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The dynamic AD-AS model
A brief overview of a useful macroeconomic
framework
Anthony J. Evans
Associate Professor of Economics, ESCP Europe
www.anthonyjevans.com
(cc) Anthony J. Evans 2016 | http://creativecommons.org/licenses/by-nc-sa/3.0/
Introduction
• This presentation will provide a brief overview of the dynamic
AD-AS model
• It can be used in conjunction with the YouTube video:
– “An introduction to the dynamic AD-AS model” September
2014*
• The model originates with Tyler Cowen and Alex Tabarrok**
2* See: https://youtu.be/qXYNUjWYopo
** Cowen & Tabarrok, (2009) Modern Principles: Macroeconomics, Worth.
The dynamic AD-AS model
• It is a useful and relatively simple framework to make
sense of (i) economic shocks, and (ii) policy responses
• I think it is an improvement over the traditional model and
a useful tool to understand
• The main difference with the standard AD-AS model:
– Instead of showing the price level and real GDP on the
two axes, it shows inflation and real GDP growth
– A Solow curve instead of a Long Run Aggregate Supply
(LRAS) curve
– An Aggregate Demand (AD) curve based on the
equation of exchange instead of Pigou's wealth effect,
Keynes's interest-rate effect, and Mundell-Fleming's
exchange-rate effect
– A Short Run Aggregate Supply curve (SRAS) based on
the signal extraction problem rather than labour
markets
3
We can look at each of the three components in turn
4
P
Y
AD (M+V=5%)
Y* = 3%
2%
SOLOW
SRAS (Pe = 2%)
The Solow curve
• The Solow curve shows the growth rate that would exist
– If prices are perfectly flexible
– Given the existing real factors of production
– This follows from the production function used in the Solow
growth model
Y* = f (A,K,L)
• Y* is a function of capital (K), labour (L) and multifactor
productivity (A)
• We can think of Y* as being the potential growth rate
• Since Y* is independent of inflation (P), it is drawn as a vertical
line
• Let’s assume that Y* = 3%
• Causes of shifts:
– Weather, wars, strikes
– R&D, innovation, infrastructure, competitiveness
– Education/training, labour market flexibility
5
We call these
“real”,
“productivity”, or
“supply” shocks
This invokes the Classical Dichotomy – the claim that real variables are determined by real factors
Unlike the LRAS the Solow curve is a Real Business Cycle (RBC) model that incorporates any real shock
P
YY* = 3%
SOLOW
The Aggregate Demand (AD) curve
• Definition:
– AD is “total spending”
– It is combinations of P and Y consistent with a specified rate of spending growth
• It is based on the equation of exchange:
M + V = P + Y
• Let’s assume that AD (i.e. M+V) = 5%. The AD curve plots the various ways it can be
split between P + Y
• Causes of shifts:
– Change in M
– Change in V
• The “velocity of circulation” is the inverse of the demand for money (Md).
If Md is high, people hold onto it, and V falls
• By definition V is anything that affects P+Y other than M
• E.g. wealth, stimulus, tax changes
• If we look at the components of AD we can see sources of changes in V
• We can summarise V as “confidence”
6The equation of the AD curve is P=(M+V)-Y and the slope is -1
Note that changes in V tend to be temporary – you cannot have permanent increases in any of these components. This supports the claim
that only increases in M can generate sustained inflation.
P
Y
AD (M+V=5%)2%
3%
1%
2% 3% 4%
AD = C(i
-
, y-t
+
)+ I(i
-
, y
+
)+G+(X - M)
We can view QE
as a way for
central banks to
switch from using
i/r to boost AD
(via an impact on
V) to using M
directly
The Short Run Aggregate Supply (SRAS) curve
• Definition
– Relationship between P and Y for a given expected inflation rate
• SRAS shows the supply side of the economy whilst prices adjust
• There is a positive relationship between inflation and output due to signal
extraction problems
– If prices are rising at a faster rate than wages (which constitute a large
share of the firms costs), firms will appear to be profitable and will
expand their output
– If prices fall quicker than wages, production will appear to be
unprofitable, and they will reduce output
• The SRAS curve is flatter below Y* and steeper above Y* is because wages are
especially sticky in a downwards direction. Basic money illusion means that
workers tend to be hostile to nominal wage cuts. In addition there’s a limit to
how fast the economy can grow – it can’t indefinitely exceed the Solow growth
rate
• Cause of shifts
– Change in inflation expectations (Pe)
7
P
Y
SRAS
(Pe = 2%)
The dynamic AD-AS model in equilibrium
8
P
Y
AD (M+V=5%)
Y* = 3%
2%
SOLOW
SRAS (Pe = 2%)
Assume Y* = 3% and AD (M+V) = 5%
This implies P = 2%
Assume inflation expectations are
consistent with this, also at 2%
If prices are perfectly flexible we only need the Solow
curve and AD.
