2. Aggregate Demand
Consider the IS-LM diagram from Chapter 5 (see Figure 7.1). The diagram takes the price level, which affects the real money supply, as given. For given G, T, and M, an increase in the price level reduces the real money supply, shifts the LM curve up, and reduces output. Plotting all combinations of Y and P implied by the IS and LM model produces a downward-sloping relation, called the aggregate demand (AD) curve (Figure 7.1). For any given price level, the AD curve plots the level of output consistent with equilibrium in both the goods and financial markets.
The position of the aggregate demand curve depends upon the factors that determine the positions of the IS and LM curves. For a given price level, any change that increases output in the IS-LM diagram will shift the AD curve horizontally to the right by the increase in output implied by the IS-LM model. In symbols, the aggregate demand relation is given by
Y=Y(M/P,T,G). (7.2)
+ - +
The signs below the arguments in equation (7.2) indicate the effects of an increase in the variables on output in the IS-LM model and thus on the position of the AD curve.
3. Equilibrium in the Short Run and in the Medium Run
Figure 7.1 plots the AD and AS curves. The intersection of these curves is the short-run equilibrium of the economy. If it happens that P=Pe, then the economy is also in medium-run equilibrium. If PPe, then the text assumes that expectations will adjust. In particular, the text assumes that if P>Pe, the expected price level in the future will increase. If P<Pe, the expected price level in the future will decrease.
In the short run, there is no presumption that P=Pe. Suppose that P>Pe, which implies that output is higher than its natural level. Given these initial conditions, the expected price level will increase in the future, causing the AS curve to shift up. The price level rises, and output falls. As long as output remains above its natural level, the actual price level will exceed the expected price level, and the expected price level will increase in the future, leading to further shifts of the AS curve. The process will stop when the AS curve intersects the AD curve at the natural level of output, corresponding to the natural rate of unemployment.
Figure 7.1: The IS-LM and AD-AS Models
In general, when the price level is higher than the expected price level, the AS curve shifts up over time. When the price level is lower than the expected price level, the AS curve shifts down over time. The next three sections reinforce this point by considering the short- and medium-run effects of specific shocks.
4. The Effects of a Monetary Expansion
The effects of a monetary expansion are described in Figure 7.2. Suppose the economy begins in medium-run equilibrium, with the expected price level equal to the actual price level, and output at its natural level. An increase in the money supply shifts LM down in the top panel of the figure (to LM'), and simultaneously shifts AD to the right in the bottom panel. At the original price level, the horizontal shift of the AD curve (point B in the figure) equals the change in output in the IS-LM diagram before considering the change in the price level.
The shift of the AD curve, however, tends to increase output, reduce the unemployment rate, and increase the nominal wage (through wage bargaining). The latter effect leads to an increase in the price level (through price setting). In other words, since the AS curve is upward-sloping, the new short-run equilibrium (point C) involves a higher price level. The increase in the price level shifts the LM curve up (to LM'') through its effect on M/P. This secondary shift of the LM curve offsets some of the initial shift of the LM curve. As a result, in the short run, the output increase from a monetary expansion is less in the AD-AS model than in the IS-LM model. The increase in the price level offsets some of the effect of the monetary expansion on the real money supply.
Figure 7.2: A Monetary Expansion in the AD-AS Model
At the new short-run equilibrium (point C), the price level has increased above its expected level. As a result, in the next period, the AS curve will shift along the segment CD. AS will continue to shift up until Y returns to its natural level at point D in the bottom panel. AS shifts up, and P increases, reducing M/P and shifting the LM curve up. At point D, P has increased sufficiently to restore M/P to its original value, which implies that the LM curve has returned to its original position.
The new medium-run equilibrium is exactly the same as the original one, except that the price level has risen in proportion to the increase in M. The composition of GDP is the same as in the original medium-run equilibrium. Since a monetary expansion does not affect any real variables in the medium run, monetary policy (or in short, money) is said to be neutral in the medium run.