Macroeconomics

Lecture 11Chapter 9

AD-AS analysis

Organization• Chapter 9 -- Introduction to business cycles, “AD-

AS” analysis

• Chapter 10 -- “Keynesian cross” and “liquidity preference”: basis for IS-LM model

• Chapter 11 -- “IS-LM” analysis (most important)

• Chapter 12 -- Extension to an open economy: Mundell-Fleming model

• Chapter 13 -- Aggregate Supply (may be skipped)

Business CyclesFluctuations in output and employment

in the short run

What is the short run?

• The business cycles occur in the time horizon of three to five years

• In the short run, the prices of goods and services and the nominal wage do not fully respond to changes in demand and supply

• As a result, the output and employment can fluctuate in the short run

AD: Aggregate demandAS: Aggregate supply

LR: Long-runSR: Short-run

Aggregate DemandRelationship between output and price level

A simple example of the aggregate demand function

• M/P = k Y

• k: “Marshallian k”

• Same as the quantity equation MV=PY

• “Monetarist” premise -- an increase in real money balance directly affects the aggregate demand

Long-Run Aggregate Supply

• This is the classical case -- the output determined by the fixed amount of factors and the available technology: Y = F(K,L)

Long-run equilibrium

Short-Run Aggregate Supply• Case of the inflexible price level

Short run equilibrium

Transition from short-run to long-run

Shifters of AD and AS

• Aggregate demand curve is shifted by money supply, money demand function, and other various shocks discussed in later chapters

• Aggregate supply curve is shifted by shocks that affect the price level directly: weather, Kyoto Protocol, union, oil, etc

Supply shock (price shock)

Stabilization policy• Shocks to AD or SRAS can be accommodated

by monetary policy which shifts AD

• Fed has been raising the interest rate

• But the long-term rate is not rising -- A “conundrum” to Mr. Greenspan

• Inflation is at its highest in six years

• What would happen to the bond market?

• What’s the Fed’s intention, and its expectation?

• It’s not only Mr. Greenspan who is puzzled..

The central bank raised the federal funds rate on overnight loans between banks from 2.5 to 2.75 percent, and restated its intention to continue raising rates at a "measured" pace. It was the seventh rate hike since last June and almost certainly not the last one this year.

In a statement accompanying today's decision, the Fed said: "Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident."

"But," it added, "the rise in energy prices has not notably fed through to core consumer prices."

The warning is certain to diminish the expectations of many forecasters that the Fed might slow down the pace of rate hikes later this year. Indeed, the statement could prompt investors to ratchet up their bets on the possibility of bigger rate increases in the months ahead.

(The New York Times, March 22, 2005)