We can call these 2 curves a Real Business cycle model
We can use this model to answer some simple questions:
1. In a Real Business Cycle model, what is the impact of an
increase in the money supply?
2. In a Real Business Cycle model, what is the impact of a
collapse in confidence?
3. What would be the impact of the rise of 3D printing, or
some other increase in productivity?
4. What happens if there’s a hurricane?
5. What is the impact of a reduction in the growth rate of the
money supply?
6. How can monetary or fiscal policy help us avoid a
recession?
7. Why doesn’t monetary or fiscal policy help if the economy
suffers a negative productivity shock?
9
1. In a Real Business Cycle model, what is the impact of an increase in
the money supply?
10
P
Y
AD (M+V=5%)
Y* = 3%
SOLOW
2%
AD (M+V=10%)
7%
Assume Y* = 3% and AD
(M+V) = 5%
Hence P = 2%
Now assume M increases
by 5%
AD is now 10%
We move up the Solow
curve and P rises to 7%
An increase in M leads to
a proportional increase in
P
With no extra supply the
extra aggregate demand
merely bids up prices
Result:
Higher inflation
Same growth
In an “RBC model” we
are always at Y*
We can ignore the SRAS
M  by 5%
P  by 5%
2. In a Real Business Cycle model, what is the impact of a collapse in
confidence?
11
Assume Y* = 3% and AD
(M+V) = 5%
Hence P = 2%
Now assume V falls by
3%.*
AD is now 2%.
We move down the Solow
curve and P falls to -1%
Result:
Lower inflation
Same growth
P
Y
SOLOW
AD (M+V=5%)
2%
Y* = 3%
(M+V=2%)
-1%
* A Keynesian economist might blame a fall in V due to “animal spirits” whilst Austrian economists would call it “regime
uncertainty”
In an “RBC model” we
are always at Y*
We can ignore the SRAS
in the real world many economists believe that prices
don’t adjust immediately
The signal extraction problem means that people respond
to nominal shocks, and so Y may deviate from Y*
The SRAS curve is needed to show this process
3. What would be the impact of the rise of 3D printing, or some other
increase in productivity?
12
P
Y
AD (M+V=5%)
Y* = 3%
2%
SOLOW
SRAS (Pe = 2%)
SOLOW’
1%
SRAS (Pe = 1%)
4%
A
B
In a section on sticky prices Cowen and Tabarrok argue that the above only holds if prices are flexible. Sticky prices would mean
that SRAS shifts even further, such that it intersects the AD curve at a point beyond B. In this sense sticky wages amplify real
shocks. For simplicity, for now, we assume flexible prices.
Productivity growth will
cause Y* to shift to the right
(e.g. to 4%)
If total spending doesn’t
change, inflation will fall
from 2% to 1%
We move down the AD curve
from A to B
As inflation falls below
expectations people will
reduce their inflation
expectations, causing SRAS
to shift down
Inflation might even become
negative, but this would be
benign
Result:
Lower inflation
Higher growth
4. What happens if there’s a hurricane?
13
P
Y
SOLOW
AD (M+V=5%)
2%
Y* = 3%
SRAS (Pe = 2%)
Y* = 1%
4%
SOLOW’
SRAS’ (Pe = 4%)
A hurrican is a negative
productivity shock and will
cause Y* to shift to the left
(e.g. to 1%)
If total spending doesn’t
change, inflation will rise
from 2% to 4%
We move up the AD curve
As inflation rises above
expectations people will
increase their inflation
expectations, causing SRAS
to shift up
Aside: On p.280-281 Cowen and Tabarrok discuss how the SRAS curve responds to a real shock. They say that if prices are perfectly
flexible the SRAS will instantly shift to coincide with the intersection of the Solow curve and AD (point b). But if prices are sticky it will
shift beyond the Solow curve (point c). But how do we go from a to c without going through point b?
