Chapter 7. Putting All Markets Together:

The AS-AD Model

I. Motivating Question How Are Output, the Unemployment Rate, and the Interest Rate Determined in the Short and Medium Run?

Output, the unemployment rate, and the interest rate are determined by simultaneous equilibrium in the goods, financial, and labor markets. Simultaneous equilibrium in the goods and financial markets is summarized in an aggregate demand relation; equilibrium in the labor market is summarized in an aggregate supply relation. Labor market equilibrium is conditional on the expected price level. In the short run, the expected price level may not equal the actual price level, and thus the unemployment rate may not equal the natural rate. Over time, the expected price level will tend to converge to the actual price level, and the unemployment rate will tend to return to the natural rate.

II. Why the Answer Matters

This chapter integrates the goods, financial, and labor markets in short-run and medium-run equilibrium. It maintains the assumption that changes in monetary policy are discrete changes in the level of nominal money. The next two chapters introduce money growth and inflation into the analysis and begin to discuss the economy in terms of growth rates (except for the unemployment rate) rather than levels of variables.

III. Key Tools, Concepts, and Assumptions

1. Tools and Concepts

i. The chapter introduces the aggregate demand and aggregate supply relations.

ii. The chapter makes extensive use of dynamic analysis, introduces the term business cycle, and distinguishes between shocks and propagation mechanisms.

2. Assumptions

The chapter assumes that the expected price level adjusts to differences between the actual and (previously) expected price levels. If the actual price level is greater (less) than the expected price level, wage setters are assumed to increase (decrease) their expected price level in the future. This adjustment mechanism is essential for the dynamic analysis presented in the text.

IV. Summary of the Material

1. Aggregate Supply

Substitute the wage-setting relation into the price-setting relation to obtain

P=P^e(1+)F(u,z).

Express the unemployment rate in terms of output to derive the aggregate supply (AS) relationship:

P= P^e(1+)F(1-Y/L,z). (7.1)

For any price level, the AS relation gives the level of output consistent with equilibrium in the labor market, conditional on the expected price level, the degree of product market competition (), and institutional and structural conditions (z). As output increases, employment increases, the unemployment rate decreases, the nominal wage increases (since workers are in a better bargaining position), and the price level increases (since price is a constant markup over the wage). Thus, the AS curve slopes up in Y-P space (Figure 7.1).

Along the AS curve, the price level equals its expected level when output equals its natural level. This statement is true by construction. It is merely a restatement of the definition of the natural level of unemployment. The price level exceeds its expected level when output exceeds its natural level. The high level of output leads to a low unemployment rate, which tends to increase the nominal wage and the price level.

The AS curve is shifted by the factors that influence labor market equilibrium. For example, an increase in the expected price level leads workers to bargain for a higher wage (for any given unemployment rate). The increase in the wage increases the price level through price setting. Thus, an increase in the expected price level causes the AS curve to shift up.