Principles of Macroeconomics

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1 Principles of Macroeconomics Academic Program: MSc in Banking and Finance Semester: Spring 2012/13 Instructor: Dr. Nikolaos I. Papanikolaou Office: Luxembourg School of Finance, KB2-E02-21 Phone: (00352) Home Page: Office hours: Thursday 10:00-12:00 or by appointment Course web site: (use your enrollment key to access the course content) 1 Principles of Macroeconomics-MSc in Banking & Finance

2 Lecture notes Set 5 The AD-AS model a) Introduction b) Aggregate Demand (AD) c) Aggregate Supply (AS) d) Equilibrium 2

3 The AD-AS model Introduction The AD-AS model extends the IS-LM model incorporating the labour market and approaching the economy in the long-run where price are flexible and not sticky. It is mostly useful for evaluating factors and conditions, which have an effect on GDP and the price level of the economy. It is an aggregation of the microeconomic demand-and-supply model. It is a comparative statics model. Its insights are obtained by identifying the initial equilibrium and then shocking the model by changing one or more of its parameters, and evaluating the resulting new equilibrium. 3

4 Aggregate Demand (AD) The aggregate demand curve relies on the price and output levels in which both the goods market and the money market are in equilibrium. It is derived by considering the impact of changes in price upon the IS-LM model. More specifically, as described in the graph on the following slide, a decrease in the price level from the initial price of P0 to P1 results in an outward shift of the LM curve from LM(P0) to LM(P1). The impact upon the equilibrium level of output, is that there is an increase from the initial value of y0 to the higher value of y1. This implies that both (y0, P0) and (y1, P1) lie upon the AD curve. Considering further price changes allows us to map out the complete AD curve. 4

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6 6 Aggregate Demand (AD) Changes in P are captured by movements along the AD curve. On the other hand, the entire curve will shift when there is a change affecting either the IS curve or the LM curve. Consider, for example an increase in government spending (G). This will shift the whole IS curve out., which implies that at the same price level, there is a new higher level of output at Y1, in which the goods and money market are in equilibrium. Hence, (Y1, P0) is a point on a new AD curve associated with this higher level of G.

7 Aggregate Supply (AS) The aggregate supply curve describes that amount of output that firms desire to produce, as a function of the economy s price level that exists in the economy and is derived from the labour market. An underlying assumption in standard Keynesian models is that labour market fails to clear. A crucial element of this market failure is the assumption of nominal wage stickiness. This implies at a particular point in time, that the nominal wage does not adjust to shocks to the economy or to changes in the price level. Furthermore, we will examine the case where nominal wages are set above the market clearing wage. This implies that the level of employment determined in equilibrium will depend upon the labour demand curve, as firms in general will restrict the amount of labour they hire if wages are above the market clearing wage. 7

8 Aggregate Supply (AS) The top-panel on the following slide provides a diagram of the labour market with labour demand dependent upon the marginal productivity of labour. The y-axis provides the real wage and with a fixed nominal wage, changes in the P will alter the real wage. In this case, an increase in the price level from P0 to P1 leads to a decrease in the real wage. With firms hiring labour until the marginal product of labour is equal to the wage rate, this decrease in the real wage will lead to an expansion of the amount of labour employed. This increase in labour employed leads to an increase in the amount of output produced and generates an upward sloping AS curve. 8

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10 10 Aggregate Supply (AS) Changes in the labour market will have an impact on the position of the AS curve. In particular, changes in the production function will alter the marginal productivity of labour, shifting the position of the labour demand curve and also moving the AS curve. The AS curve will also be affected by changes in the nominal wage. Consider an increase in the nominal wage from W1 to W0, which implies that firms will demand a smaller amount of labour and thus output will be lower at each price. This is represented by the AS curve moving upward and to the left of its original position.

11 Equilibrium The economy as a whole, is in equilibrium when the goods, money and labour market are in equilibrium which occurs at the intersection of the AD and AS curves. The economy then consists of three separate markets - the goods, the money and the labour market. The combination of the AD and AS curves enables us to evaluate a set of policy tools and to consider the impact of a range of exogenous factors. For example, consider the effect of an increase in G. Such a change leads to an outward shift of the AD curve from AD(G0) to AD(G1); hence, equilibrium moves from (Y0, P0) to (Y1, P1). The mechanism that produces this change in equilibrium is clear. The increase in G affects the goods market directly, and implies that the desired level of expenditure will exceed the level of output at price P0 and output Y0. 11

12 Equilibrium As a result of excess demand, firms begin to increase output and raise prices. This process continues until we reach a new equilibrium at (Y1, P1) with a new higher price and output level. The transition to this new equilibrium results in a higher interest rate brought about by the higher price level reducing real money supply and as a result a lower level of investment. 12 Principles of Macroeconomics MSc in Banking & Finance

13 Exercises 1. What happens to Y if workers attribute a higher value to leisure than before, which makes them supply less labour at any given level of prices and wages? 2. Suppose that the government imposes a higher tax on labour income. a) The government uses the tax revenue for government consumption. What are the effects on Y? b) Suppose that the government uses the tax revenue for public investment, improving the infrastructure and thus labour s productivity. What happens to the result you derived in (a)? 13

14 Exercises (cont d) 3. What happens to the labour market: a) if the government improves the flow of information between enterprises with vacant positions and potential employees? b) if administrative prescriptions prevent workers from moving across regions? c) if programmes to change professional qualifications are increasingly supported by the government? 14

15 Exercise Consider an economy that is described by the following relationships: C = Y I = r M = (0.9Y 900r)P where Y is output, C is consumption, I is the planned investment (which may not coincide with the actual investment), r is the interest rate, Ms is the money supply, and P is the price level. There are no taxes, government spending, or foreign trade. a) Suppose that the price level is equal to unity and that the money supply equals to 900 units. Sketch the IS and LM curves and show the point where interest rate and output are determined. b) Derive an algebraic expression for the aggregate demand curve. 15

16 The ISLM model in an open economy The Balance of Payments is introduced in the ISLM model, as a record of all cross-border transactions, and its mirror image, the foreign exchange market. Three main groups of participants in the foreign exchange market are identified: a) people who trade in goods and services (recorded in the current account). b) financial investors who move wealth across borders (recorded in the capital account). c) central banks (recorded in the official reserves account). 16 A central argument that simplifies the analysis and affects much of the rest of the text is that the first and the third group's activities only account for a very small share of world-wide transactions in the foreign exchange markets.

17 That is, the second group dominates this market, which makes open interest parity the equilibrium condition for the foreign exchange market and renders the FE curve, the foreign exchange market equilibrium line, horizontal in the i/y space. Adding a third market to the model adds another endogenous variable to the model. Under flexible exchange rates this is the nominal exchange rate. Fixed exchange rates make the money supply endogenous. 17

18 Exercise 1 Suppose that investors in Country A pay taxes on their interest earnings at some rate z A, where those who invest in Country B pay taxes at the rate z B <z A. a) Describe the equilibrium conditions on the international capital markets under imperfect and incomplete information between Country A and Country B due to a bank secrecy law that holds in Country A. b) What happens to the economy of Country A if the bank secrecy law is abolished? Does the result depend on whether the exchange rate is flexible or fixed? 18

19 Exercise 2 Suppose that investors suddenly lose confidence in the domestic currency and expect it to depreciate by 5% every period from now on. Trace the consequences in the Mundell Fleming model. What does the result tell you about self-fulfilling prophecies? Exercise 3 a) Discuss the conditions under which the FE curve is vertical. b) Analyse the effect of expansionary monetary and fiscal policy in a system of flexible exchange rates with perfect capital immobility. 19