Result:
Higher inflation
Lower growth
5. What is the impact of a reduction in the growth rate of the money
supply?
14
P
Y
SOLOW
AD (M+V=10%)
7%
Y* = 3%
SRAS (Pe = 7%)
(M+V=4%)
-2%
6%
SRAS (Pe = 1%)
1%
A
B
C
If prices adjust
immediately, the fall in M
will cause a
corresponding fall in P.
But what if prices take
time to adjust?
Assume (M+V) = 10%, Y* =
3%, thus P = 7%.
We assume that M falls
by 6%.* The AD curve
shifts.
Prices aren’t rising as
quickly as people
expected. And since
wages are slower to
adjust than revenues this
means that profits have
fallen. The signal
extraction problem
causes entrepreneurs to
reduce output (A to B).
* Technically we should refer to the increase in M as an increase of 5 percentage points, but for simplicity we can write this as
5%
If point B coincides
with -2% growth this
implies inflation of 6%.
This isn’t an
equilibrium because (i)
Y needs to return to Y*
at some point; and (ii)
at point B people still
expect 7% inflation.
When people revise
their inflation
expectations
downwards this causes
the SRAS to shift down,
ultimately to point C.
Result:
Lower inflation
Same growth
ultimately, but a
temporary
recession
6. How can monetary or fiscal policy help us avoid a recession?
15
P
Y
SOLOW
AD (M+V=10%)
7%
Y* = 3%
SRAS (Pe = 7%)
(M+V=4%)
-2%
6%
A
B
Assume (M+V) = 10%, Y* =
3%, thus P = 7%.
We assume that M falls
by 6%. The AD curve
shifts.
If policymakers increase
AD they can move us
from B back to A, without
having to go to point C.
Options:
1. Monetary policy
• Boost M
• Reduce interest
rates
2. Fiscal policy
• Fiscal stimulus
Note that if the fiscal multiplier is <0 a fiscal stimulus would backfire and cause AD to fall even further. In this situation fiscal
austerity (i.e. a reduction in G) could lead to an expansionary fiscal contraction.
The policy increases
growth (let’s say from 1%
to 2%) but at the cost of
higher prices (inflation
rises to 8%).
At C inflation is 8% but
inflation expectations are
4%. When inflation
expectations adjust the
SRAS curve will shift
upwards, ultimately to
point D.
End result of the 5%
increase in AD is a 5%
increase in P, taking us
from 1% growth and 4%
inflation to 1% growth
and 9% inflation.
Any further increases in
AD will be even more
inflationary.*
The original rate of Y* is
unattainable.
7. Why doesn’t monetary or fiscal policy help if the economy suffers a
negative productivity shock?
16
P
Y
SOLOW
AD (M+V=5%)
2%
Y* = 3%
SRAS (Pe = 2%)
Y* = 1%
4%
SOLOW’
AD’ (M+V=10%)
9%
8%
2%
SRAS’ (Pe = 4%)
SRAS’’ (Pe = 9%)
A
B
C
D
Assume (M+V) = 5%, Y* =
3%, thus P = 2%. Point A.
Imagine a negative
productivity shock causes
Y* to fall to 1%.
Ultimately we’d expect
growth to fall and prices
to rise (to 4%).
But imagine policymakers
attempt to boost AD
through monetary or
fiscal policy, and
successful increase AD to
10%.
This doesn’t move us
back to A. It moves us
along the SRAS curve to
point C.
* Indeed it is reasonable to think that as P gets higher prices become more flexible money illusion is a lot easier to spot in a
hyperinflation. Hence the SRAS shifts even quicker and there is limited scope for even moderate increases in growth.
