment rate, which leads to higher wage and
higher price level.

The AS curve sloping up is NOT because firms want to

supply more goods when the price level is higher.

ANALYSIS OF SHOCKS IN THE AS-AD MODEL (1)

Unless stated otherwise, assume that the economy begins in

medium-run equilibrium. This implies that output is at its
natural level, unemployment is at its natural rate, and the price
level equals the expected price level.

Determine whether the shock affects the natural rate of

unemployment (i.e., whether the medium run outcome
changes).

If the shock is to a variable in the IS-LM model, it will not affect the
natural rate of unemployment.

If the shock is to a variable in the AS curve (other than the expected

price level), it will affect the natural rate of unemployment and thus the
natural level of output.
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ANALYSIS OF SHOCKS IN THE AS-AD MODEL (2)

Determine the initial shifts in the AS-AD diagram and

IS-LM diagram. Do not neglect the secondary shift in
the IS-LM diagram because of the change in price in
the AS-AD diagram.

Determine whether the price level is greater than its

expected level or less than its expected level.

If the economy begins in medium-run equilibrium, the

expected price level is the initial price level.

Expected price level does not change in the short run, but
changes as we move from short run to medium run.
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ANALYSIS OF SHOCKS IN THE AS-AD MODEL (3)

If the price level is greater than its expected level, the

AS curve will shift up over time until it intersects the
(possibly new) AD curve at the (possibly new) natural
level of output.

As the price level increases over time, the LM curve

will shift up until it intersects the (possibly new) IS
curve at the (possibly new) natural level of output.

If the price level is less than its expected level, the AS

and LM curves will shift down (just the opposite).
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CLARIFICATION

The short- and medium-run distinction is an analytical

aid to help economists analyze the effects of shocks
occurring at some point in time.

In the real world, the economy is always experiencing

short-run shocks and responding to previous shocks.

The medium-run equilibrium describes a point to

which the economy will tend to return to in the
absence of further shocks.

The actual path of the economy, however, will depend

on the sequence of shocks it receives.
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PRICE ADJUSTMENT AND SHORT-RUN EQUILIBRIUM

Chapters 3 to 5 discussed the short run in the context

of a fixed price level.

In this chapter, the short-run equilibrium is the

intersection of the AD and AS curves.

Prices are now allowed to change in the short run.

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PRICE ADJUSTMENT AND SHORT-RUN EQUILIBRIUM

The previous IS-LM model (Ch 5) adopts the assumption that

the price level is fixed as a simplification.

Chapter 7 shows, what is true in the short run is that prices can
change but may not adjust fully to restore the natural level of
output, and more generally, that the actual price level may not
equal the expected price level in the short run.

Going deeper, the fundamental assumption is that nominal

wages do not adjust to actual prices but to expected ones. So
we abandon the fixed price assumption in the short run (Ch 5),
but we still need the assumption that the expected price level
does not change in the short run (Ch 7).
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ABOUT INTEREST RATE

In the medium run, the interest rate is determined by the

intersection of the IS curve and the natural level of output.

Effectively, conditional on the natural level of output, the

interest rate is determined by fiscal policy.

Regardless of the value of money supply, the price level

will adjust so that the LM curve intersects the IS curve at
the natural level of output. Thus, monetary policy has no
effect on the interest rate in the medium run.

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(TEXTBOOK Q4) AD SHOCKS AND MEDIUM RUN

Suppose the economy begins with output equal to its natural level.
Then, there is a reduction in income taxes.
(a)

Using the AS-AD model developed in this chapter, show the

effects of a reduction in income taxes on the position of the
AD, AS, IS, and LM curves in the medium run.

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(TEXTBOOK Q4) AD SHOCKS AND MEDIUM RUN

Suppose the economy begins with output equal to its natural level.
Then, there is a reduction in income taxes.
(a)

Using the AS-AD model developed in this chapter, show the

effects of a reduction in income taxes on the position of the
AD, AS, IS, and LM curves in the medium run.

Answer: (1) in the AS-AD:

T (similar to G ), AD shifts right; P , P > Pe increase Pe AS shifts up.
(2) In the IS-LM:
T demand IS shifts right;
Since P in the AS-AD, (M/P) LM shifts up.

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(TEXTBOOK Q4) AD SHOCKS AND MEDIUM RUN

(b) What happens to output, the interest rate, and the price level
in the medium run? What happens to consumption and
investment in the medium run?

18

(TEXTBOOK Q4) AD SHOCKS AND MEDIUM RUN

(b) What happens to output, the interest rate, and the price level
in the medium run? What happens to consumption and
investment in the medium run?
Answer: from part (a), you know that Y returns to Yn, P (from the
AS-AD), and i (from the IS-LM).
T , (Yn T) C , G is unchanged, Investment I

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TRUE, FALSE, UNCERTAIN?

a.

b.

c.

d.

e.

The aggregate supply relation implies that an increase in

output leads to an increase in the price level.
The natural level of output can be determined by looking solely
at the aggregate supply relation.
The aggregate demand relation is downward sloping because
at a higher price level, consumers wish to purchase fewer
goods.
In the absence of changes in fiscal or monetary policy, the
economy will always remain at the natural level of output.
Expansionary monetary policy has no effect on the level of
output in the medium run.
20

(TEXTBOOK Q2) AS SHOCKS AND MEDIUM RUN

Consider an economy with output equal to the natural level of
output. Show the effects of an increase in unemployment benefits
on the position of the AD and AS curves in the short run and in the
medium run.

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(TEXTBOOK Q2) AS SHOCKS AND MEDIUM RUN

Consider an economy with output equal to the natural level of
output. Show the effects of an increase in unemployment benefits
on the position of the AD and AS curves in the short run and in the
medium run.
SR: short run

WS: wage-setting curve

MR: medium run

PS: price-setting curve

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(TEXTBOOK Q2) AS SHOCKS AND MEDIUM RUN

b. How will the increase in unemployment benefits affect
output and the price level in the short run and in the
medium run?

23

(TEXTBOOK Q2) AS SHOCKS AND MEDIUM RUN

b. How will the increase in unemployment benefits affect
output and the price level in the short run and in the
medium run?

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