Summary of how policy impacts the Dynamic AD-AS model
17
Policymakers
Aggregate Demand
(M+V)
Monetary
Fiscal
Supply side
(Y*)
Next steps
• Test yourself with the following questions from the Market
for Managers Problem Set
– Available here: http://www.marketsformanagers.com
• 8.2, 8.3, 8.4, 8.5, 8.6, 8.9, 9.4
18

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The Dynamic AD AS Model

  • 1. The dynamic AD-AS model A brief overview of a useful macroeconomic framework Anthony J. Evans Associate Professor of Economics, ESCP Europe www.anthonyjevans.com (cc) Anthony J. Evans 2016 | http://creativecommons.org/licenses/by-nc-sa/3.0/
  • 2. Introduction • This presentation will provide a brief overview of the dynamic AD-AS model • It can be used in conjunction with the YouTube video: – “An introduction to the dynamic AD-AS model” September 2014* • The model originates with Tyler Cowen and Alex Tabarrok** 2* See: https://youtu.be/qXYNUjWYopo ** Cowen & Tabarrok, (2009) Modern Principles: Macroeconomics, Worth.
  • 3. The dynamic AD-AS model • It is a useful and relatively simple framework to make sense of (i) economic shocks, and (ii) policy responses • I think it is an improvement over the traditional model and a useful tool to understand • The main difference with the standard AD-AS model: – Instead of showing the price level and real GDP on the two axes, it shows inflation and real GDP growth – A Solow curve instead of a Long Run Aggregate Supply (LRAS) curve – An Aggregate Demand (AD) curve based on the equation of exchange instead of Pigou's wealth effect, Keynes's interest-rate effect, and Mundell-Fleming's exchange-rate effect – A Short Run Aggregate Supply curve (SRAS) based on the signal extraction problem rather than labour markets 3
  • 4. We can look at each of the three components in turn 4 P Y AD (M+V=5%) Y* = 3% 2% SOLOW SRAS (Pe = 2%)
  • 5. The Solow curve • The Solow curve shows the growth rate that would exist – If prices are perfectly flexible – Given the existing real factors of production – This follows from the production function used in the Solow growth model Y* = f (A,K,L) • Y* is a function of capital (K), labour (L) and multifactor productivity (A) • We can think of Y* as being the potential growth rate • Since Y* is independent of inflation (P), it is drawn as a vertical line • Let’s assume that Y* = 3% • Causes of shifts: – Weather, wars, strikes – R&D, innovation, infrastructure, competitiveness – Education/training, labour market flexibility 5 We call these “real”, “productivity”, or “supply” shocks This invokes the Classical Dichotomy – the claim that real variables are determined by real factors Unlike the LRAS the Solow curve is a Real Business Cycle (RBC) model that incorporates any real shock P YY* = 3% SOLOW
  • 6. The Aggregate Demand (AD) curve • Definition: – AD is “total spending” – It is combinations of P and Y consistent with a specified rate of spending growth • It is based on the equation of exchange: M + V = P + Y • Let’s assume that AD (i.e. M+V) = 5%. The AD curve plots the various ways it can be split between P + Y • Causes of shifts: – Change in M – Change in V • The “velocity of circulation” is the inverse of the demand for money (Md). If Md is high, people hold onto it, and V falls • By definition V is anything that affects P+Y other than M • E.g. wealth, stimulus, tax changes • If we look at the components of AD we can see sources of changes in V • We can summarise V as “confidence” 6The equation of the AD curve is P=(M+V)-Y and the slope is -1 Note that changes in V tend to be temporary – you cannot have permanent increases in any of these components. This supports the claim that only increases in M can generate sustained inflation. P Y AD (M+V=5%)2% 3% 1% 2% 3% 4% AD = C(i - , y-t + )+ I(i - , y + )+G+(X - M) We can view QE as a way for central banks to switch from using i/r to boost AD (via an impact on V) to using M directly
  • 7. The Short Run Aggregate Supply (SRAS) curve • Definition – Relationship between P and Y for a given expected inflation rate • SRAS shows the supply side of the economy whilst prices adjust • There is a positive relationship between inflation and output due to signal extraction problems – If prices are rising at a faster rate than wages (which constitute a large share of the firms costs), firms will appear to be profitable and will expand their output – If prices fall quicker than wages, production will appear to be unprofitable, and they will reduce output • The SRAS curve is flatter below Y* and steeper above Y* is because wages are especially sticky in a downwards direction. Basic money illusion means that workers tend to be hostile to nominal wage cuts. In addition there’s a limit to how fast the economy can grow – it can’t indefinitely exceed the Solow growth rate • Cause of shifts – Change in inflation expectations (Pe) 7 P Y SRAS (Pe = 2%)
  • 8. The dynamic AD-AS model in equilibrium 8 P Y AD (M+V=5%) Y* = 3% 2% SOLOW SRAS (Pe = 2%) Assume Y* = 3% and AD (M+V) = 5% This implies P = 2% Assume inflation expectations are consistent with this, also at 2% If prices are perfectly flexible we only need the Solow curve and AD. We can call these 2 curves a Real Business cycle model
  • 9. We can use this model to answer some simple questions: 1. In a Real Business Cycle model, what is the impact of an increase in the money supply? 2. In a Real Business Cycle model, what is the impact of a collapse in confidence? 3. What would be the impact of the rise of 3D printing, or some other increase in productivity? 4. What happens if there’s a hurricane? 5. What is the impact of a reduction in the growth rate of the money supply? 6. How can monetary or fiscal policy help us avoid a recession? 7. Why doesn’t monetary or fiscal policy help if the economy suffers a negative productivity shock? 9
  • 10. 1. In a Real Business Cycle model, what is the impact of an increase in the money supply? 10 P Y AD (M+V=5%) Y* = 3% SOLOW 2% AD (M+V=10%) 7% Assume Y* = 3% and AD (M+V) = 5% Hence P = 2% Now assume M increases by 5% AD is now 10% We move up the Solow curve and P rises to 7% An increase in M leads to a proportional increase in P With no extra supply the extra aggregate demand merely bids up prices Result: Higher inflation Same growth In an “RBC model” we are always at Y* We can ignore the SRAS M  by 5% P  by 5%
  • 11. 2. In a Real Business Cycle model, what is the impact of a collapse in confidence? 11 Assume Y* = 3% and AD (M+V) = 5% Hence P = 2% Now assume V falls by 3%.* AD is now 2%. We move down the Solow curve and P falls to -1% Result: Lower inflation Same growth P Y SOLOW AD (M+V=5%) 2% Y* = 3% (M+V=2%) -1% * A Keynesian economist might blame a fall in V due to “animal spirits” whilst Austrian economists would call it “regime uncertainty” In an “RBC model” we are always at Y* We can ignore the SRAS in the real world many economists believe that prices don’t adjust immediately The signal extraction problem means that people respond to nominal shocks, and so Y may deviate from Y* The SRAS curve is needed to show this process
  • 12. 3. What would be the impact of the rise of 3D printing, or some other increase in productivity? 12 P Y AD (M+V=5%) Y* = 3% 2% SOLOW SRAS (Pe = 2%) SOLOW’ 1% SRAS (Pe = 1%) 4% A B In a section on sticky prices Cowen and Tabarrok argue that the above only holds if prices are flexible. Sticky prices would mean that SRAS shifts even further, such that it intersects the AD curve at a point beyond B. In this sense sticky wages amplify real shocks. For simplicity, for now, we assume flexible prices. Productivity growth will cause Y* to shift to the right (e.g. to 4%) If total spending doesn’t change, inflation will fall from 2% to 1% We move down the AD curve from A to B As inflation falls below expectations people will reduce their inflation expectations, causing SRAS to shift down Inflation might even become negative, but this would be benign Result: Lower inflation Higher growth
  • 13. 4. What happens if there’s a hurricane? 13 P Y SOLOW AD (M+V=5%) 2% Y* = 3% SRAS (Pe = 2%) Y* = 1% 4% SOLOW’ SRAS’ (Pe = 4%) A hurrican is a negative productivity shock and will cause Y* to shift to the left (e.g. to 1%) If total spending doesn’t change, inflation will rise from 2% to 4% We move up the AD curve As inflation rises above expectations people will increase their inflation expectations, causing SRAS to shift up Aside: On p.280-281 Cowen and Tabarrok discuss how the SRAS curve responds to a real shock. They say that if prices are perfectly flexible the SRAS will instantly shift to coincide with the intersection of the Solow curve and AD (point b). But if prices are sticky it will shift beyond the Solow curve (point c). But how do we go from a to c without going through point b? Result: Higher inflation Lower growth
  • 14. 5. What is the impact of a reduction in the growth rate of the money supply? 14 P Y SOLOW AD (M+V=10%) 7% Y* = 3% SRAS (Pe = 7%) (M+V=4%) -2% 6% SRAS (Pe = 1%) 1% A B C If prices adjust immediately, the fall in M will cause a corresponding fall in P. But what if prices take time to adjust? Assume (M+V) = 10%, Y* = 3%, thus P = 7%. We assume that M falls by 6%.* The AD curve shifts. Prices aren’t rising as quickly as people expected. And since wages are slower to adjust than revenues this means that profits have fallen. The signal extraction problem causes entrepreneurs to reduce output (A to B). * Technically we should refer to the increase in M as an increase of 5 percentage points, but for simplicity we can write this as 5% If point B coincides with -2% growth this implies inflation of 6%. This isn’t an equilibrium because (i) Y needs to return to Y* at some point; and (ii) at point B people still expect 7% inflation. When people revise their inflation expectations downwards this causes the SRAS to shift down, ultimately to point C. Result: Lower inflation Same growth ultimately, but a temporary recession
  • 15. 6. How can monetary or fiscal policy help us avoid a recession? 15 P Y SOLOW AD (M+V=10%) 7% Y* = 3% SRAS (Pe = 7%) (M+V=4%) -2% 6% A B Assume (M+V) = 10%, Y* = 3%, thus P = 7%. We assume that M falls by 6%. The AD curve shifts. If policymakers increase AD they can move us from B back to A, without having to go to point C. Options: 1. Monetary policy • Boost M • Reduce interest rates 2. Fiscal policy • Fiscal stimulus Note that if the fiscal multiplier is <0 a fiscal stimulus would backfire and cause AD to fall even further. In this situation fiscal austerity (i.e. a reduction in G) could lead to an expansionary fiscal contraction.
  • 16. The policy increases growth (let’s say from 1% to 2%) but at the cost of higher prices (inflation rises to 8%). At C inflation is 8% but inflation expectations are 4%. When inflation expectations adjust the SRAS curve will shift upwards, ultimately to point D. End result of the 5% increase in AD is a 5% increase in P, taking us from 1% growth and 4% inflation to 1% growth and 9% inflation. Any further increases in AD will be even more inflationary.* The original rate of Y* is unattainable. 7. Why doesn’t monetary or fiscal policy help if the economy suffers a negative productivity shock? 16 P Y SOLOW AD (M+V=5%) 2% Y* = 3% SRAS (Pe = 2%) Y* = 1% 4% SOLOW’ AD’ (M+V=10%) 9% 8% 2% SRAS’ (Pe = 4%) SRAS’’ (Pe = 9%) A B C D Assume (M+V) = 5%, Y* = 3%, thus P = 2%. Point A. Imagine a negative productivity shock causes Y* to fall to 1%. Ultimately we’d expect growth to fall and prices to rise (to 4%). But imagine policymakers attempt to boost AD through monetary or fiscal policy, and successful increase AD to 10%. This doesn’t move us back to A. It moves us along the SRAS curve to point C. * Indeed it is reasonable to think that as P gets higher prices become more flexible money illusion is a lot easier to spot in a hyperinflation. Hence the SRAS shifts even quicker and there is limited scope for even moderate increases in growth.
  • 17. Summary of how policy impacts the Dynamic AD-AS model 17 Policymakers Aggregate Demand (M+V) Monetary Fiscal Supply side (Y*)
  • 18. Next steps • Test yourself with the following questions from the Market for Managers Problem Set – Available here: http://www.marketsformanagers.com • 8.2, 8.3, 8.4, 8.5, 8.6, 8.9, 9.4 18